The Federal Reserve must start to lower the nominal interest rate since inflation is now at 3% and the real market rate of interest is sufficiently positive after two decades of negative real interest rates through “persistent liquidity” injections by the Fed that have led to over $4 trillion in reserves sitting at the Fed, as the Fed pays banks not to lend out money. This is the definition of moral hazard in monetary policy.

Wicksell (1898) in Interest and Prices wrote about a natural rate of interest as being the market value that exists in the absence of central bank interference with the rate. That interference would traditionally be done, Wicksell wrote, by increasing or decreasing the supply of money faster or slower than the economy’s demand for money in order to lower or raise interest rates temporarily as a “liquidity effect.” Wicksell wrote that this could even be a “persistent liquidity effect” if the central bank for example kept increasing the money supply (by buying Treasury debt) at an increased rate for a sustained period of time, which the Fed has done over the last two decades.

Then came Woodford (2003) writing a book called Interest and Prices, again, even though he ingeniously miscontrues the money message of Wicksell. Woodford allows money to be used only for reserves in this early chapter and then eliminates money from the rest of the book. Wicksell in contrast was focused on the natural movements of capital markets over the business cycle and how the real rate of interest naturally fluctuates with the expansion and contraction of credit. Wicksell made clear what was monetary interference by the central bank, while Woodford champions the idea that the central bank can set the interest rate at any level it wants without regard for the central bank money supply.

There is no government budget constraint with money in any standard New Keynesian model. Gali’s (2008) cookbook distillation of the NK Woodford world uses money in the utility function in his lead-in chapter about why we do not want money in the model. His model’s equilibrium conditions are flawed by the fact that there is money in the economy, but no way in which the money enters the economy since there is no government budget constraint in which government expenditure is financed in part by printing money (buying Treasury debt). Gali justifies leaving money out by using an incomplete model in which the log utility specification gives money no role in the economy except to affect utility. There is no inflation tax in Gali or ANY NK model.

Laubach and Williams (2003) and their international follow-up with Holston is supposed to measure some constant that they call the natural rate of interest using the Gali 3-equation model. They estimate the Phillips curve there by very carefully picking a data period in which the inflation – output-growth relation is positive. They do this by including the 1960-1969 Phillips curve era of the Vietnam wartime build-up in which government spending and money printing were so high as to break down the Bretton Woods gold standard. Naturally in war inflation and output growth move together positively. In fact, and despite the sharply documented monetary phenomenon of that War, a Review of Economic Dynamics article explains the Vietnam War inflation as a long monopoly mark-up shock and like Woodford, Gali and Laubach and Williams omits money from the model.

We know that money supply printing through the Fed buying Treasury debt during war, pandemics, or as in every crisis in every country historically typically causes inflation. For example, see the nice article in the 2023 STL Fed Review by Kevin L. Kliesen and David C. Wheelock “The COVID-19 Pandemic and Inflation: Lessons from Major US Wars.” All NK models from Woodford to Gali to Laubach and Williams leave out money and the inflation tax used to finance government expenditure. That is a fact and that is why NK people do not like to use the cash-in-advance (CIA) economy in which inflation is always a tax. In a CIA economy, by adding exchange credit to avoid the tax, you get a downward sloping money demand per unit of consumption and a realistic view in the model about how inflation effects the economy negatively. Add in endogenous growth and the inflation tax lowers the output growth rate, which was emphasized by the originator of the NK 3-equation model, in Kenneth N. Kuttner’s Estimating potential output as a latent variable (JBES 12:361-368, 1994). The same year Kuttner also produced in Sbordone & Kuttner, 1994, “Does inflation reduce productivity?, Chicago Fed Economic Perspective, about how inflation and productivity move opposite of each other in both trend and cycle. And we know well that productivity is very procyclic and the very definition of the business cycle through Ed Prescott and Fynn Kydland’s ever-lasting work on real business cycles that has yet to be overturned in any way. Here is the 1994 graph:

Inflation therefore moves opposite of output growth in the work of the founder of the NK 3-equation model, all the way back in 1994, although there may have been earlier such contributions of which I am unaware.

