Reforming the US Banking Insurance System and its Conflation with Monetary Policy

Reforming the US Banking Insurance System and its Conflation with Monetary Policy.

The main problem with Federal Reserve monetary and “macroprudential” policies (the latter means government bank sector insurance policy) is that after 2008 the two became conflated so as to distort both sets of policies. Before 2008, it was believed that the non-FDIC financial intermediary sector could not have a bank panic and so designing an efficient ex-ante risk-based deposit insurance premium system for the non-bank banks, as they have been called, was deemed unnecessary. It was considered additional regulation that was unwanted and unneeded.

Charles Goodhart (former Bank of England Chief Economist) wrote in The Evolution of Central Banks how the mutual funds were backed by marketable assets that would be valued with the market fluctuations and somehow (it is not explained but rather claimed) always have sufficient liquidity and solvency. Additional regulation was deemed unnecessary although Goodhart is addressing the risk of the banking sector throughout his treatise, or what he called the micro function of central banks: the regulation of the private banking sector. Now we call this macroprudential policy although since the bank market was viewed as a microeconomic market that can be studied outside of the macroeconomy, the term micro policy made sense at the time (1994) of his treatise. However Goodhart and most other economists turned out to be wrong about this, as the 2008 investment bank collapse proved.

The vast majority of economists that write about the need to “re-regulate” the bank sector completely shy away, as did Goodhart, from discussion of systematic bank deposit insurance for the entire financial intermediary sector and the provision of efficient ex-ante insurance for the entire sector, although Mervyn King (2017) was clear that ex-ante insurance is indeed the goal. One might forgive Goodhart who very briefly mentions bank insurance, since at the time the FDIC still charged a single premium for all banks for each deposit insured regardless of the riskiness in their asset sheet. This was known to induce the “moral hazard” of incentivizing banks to take on more risk since than was otherwise (in the absence of insurance) advisable since their premium would not go up. Its like speeding and crashing in your car and never seeing your insurance premium go up, which it obviously does in private markets. At the economy-wide level, when a US law creates an institution such as the FDIC that provides insurance, rather than the Federal Reserve which totally failed to provide bank insurance during the Great Depression, then if that FDIC structure causes an increase in the probability of bank failure and bank runs then we call that inefficient government policy because this is the definition of causing “moral hazard,” an increase in the bad state of affairs relative to what is being insured.

Goodhart not embracing an FDIC insurance in 1994 can be forgiven because economists widely accepted that moral hazard resulted from a fixed FDIC premium. However, after the bank crashes in the late 1980s and early 1990s, economists realized that different the degree of different bank risk within each could be quantified and was in the market naturally. This gave rise to the concept that the FDIC could likewise assess the riskiness inherent in each bank’s assets and balance sheet. This realization led finally to the reform of FDIC insurance in the 2006 FDIC reform act that instituted risk-based premiums for each bank, with different banks paying premiums based on their perceived riskiness. This made FDIC insurance efficient, potentially allowing the FDIC to charge premiums for each bank that covered both idiosyncratic bank risk and aggregate bank panic risk. The FDIC keeps a reserve pool from the premiums at around 1% of the deposits insured and this allows it to offer exactly the type of reserves to finance the absorption of failing banks into other banks and stop any panic for FDIC insured banks. After 2008, the FDIC raised this reserve pool slightly, to 1.35% from 1.15% and so increased its reserves to cover aggregate risk.

While this very efficient system runs, as legislated the by the US Congress and signed into law by US Presidents Roosevelt and Bush, the Federal Reserve has never had any ability whatsoever to insure against bank panics. It then becomes a small wonder why the world looks to the Federal Reserve to insure the financial system against panics. Indeed in its inception after the 1906 bank panic, all thought the Fed was created to stop future bank panics. But it was not a Bagehot Bank of England that received reserves willingly, voluntarily deposited into it by the private bank sector. The only reserves the Fed has had throughout its history up to 2008 were a small amount of mandated reserves. This is viewed by banks as a tax. In Bagehot’s (1873) Bank of England days, the voluntarily supplied reserves certainly earned no interest but were not viewed as a tax since the private banks then could depend on the Bank of England to provide each bank with its reserves plus any additional amount of reserves that were needed (on a loan basis at a higher-than-prevailing interest rate). The Bank of England pooled reserves so that the entire banking system held less reserves overall than if there were no Bank of England, according to Bagehot, and then acted to give out these pooled reserves to stem bank panics. There was no perfect way to do this policy of bank insurance by the Bank of England, and so Bagehot wrote an entire treatise, Lombard Street, discussing how it might be done most efficiently, and if at all possible, Bagehot wanted it to be done systematically in an efficient way. This was the central bank providing private banking insurance.

