The Spectre of Price Inflation

Inflation was said to be a temporary blip during Covid. In this new book by Agenda Publishing, and Columbia University Press in the US, I go through the history of money and banking policy, how inflation episodes have occurred and why this inflation increase of 2021-2022 is likely to be more of an episode as in the 1970s than a quick blip in the economic landscape.

I describe how the conflation of monetary policy designed to target a low inflation rate became obstructed by central banks conducting banking insurance policy, after the bank crash of 2008. By subsidizing private banks to avoid financial collapse after 2008, central banks began fixing short term market interest rates below the inflation rate for all but three of the last twenty years. This occurred in the US when the Federal Reserve moved up to 2008 during the crisis a policy of paying interest on “required reserves” that was to take place in 2011. Then the Fed instead paid interest on ALL reserves held at the Fed.

Instead of the zero excess reserves held at the Fed in all previous modern history before 2008, reserves built up at the Fed almost exactly to the amount of new money that the Fed created by buying Treasury debt, up to September of 2014 as in the below graph from the Federal Reserve Bank of St. Louis (FRED).

This increased money supply from 2008 to 2014 was as a result completely “sterilized”: meaning the private banks were paid not to lend out the reserves and the reserves stayed in place at the Fed. This new money, manifested by the build up of new reserves, followed almost exactly in line with the money printed by the Fed buying Treasury debt from the private banks. Normally, banks lend out all reserves as soon as possible and hold zero excess reserves, as was the case before 2008.

The disconnect between the money supply growth and the inflation rate then appeared. Since nearly all of this new money creation after 2008 until 2014 did not enter circulation, which is the key to causing inflation, the inflation rate did not rise.

Once the reserves began to be lent out, the money entered circulation. If you study the graph, it is clear that after 2014 the reserves began falling, thereby entering circulation. This happened as the Fed started in December 2015 to raise the interest rate paid on reserves. This rate was thought to create a floor on interest rates. But because of the “fungibility” of money, the Fed-diktat interest rate on reserves also became the interest rate on the 3-month Treasury bill, and on the Federal funds rate, not to mention also the 1-year Treasury bill rate being very close as well.

This Fed policy was meant to build up a reserve pot of bank insurance money at the Fed, since the investment banks that failed in 2008 were not part of the Federal Deposit Insurance Corporation (FDIC) and their money market funds were not FDIC insured. The Fed in effect supplied an unending subsidy to private banks as bank insurance after the investment bank sector collapsed in 2008, just like getting insurance paid out to you for a car crash that you had while being uninsured!

The subsidy was the interest paid on these reserves. And the Fed also bought up the class of assets that caused the investment banks to collapse: the Mortgage-backed Securities (MBS) by billions of dollars. By conflating monetary policy with bank insurance supplied after the crash, the Fed bought huge swaths of Treasury debt, increased the money supply dramatically, sterilized the increase in money supply up to 2014 completely, set international short term market interest rates below the inflation rate, induced internationally adopted negative real interest rates on short term Treasury debt, distorted capital markets, paid banks not to lend out money for investment, and so created the moral hazard of a poorly designed after-the-crash bank insurance policy that induced less investment and greater financial risk undertaking.

The latter resulted from portfolio managers taking on greater risk/great yield assets to offset the negative return on the “risk-free” US Treasury debt. This is also why MBS were bought up by a triple-fold amount after 2001: because the Fed forced down the market interest rates by flooding the market with new money after the 2001 terrorist attacks. But they did this from 2002-2004, causing three years of negative real Treasury interest rates, inducing the flight towards MBS. Then the Fed decided to quickly “normalize” market interest rates and induced the Federal Funds rate up from 1.0% in 2004 to 5.24% in 2006, causing mass default on mortgages and the onset of the collapse of MBS that investment banks were holding to avoid the negative Treasury interest rates, and the collapse of investment banks in 2008.

After 2008, the Fed then set by diktat the interest rates in international capital markets. Why international? Because main Western economies emulated US policy in order to induce the same negative short run real interest rates so that their currencies would not appreciate relative to the US dollar.

This distorted international capital markets by inducing greater risk being invested in so as to balance the return on portfolios internationally. The moral hazard is that the international financial system has been “seeking yield” through riskier portfolios while expecting to be bailed out if a financial crisis occurs. This is in lieu of having an efficient bank deposit insurance system put in place systematically before the crisis.