The Laubach and Williams natural rate is a fantasy of an econometric estimation of a Phillips curve that existed because inflation results from money printing during wars. Phillips curves also exist after financial deregulation, which I call a bounce-back Phillips, and during every recession almost without fail. These Recession Phillips curves are of course Irving Fisher’s debt-deflation curves that show how when private bank money contracts during recessions as investments and loans drop, the inflation rate is pressured downwards. While the wartime or Covid build-up Phillips curves are caused by government money printing, the recession Phillips are caused by private bank money relative contraction.

During these business cycles the “natural” real rate of interest rises and falls. If the central bank did not intervene in markets at all, in Wicksellian terms, you would see the real rate of interest almost always being above zero and fluctuating up with expansions and down with contractions. Mind you the real rate was positive 10% during the Great Depression, which those advocating zero market interest rates seem to ignore, from Keynes onwards.

Now we live in a world where the Fed as in Woodford actually sets the market interest rate by diktat regardless of the money supply growth rate. They have made the surreal world of Taylor’s rule of the NK fiction in which monetary policy is setting the interest rate come true: Stranger than fiction but the Fiction becomes the absurd fantasia reality.

What matters is the real rate of interest that occurs naturally in capital markets over the business cycle. It is not a constant. It rises with productivity, which is why the interest rate is the marginal product of capital in our models (though NK models typically omit capital as in Laubach and Williams). This real world is the world of Ed and Fynn in which we actually labor.

The Fed now must decide how to set interest rates and that is what we call monetary policy. Wicksell called monetary policy how you set the government money supply growth rate. So do the Cash-In-Advance monetary models. So does anyone without a vested interest in the fictional world of the NK industry in which there exists zero money and inflation ALWAYS is from a monopoly mark-up shock. Right.

Actually monetary policy is supplying money. That is the only thing a central bank has the legal right to do. The Fed sets the Interest on Reserve Balances by violating the intent of the 2006 Financial Services Regulatory Relief Act (FSRRA) designed to pay interest only on (Woodford’s) required reserves. See Mark Guzman’s (Reading U, UK) work on the Fed paying interest on required reserves. The US moved the 2006 FSRRA’s starting date from 2011 up to 2008 during the Fed’s run on reserves in 2008, and then the Fed starting paying interest on ALL reserves instead of the intended required reserves only that was designed so as to not tax small banks by more than big banks. Well, now the big banks have hugely gained over the small banks because they get paid the interest rate of 5.2% on the $4 trillion in reserves at the Fed. The Fed turned the Congressional writers of the 2006 FSRRA on their heads and must have laughed at their own wit in increasing their power along with the transfer of seigniorage to the private banks instead of the US Treasury. This is why the Fed is running into budget problems: the interest paid on reserves.

We should lobby: STOP INTEREST ON RESERVES for a bumper sticker. Or RETURN THE INFLATION TAX TO THE TREASURY, which probably would not fit on a bumper sticker. Or: FED: SET MONEY NOT INTEREST RATES. Any of these would return the natural rate of interest to the normal one that fluctuates over the business cycle at a positive rate.

Especially, this would work if the Fed would respect the statutory law of the 1978 Full Employment and Balanced Growth Act that sets the inflation rate target legally at zero percent in 2023.

The Federal Reserve increase in interest rates to the 5.25-5.5% level in July 2023 was unnecessary and unwise. Inflation is now falling and will continue to fall. Having come in at 3% in June, the real rate of interest is now more than 2% and rising. This is after having been negative for many years.

The Federal Reserve Economic Data graph that I constructed here shows the real interest rate in black, it being equal to the market rate minus the inflation rate.

The real rate fell to a low of minus 8% in March 2022. It has been negative for 12 of the last 13 years ending in 2022, as the graph shows. Now at more than 2% and rising quickly as inflation falls, the Fed needs to stop raising rates and begin a gradual decline.

None of this control of interest rates by the Fed would be necessary if the Fed stopped paying interest on reserves. Reserves owned by private banks but held at the Fed because the Fed pays interest on reserves were $3.3 trillion in June 2023. The Fed is paying banks to not lend out money, to not intermediate savings into investment, and to decrease economic growth. Why? Supposedly for banking insurance policy. But the Fed cannot use any of these funds for any bailout since the Fed does not own them.