Reading Goodhart’s (1994) Appendix, he describes the evolution of central banks across Europe and Japan. You see there a combination of the central bank gradually evolving to provide bank insurance policy or the legislature passing laws or “regulation” to accomplish that, or a mix of measures. The uptake is that this bank insurance policy concept is a difficult one that has been approached in a variety of ways historically.

The FDIC insurance of the 1933 Banking Act that began (on a temporary basis at first) in March 1933 abruptly ended the Great Depression as Roosevelt’s first fireside chat told the citizens that deposits were fully insured and they responded by pouring their money back into bank deposits, which in turn then lent them out and increased investment and GDP. At the time, the limit on FDIC insurance per depositor was broadly seen as sufficient to cover nearly all deposits, so it was true in this sense that all deposits were covered. The beauty of the risk-based premiums of the 2006 Act reforming the FDIC insurance system is that it perfectly fits Bagehot’s definition of devising an efficient way to conduct insurance for the banking sector. Nothing in Bagehot indicated this had to be done by the central bank. Rather Bagehot carefully details how history came to evolve in such a way that it was the Bank of England providing this deposit insurance after the finance industry in Great Britain exploded once limited liability corporations were allowed for all banks (by the Companies Act of 1862).

The US made a fantastic innovation to the scheme of how to efficiently insure the private bank sector with the creation of the FDIC. It was flawed by having a constant risk premium regardless of risk, so it was imperfect and often deemed by most economists including Goodhart to be a mere subsidization of the bank sector. This is broadly, inherently untrue, since premiums are paid with the idea of forming an actuarially fair insurance scheme whereby what is collected in premiums equals the expected pool of reserves needed to be paid out in time of crisis. With the well-recognized moral hazard of a constant risk premium eliminated by the 2006 FDIC reform, it became exactly the type of system that Bagehot envisioned, especially with the FDIC keeping an “apprehension minimum” of reserves, as Bagehot called it, in the form of the 1.35% of reserves that they hold relative to deposits insured. Bagehot at length presents different ways on how the apprehension minimum might be established. One might say he agonized over how to establish this. He recommended that it should be scientifically studied as far as was possible. It should not be 40% of 33% of deposits, some fixed number, but rather must take into consideration not just the quantity of deposits but also the quality. Those are Bagehot’s words. It means that the risk of the assets gathered by private banks from the deposits made into the bank should be part of the equation of how to determine a sufficient amount of reserves to hold relative to insured deposits so that there would be no perceived risk of a bank panic: the apprehension minimum.

The risk-based insurance system of the FDIC, not the Fed, exactly meets the criterion of Bagehot in creating an efficient deposit insurance system. Unfortunately, history in the US intervenes here and has caused the fractured inefficient insurance financial intermediary insurance system that the US now endures. This history is that the Vietnam War was financed by the Fed buying an increasing share of a growing Treasury debt to finance the war by printing so much money that it broke down the Bretton Woods gold standard. This led to inflation rising after 1971 well above the 5.3% interest rate limit that was imposed also by the Banking Act of 1933 to avoid “usurious” rates on interest. Under a gold standard, going back to 1792 in the US, inflation fluctuated around a zero trend up to 1958 when the US Vietnam War engagement began. Normal market interest rates cover the rate of inflation and then are higher to give a positive return to capital after inflation. With zero inflation as the trend, a 5.3% interest rate seemed sufficiently high that it would never be binding. With the unconsidered end-for-all-time of the gold standard in 1971 and the beginning of a fiat money world, inflation could be anything and was high then at over 10% (and is high now). Banks in the 1970s were desperate to offer a normal market interest rate that included at least the inflation rate so as to have a positive return for depositors after inflation. Credit unions, mutual funds, money market funds all devised ways to avoid the law governing FDIC-insured banks, as well as the Federal Reserve System reserve requirements, and offer a “normal” unregulated interest rate. This began noticeably around 1978. Deposits in non-bank banks germinated, then mushroomed, and have never been insured to this day, remaining outside of the FDIC system.

