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.

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.

 

 

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%.

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

Below is Section 2 of this article:

“US Law on the Target Inflation Rate”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(https://fred.stlouisfed.org/series/UNRATENSA)

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

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

The Wall Street Journal: Letter

“Fed Should Slowly Unwind Excess Reserves”

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

4 Comments

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

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

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

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

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

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

Profs. Max Gillman and David C. Rose

University of Missouri-St. Louis

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

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

Max Gillman just now

@Thomas Gordon @Max Gillman

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

By MAX GILLMAN and DAVID C. ROSE

April 2017

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

St. Louis Post-Dispatch

stltoday.com

St. Louis Post-Dispatch Column

Is the House blueprint for tax reform good for St. Louis?

• By Max Gillman and David C. Rose
• Mar 8, 2017

President Donald Trump recently stated that he will release an outline for comprehensive tax reform in the coming weeks, and if his previous statements are accurate, his eventual plan will likely look substantially similar to the House Ways and Means Committee’s blueprint for tax reform. It is not too early to ask if the other parts of the plan are generally good for the country and St. Louis.

The blueprint plan reduces both personal income tax rates and the corporate profits tax rates. It also simplifies a number of elements of the tax code. Current rates are high enough to reward avoidance behavior for both individuals and firms. This reduces the effective base upon which the rate is applied and suggests that a reduction in rates might actually increase tax revenues.

Modern models of the economy show that the lower rates are on personal income and corporate profits, and the closer these rates are to being equal on average, the better for economic growth. These models also show that the flatter both rates are, the better. The House blueprint plan moves in the right direction on each of these fronts.

Through most of the 20th century, the U.S. was the manufacturing juggernaut of the world. As a competitor to U.S. firms and workers, China, which is today an industrial giant, was completely out of the picture. This was also true for many countries in Eastern Europe. But all of that has changed. Whereas the U.S. federal tax rate is 35 percent, the European Union and world averages are both about 22.5 percent, and Russia’s rate is 20 percent. Higher rates relative to the rest of the world drive firms out of the U.S. so they can enjoy lower tax bills.

Our firms and workers must now compete with firms and workers from not only China and Eastern Europe, but increasingly with South Korea and Southeast Asia. Even in Northern European countries like Ireland, with its 12.5 percent corporate tax rate, the competition is heating up.

The St. Louis region has been hit hard in recent years by this foreign competition, particularly in manufacturing. Unfortunately, the harm caused by this trend does not fall equally. Those hurt the most are honest, hardworking, unskilled workers who could have earned a good living in manufacturing employment.

These changes have hit St. Louis especially hard because manufacturing has historically been such an important foundation for our regional economy. It follows that increasing the net rate of return on capital investment as well as relaxing and streamlining capital deduction rules will help the St. Louis region more than many other regions since the St. Louis region has been faltering because of the lack of manufacturing jobs.

Still, St. Louis has many natural advantages. Being centrally located and serving as a rail and interstate hub, it is cheap to bring unrefined resources in and cheap to ship them out. Fresh water is a very important resource, and we have it in great abundance. Strong education produces a good workforce even among unskilled workers. Remove the corporate profit tax impediment and St. Louis’ natural advantages will likely reassert themselves.

Additionally, in the U.S., politicians have been using corporate tax policy as a political game. The higher the average effective rate, the more valuable are tax loopholes. This makes it easier for politicians to buy votes from corporations in return for loopholes. The result is a system with high rates and low yield in part because it is riddled with loopholes that reward the politically savvy at the expense of everyone else.

These loopholes are not just unfair to the rest of us. They also distort investment decisions. The richest firms are able to pay the most to get loopholes that are favorable to them, so high rates plus lots of complexity that hides loopholes is a good example of how the rich get richer at the expense of everyone else.

The House blueprint brings down the top and average effective rates significantly but, even more importantly, it closes many of these loopholes. This is fairer and better for general economic growth, and we think the St. Louis region stands to benefit.

Max Gillman is a professor of economic history and David C. Rose is a professor of economics, both at the University of Missouri-St. Louis.

With the December 2017 quarter of a percent hike in the Federal Reserve Bank interest rate to 1.5%, banks will receive 1.5% interest on reserves parked at the Fed instead of lending them out. Lending them out means added investment. Lending out the excess reserves means increased demand deposits at private banks. And increased demand deposits means more money supply as measured by the M1 aggregate of currency in circulation plus demand deposits.

With $2.1 Trillion in excess reserves now parked at the Fed, private banks on an annual basis will earn (0.015)($2.1 Trillion) or $31.6 Billion dollars. Fed minutes apparently show this 31.6 going to only 10 banks. That is $3.16 Billion being paid per bank on average by the Fed, outside of the Congressional Budget process.

