Fed’s Dudley Agrees: QE is Not About the Reserves, or “Printing Money”

May 21st, 2013

Or: “Dudley Makes Mock of the Monetarists.”

In my post The Fed is not “Printing Money.” It’s Retiring Bonds and Issuing ReservesI said:

…when the Fed gives the banks reserves and retires bonds, it’s taking on market risk/reward, replacing it with absolutely nonvolatile, risk/reward-free assets (at least in nominal terms). It’s removing leverage and volatility from the banking system.

And:

The banking system doesn’t “take money” out of total reserves, or reduce those reserves, to fund loans.

And now I find this in a speech today at the Japan Society by FRBNY President and CEO William Dudley (HT Matthew Klein). Emphasis mine:

asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet.  This pushes down risk premia, and prompts private sector investors to move into riskier assets.  As a result, financial market conditions ease, supporting wealth and aggregate demand.  The fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct — not the goal — of these actions.

Or to put it another way: when you increase M in MV = PY, the most likely result — the result you have to assume by default absent some convincing story about real-economy incentives, causes, and effects —  is a purely arithmetic decline in V (cf. Dudley’s “byproduct”), with zero effect on P or Y.

This is doubly true if by M you mean the Monetary Base (as do monetarists, inconsistently but often) — the only measure of money that includes reserve balances. Increasing the quantity of reserve balances (hence the monetary base) does not magically increase either P or Y.

Cross-posted at Angry Bear.

  1. May 21st, 2013 at 14:22 | #1

    V decreases because the amount added to the monetary base has a velocity of almost zero. Because it basically sits in the reserve accounts. Is that a correct deduction?

  2. May 21st, 2013 at 16:07 | #2

    Edward Lambert :

    V decreases because the amount added to the monetary base has a velocity of almost zero. Because it basically sits in the reserve accounts. Is that a correct deduction?

    Here’s how I think about it (maybe it’s useful to others):

    Financial transactions happen — transfers of financial assets from one party to another. (I define financial assets as things with exchange value that have no consumption value — can’t be consumed by humans to derive utility, or used to produce things that can be consumed.) Most financial assets can only be exchanged within certain domains, and only for certain other financial assets/real goods. You can’t buy a house with rolls of quarters, I can’t buy anything in Afghanistan with pesos, and you (Edward) can’t buy reserves — financial-industry “currency” — with dollar bills, bank deposits, or anything else.

    Some of those financial-asset exchanges are reciprocated by exchanges of real goods. I hand you a dollar and get a candy bar. Others don’t: a bank gives another bank reserves and gets bonds. The first, within the financial system, is a one-way transfer. But it triggers a corresponding one-way transfer in the real economy. The second is a two-way transfer within the financial system, and has no direct effect on the real economy.

    The first has a direct effect on real production. These transactions explicitly, directly cause more production — either immediately in the case of services or just-in-time iphone production (80+% of our economy), or over time as inventories need to be replenished.

    So to answer your question straightfowardly, reserve balances only can sit in reserve accounts. That’s the only place they exist, and they can only be exchanged between entities that that have accounts at the Fed — banks, the IMF, etc. etc..

    But those account holders are not generally producers of real goods. So even if they wanted to, it’s quite difficult for banks (individually or collectively) to transfer reserves to producers in exchange for real goods, spurring production. And they don’t buy much real goods anyway, compared to 330 million Americans. The exchanges of reserve balances are almost all two-way exchanges of financial assets.

    Those two-way financial exchanges (especially in aggregate) can certainly change the prices, proportions, and distributions of financial assets, and that can certainly have second-order effects on markets for real goods. In some situations those second-order effects can be very powerful and widespread. But those effects are much less certain than straightforward buying of (“demand” for) real goods, and require more complex and contestable cause-and-effect theorizing.

    I’m starting to think about “central-bank reserves” as simply a top-of-the-pyramid, consolidated, netted-out tally sheet that doesn’t tell us very much about how the domestic economy is operating. (Possibly quite the contrary for international, where countries trade with countries, and reserve transfers spur transfers of shiploads full of real goods…) All the real action is revealed at lower accounting levels.

    I’m still not totally satisfied with this thinking, but FWIW…

  3. May 21st, 2013 at 18:41 | #3

    It’s the second order effects that affect production and demand.
    Labor depends on bargaining ans such to share in those 2nd order effects.

    you say above…
    “So even if they wanted to, it’s quite difficult for banks (individually or collectively) to transfer reserves to producers in exchange for real goods, spurring production.”

    Yet banks can transfer the reserves like drawing water from a pool. They increase lending and such using the base interest rate as a measure. A low Fed rate encourages lending backed by the reserves. A higher rate “usually” corresponds with the end of an expansionary phase and encourages more selective lending. (For instance, the Taylor rule uses the output gap to adjust the Fed rate)

    We have an environment now where businesses do not want to invest because of high unemployment and relatively low capacity utilization. (Low TFUR). So the low Fed rate is trying to encourage lending as a 2nd order effect. But business are not cooperating. They know the demand is not there. Businesses see profit rates peaking meaning that the expansion is nearing an end anyway.
    Yet, the Fed has to hold out hope that businesses will borrow and invest in job creation. It is not going to happen. Businesses are more than happy building more cash reserves in preparation for possible hard times ahead.
    If you raise the Fed rate now, lending will slow down and be more selective. A good thing in my opinion. There is already a lot of liquidity sitting out there within businesses for the sake of lending and investment. There are higher retained earnings in corporations. This supports the rise in stocks. And retained earnings are mainly for reinvestment in the company or paying down debt. but the problem as I see it… the economy has moved backwards. We have unused capital from when we were more prosperous, which implies less need to invest in capital accumulation now.