Since 2008, when the Fed’s reserves went into negative territory (not counting their borrowing from other central banks in Liquidity Swaps), the Fed started paying interest on reserves to build up a reserve pot such as that at the FDIC or that at Bagehot’s Bank of England. The problem was that the Fed could not lend out these “excess reserves” since they did not own them, while the Bank of England could pool them and lend them out. The Fed paid banks to keep reserves; the Bank of England took in reserves willingly offered for insurance purposes. This is a huge difference ignored today as the Fed’s trillions of reserves are viewed as some sort of insurance for the banking system, which they are not.

Largely discussed finally since the SVB collapse, the Fed still has no bank insurance policy. It had to get five banks to agree to pool their reserves held at the Fed and lend them out to First Republic Bank to avoid its collapse, just as did J P Morgan in the days before the Fed existed. This is not an insurance system. This is the Fed scrambling to pretend it insures the banking system.

An extremely easy and comprehensive solution is to allow voluntary expansion of FDIC insurance to any financial intermediary, with the FDIC determining the risk-based premium fee that it would charge. This can be offered to any investment bank, any insurance company, any pension fund, any mutual fund or exchange traded fund, or any of the new financial innovations coming into the market. How did the FDIC determine risk-based premiums for FDIC-insured banks: by looking at the assets and assessing what deposit insurance rate to set. This should be made a voluntary system for the entire financial intermediary system instead of the current mandatory system that covers of only a fraction of the financial intermediary system. Then financial intermediaries without the FDIC sticker on their door would be seen as riskier and people would go to the FDIC-insured investment bank or any such intermediary instead. This would induce most of the system to seek such FDIC insurance.

The alternative always proposed from Goodhart to Mervyn King to Thomas Hoenig even when Vice-Governor of the FDIC has been to increase capital reserve requirements such as in Basel I, II, and III. Quantity restrictions can be evaded just as any tax. They can never emulate an efficient price-based system of insurance, even if it is a semi-governmental body operating it like the FDIC. Offering price-based insurance in terms of a risk-premium with a fee schedule that rises as the amount of deposits insured rises, so that any amount of deposits at any financial intermediary can be covered, can through trial and error create an ex-ante efficient financial intermediary insurance system that can be modelled around the world and induce financial stability.

Such insurance, if all moral hazard were eliminated, would be a perfect insurance system rather than a tax, regulation, or quantity restriction that intermediaries would avoid up to the point where the marginal benefit of avoidance equals the marginal cost of complying. No inefficiency exists in a perfect ex-ante insurance system, and no margin of avoidance would exist either. In the real world, the FDIC is best positioned to offer such an insurance system, where they would allow it to evolve over time to become increasingly efficient.

With such a broad-based FDIC system the Fed would not have to print money at accelerated rates as after 2008 to finance a bank bailout and continued subsidization of the bank sector through interest on all reserves and continued purchases of mortgage-backed securities. Instead, the Fed could finance Treasury expenditure at a more constant rate. There would be fewer and fewer such financial crises causing explosions of Treasury expenditure as a result of experiencing exactly what was the long-claimed inefficiency of the FDIC that is no longer true: increasing moral hazard. This very heart of the claim against the FDIC, of it causing moral hazard, is exactly what now is ongoing and increasing as the FED bails out financial intermediaries, ex-post, after the crisis. The non-bank banks are encouraged by market competition to take increasing risk leading to an increasingly risky and volatile global financial system since they have a plausible experience-based expectation of being bailed out ex-post.

The solution is easy: Make FDIC risk-based premium coverage 1) a voluntary system, 2) offered to any financial intermediary of any form, 3) allowing unlimited deposit coverage with an increasing schedule of fees per dollar of coverage as the amount of dollar coverage increases. This is of course an upward-sloping supply curve for FDIC insurance to those familiar with economics in which the supply schedule is the upward sloping marginal cost schedule in a competitive market. A semi-government agency would want to emulate that type of supply in competitive markets if competitive markets cannot cover the aggregate risk but the agency (FDIC) could.

The reform of the FDIC to cover the entire financial intermediary sector requires Congressional legislation not Federal Reserve Action. That is the fundamental problem in reforming the banking insurance system in the US. It evolved into law from the Great Depression. It took another 73 years before the moral hazard component of the FDIC was eliminated. The 2008 crisis and the 2023 SVB crisis is sufficient to get an educated Congress to enact the reforms necessary for an efficient US bank insurance system, based on offering a voluntary expansion of FDIC coverage rather than a mandatory FDIC expansion that rightfully so would be viewed as a taxing regulation. In contrast, this can never by design of the institution come happenstance from the Federal Reserve System. US law must be changed, or the FDIC could simply reform their system as their own prerogative. My understanding/suspicion is the FDIC may not have the power to do these reforms without the US law mandating them.

