Flying Blind:
How The Fed Lost Control, and How to Regain It
By John Atlee, 4/18/01

Fed Chairman Greenspan's peerless reputation as money manager is now being sorely tested by the present "growth recession" and stock market crash. But his problem isn't so much in his personal judgment and timing as in the traditional institutional and conceptual framework -- as he humbly acknowledged in remarks last October 19th to the Cato Institute:

" is essential that we not be deluded into believing that we have somehow discovered the Rosetta stone of monetary policy...
...what specifically constitutes money is a notion that has, so far, eluded our analysis."

The problem has three main aspects --

What is Money and How Does It Work?

We need to think of money as the economy's pseudo-physical inventory stock of what we actually pay bills and buy things with: checking accounts and currency (bills and coins). This is the money-flow version of the role played by real physical inventories between incoming shipments and outgoing sales. It's best illustrated now by what the Fed now calls M1.

Greenspan's money confusion was caused originally by the medieval goldsmiths' clever "credit creation" scam of lending out far more negotiable "deposit receipts" than the amount of gold coins actually deposited in their vaults, thus linking money creation with the granting of credit.

Current monetary theory and policy says that the Fed stimulates economic growth by reducing interest rates. But it's the accompanying money growth that actually finances economic growth -- by a very different mechanism.

Understanding the real transmission mechanism between money growth and economic growth, requires a conceptual and empirical definition of money that clearly distinguishes money from credit -- as in a 100% reserve version of the pre-1980 (non-interest-bearing) M1.

Our present Checking Account Money, like the goldsmiths,' is created in the banking system ("out of thin air," as they say) by an accounting sleight-of-hand in the process of making loans. However, in the U.S., the amount of this money that banks can create is theoretically limited by the requirement that they maintain a Reserve Money balance -- in their own accounts at the Fed (or in vault cash) -- equal to 10% of their depositors' checkable balances.

Thus, to increase the economy's money supply, the Fed must create additional Reserve Money and inject it into the banking system by buying Treasury securities. This allows the banks to make more loans with newly-created Checking-Account Money. (It is this dual effect that gives rise to the analytically ambiguous concept of "credit creation.")

The additional supply of credit tends to reduce interest rates -- which tends to stimulte the economy mainly by leaving debtor households and business with more to spend on other things. (In a recession environment, the debtors' spending increase will tend to exceed the concurrent spending reduction of those who receive most of the interest income.)

But it is the money growth that most directly finances the growth of Gross Domestic Product (GDP) -- by providing an additional ("exogenous") source of purchasing power that did not come from anyone else's prior income or saving. Moreover, bank-created New Money also has a powerful "Multiplier Effect." When it is first spent, it increases GDP by the total amount of that credit-financed spending. Then, as it continues to circulate around the economy, each additional transaction increases GDP again by almost the amount spent -- until all the New Money becomes absorbed into the economy's increased Money-Inventory at the New Money-financed higher level of GDP. (This process is similar to the way new Reserve Money is multiplied as it increases Checking Account Money.)

This process can also be expressed in traditional economic supply-demand terms: GDP increases as long as the supply of New Money (M1) exceeds the economy's growing demand for Money-Inventory, as indicated by the Money Demand Ratio (MDR = M1/GDP). This relationship is most succinctly expressed in the Money-GDP Growth Formula (gr = growth rate):

GDPgr = M1gr - MDRgr

The Key Importance of Reserve Requirements

The amount of additional GDP financed by each additional dollar of New Money is called the Money-GDP Multiplier. Its empirical value is equal to the reciprocal of the MDR. For instance, in the 4th quarter of 2000, M1 was about $1.1 trillion, GDP almost $10 trillion, for an MDR of 11%. Thus, each dollar of New Money could theoretically finance about $9 of additional GDP. This 9 to 1 leverage could probably be effectively managed by the Fed. But the Fed's actual effective leverage via present bank reserves is now an incredible 1400 to 1 -- far beyond effective control. This inappropriate condition is due to several factors:

  1. The Fed has been gradually reducing the legal reserve requirement -- from the pre-1958  20% (for the biggest banks) to 10% in 1992.

  2. Since 1994 the Fed has permitted banks to "sweep" (reclassify) checking accounts into savings accounts overnight to reduce required reserves.