The Spectre of Price Inflation explains this background and how the inflation rate rose as the money held as reserves entered circulation, very quickly after 2020, as can be seen in the graph above. The book sets out how efficient banking insurance can be set up potentially. This would enable an untangling of monetary policy and banking insurance policy that now goes by the name of macroprudential policy.

Then the central banks could go back to their objective of targeting a low inflation rate and avoid meddling in and subsidizing banks in order to supply very inefficient bank insurance that distorts global capital markets. The Fed had suppressed inflation as long as the private bank reserves stayed at the Fed, so they achieved their low inflation target up to 2018. But then this same strategy failed after 2020 when the Fed printed money (Treasury debt held by the Fed) at a dramatically accelerated rate. This increase money flooded from reserves into circulation and drove up the money supply and the inflation rate, just as the age-old quantity theory of money predicts.

The Trojan Horse in the Gates of US Monetary Policy

The Federal Reserve is embarked upon increasing the interest rate that they set on reserves held at the Fed. This is the interest rate that the Fed determines by diktat, coming after interest was allowed to be paid on reserves for the first time in 2008. This is being done to combat inflation.

Consider how interest rates are normally determined in free markets. They build in the amount of inflation to give a positive return to the dollar investment. That means that free market determination of interest rates will always equal whatever the inflation rate happens to be, or is expected to be, plus a positive return to the saver offering the funds for investment. Interest rates equal the sum of the inflation rate plus the equilibrium market return to the capital being lent.

Before 2008, the Federal Reserve set interest rates by how much Treasury debt that the Fed bought. If the Fed buys more Treasury debt, the money supply reserves at banks are increased as the banks sell the Treasury debt to the Fed in secondary Treasury debt markets. Before 2008, banks would lend out all but the required reserves, keeping just a small fraction of their new reserves still held at the Fed. The rest of the reserves would then enter circulation as the money was lent out for new investment.

Before 2008, free markets and the Fed worked hand-in-hand by determining interest rates according to how much Treasury debt that the Fed would buy. When the Fed increased its rate of purchasing Treasury debt and the growth of new reserves rose at an accelerated rate, then market interest rates would be driven down as the new reserves enter circulation and increase the supply of capital in capital markets. This lowers interest rates in the short term due an increase in liquidity in capital markets.

An abrupt change in Fed policy took place in 2008. Rather than letting market interest rates be determined freely in markets, the Fed used an esoteric law – The Financial Services Regulatory Relief Act of 2006 – to pay interest on all reserves held at the Fed. This Act was intended to pay interest only on the 1% of all commercial bank deposits held as required reserves, not on any amount of reserves. The Act’s legislative history is clear that it was aimed at helping smaller banks that had a larger percent of required reserves that did not earn interest, than did larger banks, thus providing “regulatory relief” to smaller banks. However, the Act’s exact wording is that it allows the Fed to pay “interest on reserves.” The Fed ignored the intent of the law, effectively lobbied to move its effective date up to 2008 instead of 2011, and began paying interest on all reserves instead of only on required reserves.

Paying interest on reserves created a Trojan horse whereby the Fed could set interest rates on the most important source of international financial liquidity – US Treasury short term debt – by dikdat. This is because the interest paid on reserves has set in tandem the US Treasury debt interest rates as well, even if this was “unintended.” 

The Fed paying this interest on reserves caused reserves to build up so that the new money supply has effectively sterilized in part by inducing it to remain in the Fed’s coffers. Thus began the disconnects that exist to this day. The amount of the Treasury debt that the Fed purchases does not automatically enter circulation since banks can sell their Treasury debt to the Fed, get credited for the sales as new reserves, and then still earn interest on all reserves. This is despite that fact that banks sold their right to earn the interest stream on the Treasury debt by selling it to the Fed. This created the first disconnect: the money supply increase no longer automatically goes into circulation ever since banks began building up excess reserves at the Fed. The 2020-2022 surge in Fed-bought Treasury debt and in the reserves held at the Fed caused our new episode of inflation, similar to that of the 1970s and early 1980s. This inflation results since so much money was printed that it escaped from reserves into circulation at a high rate. The money supply that entered circulation at an accelerated rate caused the acceleration in inflation, unlike directly after 2008 when almost all new money was held as reserves at the Fed, right up until 2014.