Stopping the payment of interest on reserves, which was authorized during the banking crisis of 2008 through the The Emergency Economic Stabilization Act (EESA) of 2008. All excess reserves had been zero (or as close as was feasibly possible) before 2008, with only about 1% of deposits held as required reserves coming into 2008. Essentially 1% of deposits held as reserves meant close to zero required reserves and zero excess reserves. The Fed was in a bind with the 2008 investment bank crisis, hit negative reserves without counting their borrowing through swaps, and instituted the policy of paying interest on reserves. This is a pure diversion of the inflation tax seigniorage from the US Treasury to private banks: a subsidy on the scale of billions of dollars that grows each time the interest rate rises and these reserves stay the same.

The bigger problem is that it disconnects the monetary policy of the Fed buying Treasury debt to finance the government spending through money supply increases from the market interest rates. The two are now set separately. The money supply does not automatically enter circulation. Part of it goes into these excess reserves held at the Fed. Therefore the interest rates are no longer market determined. The money supply entrance into markets and into inflation pressure is no longer known or determined by the Fed. What enters into circulation from reserves is determined by private banks. So the Fed money supply policy is determined in part by private banks, who get paid to keep the money sterilized but can renege on this deal at any time and lend out the reserves so that the money enters circulation.

With the Fed by diktat setting market interest rates, it is now setting them too high since inflation is falling fast.

The Wall Street Journal today reports:

“Employers added 209,000 jobs last month. The unemployment rate fell to 3.6%.”

By this criterion alone, a 3.6% employment rate, it is possible to state with certainty what the legal inflation rate target of the Federal Reserve System.

By the 1978 Full Employment and Balanced Growth Act, if the unemployment rate is below 4% then the inflation target (from 1988 onwards) is 0%.

As I have noted before, this statutory US law that states a 0% target for the Fed also states in the same statute that this inflation rate target cannot be changed by the anyone except the US President of or the US Congress.

To say the old dictum that central banks in developed economies are independent ignores history and modern politics. The central bank, and with a focus on the Federal Reserve, has always printed money at a rate dependent upon the fiscal exigencies put upon the US government during crises or during stable periods.

First note that the Fed “prints” money when the Fed buys US Treasury debt, whether directly from the Treasury or indirectly from private banks and special Treasury dealers who have bought the Treasury debt in primary or secondary markets. The Fed effectively buys all the Treasury debt in the secondary market from bankers, but they are just the middlemen.

The Bank of England in 2020 allowed the Bank to directly buy UK Treasury debt: so here the link of “printing” money to finance deficits is more direct.

An amazing graph exists that Milton Friedman did not have since FRED the Federal Reserve Bank of St. Louis database was not yet around. Graph the Treasury debt held by the Fed and the currency in circulation. They match one-for-one almost exactly from 1959 to 2008 when Fed policy was almost completely “normal”. Reserves held at the Fed fell from 5% of deposits in 1970 to 1% in 2008. Reserves per-2008 are the only difference between currency in circulation and Fed-held Treasury debt. So the fact that Fed holdings of Treasury debt and currency in circulation marched along together shows how the Fed really does “print” money by buying Treasury debt. Of this the data leaves no doubt.

Also of little doubt is that the Treasury borrows heavily when crises hit the economy, be it the Vietnam War financed by Treasury borrowing, the banking crisis of 2008, or the Covid pandemic. Equally clear is that the Fed buys a large fraction of this increased Treasury debt during crises. Surprisingly perhaps this fraction of Treasury debt that it buys typically rises during these crises when the Treasury debt as a percent of GDP is rising. This means that the Fed printing of money as normalized by GDP rises by even more than the Treasury borrowing as a percent of GDP. This is consistent with findings in the academic literature such as by Eric Leeper as to how during high deficit periods, the Fed prints more money and increases the inflation tax as it is deemed rather than raising other statutory income taxes.

The fiscal theory of the price, with a new book by that name by John Cochrane, in short says that the amount of Treasury debt influences by how much the Fed prints money by buying more Treasury debt. This is self-evident when examining any historic crisis period. The Fed typically buys at least the same share of the rising Treasury debt during crisis, and the Fed even buys a higher share than normal of the higher-than-normal Treasury debt.

Central bank independence has NEVER existed in the United States. The Fed was established in 1914 and quickly allowed gold reserves to shoot up beyond what was deemed appropriate for a stable inflation rate. The money supply under this gold standard period then shot up and WWI inflation was substantial. Michal Bordo marks 1914 as the end of the classic gold standard period that had been in effect since 1834, with the US bimetallic standard going back to 1792. During WWI, other countries’ gold flowed into the US and caused US inflation.