Reforming Monetary and Banking Insurance Policy: Excerpt from Last Chapter, The Spectre of Price Inflation

The FDIC could offer a specifically determined risk-based premium, according to the FDIC’s own assessment of risk, for different types of deposits across the financial intermediation spectrum, including pensions, insurance companies, investment banks and the host of new innovative financial institutions that are arising. This would simply allow any financial institution to apply for FDIC insurance. The institution could then pay the FDIC-stipulated premium and receive coverage or choose not to participate.

With a well-formulated set of FDIC premiums, market competition would gradually drive investors towards the insured financial institutions, because they would be safer. This would work only if moral hazard were eliminated through bailouts that encourage financial institutions to flee FDIC coverage in the belief that they will be helped by the government in time of crisis even without FDIC insurance. This means that the FDIC insurance expansion would have to be carried out in tandem with the ending of the Fed’s IOER policy.

The government would not have to help financial institutions in times of crisis, if enough of them were part of an efficient bank insurance system anchored by an expanded FDIC. This would make the expanded FDIC insurance policy a means of slowly halting the expansion of uninsured banking and begin pulling the fragments back into an insured centre of banking. This would simultaneously reduce the liquidity problem.

To work well, the FDIC would also need to drop the policy of a fixed risk- based premium for each insured financial institution. Rather, since the amount insured becomes increasingly risky as the amount of deposits increases, the FDIC premiums should also rise in accordance with the rising “marginal cost” of the amount of deposits insured. The FDIC-offered schedule for each risk-based premium for each financial institution should rise in segments as the quantity of deposits insured rises.

Supply by firms is offered at a lower price for each unit of a lower quantity supplied. When the price of each unit rises, firms offer more quantity at a higher price. Firms face an increasing cost of production for a higher quantity of units supplied because of constraints on resources, which become increasingly scarce as more resources are used.

This is also seen in private insurance. For a large excess (deductible) of the insured amount, the insurance premium is low. For a lower excess, and therefore a greater quantity of insurance provided, the insurance premium rises. These excesses are highly variable in private insurance markets, with the result that the cost of insurance rises as the quantity of insured dollars increases.

Insurance, just like the production of all goods, supplies the coverage or output of the insurance company, as in a normal upward-sloping supply of any good. The cost of insuring more goes up as the amount of coverage rises. This means that the “marginal cost” of additional coverage rises as the amount of coverage increases, giving rise to an upward-sloping supply of insurance that equals the marginal cost of the coverage.

The FDIC insurance policy could make the amount of insured funds almost unlimited for each type of institution insured by having tiered differentiated pricing, as in an increasing marginal cost of coverage that forms the “upward- sloping” supply of insurance coverage, or any output. Up to a certain quantity of funds supplied, the risk premium would be the base level. For the next additional set of funds to be insured, the risk-based insurance premium would rise, and this rise in the FDIC premium would continually increase as the amount of insurance of funds increases.

The other issue is information revelation. The FDIC would need to induce transparency in terms of the balance sheets of the institutions to which it offers insurance. The FDIC could do this by offering a higher insurance premium the opaquer the balance sheet is of the institution applying for insurance coverage, and by conducting (or outsourcing to other federal agencies) “stress tests” of financial institution resilience like those that began in the United States after 2008.

If the FDIC prices well, shadow banks would start joining the system. By giving investors confidence in the solvency of institutions, and with the institutions voluntarily allowed to join, then greater participation in the FDIC would decrease the liquidity problem. Once solvency is guaranteed more and more by the FDIC, liquidity becomes less of a problem – although it is still a problem.

The first problem of the current liquidity system is that the Fed operates it without any budgeting of the loans being offered and in any fashion it pleases. For example, there was a $1.5 trillion sale of mutual funds and ETFs in the first quarter of 2020 that caused a short-lived bank panic. The Fed intervened by providing massive liquidity in the short-term Treasury debt money market (Tooze 2021).

A line of credit can be added to the annual congressional budget for this liquidity provision. Irving Fisher (1932) wanted a facility to be devised that guarantees loans for banks in times of a liquidity crisis. The US Treasury can indeed provide this service by guaranteeing loans made through a designated facility, using the line of credit approved by Congress, to provide loans during a liquidity crisis.