The second disconnect is that market interest rates became set by the Fed. When the Fed set the interest on reserves at a quarter of one percent for seven years from the end of 2008 until the end of 2015, the fungibility of capital meant that the Treasury short term interest rates were all below or equal to the Fed’s arbitrary setting of what interest rate to pay on reserves. This meant the Fed was setting interest rates by diktat rather than by the amount of money it was creating by buying Treasury debt.

The Fed was setting interest rates below the normal market rate that would include at least the inflation rate and has been ever since 2008, with only eleven months of a positive real return in 2018-2019. This is like how the Soviet Union set the price of bread in markets below the competitive equilibrium price in order to subsidize the price. The problem when the Fed does it is that it causes the international financial system to seek a higher yield by buying up what is viewed as the next best low-risk, high yield asset. Since the mortgage-backed securities crash, this has led to all types of diverse and increased risk-taking by the financial system to offset negative yields on Treasury debt.

The payment of interest on all reserves is equivalent to an allocation that should be approved by the Congressional Budget Reconciliation process each year. The same goes for the Fed’s continued purchase of mortgage-backed securities that is illegal under the Federal Credit Reform Act of 1990 that requires all loan purchases to be approved in the Congressional budget process. The Fed buying mortgages is a misdemeanor compared to the felony of paying interest on reserves, which sets interest rates by diktat below free market rates, induces greater international financial fragility through increased risk-taking, and allows into the gates of finance the Trojan horse of direct government takeover of interest rate setting. The free market determination of rates was thus vanquished in 2008. That practice can be ended in a single day, by the Fed setting the interest rate on reserves at zero.

Max Gillman is the Hayek Professor of Economic History at the University of Missouri – St. Louis and author of forthcoming book The Spectre of Price Inflation.

How the US Got its Inflation

Here we present the graph showing the amount of US money that actually entered circulation since 2003. Gathering the data from the Federal Reserve Bank of St. Louis economic data base called FRED, the graph shows in the dashed black line this amount of money that entered circulation. It equals the amount of money that was printed by the Fed as they bought Treasury debt and, since 2008, Mortgage backed securities (MBS), that first entered as reserves held at the Fed and subsequently entered circulation when the reserves were lent out.

This image has an empty alt attribute; its file name is image-1.png

The total assets of the Fed is given in the blue line that is in large the sum of the Treasury debt the Fed bought (solid black line) and the MBS (red line). The money that entered circulation is the total assets of the Fed (blue) minus the reserves (green), which gives the dashed black line. This line coincides almost exactly with the Treasury debt bought by the Fed (solid black) and with the total assets of the Fed (blue), before 2008 but not after 2008. The required reserves before 2008 are shown in the green line near to zero on the horizontal axis.

In 2008, after the Fed began skirting the Congressional Budget Reconciliation Act of 1974 by directly buying mortgage-backed securities, which by the Federal Credit Reform Act of 1990 have to be approved as loan purchases in the annual Congressional budget process, the Fed also skirted another law and began paying interest on all reserves.

The interest rate paid on reserves was authorized by the Financial Services Deregulatory Relief Act of 2006, but this was designed only for required reserves and legislated to become effective in 2011. The legislative history is clear that the idea was to pay interest on required reserves so that small banks were not penalized relative to large banks, since small banks had a larger proportion of their deposits held as reserves as compared to large banks. And the required reserves earned no interest. So the deregulation was to level the field slightly between small and large banks by paying interest on required reserves, but not on all reserves. Unfortunately, the law as written says it allows the Fed to pay “interest on reserves”. It should have read “interest on required reserves”, but it would be fair to say that no one envisioned (except the Fed itself perhaps) that this interest would ever be paid on all reserves.

The Fed took advantage of the wording of the 2006 Act, had the effective date moved up to 2008, and instead paid interest on all reserves. The green line shows that reserves built up almost exactly in line with the Treasury debt bought by the Fed. This sterilized the money creation of the Fed by leaving it in the coffers of the Fed, in the accounts of the large banks that sold the Treasury debt to the Fed and then left this in the Fed: This account at the Fed for the banks is called their “reserves.” Getting paid not to lend out these reserves, the reserves built up until 2014. And the Fed could claim it met its self-proclaimed inflation rate target of 2%, implying that their policy was successful.