The Fed had been established after the 1906 banking panic ensued and the Aldrich Commission was tasked with creating a central bank that could stop such panics and therefore provide insurance against bank panics. Nothing in the Fed’s 1913 statute allowed such banking policy and the Fed today still has no such banking insurance policy in its statutes (The 1946 Full Employment Act as fully amended by the 1978 Balanced Growth and Full Employment Act).

Federal Reserve independence has no real statutory basis and does not exist in any meaningful way. The only mandate of the Fed is a zero percent inflation rate target by the 1978 Act. The Fed ignores this. During the gold standard of Bretton Woods, post-1946, the Fed also ignored the strictures of that mandate.

During the Vietnam War, the Fed bought an increasing share of Treasury debt relative to GDP, caused the price of gold to rise in markets above $35 an ounce of gold that the Fed was mandated to keep, induced the Bretton Woods countries to agree to suspend redemption of currency into gold by ordinary people, allowed redemption only by other central banks in Bretton Woods, and led to these other central banks buying up the US dollars to hold as excess reserves. This imported the US inflation into those other countries. It continued until France began cashing in US dollars for gold in 1971 and that ended the gold standard as Nixon closed the gold window at the Treasury. The Fed was not independent then.

Inflation rate targeting started in the 1978 Act was carried out by Volcker after Carter fired Miller after 11 months since inflation was still rising. Volcker succeeded in carrying out the 1983 target of 3% inflation, as stipulated in the 1978 Act (which stipulated 0% inflation from 1988 onwards). The Fed was briefly independent then.

This period of stability was ended with the terrorist attacks in 2001. Greenspan printed enough money to drive the short term market interest rates below the inflation rate for three years. Inflation steadily rose from 1% to 4% from 2002-2004, and then the Fed decided to quickly raise interest rates to “normalize” them: that is to make them higher than the inflation rate to yield a positive real interest rate. The Fed was not independent then.

The sudden unexpected increase in interest rates caused the 2008 financial collapse. Then the Fed again began printing so much money to finance the banking crisis Treasury expenditure that the Fed also began sterilizing freshly printed money by inducing banks to keep it as reserves by paying interest on reserves. This diverted the inflation tax revenue from the US Treasury (taxpayers) to private banks (a special interest group adversely affected by the bank panic). The Fed was not independent then.

In 2012 the Fed created a 2% inflation rate target in direct violation of the 1978 Act. It had printed so much money for so long with a 2% target murmured throughout central banks that the Fed did not bother to mention that this was illegal by US statutory Congressional law. The Fed was not independent then. Today, after printing so much money to finance Treasury spending during the pandemic, inflation is still high but falling. The Fed actively supported Treasury spending by increasing the inflation tax and allowing the President and Congress to avoid raising statutory taxes or to reduce spending. The Fed was not independent then or now.

There are many economic distortions when the US Federal Reserve System sets interest rates below the inflation rate at an “unnatural” level. It is not an equilibrium level since the market interest rates normally, naturally in line with the business cycle supply and demand for capital, fall below the inflation rate only rarely during pre-2008 US monetary history. In our stochastic, dynamic, general equilibrium models based on Keynes’ student Frank Ramsey, the real interest rate cannot be negative along the stationary equilibrium. Clearly twenty years of negative real interest rates, which started in 2002, are not “natural” real rates of interest that Knut Wickcell famously wrote about. Ignored in those NK theorists quoting Wicksell about the natural rate is that he clearly states that temporarily the government can drive down the market interest rate through money supply increases. Further he states this can be a “persistent liquidity” effect if the government does it for a prolonged period. This the Fed did from 2002-2004 and then decided as inflation began to rise from 1% in 2002 to 4% in 2004 that they need to start raising the Federal Funds interest rate (FFR) quickly. That they did. So quickly that the investment banks seeking the next best “safe asset” other than negatively yielding Treasury debt bought massive amounts of safe mortgage backed securities (MBS). These had been safe and probably would have continued to be safe. But then the Fed quickly raised interest rates starting in 2004-2006 in order to get a “normal” market rate above the inflation rate. With inflation rising, the Fed had to keep raising the FFR even higher.

