A Keynesian Liquidity Trap?

by Liberty and Power

The recent explosion of the monetary base has caused some to raise the specter of a Keynesian liquidity trap, because nearly all of the increase has so far gone into bank reserves. Bryan Caplan challenged this concern over at Econ Log. I chimed in with the following comment:

"But this hardly indicates a liquidity trap, for at least four reasons: (1) Base money can only be held as reserves or currency, and the allocation of a massive base increase between the two tells you absolutely nothing about the overall demand for base money. (2) At the same time that the Fed stomped on the monetary accelerator, it began paying interest on bank deposits at the Fed, obviously increasing the demand for reserves. (3) A sudden SHIFT outward in the demand for base money does not in and of itself demonstrate a liquidity trap, as the history of bank panics teaches us. (4) You must allow for lags to see whether this incredibly sudden base increase works its way into the broader monetary aggregates. The year-to-year annual growth rate of M1 has already risen from 0 to over 7 percent, whereas that of M2 is up slightly from 6 to 7 percent."

Bryan also questioned whether all of the base increase was indeed going into reserves. Again, my comment:

"Accurate numbers on bank reserves are devilishly difficult to get and interpret, because the official figures are often adjusted for changes in reserve requirements and do not include excess vault cash, required clearing balances, and Fed float. But you can tease out recent estimates by going to the Fed's weekly H.3, H.4.1, and H.6 releases and by checking against how much of the base increase has ended up as currency in the hands of the general public. Using these means, I put total reserves for the entire banking system (not adjusted for changes in reserve requirements and not seasonally adjusted but counting all vault cash and clearing balances) at $72 billion in August. Currently, as of October 22, total reserves are somewhere between $343 and $358 billion. Notice how close this comes to matching the corresponding increase in the base, from $847 billion to $1,149 billion. The remaining increase constitutes currency in circulation."

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Adam Smith - 11/6/2008

Prepare for the New World Economic Order
Interest Rates [Credit] are the Cause and Consequence of the Explosion of Income/Wealth Disparities and, Hence, of the Inherent Instability of this Economy:
The Ominous Keynes' Liquidity Trap. The Origin of Economic Chaos.
Everyone Need an Economy, Don't They?
There Is One Solution That Works:
A Credit Free, Free Market Economy:
The New World Economic Order.
The Only Goal of 1776 - Annuit Cœptis is to Implement It.
They Can Transfer Their Assets & Forget Their Liabilities.
Anyone Can Join But Still Needs to Ask for It.
http://www.17-76.net/
The Purpose Is to Provide Both a New Deal and a New Game.
It is NOT to Fix This Economy Which is Already Beyond Repair.
The Intention Is to Create a New Economy With the Assets of the Old One Without its Liabilities.
Why Not Insure Against the Worst Case Scenario?

Bill Woolsey - 11/1/2008

The "other assets" includes foreign currency holdings. Anyone know how to find out what it is exactly that is making up more than 1/4 of the Fed's assets? I am not finding current figures on Fed foreign currency holdings.

Also, that the Treasury special balance is close to the "other assets" may be no accident. This could all be about heroic efforts to keep the dollar from rising "too much."

The banks that "own" the Federal Reserve contribute capital to the Federal Reserve and a subject to a call up of additional capital. In other words, if the Fed was in danger of failure, the member banks could be required to chip in 3% of their own net worth each.

I aways considered this unimportant. How could the Fed have solvency problems? Investing in T-bills? Not obligated to pay off in anything but its own liabilities?

If we have a central bank, then it should act as lender of last resort, but part of that scheme is to stand ready to reverse course. Destroy the reserves created when the crisis ends.

Will the Fed be able to do that?

Bill Woolsey - 11/1/2008

I agree with Hummel that it is hard to tease out these figures, but it is clear that the U.S. Treasury Supplementary Account at the Federal Reserve is _not_ included in the reserve figures.

http://www.federalreserve.gov/releases/h41/Current/

The Treasury is holding $558 billion (Oct. 29) in that fund, plus another $19 billion in its regular "checking account."

The Treasury has borrowed $558 billion and lent it to the Fed, which in turn is lending it to banks and other fiancial institutions. This really has nothing to do with monetary policy. The same procedure could be used in the context of a 100% reserve gold standard. (Persumably lending to whatever insolvent financial institutions would be making loans in such a world.)

Depository institutions were holding $426 billion in depository accounts at the Fed. (More than the figures I used for the post just the other day.) This doesn't include vault cash.

The Fed's balance sheet is now close to 2 trillion.

On the liability side, the big items are currency at $800b, bank reserve deposits, at $425b, and this Treasury Supplemental account at $558b.

On the asset side, Treasury securities are 476b, term loans to banks 301b, primary credit loans (the old discount window loans) 111b, 100b to the money market mutual funds, 40b to the commercial paper facility.

And 546b in "other assets." (up from 5b a year ago.)

Robert Higgs - 10/30/2008

Bill,

After seeing the huge spike in reserves at the Federal Reserve banks, I got to wondering whether some of it might be the result of additional Treasury deposits, rather than additional member-bank reserves. I haven't mastered the way the Fed and the Treasury are doing the accounting for all of the recent bailout actions. Do you happen to know?

Bill Woolsey - 10/30/2008

The reserve ratio (weekly total resrves divided by weeking t otal checkable deposits) was over 50% in mid-October.

Jeffrey Rogers Hummel - 10/28/2008

All excellent points, Bill.

Bill Woolsey - 10/28/2008

Well...

The reserve ratio went from around 7% to 15% in September according to monthly figures. August isn't out. This is the Board of Governors total reserves not adjusted for changes in reserve requirements divided by total checkable deposits.

Looking at weekly figures, in October both checkable deposits and M1 fell about $150 billion. They are now back to where they were in mid-September.

Bill Woolsey - 10/28/2008

A liquidity trap is when an increase in the money supply fails to reduce interest rates. This is supposed to matter because the lower interest rates are "the" transmission mechanism to increased aggregate demand.

It looks to me like the money supply has risen, and riskless interest rates (like on T-bills) have fallen. What liquidity trap?

An inability of the Federal Reserve to increase the money supply because of an increasing reserve ratio and falling money multiplier isn't quite the same thing.

The reserve ratio (total reserves unadjusted for changes in reserve requirements to total checkable deposits.) has gone up a lot. (last I checked, it was up to about 25%) They went up more in the Great Depression. So what? If you have a central bank, then the whole point of having one is to undertake open market operations to offset the effects of increases in reserve ratios--no matter how high they go. (And, of course, currency drains.) And, to be prepared to reverse course. Well, at least, that is the orthodox monetarist view of these things.

Anyway, base money has risen, and so has the M1 money supply.

Because the Fed is using interest rate targetting, its effort to keep the federal funds rate at 1.5% might require that the quantity of money decrease.

To me, a liquidity trap would mean that interest rate targetting would fail. The Fed would target the Federal Funds rate at 1% (for example) but the actual transactions would be at 1.2%. And no matter how many open market operations the Fed did, the actual transactions would be stubbornly fixed at 1.2%, above the target.

Currently the actual transactions are running below the target. Again, completely inconsistent with a liquidity trap.