However, once the Fed began raising the interest rate on reserves, the private banks began lending out this money held at the Fed and the reserves began entering circulation.

The dashed line shows that the amount of newly printed Fed money entering circulation is growing largely at a rate up to 2014 as it had in all previous history. But then the dashed line slopes up after 2015 as reserves enter circulation at a faster rate. Inflation remained moderate but increased from 0% in January 2015 to 2.5% two years later in January 2017.

However, the money entering circulation (black dashed line) shoots up beginning in 2020. Even though reserves built up even higher than their September 2014 peak of $2.8 trillion, to $4.2 trillion in September 2021, the Fed bought so much Treasury debt and MBS after 2020 that the money entered circulation at a hugely accelerated rate.

The quantity theory of money is well alive. As the Fed-printed money entered circulation at a dramatically accelerated rate, the US inflation rate rose dramatically after 2020. When the new money supply was effectively sterilized by banks holding it as reserves in their accounts at the Fed from 2008 to 2014, the money supply grew but the money supply that entered circulation did not grow much because it remained as reserves at the Fed. After 2020, the US Treasury borrowed so much to cover Treasury deficits, which rose above 10% of GDP, that the Treasury debt to GDP ratio rose dramatically, from 107% of GDP in the first quarter of 2020 to 134% of GDP in the second quarter of 2020. As in most major crises, the Fed helped out by buying large swathes of the new Treasury debt. After 2020, this time the new money did not all stay sterilized as reserves held at the Fed. Rather much of it was lent out, the money in circulation surged upwards, and the inflation rate followed with its surge upwards.

This is how the US got its inflation.

Turkish Economic Summit: September 29

Professor Max Gillman invited to speak at Turkish summit on “Economic Transformation and New Paradigms”

Max Gillman, the Friedrich A. Hayek Professor in Economic History at the University of Missouri–St. Louis, joined a select group of economists from around the world at Turkey’s first Economic Transformation Summit, held Sept. 29 in the capital city of Istanbul.

The Turkish Treasury and Finance Ministry organized the one-day summit, “Economic Transformation and New Paradigms,” which explored major shifts that have taken place in the global economy in recent years, including but not limited to those caused by the COVID-19 pandemic.

Gillman joined a panel of economists from South Korea, the Netherlands and Italy discussing the “Importance of Investment-Production-Export model for Developing Countries.”

Turkey has this new economic model, which is part of non-orthodox policies called heterodox economics. The panel put into perspective the Turkish economic model, which is emphasizing investment in infrastructure. Gillman was emphasizing also investment in the education sector. Human capital investment is essential for the developing economies to become developed economies. He stressed the structural transformation of moving from agriculture towards manufacturing towards high-tech industry.

Last year, Gillman published a paper in the journal Economic Modelling titled “Steps in Industrial Development through Human Capital Deepening” that served as the foundation for the talk. The paper presents a model for industrial development in which human capital is deepened, education time increases and labor shifts away from agriculture. As that occurs, labor shifts toward new industry and away from traditional industry.

“The model explains rising education levels, growth and labor reallocation using a minimally complex approach that jointly explains stylized facts through human capital deepening within each industry,” according to its abstract.

Other panels explored “New trends in economic policies in the post-pandemic period,” the “Growing importance of infrastructure investments in the new period” and the “Growing importance of a financial architecture that supports growth in the new period” with economists from Australia, Germany, Japan, the Philippines, Portugal, Sweden, Singapore, the United Kingdom and the United States.

The next morning, the speakers were invited to a breakfast with Turkish President Recep Tayyip Erdoğan at the Presidential Palace.

Gillman along with his fellow economists had an opportunity to offer advice to the Turkish leader. A wide range of nuanced views was presented by the professors that supported the path that Turkey was taking.

Gillman, who researches inflation, stressed the importance of Turkey to the Western economy and the Western alliance, while agreeing that controlling inflation is an important objective. Gillman acknowledged the tightrope that Turkey was balancing along as one of the most important countries in the world that intermediates the aspirations of the East with those of the West, while remaining a key part of the Western firmament.

Gillman also expressed confidence in the economic policy path that Turkey was taking as shepherded by the Minister of Treasury and Finance, in terms of its investment strategy as long as inflation could be brought under control.