Repeat this again in 2021. With the payment of interest on reserve balances held at the Fed (IORB) through the Fed setting the market interest rate by diktat at levels below the inflation rate since 2019, combined with massive Treasury deficits financed by increasing Fed purchase of Treasury debt during 2020-2022, the inflation rate finally took off far above the near zero IORB. Then again came the catch-up by the Fed to try to get the IORB above the inflation rate. The result was a steep sudden rise in interest rates that markets did not anticipate.

Inflation is finally coming down. The IORB has just barely crested above the inflation rate, being about equal to it now but probably soon to exceed it for a positive real interest rate for the first time since the eleven months from 2018-2019.

Many distortions have resulted from the Fed intervening in capital markets and setting interest rates separately from what the money supply growth would dictate. Normally the money would enter circulation and inflation would have begun rising well above 2% back in 2011 or so. But about $3 trillion in excess reserves stayed at the Fed as it “sterilized” their increase in the money supply by paying banks not to lend it out and instead leave it at the Fed. They are still doing this, with over $4 trillion in reserves in 2023. This disconnect between the money being created through Fed financing of Treasury deficits and the market interest rates that would exist in equilibrium if the money entered circulation as in all pre-2008 history when there were zero excess reserves at the Fed (or 1000 times less at about $1 billion on average – banks tried to keep these as close to zero as possible) has caused untold economic distortions throughout capital markets and internationally as other countries mimic US policy of negative real rates so as to not experience currency appreciation vs the US dollar.

Now it is common internationally for central banks to intervene in capital markets and set interest rates below the inflation rate. This is true in the inflation rate is 80% as it was in Turkiye, 50% in Hungary, or many variations of this. These countries set interest rates far below the inflation rate to create vastly negative real rates of return on “risk-free” government Treasury debt.

Of course this causes portfolio managers that invest in US Treasury debt or international portfolios investing in other sovereign nation debt to balance out the “safe” negative return on Treasuries with riskier higher yielding alternative investments. This makes the entire financial system more instable.

Silicon Valley Bank went from short run Treasuries to higher yielding longer term Treasuries. This was sensible, safe, investing, just moving to the next best asset that had a slightly positive yield. Just as it was after 2002-2004 to move into MBS.

Yet again, SVB and Credit Suisse were bankrupted in essence because the Fed had to quickly, suddenly chase the rapidly rising inflation by rapidly increasing the IORB interest rate that they set by diktat. This would never have happened if the Fed allowed the “natural” rate of interest to prevail in which the Fed is not intervening in capital markets. The risk the investment banks in 2008 and SVB and Credit Suisse in 2023 did not anticipate was the risk created by the ad hoc intervention policy of the Federal Reserve System.

This could be ended by ending Fed payment of interest on reserves. Then no money would be sterilized. It would enter circulation as it was printed. Interest rates would reflect this and rise with inflation and with business cycle changes in the real interest rate (fluctuations almost always above a zero rate).

The unintended consequences are that markets have no idea when the money that has been sterilized as reserves will actually enter circulation and cause inflation. Then markets have no idea what the Fed will do once inflation starts up again. All of this Federal Reserve created risk could be eliminated: Stop the payment of interest on reserves.

The Fed likes IORB policy because first, inflation can be suppressed through reserves held at the Fed. Second, the Fed gets to pay the interest to the largest most powerful private banks holding most of the reserves rather than to the US Treasury as required under Federal Reserve mandates. This earns the Fed a lot of gratitude from the finance industry. Third, the Federal Reserve officials become ultimately powerful by dictating interest rates rather than letting markets do that job.

Since the banking industry lobbies the Fed, and the Treasury and Fed officials go through the revolving door often to the finance industry, the Federal Reserve officials benefit from this unprecedented upsurge in discretionary policy. They are not bad people, but they are doing bad policy and gaining fame in the process (even Nobel prizes). George Stigler also won the Nobel prize; his was partly for the Economics of Regulation in which those in government doing the regulation over private industry create benefits for the private industry that they are regulating, since it also yields benefits to them personally.

Try reading my book The Spectre of Price Inflation, Columbia U. Press in the US, for more policy analysis.

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.

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:// ffb.treasury.gov) 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.

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).

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.

Here are five books recommended for understanding

central bank insurance policy for the private bank sector, on Shepard.com:

https://shepherd.com/best-books/walter-bagehots-challenge