For example, a facility already exists in the United States that is designed for exactly this purpose. Rather than having loans being made by the Fed in an ever-expanding way, uncontrolled and outside the US Congress’s budget, the role can be taken over by the on-budget Treasury’s Federal Financing Bank (FFB), which was established in 1973 for exactly such a purpose. The FFB’s website (https:// describes its role thus:

“Congress created the Federal Financing Bank (FFB) in 1973 to help meet the demand for funds through Federal and federally assisted borrowing programs, and to coordinate such borrowings with overall Federal fiscal and debt management policies. The mission of the FFB is to coord- inate these programs with the overall economic and fiscal policies of the Government, to reduce the costs of Federal and federally assisted borrowings from the public, and to assure that such borrowings are financed in a manner least disruptive of private financial markets and institutions.”

The US Treasury FFB could be allocated a credit line in the annual budget, including a special emergency catastrophe line of credit. The FFB could then coordinate with other agencies the allocation of loans needed in the event of a crisis in the global financial system. The FFB could use other agencies, including the Federal Reserve System and FDIC, to carry out any such operations, which would then be overseen by the Congress budget process and could include the buying of Treasury debt.

A complementary way to bring together Treasury debt for liquidity use, while also enhancing FDIC insurance against insolvency, would be to build a reserve of private Treasury debt directly within the FDIC. What would help bring shadow banking into FDIC insurance would be the provision of an intermediate step towards FDIC insurance.

The FDIC could offer to hold Treasury debt for any mutual fund, ETF or other financial entity, which it could add to or subtract from at will. The FDIC could then designate the financial entity as “FDIC-registered” rather than FDIC- insured. The FDIC registration could include a rating tied to the amount of Treasury debt deposited at the FDIC relative to the entity’s total assets. This would work in the same way as the FDIC’s current practice of offering a different deposit insurance premium based on its evaluation of the bank’s asset risk.

The FDIC would thereby gather a pool of Treasury debt supplied voluntarily by shadow banks, just like the reserves of Bagehot’s Bank of England. The FDIC would then allow the lending of pooled Treasury debt to any registered financial entity during a panic. Alternatively, the FDIC could provide pooled Treasury debt to the FFB as collateral for loans made by the FFB to banks for sudden liquidity needs, so that the FFB would incur almost no budget expense in making the loans under the 1990 Federal Credit Reform Act. This would encourage shadow banks to register their Treasury debt with the FDIC. With the Fed’s IOER and IORB rates eliminated, the shadow banks would enjoy a normal interest rate yield on their reserves of Treasury debt held at the FDIC. There would be no distortion from such a liquidity policy, and no moral hazard.

In turn, the FDIC insurance would become more attractive to FDIC-registered financial entities, as in lodging Treasury debt the FDIC would be able to learn about the entity’s risk structure and could offer a certain FDIC insurance risk premium. Competition between shadow banks would drive them through the door opened by the FDIC to obtain liquidity insurance and insolvency insurance through FDIC deposit liability insurance.

A twofold plan of voluntarily inducing insolvency coverage across the global financial system through FDIC insurance and offering special liquidity during crises through the FDIC’s pooling of US Treasury debt would provide a global finance insurance system. By continually monitoring and adjusting accordingly, both the FDIC premiums and the pooled Treasury debt through FDIC registration would make the banking insurance system increasingly efficient and increasingly global in coverage.

The elimination of moral hazard in banking always remains a problem. A perfect global financial insurance system is impossible. But by basing the insurance in the United States and building it around the use of US Treasury debt by financial institutions around the world, the global financial insurance system could be resurrected. This would decrease the frequency of financial crises, and even eliminate many of them.

There are country-specific deposit insurance systems in a vast number of nations around the world. The European Union is actively trying to design and implement an EU-wide deposit insurance system. Global flows across countries make national bank insurance systems difficult to manage.

All the individual national deposit insurance systems can complement the expansion of FDIC insurance and FDIC Treasury debt registration in a fiscally responsible way. A coherent Federal Reserve and international central bank policy after the Covid-19 pandemic is possible and desirable.

The Fed has tried to provide liquidity to the banking system through its reserves. The FDIC currently does not normally provide any use of its reserves for liquidity in the banking system. Therefore, the two systems have continued to operate in parallel and more haphazardly, while finance institutions grow outside both the FDIC and Fed systems of banks.

The solution is to bring together the ability to insure against both insolvency and illiquidity in an evolving and innovative financial world. A key to this is that the US Treasury short-term debt is the main source of liquidity throughout the financial system, including FDIC-insured banks, Federal Reserve System banks and the shadow banks engaged in money market funds, mutual funds, ETFs and person-to-person payment systems and blockchain coins. All the shadow banks must resort to finding US Treasury debt for liquidity when their funds experience a sudden massive withdrawal, as Clayton (2021) describes.