International Deposit Insurance with Risk-Based Premia

Friedrich A. Hayek’s 1944 acclaimed Road to Serfdom (reproduced by the Institute for Economic Affairs online) supports social insurance for when markets work imperfectly, a long tradition in neoclassical economics now reflected in practice by the implicit or explicit social insurance linked to nearly all fiscal policy:

“Nor is there any reason why the state should not help to organize a comprehensive system of social insurance in providing for those common hazards of life against which few can make adequate provision (Hayek, p. 67)….If we are not to destroy individual freedom, competition must be left to function unobstructed (p. 69).”

Our bank insurance system is a part of social insurance for aggregate financial risk to competitive asset markets; efficient social insurance “completes markets” rather than distorting either competition or capital markets. Our monetary policy likewise provides social insurance based trust in exchange means that allows competitive goods markets to optimally allocate resources.

With respect to banking, also from the Institute for Economic Affairs, consider my 2009 “Commentary” found  on their website at

International Deposit Insurance

and attached Gillman Economic Affairs of Institute for Economic Affairs 2009.



WSJ: Time for Positive Interest Rates for Savers

Time for Positive Interest Rates for Savers

Federal Reserve interest rates of 2% to 2.25% aren’t neutral if the inflation rate is 2.61%.


Federal Reserve Chairman Jerome Powell speaks in Washington, June 13.
Federal Reserve Chairman Jerome Powell speaks in Washington, June 13. Photo: michael reynolds/EPA/Shutterstock

In “Pause Interest-Rate Hikes to Help the Labor Force Grow” (op-ed, Oct. 26), Federal Reserve Bank of Minneapolis President Neel Kashkari is mistaken in two important ways. Federal Reserve interest rates of 2% to 2.25% aren’t neutral if the inflation rate is 2.61%, as it is as of the third quarter of 2018. This gives a negative real interest rate of at least 0.36%. Only a positive rate of real interest in the 2% to 3% range is “neutral,” as during phases of the high-growth era of the 1980s and 1990s.

The Federal Reserve’s forcing of negative real interest rates for most of the 18 years since 2000, with the exception of about three years, has encouraged the substitution of capital for labor. This means the labor force gets paid less. This can help explain why the labor participation rate fell from 2000 to 2017, and now is finally starting to turn upward as interest rates rise.

Note that the Fed targets the personal consumption expenditures deflator index, and not the consumer price index, as a possible defense for President Kashkari. Everyone else across the globe uses the CPI as the key price-index measure of inflation.

Profs. Max Gillman

David C. Rose

University of Missouri

St. Louis

US Law on the Target Inflation Rate

Extract from new forthcoming Berkeley E Journal of Macroeconomics: Advances, “The Welfare Cost of Inflation with Banking Time”, Max Gillman, 2018.

Below is Section 2 of this article:

“US Law on the Target Inflation Rate”

According to the US Federal Reserve Bank the FOMC (Federal Open Market Committee) has since 2012 adopted an explicit inflation target of 2%. In January 2012 the FOMC stated ( https://www.federalreservehistory.org/essays/humphrey_hawkins_act#footnote3)

“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate (Board of Governors of the Federal Reserve System 2012).”

The same January 2012 FOMC statement continues that it will not specify the level of employment to be targeted:

“The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment” [bold added].

In contrast, current US law in the form of the 1978 Amendments to the 1946 Full Employment and Stability Act precisely sets both the targeted US inflation rate and the US unemployment rate. For inflation, it states that the US inflation rate should be 3% by 1983 and should be 0% by 1988 and afterwards, unless it conflicts with the employment goal. For unemployment, rates of 4% for aged 16 and over, and 3% for aged 20 and over, are to be met within 5 years of the passing of the 1978 Act (so by 1983).

Further, the Act specifies that only the President or Congress can change these goals. The US Federal Reserve Bank (Fed) is not allowed, by any existing law, to change these goals. Therefore, it is not authorized, without Presidential or Congressional mandate, to set a 2% inflation rate target as it did in 2012, because the target is currently specified in law as zero percent unless it conflicts with achieving the unemployment target. And it is not authorized to change the target unemployment rate of the 1978 Act.