  4. May 22nd, 2013 at 06:58 | #4

    @Edward Lambert “Labor depends on bargaining ans such to share in those 2nd order effects.”

    Yes: though there are policies that can address it without unions. See my rabid posts on expanding the EITC.

    “Yet banks can transfer the reserves like drawing water from a pool. They increase lending and such”

    Not sure what you mean by “and such,” but this is a common misconception — not surprisingly because it’s been standard (and simply incorrect) textbook fare for many decades.

    Your kind of analytical mind will totally get this once you see a good explanation. The “money multiplier” and “loanable funds” notions make absolutely no sense.

    See this paper from the Bank of International Settlements, notably page 19 beginning with this:

    “Does financing with bank reserves add power to balance sheet policy?
    The underlying premise of the first proposition, which posits a close link between reserves expansion and credit creation, is that bank reserves are needed for banks to make loans. Either bank lending is constrained by insufficient access to reserves or more reserves can somehow boost banks’ willingness to lend. An extreme version of this view is the text-book notion of a stable money multiplier: central banks are able, through exogenous variations in the supply of reserves, to exert a direct influence on the amount of loans and deposits in the banking system. 30

    30. The money multiplier view of credit creation is still pervasive in standard macroeconomic textbooks including, for example, Walsh (2003), Mishkin (2004), and Abel and Bernanke (2005).”

    http://www.bis.org/publ/work292.pdf

    And in general, read stuff you find by searching for “Modern Monetary Theory.” I think Randall Wray and Scott Fullwiler especially rock.

    “We have unused capital from when we were more prosperous, which implies less need to invest in capital accumulation now.”

    I vehemently object to the undifferentiated (actually, just undefined) use of the word “capital.” Financial and real capital are absolutely not the same thing, nor are they some kind of homogenous or vaguely undifferentiated blob of “capital.” I don’t think your sentence says anything coherent. (Though it’s pointing in the direction of coherent — and IMO correct — statements.)

  5. May 22nd, 2013 at 10:47 | #5

    Actually, Dudley said during the Q&A session that the “V” was being restrained because, as of 2008, the Fed had the ability to pay interest on excess reserves. He said that this was a new tool of the Fed. Essentially, he said that MV=PQ — “the old Money & Banking” text — was obsolescent (if not obsolete) because the ability to pay interest on excess deposits keeps money in the system (and limits inflation.)

    Today, less than 24 hours later, Chairman Bernanke directly countered that view in questioning before Congress. But given the level of pumping and the inability of many small and medium sized businesses to access credit, I would be inclined to agree with Dudley: money is retained in the banking system because the Fed pays interest on excess reserves.

  6. May 22nd, 2013 at 10:50 | #6

    We have a discussion of Dr. Dudley’s Japan Society comments in our blog post, including news he made during the Q&A session that was mostly not reported (presumably because reporters only read the text of his speech from the NYFed website.)

  7. May 22nd, 2013 at 11:27 | #7

    @Asymptosis

    “We have unused capital from when we were more prosperous, which implies less need to invest in capital accumulation now.”
    I vehemently object to the undifferentiated (actually, just undefined) use of the word “capital.” Financial and real capital are absolutely not the same thing, nor are they some kind of homogenous or vaguely undifferentiated blob of “capital.” I don’t think your sentence says anything coherent. (Though it’s pointing in the direction of coherent — and IMO correct — statements.)

    Clearer to say, “We have unused stock of capital from when we were running at optimal output, which implies less need to invest in physical capital accumulation now.”

    BTW “capital stock” is used to mean both stock of physical capital and equity shares of a corporation, so I used “stock of capital” for physical capital (means of production).

    The investment need is for hiring and materials to produce goods, not more physical capital when there ample capacity of physical capital to expand production and plenty of idle labor. But investment is a response to a signal of increasing effective demand, which so far is absent owing to demand leakage to saving. With the consolidated domestic private sector desiring to net save in aggregate, this net saving can only come from the other two sectors, government or the external sector. But the US is a net importer and it is also unreasonable to expect to increase exports in a stagnant global economy when everyone else is trying to increase exports. So the remaining option is govt, which is tied up in gridlock.

    The Fed is doing everything possible to facilitate banks’ lending, but it cannot increase customer demand when the domestic private sector wishes to net save in aggregate. So monetary policy is a failure in this regard. The Fed is also trying to increase spending in the economy through building up the wealth effect by making asset prices higher than they would be. So far it has been quite successful in this, but the wealth effect is not spurring new spending so far, just concentrating wealth at the top and increasing inequality.

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