Aggregate risk in the innovating financial sector, as based on US Treasury debt for liquidity, was the main concern recognized by the US Financial Stability Oversight Council, under US Treasury auspices, as Omeokwe (2021) describes.

    The evaders of FDIC insurance continue to grow. The Fed continues to handicap the “good” banks in the efficient FDIC system by excluding the “bad” shadow banks that earn more profits through non-FDIC- insured money market accounts. This encourages more diffuse forms of shadow banks to emerge and makes banking insurance as an efficient social insurance component ever more distant.

After 2008 the world was still in a state of prolonged fear of global financial crisis. The 1978 zero-inflation-rate law had long been forgotten, and the Fed was operating at odds with several other laws through its new policy of massive purchases of mortgages and payments directly to banks. The Fed’s mortgage purchases have continually violated the 1974 Congressional Budget Act and the 1990 Federal Credit Reform Act, which together require the US Congress to budget for the expected costs of buying loans.

The Fed started paying interest to private banks in 2008 on all reserves they held at the Fed. This violated the spirit of the 2006 Financial Services Regulatory Relief Act, which allows interest payments on reserves (starting in 2011), with the legislative background statements making it clear that this was to be interest only on required reserves and not on reserves in excess of what was required. By paying interest on all reserves, the Fed essentially transferred US inflation (tax) revenue from the US Treasury to the private banks, which violates their original by-laws that all interest earnings must be transferred to the US Treasury after subtracting the cost of running the Fed.

After the 2008 bank panic the Fed further violated its own by-laws, which had historically required Fed actions not to favour any one sector of the economy, on the grounds that the Fed should be an unbiased foundation for conducting monetary policy. The Fed simply changed the by-laws to allow it to subsidize the bank sector through the interest payment to banks on all reserves and through buying mortgage-backed securities, which were the weakest asset group on bank balance sheets.

The gold standard had kept average inflation near zero. Dropping this basis for monetary policy, trying to reacquire the essence of the gold regime through a zero-inflation-rate target mandated by law in 1978 but then discarding this target drove the United States towards an increasingly disparate money and banking policy, with the efficient bank insurance system based on the FDIC becoming a shrinking enterprise.

Our central banks evolved during times of metallic standards for currency. They could keep only enough reserves as were likely to be needed in the event of a bank panic. Central banks suspended the metallic standards as wartime needs arose and have long financed war by their governments by means of buying the government debt through new money.

Although the inflation tax is controlled by how much Treasury debt the central bank buys and does not sterilize, explicit income taxes require legislation. When the inflation tax goes up during a crisis, markets build in the expected inflation into energy prices, gold prices and government long-term debt interest rates. Sustained high inflation causes lower economic growth and higher tax rates on income.

Financial markets are highly flexible, adaptive, and innovative. Risk can be diversified through capital allocation within a mixed portfolio. Markets strive to anticipate normal business cycle risk, financial volatility, and the rare collapse of markets.

Financial intermediaries create capital markets. These entities specialize in different types of capital risk. They act to create a high real return on capital given the laws and regulations in which they operate.

Aggregate risk, just like the aggregate price level, is the risk for the whole economy. Aggregate risk is different from individual risk to any one person or firm, or “idiosyncratic” risk, because of the inability to pool and eliminate aggregate risk through private, financial-intermediary-diversified capital holdings. The whole sector of financial intermediation provides a range of insurance against as much risk within capital markets as is possible, but it typically excludes aggregate risk.

Aggregate risk for private financial intermediaries is aggravated when competition drives these intermediaries to minimize consideration of this type of risk as long as the government covers aggregate financial risk. Whereas the global business cycle creates volatility for the globalized economy that is hard to insure, governments take on aggregate business cycle risk in a variety of ways, including unemployment insurance, health insurance and insurance of the financial sector. A meticulous bank insurance policy gauges the normal business cycle defaults of financial institutions, along with the rare risk of contagion across a set of financial institutions because of their holdings of a common bad asset. Private insurance charges a premium in the good state and pays out the insurance in the bad state, and a comprehensive government bank insurance can be designed in the same way.

During the Great Depression, as the malaise it engendered continued throughout the 1930s, Keynes (1936) suggested the government step in and invest the savings that the private bank sector could not invest. This justified government intervention in markets in wide, unspecified, ways. Fisher (1932, 1933) instead stated that regulation of the bank sector needed to be reformed since it was the private bank credit that collapsed during the Great Depression, not the government money supply.