(Public Law 95-523, passed October 27, 1978, is known as the Humphrey-Hawkins Act or officially within its Section 1 as “Full Employment and Balanced Growth Act of 1978”. https://www.govtrack.us/congress/bills/95/hr50/text
Alternatively, a pdf of the law is found at https://onlabor.org/wp-content/uploads/2016/12/STATUTE-92-Pg1887.pdf)

The Fed seemingly has a big loophole in that the 1978 Act specifies that the inflation rate target may be higher if it conflicts with the unemployment rate targets. But when the Fed set its 2% inflation target, it also specifically stated that the inflation target does not affect the unemployment rate, in that this is set by “nonmonetary factors”. So the Fed closes the loophole offered to it under the 1978 Act by saying the inflation and unemployment rates are “largely” unrelated.

However the Fed’s logic for not setting an unemployment rate goal is faulty. Rather than its authority to set unemployment rate targets being based on some envisioned relation between the inflation rate and the unemployment rate, the Fed has no authority to set unemployment rate targets since the fact is that these are already set in the 1978 Act, which provides no authority to the Fed to alter these targets. It is the specific US 1978 statutory law, which specifically precludes the Fed from having authority to change the unemployment rate targets, that implies that for the Fed: “it would not be appropriate to specify a fixed goal for employment”. The end result is that today the Fed has given no Congressionally valid reason for setting a 2% inflation rate target in deliberate contradiction of the 1978 Act’s target of a zero inflation rate.

There are four relevant sections of the Act, 4.b1.-4.b.4, which respectively set out the unemployment rate goal, the inflation rate target for the first five years, the inflation rate target for all years after 1988, and the authority for changing these targets.

“Section 4.b.(1). reducing the rate of unemployment, as set forth pursuant to section 3(d) of this Act, to not more than 3 per centum among individuals aged twenty and over and 4 per centum among individuals aged sixteen and over within a period not extending beyond the fifth calendar year after the first such Economic Report; and
Section 4.b.(2) reducing the rate of inflation, as set forth pursuant to section 3(e) of this Act, to not more than 3 per centum within a period not extending beyond the fifth calendar year after the first such Economic Report: Provided, That policies and programs for reducing the rate of inflation shall be designed so as not to impede achievement of the goals and timetables specified in clause (1) of this subsection for the reduction of unemployment.”

“Section 4.c.(2). Upon achievement of the 3 per centum goal specified in subsection (b) (2), each succeeding Economic Report shall have the goal of achieving by 1988 a rate of inflation of zero per centum: Provided, That policies and programs for reducing the rate of inflation shall be designed so as not to impede achievement of the goals and timetables specified in clause (1) of this subsection for the reduction of unemployment.”

Section 4.d states that only the President or Congress may change these goals:

“if the President finds it necessary, the President may recommend modification of the timetable or timetables for the achievement of the goals provided for in subsection (b) and the annual numerical goals to make them consistent with the modified timetable or timetables, and the Congress may take such action as it deems appropriate consistent with title III of the Full Employment and Balanced Growth Act of 1978.”

Using data from the US Bureau of Labor Statistics, the unemployment goal of 4% for over 16 years of age was achieved for briefly in December 1999, and for several months into 2000, when it dipped into the 3+% range. Now, in April, May, and June 2018, the rate has been again below or equal to 4%.


The rate for ages over 20 has been below 4% since September 2017.
The legislatively binding US law, which sets the US inflation rate to be 0% permanently, seems to be contraindicted permanently such that a permanent 2% inflation rate target is set “de facto” by the Fed. Would this contradiction of US law be based on the inability to meet some unemployment goal, it might be acceptable as an interim policy. But, 1) the Fed FOMC openly admits in January 2012 that monetary policy has little if any ability to affect the long term employment rate (as quoted above). And 2), the goals of the 1978 law on unemployment are now largely met, although having taken longer than the five years allowed. This achievement of the statutory US unemployment goals seems to imply unambiguously that the inflation target should now be zero.

To summarize and emphasize the conundrum here: First, the Fed claims the 2% inflation target is not chosen to achieve the unemployment goal, since it cannot affect unemployment. Second, the unemployment goal appears to have been met as of now anyway. Third, the inference results that the Fed appears to be contravening statutory law of a 0% inflation rate by their self-established 2% target. If so, then by US law, the Fed 2% inflation target is a judicially challengable over-reach by the Fed relative to US statutory law. While economists can consult the lawyers, this is clearly controversial, if not illegal, policy practice by the Fed, even though there not much of a fuss made over it by academics. Economists though can propose ways to quantify the cost of the Fed’s contraindiction of the zero inflation rate in favor of the 2% target. This is done here through the standard approach of the welfare cost of inflation, in terms of a 2% rate compared to zero.