Why? Interest on excess reserves (IOER by its acronym) was begun by the Fed in October 2008 at the height of the financial crisis. At first substantial interest was paid for excess reserves. (See Federal Reserve Data at https://fred.stlouisfed.org/series/IOER ). Once the liquidity crisis passed, the Fed kept paying such interest and excess reserves, which are those reserves greater than what banks are required to hold, began piling up. They reached $2.6 Trillion and now are finally starting downwards, standing at $2.1 Trillion. In contrast, required reserves are the 10% of demand deposits that are held as reserves at the Fed (Dodd-Frank 2010 legislation changed some reserve requirements, but this is irrelevant here).

When the Fed buys Treasury debt, the money multiplier occurs as this creates excess reserves that are lent out until only the required reserves are held. But the Fed has induced “moral hazard” by paying banks not to lend out reserves. This increases the probability of the bad state, which is too low of an investment level, even after the crisis has passed. So the money multiplier is suppressed. Excess reserves earn interest instead of loans by banks and investment by firms earning market interest rates.

By raising the “interest rate” in December, the Fed is not raising the Federal Funds rate. It is raising the interest rate on excess reserves: the IOER. The Federal funds market is basically defunct since it is used by banks to borrow from other banks in order to meet their weekly required reserve level. Now reserves are in excess.

If all of the excess reserves are lent out now, inflation will increase above the Fed’s 2% target. So the Fed does not advertise the off-the-federal-budget expenditure that it makes exclusively to the private bank sector. The Fed has become a drug addict: it keeps raising the opioid amount that banks receive every time it increases interest rates. Private banks are happy. The Fed is happy since its inflation target of 2% has not been exceeded nor is its ability to meet its target seriously threatened (generally meaning that the inflation rate is 2% or less). Ironically the Fed has not been able to understand why inflation had been low, below 2%, for so long. It is because they have paid banks not to lend out money, which the Fed knows of course.

The Catch 22 is that if the Fed stops paying IOER, the excess reserves will get lent out and the inflation target gets a miss. Too bad. An immediate ceasing of the subsidization of the bank sector should begin as soon as possible. Jerome Powell knows of this, but has he either the moral fiber, a consensus over the issue, and/or the courage to stop it, by himself? Probably not.

Yes the inflation rate would jump, but not for so long. Then interest rates could be truly normalized, with a normal positive real interest rate. This means the short term Treasury Bill rates rise above the inflation rate.

Why was interest on reserves begun? Long story. Economists argued that if we “tax” banks by making them hold reserves at the Fed, then we should decrease that tax by paying interest on the REQUIRED reserves. Even this would be a subsidy. Why? Because banks would hold say 7% of reserves anyway. So the tax is only on the 3% extra amount of reserves held when 10% of deposits are held as reserves. But the Congress passed a 2006 law (Financial Services Regulatory Relief Act) allowing the Fed to pay interest on reserves, starting in 2011. Here the intent was to pay interest on required reserves, as consistent with the academic debate on whether this was a good idea or not. Interest paid on excess reserves was not part of this debate (although some might debate this). Of course banks favored this interest on required reserves. It is still a subsidy to banks since they would have held some zero- interest earning reserves anyway as a natural part of running a financial institution. Crisis hit in 2008 and the law was allowed to start in 2008.

Most insidiously of all, the Fed allowed interest to be paid on all reserves, not just required reserves. This began the Fed’s complete control over the Federal Funds market. In order to avoid appreciating against the US dollar, major trading partner countries followed the US and increased their money supply in order to create a persistent liquidity that suppressed short term interest rates, while inflation was above these rates. This achieves negative real interest rates, matching the US and avoiding currency appreciation.

Here a study of the Swiss National Bank actions is recommended (at first they appreciated and then started printing money and buying anything they could, now owning a substantial share of the Swiss private sector: because they had little government debt to buy).

Going Cold Turkey on IOER, and setting it to zero, is the easiest way out of the Fed’s morass, its quagmire, its “illegal” subsidization of the private bank sector. Sure. Pay interest on REQUIRED reserves, but not on excess reserves. That policy, paying IOER, causes moral hazard. The increase in the probability of the low investment “state” of the economy has caused the Lost Decade that the US is finally exiting. Let it exit it completely and stop the Fed’s direct revenue subsidization of the “Lucky 10” private banks who get the IOER. $31 Billion is a lot of money to any private company, especially free money from the US government.

UMSL Economics Research Associate Tamas Csafabi (Cardiff PhD, 2016) has started  a new STL Macro Dynamics Club.

Click on this weblink to learn about and join the club http://stlmacroclub.com/markdown/.

For more information please contact Tamas directly at csabafit@umsl.edu.