  3. Over 80% of the banks' present $40 billion total reserves is actually part of their normal working inventory of vault cash, which they would maintain regardless of the reserve requirement, so that most banks are effectively "unbound" by the Fed's reserve control.

  4. As a result, bank reserve balances at the Fed -- the only reserves the Fed actually controls by its open market operations -- are now only about $7 billion. That's a miniscule 1.3% of checking accounts (not the official 10%), resulting in the following extreme leverages:

    That kind of leverage is like trying to use a 20-foot spoon to put peas in a bottle.

No wonder Greenspan now largely ignores the key relationship between bank reserve deposits and M1, and tries to manage economic growth indirectly, through interest rates. But the relationship between interest rates and economic growth is neither precise nor immediate, either conceptually or empirically.

Therefore, Greenspan is forced to rely mainly on his own judgment ("flying blind, by the seat of his pants," as the old pilots used to say), based on a vast array of economic data that is often difficult to integrate and interpret. But however good his judgment, reliance on one man's personal judgmental management isn't scientific, democratic or safe, and his successor may well lack his skill.

For the Fed to regain adequate control of the money supply -- and the economy -- it needs to:

  1. Restore the pre-1980 clear distinction between money and other financial assets, by again prohibiting interest payments on checkable accounts (and third-party checks drawn on money-market accounts). (That deregulation was inspired largely by the OPEC-induced inflation of the 1970s and '80s.)
  2. Sharply increase the reserve requirement on checkable accounts.
In fact, it would be quite simple now to go all the way to the ideal 100% reserves long recommended by leading economists like Irving Fisher. Total checkable deposits are now about $550 billion. Banks already have over $50 billion of reserves and excess vault cash. And ending interest payments on the $240 billion of NOW and ATS accounts that are now part of M1 would undoubtedly induce the transfer of part of these into money market accounts. So the needed additional reserves might be only about $400 billion. And since banks now hold about $800 billion in T-bonds, they could easily sell half of them to the Fed. To sweeten this reform for the banks, the Fed should pay interest on their reserves -- as the Fed and the banks have long advocated.

Targeting Stable Economic Growth

The Fed should use the basic Money-GDP Growth Formula cited above to target potential (full-employment trend) real GDP, by carefully monitoring the Money-Demand Ratio's trend growth rate, and controlling money growth accordingly -- by precise control of bank reserves. Monitoring the MDR trend requires just as skillful economic analysis as Greenspan's current policy. But the Money-Growth Formula approach is more precise, credible and "transparent" (understandable), and would tend to increase business confidence.

The Need for Systematic Coordination of Monetary and Fiscal Policy

As noted earlier, in our present credit-money system, the money supply grows primarily through bank lending. But in a severe depression (like the 1930s, and now in Japan) the private demand for credit (and bank ability to find credit-worthy borrowers) falls so low that interest rates approach zero. Trying to increase the money supply then is "like pushing on a string." In this situation, the government needs to "prime the pump" by increasing its own borrowing to finance additional spending or tax reduction.

But why wait until the economy stalls and interest rates fall to zero? Forty years, ago the prestigious "Report of the Commission on Money and Credit" suggested that the best policy tool for actually stabilizing an economy would be a formula-controlled adjustment of withholding taxes. Today, the Treasury could send out a monthly or quarterly fax or e-mail to all computerized payroll offices with the amount of the needed adjustment.

The original proposal foundered on the needed formula -- unemployment and inflation sometimes give conflicting signals. But real interest rates, which indicate the balance between the economy's total supply and demand for credit, would be an ideal basis for such a formula -- above historically-normal rates call for less federal borrowing; below normal rates call for more federal borrowing. Thus, the Fed manages economic growth by the Money Growth Formula, and fiscal policy manages the other side of the financial system by balancing the total supply and demand for credit, at stable low interest rates.

If this kind of systematic coordination of monetary and fiscal policy were adopted worldwide, it might be possible to finally eliminate the worldwide financial crises that are basically triggered by inappropriate and uncoordinated monetary and fiscal policies. Moreover, now that the U.S. is the world's largest debtor, lower interest rates worldwide would seem to be in our own national interest.

For more on the dynamic money-flow perspective underlying this proposal, see "The Conceptual and Analytical Framework for Macroeconomic Science and Policy" on the IEA web site.

Posted: March 19, 2001
Last revised: October 12, 2010
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