How to Deal with the Monetary Overhang

Let’s assume that Obama’s stimulus plan works, namely, that this year’s exorbitant budget deficit provokes an economic recovery of such magnitude that, five to ten years from now, the public debt to GDP ratio stabilizes at 65-70% (from 40% last year) without a major increase in US inflation.[1] Even then, the government will have to deal with the problem of a large monetary overhang: $700bn in excess reserves sitting ominously in the vaults and Fed accounts of commercial banks waiting to exit when the time is right.

The Fed has tried to reassure the public that it has the tools to prevent a new inflationary cycle from being created and will not hesitate to use them once fears of deflation dissipate, but many observers are skeptical.[2] One reason is that the Fed does not have enough Treasuries to absorb the huge amount of money created since October of last year. Another is that, to prevent a rapid surge in the money supply, good timing is of the essence, and the Fed has no way to guarantee that it will be ahead of the curve when it’s time to tighten.

In our opinion, all the Fed needs to nip inflationary expectations in the bud is to increase liquidity requirements up to the point where excess reserves are fully sterilized. Once this is done, the money supply can be expanded as much as needed to reactivate the economy via open market purchases or by allowing financial institutions controlled access to the rediscount window. The benefit of this approach relative to the one being pursued at present is two-fold. First, the monetary overhang would be eliminated in one stroke. Second, the Fed would get a strong grip on M1 and M2, which would increase as the Fed, not the commercial banks, sees fit. Naturally, for this strategy to work, the Fed would have to continue to pay interest on bank reserves to protect the bank’s profitability.

There is no reason why the Fed should not implement this policy right away. If it did, worries about future inflation would disappear preventing a steepening of the yield curve, which could abort an incipient recovery. The choice of legal reserves as a sterilizing mechanism is not arbitrary: just as preventing deflation required quantitative easing preventing a resurgence of inflation will require quantitative tightening.

Our friend Larry Kotlikoff has also proposed something along these lines, except in a broader and more structural context. His objective is not just to eliminate the current monetary overhang, but to reform commercial banking to protect the integrity of the payments system from the behavior of financiers towards risk.[3] We are not ready to go that far. Our main motivation is to avoid a resurgence of inflation in the US and, by extension, the rest of the world. Once it demonstrates that the risks of deflation and excessive inflation have been abated, the Fed should, in our opinion, be free to lower reserve requirements since under normal conditions some degree of traditional bank intermediation might still be optimal.

[1] These figures exclude intra-governmental debt or debt held in the Social Security Trust Fund, and are roughly consistent with the projections of the Congressional Budget Office.
[2] See, for esample, John Taylor, “The threat posed by ballooning Federal reserves.” FT, March 23, 2009, and Martin Feldstein, “Inflation is looming on America’s horizon.” FT, April 19 2009.
[3] See Laurence Kotlikoff and Edward Leamer, “A Banking System We Can Trust,” Commentary April 23, 2009. Their proposal, which they call “Limited Purpose Banking,” is an updated version of the “narrow banking” idea exposed by Irving Fisher, Frank Knight, and Henry Simmons in the first half of the last century.