WSJ:”Fed Should Slowly Unwind Excess Reserves”

The Wall Street Journal: Letter

“Fed Should Slowly Unwind Excess Reserves”

Before 2008, competition between banks forced them to loan out or otherwise invest excess reserves.


Sept. 26, 2018 3:15 p.m. ET

SEC chairman, Jay Clayton in April Photo: Yuri Gripas/Bloomberg News

Regarding your editorial “Sharing the Wealth of Markets” (Sept. 21): Yes, recent stock price increases aren’t creating new wealth as broadly as most would like because the market isn’t providing adequate liquidity for the kind of firms that drive economic growth. We believe that much of the blame rests with Federal Reserve policy.

The New Keynesian model the Fed uses led, in part, to paying banks interest on excess reserves in 2008. Before 2008 excess reserves were virtually zero but now hover near $2 trillion. This is no longer a rational response to the financial panic of 2008-09. Interest payments made by the Fed on those reserves have helped make major banks richer by not issuing loans from reserves but instead earning interest at no risk.

Before 2008, competition between banks forced them to loan out or otherwise invest excess reserves. This produced new economic activity that produced economic gains outside the banking sector. If the Fed began reducing the interest paid on excess reserves, the excess reserves would begin to enter the system and make capital available to startups by increasing liquidity.

If the near $2 trillion of excess reserves entered circulation tomorrow, it would soon expand the money stock, igniting a major inflation. Interest rates paid on excess reserves should therefore be cut in several stages. But if there ever was a compelling argument for paying banks to hold on to excess reserves, that time is past. The sooner the Fed unwinds this practice the sooner we can avoid frustrating the emergence and expansion of a new generation of wealth-creating firms.

Profs. Max Gillman and David C. Rose

University of Missouri-St. Louis

Comment on “Cold Turkey and Moral Hazard”

Thomas Gordon : Writing in Wall Street Journal: December 14, 2017

@Max Gillman Good comments and informatory about why banks are now paid interest  on reserves.   As it concerns the article, I don’t think they were paying a huge interest rate (I thought it was less than 1%, but probably more than most banks were paying depositors ).   Not enough in my mind to get banks to hold excess reserves, but I suppose it is risk free.   The other unspoken thing is that back when Wachovia and WaMu were going broke maybe Fed/Treasury type people were looking for ways to strengthen the banks.  Pay them directly and you get a riot about subsidizing hated banks.   Do it this way and you’re “paying interest on reserves”, a topic that puts most people to sleep.

Avatar for Max Gillman

Max Gillman

@Thomas Gordon @Max Gillman

Thomas, Thank you. The reason why the interest is still “high” is that every time the Fed “raises interest rates”, it is actually raising the Interest rate on excess reserves; the Federal Funds rate remains (since 2008) below the interest rate on excess reserves. This way the Fed induces these 10 systematically important banks to keep holding the (now) $2.1 Trillion in excess reserves. If lent out, and so there were zero excess reserves,  a normal “money multiplier” would cause the money supply to jump by 10 times $2.1 Trillion, or by $21 Trillion dollars. GDP is about that now, so it would be an amount of new money equal to GDP. Inflation would rise significantly, but capital markets would “normalize”. Real interest rates on short term debt would no longer be negative. So I believe the jump in inflation would be best overall, and the elimination of interest on excess reserves the route to such normality in Capital markets.

Turning a Good Blueprint for Tax Reform into a Great One


April 2017

Two weeks ago President Trump told House leaders that he liked most of the House Ways and Means Committee’s “Blueprint” for tax reform. The blueprint does indeed significantly improve tax policy in a number of ways. But a careful consideration of what the latest economic theory has to say about economic growth suggests that it could be even better. Republicans should not miss this once in a generation opportunity to significantly improve the US tax code.

Governments tax so they can spend. An important fact about federal spending is that in the US over the last 60 years it has been a rather stable proportion of GDP (we ignore entitlement spending since, for the most part, these programs have dedicated funding). The trend is downward from about 24% (in 1958 and 1967) to about 18% (1998-2000). In 2016 it was a little over 19%.