Today’s central banks follow the advice of Keynes and not of Fisher. Rather than reforming the bank insurance system at its root causes of dysfunction, the Fed chose to intervene heavily in capital markets by fixing interest rates, without restraint or checks on its power to subsidize in extraordinary ways. The dysfunction led to growing sectors of the financial system finding themselves outside the bounds of the FDIC and the Federal Reserve System.

Reform can be enacted by inducing financial intermediaries back to the FDIC system. A tax through inflation is bad. A tax on the global economy through usury prohibition via enforced negative real interest rates on Treasury debt is worse.

When fringe benefits proliferated in the United States, so that companies could pay out more income in kind without employees or the companies facing taxes on that income, after a decade of effort the US Congress finally reigned in this tax avoidance with title V, subtitle C, “Tax treatment of fringe benefits”, of the Deficit Reduction Act of 1984, which specified what and how fringe benefits were to be taxed. This 1984 Act broke the impasse and allowed the US Congress to continue with tax reform, once the income tax base was well defined. The Tax Reform Act of 1986 followed by lowering tax rates further, inducing rising productivity and making both tax avoidance and tax evasion less worthwhile.

The 2017 US Tax Act lowered tax rates further. The world economy has been lowering and flattening out tax rates, albeit unevenly, as productivity rises steadily, and tax evasion becomes less worthwhile. This has increased world development and wealth.

Bank insurance likewise needs to broaden the base of coverage through FDIC insurance premiums and FDIC registration, which pools Treasury debt for financial intermediation. The avoidance and what can be called evasion of FDIC insurance became apparent after the 2008 financial panic and global capital market repression of real interest rates. The repression of capital has led to the repression of capitalism and the rise of political regimes favouring the allocation of resources towards their own clientele rather than to their broad citizenry. By offering bank insolvency and illiquidity insurance to all financial intermediaries, the arbitrary bank policy and capital market repression loses any justification and can simply be eliminated. In contrast, competition would drive financial companies into such a broad-based system, if they are otherwise left out of all government insurance. Broadening the base for bank insurance would lower the real cost to all financial intermediaries in the long run and stabilize global capital markets, capitalism and political systems on the basis of free exchange.

The story of inflation continues as the money supply increases in major nations aligned within the global financial system. The aggregate price level rises as the histories of money supply growth, inflation and wars coincide. Providing a reformed banking insurance system that efficiently safeguards against both global financial insolvency and illiquidity is the best way to tame inflation.

When the inflation tax goes up in markets with a broad-based, fair and transparent bank insurance system, there will be only the consequence of the cost of inflation. It will just be an increase in a single tax rate, perhaps in a new moderately high inflation episode. High inflation and hyperinflation will be different but less likely in a well-founded democracy with a fair and open tax system and with a well-insured financial system as part of an efficient social insurance policy. After 2008 populist parties arose across the Western world and the Eastern world alike, economies stagnated at the edges of the globalized financial system, just as had happened during the Great Depression of the 1930s.

Repressed global finance threatens modern democracy, in which today’s wars are fought over scarce resources, including technology financed through global capital. Allowing inflation to rise to a moderately high rate is better than allowing capitalism, democracy, and freedom to fall.

The Spectre of Price Inflation

Bank runs even with over $3 trillion in reserves held by private banks at the Fed. What are those reserves doing other than leading to less investment? Certainly they are not preventing bank runs as we see today.

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).

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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

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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.

The Federal Reserve is Breaking US Federal Law

The Fed is breaking US federal law in two direct ways, skirting federal law in one important way, and disregarding the intent of Congress in a third crucial way. All of this shapes post-2008 monetary policy and distorts capital markets.

First, the Balanced Growth and Full Employment Act of 1978 fully amends the Employment Act of 1946 that regulates in law Federal Reserve action. This 1978 act stipulates an inflation rate target of 3% by 1983 and 0% thereafter. It allows leeway in not meeting this target if the unemployment rate is above 4% for aged 16 and over. This rate has been less that 4% since February 2022, and was less than 4% from May 2018 through February 2020.

In 2012 and still following this today, the Fed declared it would establish a 2% inflation rate target. This was done despite the 1978 Act’s stated provisions (Section 4.d) that only the President or Congress can modify the inflation rate or unemployment rate target. Further, the Fed in its 2012 statement disregarded the unemployment part of the 1978 Act by stating that “it would not be appropriate to specify a fixed goal for employment” even though this was already a part of the 1978 Act at a 4% unemployment rate. Declaring a 2% inflation rate target violates federal law guiding the Fed in the 1978 Act. Disregarding the 4% unemployment rate target in the 1978 Act is the second explicit violation of US statutory law.

