Feb 25, 2023
Welcome to episode 141 of Activist #MMT. Today's part two of my three-part conversation with Scott Fullwiler, on his 2008 paper, Modern Central Bank Operations: The General Principles. Last time in part one, we discussed some generic but related topics, and then principles one and two. Today in part two, we discuss principles three to six. Next time in part three, we discuss seven through ten. My full and detailed question and summary list can be found in the show notes to part one. Also, be sure to check out the list of audio chapters at the bottom of today's show notes, to find precisely where each principle, and otherwise, can be found.
(A list of the audio chapters in today's episode can be found at the bottom of this post.)
Principal three is that, outside of a floor system, it's not possible for the central bank to target the quantity of reserves. This is for two reasons: first, as in principle one, banks need reserves to settle payments and meet reserve requirements. Both of these are rigid needs. They need exactly that amount, no more no less. In other words, banks' demand for reserves is always vertical. Any less, and the payment system, and consequently society, breaks down. Any more and the reserves sit around unused. (The excess may earn a bit of interest, but, outside of a Volcker shock, where rates are set up around 20%, it's not much.) This means the amount of reserves in the system is determined by commercial banks (that is, it's endogenous) not the central-bank (which would be exogenous).
The other reason the central bank can't set the quantity of reserves (outside a floor system), is because many transactions occur that are outside the central bank's control. A few examples are government spending and taxation (both of which the central bank must do), and calendar factors such as more cash being desired by the public as each weekend and vacation day approaches.
Related is principle four, which is that all of these extra transactions must be offset. This is required if banks' demands for reserves is to be met, which is required to manage the payment system, which is required to have a stable society. Specifically, these extra transactions result in reserves entering and leaving the system in an uncontrollable and volatile fashion, making it less likely that banks' needs will be met. Therefore, the central bank must buy and sell bonds in order to keep reserve levels sufficient.
Principal five is that reserve requirements are not for controlling reserve aggregates (which as in the previous principal, isn't possible anyway), but rather are an additional tool for reducing interest rate volatility. Although nothing changes what the central bank has to do, correctly designed reserve requirements allow the actions to occur at a more measured pace. They also provide some foresight and notification before some actions become urgent.
(Think of it in terms of the tickets and doors at a sports stadium. Everyone with a ticket needs to get inside before the game starts and outside after it ends. The doors and the tickets make it such that the crowd enters and exits in a controlled fashion, distributed over time.)
Finally, principle six is that volatility in the target rate can only exist within the central bank's corridor, meaning interest on reserves at the minimum and the discount window's penalty rate at a maximum. The decision to not regulate, or not enforce existing regulations, is just another form of regulation. When there is no deliberate floor or ceiling, as is our current reality, it means the highs will be dangerously high and lows dangerously low.
In the same way, Minsky's financial instability hypothesis is only true within the ceiling and floor set by governments. We could set a rigid floor and ceiling such as with a job guarantee, but then, as Kalecki says in his 1942 paper, Political Aspects of Full Employment, if the government governs, then the rich and their feelings can't. This is why the rich pay our legislators to not legislate, especially when it comes to employment.
Principals seven through ten come in part three, but for now, let's get right back to my conversation with Scott Fullwiler. Enjoy.
Audio chapters
- 6:07 - Relation between fractional reserve banking and money multiplier
- 9:10 - Principle 3: Outside a floor system, it's impossible for the central bank to target the quantity of reserves.
- 15:12 - Another comment regarding the Fed being in charge of the government (not)
- 15:54 - Principle 4: The CB must offset many things out of its control, and government spending is mind-twisting!
- 28:21 - Principle 5: Unless using a floor system, it's impossible for the CB to control the amount of reserves. It can only control the price of those reserves (the interest rate). Also, reserve requirements (and TT&L accounts) are to BUFFER.
- 34:51 - Using the target rate to manage inflation is a terrible thing to do (it has real-world consequences) but does not limit the ability of the central bank to manage the stability of the payment system.
- 38:28 - Liar, Liar reference
- 39:18 - Principle 6: How does the CB defend a precise target, as opposed to only ensuring it's remains within the corridor?
- 48:38 - What if the penalty rate was intentionally set below interest on reserves (IOR)?
- 52:16 - It would mean they could buy reserves for low interest (penalty rate) and then earn high interest for holding it (IOR)
- 54:33 - Principle 7: There is no "liquidity effect" associated with central bank changes to its operating target. (Apologies for the very long question! I got it wrong at first, and scrambled to rewrite it at the last minute.)
- 58:36 - Duplicate of introduction, with no background music (for those with sensitive ears)