As a practical matter, then, the ultimate objective of tax policy should be to extract enough resources from the economy to support spending of 18-20% of GDP as efficiently and as fairly as possible. Extracting less, such as what has been the average tax revenue share of GDP over the last 60 years of 17% leads to ever increasing debt. Extracting more reduces consumption for no good reason and weakens incentives that support rapid growth.

The blueprint can be improved by adopting a top rate of 22% on personal income and a 22% rate on all corporate profit coupled with: 1) eliminating taxation on dividends (to avoid double-taxation of dividends and remove the differential treatment of debt and equity), 2) eliminating capital gains taxes on stock holdings, and 3) removing all deductions and loopholes except those that exist to properly define corporate and personal income.

There is a very important finding in macroeconomic theory that has gotten surprisingly little attention. In pioneering work Robert Barro, in an article in the Journal of Political Economy (1990), considered government spending to be a constant share of GDP. Then Stephen Turnovsky, in an article in the Journal of Monetary Economics (2000), showed that under this condition income tax policy should be neutral with respect to rates applied to human capital (personal income) and physical capital (corporate profit).

This type of tax neutrality is an established result that no one we know of has successfully challenged. It makes intuitive sense that policy should not favor one over the other and thereby distort resource allocation.

Moreover, no serious economist we know of supports the double taxation of corporate profit. So the real question is, therefore, how to best insure that all corporate income is actually taxed, but only once. Some favor accomplishing this by not taxing corporate profit because dividends will produce personal income which will ultimately be taxed anyway.

This approach is attractive because it recognizes that it is people, not firms, who ultimately bear the burden of paying taxes. But the problem with this approach is that not all corporate profit is distributed as dividend income that is later subject to the personal income tax. This simple fact is particularly relevant when considering a zero corporate profit tax rate.

A zero corporate profit tax rate will induce firms to hold back on dividends so as to reward shareholders mainly through capital gains appreciation arising from retained earnings. This subsidizes physical capital relative to human capital by inducing more earnings retention at zero cost to the firm. If retaining such amounts for firm reinvestment was the best use of these funds, it would have happened already without the tax code inducing such action.

There is another benefit from taxing corporate profits at the source rather than indirectly through personal income that is increased by dividends. The latter approach requires monitoring over 100 million payers to minimize avoidance. Our society makes it hard for government to know much about each household’s finances. Taxing corporate profits at the source, however, requires the monitoring of far fewer firms. And with corporate firms especially, their financial situations are very transparent. This means the effective rate – after accounting for avoidance – is more likely to be close to the official marginal rate when corporate profits are taxed at the source.

Achieving neutrality in how human capital and physical capital is taxed also affects how capital gains should be treated. If we choose to tax corporate profits at the source, then capital gains realized through the appreciation of the value of stock holdings should not be taxed. This approach also cuts off a means by which the federal government can increase taxes through inflating the value of the currency to drive up the price of stocks.

This problem is often cited as a rationale for having a lower tax rate on capital gains, but our approach renders this issue moot. It also vastly simplifies the filing of tax returns by eliminating at one stroke the vast financial industry of “cost-based” accounting of stocks, needed to determine the size of the reported capital gain.

Most discussions about tax rates involve a false choice between having a flat or progressive tax system. We think the blueprint can be greatly improved by not falling prey to this false choice. For personal income, an approach that is better than a pure flat or a thoroughly progressive tax is a progressive system that reaches its top bracket so quickly that it is effectively flat for the vast majority of income for the majority of tax payers. This is where progressivity is needed most – to have a lower or zero rate for those who earn the least. What matters most is not that the rate be perfectly flat, only that it is flat for the people who will be paying most of the taxes.

A tax blueprint with a top rate of 22% on personal income and a flat rate on all corporate income would be a better blueprint. It would move us much closer to taxing human and physical capital equally, which removes a major inefficiency of the current system and the existing blueprint. Its rate of 22% should be high enough to ensure sufficient revenue yield to cover 18% – 20% of spending out of GDP given there is always some avoidance and given that the lowest income individuals will pay lower rates (some zero). Finally, 22% is just below the corporate rate for a number of large countries. This will give American firms a stronger incentive to stay in the US and foreign firms a powerful incentive to move to the US.

Max Gillman is the F.A. Hayek Professor of Economic History and David C. Rose is a Professor Economics, both at the University of Missouri-St. Louis.