Why the Economy Is In a Tailspin

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On October 6, 2008, the Federal Reserve announced that it would start paying interest on the excess reserves that it holds on behalf of its member banks. On November 6, it increased the interest rate that it pays on those reserves. The Fed must rescind this policy immediately to avert the possibility of an economic collapse.

Right now, the Fed is paying 1.00% interest on excess reserves (which are the vast majority of bank reserves right now). This is equivalent to offering banks one-day T-bills at an interest rate of 1.00%. The current yield curve for T-bills starts at 0.01% for 3 months, rises to 0.28% for 6 months, then to 0.50% for 12 months, and then reaches 0.92% for 24 months. Given this, it is clear that the interest rate the Fed is offering on bank reserves is far above market for a risk-free investment.

Given that the Fed has been offering banks an above-market return for sitting on their money, it is not surprising to find that this has been exactly what they have been doing. Bank lending has plunged. The velocity with which money circulates through the economy has also plunged, taking demand, output, and employment with it.

The Fed’s goal in paying interest on bank reserves was to improve the technical accuracy of its Open Market operations in managing the effective Fed Funds rate and holding it close to the Fed’s target rate. This has not been achieved. The effective Fed Funds rate has been far below the target rate since the new policy was instituted.

What the Fed’s new policy has accomplished is to “sterilize” the massive increases in the monetary base the Fed has been engineering in an effort to prop up demand and the economy. From August 1 to November 1 (the last data point available) the monetary base increased from $871 billion to $1.482 trillion. This 70% expansion in just three months is more than the percentage increase over the preceding ten years.

Despite this enormous increase in the supply of dollars, gold prices fell from $912.50 on August 1 to $729.50 on the first trading day after November 1, a decline of 20%. Meanwhile, the economic decline threatened to turn into a rout, with the economy shedding 533,000 jobs in November—the most for a single month since 1974. Stores have been closing, unsold inventory has been piling up, and the prices of oil and other commodities have crashed.

It is interesting to note that major stock market declines started just before each of the two Fed press releases mentioned above. The Dow Jones Industrial Average plunged 2400 points (22%) during the first 10 days of October. Then, after recovering almost half of this by November 4, the Dow plunged again, losing almost 2100 points by November 20. As of this writing, the Dow is still down more than 1900 points since the beginning of October.

Clearly, aggregate demand is falling. The velocity with which money is circulating through the economy is declining, taking demand and economic output down with it. We have seen this phenomenon before, but never to this degree.

When people are fearful about the economy, they try to hold on to their money. Both individuals and companies seek to become more liquid. This causes the velocity of money to fall.

From 1929 to 1930, the velocity of the monetary base fell by 9%. This decline, coupled with a 3% reduction in the size of the monetary base, touched off the Great Depression. By 1933, base velocity had fallen to less than half of what it had been in 1929. By then, the Fed had increased the monetary base by 16% over the 1929 level, but this was not nearly enough to offset the fall in velocity.

In contrast, with the monetary base expanding at a 70% annual rate over the three months ending November 1 and GDP contracting at an estimated 4% rate in the fourth quarter, it appears that base velocity has fallen by more than 40% in just a few months.

However, rather than the circulation of money in the economy truly slowing down by more than 40%, the Fed’s policy of paying interest on bank reserves has effectively immobilized a large part of the monetary base. Money that is sitting in an account at the Fed earning risk-free interest is not out in the economy driving transactions.

Normally, the Fed can increase demand by simply buying Treasury bonds and creating additional money. Take a simplified example where the excess supply in the economy consists of a $30,000 Buick sitting on a dealer’s lot. If the Fed buys $30,000 of Treasury bonds, the person who sold them will now have $30,000 in cash. That person will turn around and do a transaction of some kind, thereby passing the money onto someone else. At some point, someone will buy the Buick because, on the margin, there is nothing else available to buy. The sale of the Buick will show up as an increase in GDP when the factory builds a new Buick to replace the one that just got sold.

The Fed’s policy of paying interest on bank reserves at an above-market rate alters this basic mechanism of money. Once again, imagine that there is a $30,000 Buick sitting unsold on a dealer’s lot. Now imagine that “A” has a $30,000 worth of 12-month T-bonds that are currently yielding 0.50%). The Fed buys the bonds from A for $30,000. The newly created $30,000 is deposited into A’s checking account at XYZ Bank. The same $30,000 also shows up as an increase in XYZ’s reserves at the Fed.

Now, with the Fed paying 1.00% interest on bank reserves, XYZ has no incentive to lend out the $30,000. However, XYZ can afford to pay A (say) 0.75% interest on his checking account balance. Because of FDIC insurance, the interest-paying checking account is as safe as the bond that A used to own—and it has a higher yield. In essence, the Fed has “sterilized” its Open Market operation. Under these conditions, the Fed could buy up the entire national debt without having any effect upon demand.

If we want the economy to recover, the Fed has to stop paying interest on excess reserves. When the Fed Funds rate is near zero (as it is now), it may even be necessary to charge banks for holding them. Once this is done, attention should turn to fundamental monetary reform. To have a stable economy, we must have a stable U.S. dollar.

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