Second the Fed is skirting federal law. Sponsored by now-retired Bill Gradison (R-Oh), the Federal Credit Reform Act of 1990 stipulates that all direct loan purchases by the US government need to be approved within Congress’s official budget by the Congressional Budget Reconciliation Act of 1974. Under President Bush, in 2008 the US Treasury bought mortgage-backed securities during the bank crisis. The expected loss on these at the time of purchase had to be included in the Congressional budget process. This is true even if the US eventually made a profit on such purchases, which is irrelevant to the Federal Credit Reform Act.

Under President Obama, instead of Treasury the Fed bought the MBS directly and continue to do this today. This skirted the Federal Credit Reform Act as the Fed purchases replaced the US Treasury purchases of MBS. In doing this, the Fed violated their own internal guidelines that prohibited action that benefited any one industry, which was the financial industry holding and issuing new mortgage loans. To address this violation, the Fed changed their guidelines to allow favoring any industry that the Fed chose. This displays the lengths by which the Fed went to skirt federal law as well as violated US law targets on inflation and unemployment.

A third action has blatantly disregarded the intent of Congressional law ever since 2008. The Fed began paying interest on all reserves held at the Fed. This was enabled through the Financial Services Deregulatory Relief Act of 2006. That act was meant to relieve small banks of the burden of holding more required reserves relative to assets than the large banks had to hold, the latter being close to negligible. Required reserves were limited up to a certain dollar amount and were set to zero on “non-depository” accounts such as money market funds. In the 2006 Act, its wording allows the Fed to pay “interest on reserves”, which was meant for the only reserves ever held previously at the Fed: required reserves. Excess reserves historically were as close to zero as banks could possibly make them. By emergency legislation in 2008, the Fed was allowed to move up the 2006 Act’s effective date of 2011 right to 2008, so that the Fed could immediately begin paying interest. But contrary to the clear Congressional intent of Senator Crapo who sponsored the legislation, the Fed paid interest on both required and all other reserves. This seemingly tiny change in the intent of federal law led to the build-up of trillions of dollars of reserves by private banks that were held at the Fed after 2008 instead of being lent out and invested in consumer and firm projects. As a result of the fungibility of money, the Fed interest rate paid on reserves then set the interest rates in all short term markets. This means that since 2008, the Fed has been setting short-term US Treasury debt rates by diktat rather than through natural equilibrium of supply and demand in capital markets.

Then the Fed totally eliminated reserve requirements on March 26, 2020 since they were no longer relevant given the “oceans of reserves” as one Fed white paper put it that were now held at the Fed instead of being invested in the US economy.

What did the Fed gain by all of these post-2008 policy changes that violated, skirted and undermined the intent of US statutory law? By financing the growing US Treasury debt after 2008, and again after 2020, the Fed could print money at an accelerated rate but it did not enter circulation as long as a large part of this was held as excess reserves at the Fed. This kept inflation down, or “suppressed.” Finally, the dam broke after 2021 when there were so much reserves created as the Fed bought US Treasury debt from banks that the reserves entered circulation at a fast rate and we found the US economy in a new prolonged episode of inflation. The Fed in the end gained little by circumventing federal law in myriad ways. But capital markets have remain distorted by interest rates lower than the inflation rate for some twenty years as a result of the Fed-set interest rate on reserves. The real return to short-term Treasury debt after inflation has remained negative and induced greater riskiness in bank equity portfolios worldwide to balance out the negative real return on Treasury debt.

The higher is the inflation rate, even above 0%, the more variable are both the inflation rate expectations and the effective inflation tax that is imposed on capital markets. This causes greater risk-premiums to be built into government debt returns. Greater risk is faced when holding “risk-free” US Treasuries, the most fundamental liquid asset used globally to create immediate reserves when needed. The increase in risk from the Fed targeting higher inflation rates than stipulated under US statutory law increases the risk of the aggregate market portfolio that is divided between “risk-free” Treasury government debt and a more risky equity portfolio. The increased risk of the aggregate market portfolio increases the riskiness of the global financial system.

Max Gillman is Hayek Professor of Economic History at the U. of Missouri – St. Louis and author of The Spectre of Price Inflation (2023).

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.

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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