Wednesday, August 27, 2014

IOR caused the recession!

Apparently saying something nice about the Fed last week stepped over some bright line somewhere.
Lois Woodhill, writing at, wrote one of the most unintentionally hilarious rebukes here.

Source: Louis Woodhill at

The above chart
...shows what happened the last time the Fed raised the IOR rate [to 0.25%] (remember, it was zero for 95 years). 
The plunge in velocity overwhelmed the Fed’s frantic money creation during the period immediately after it started paying IOR.  NGDP tanked, taking RGDP and employment with it. 
Look, something caused the economic collapse of 2008-2009.  Given the evidence, IOR looks a lot like a man caught at a murder scene with a smoking gun in his hand.
Interesting.  Interest on reserves caused the recession!

Well, well. For 6 years now, we've been debating the cause of the recession and financial crisis. Was it "global imbalances," "savings gluts," Fannie and Freddie and the CRA, "deregulated" finance, "Wall Street greed," too big to fail guarantees, predictable engineering around bad regulation, housing bubbles, and on and on. Was the recession going to happen anyway, caused by credit supply disruptions, caused by a flight to quality in a systemic run, a technology shock or what... Thank you Mr. Woodhill, we've finally found the smoking gun -- 25 bp of interest on reserves!

No, this does not appear to be a joke.  It certainly gets the correlation vs. causation gold star for the week.

I'm still in "say something nice'' mode, so there are quite a few sensible things in Woodhill's column:
Given that the Fed stands ready to serve as the “lender of last resort,” it is capital, not reserves, that determines a bank’s ability to weather a financial crisis.
JC: Yes, and I think I'm pretty vocal on the extreme end of the narrow deposit-taking, 100% capital investment banking fringe. (I've plugged my papers enough on the blog already, so won't do so again.)
The Fed’s most important job—and one that only it can do—is to provide the U.S. economy (and the world) with a stable dollar.  
JC: Indeed on the former, and not so sure on the "can do" part even there.

I think our confusion stems from the fact that I stuffed an entire narrow deposit-backing / equity financed banking proposal into one sentence: "Banks holding lots of reserves don’t go under." Oh well, opeds are short.

And to be sure, there are plenty of thoughtful reasons to disagree with my analysis. And there are plenty of other areas to remain critical about Fed policy. I remain dubious of "macroprudential" policy and whether monetary policy can do anything at all about long-term labor-force participation -- people who aren't working and aren't even looking for work.


  1. Market Monetarists think we would be in full employment by now if not for IOR, so the guy is not far out there.

  2. This isn't a correlation/causation error, it's "post hoc ergo propter hoc". The plunge happened after the institution of IOR, therefore IOR was the cause of the plunge.

    Nevertheless, I think he brings up a valid concern that the Fed could end up being forced to raise IOR to keep the genie in the bottle when short-term rates start to rise. You mentioned this consequence yourself in the 8/28 post.

    IOR is just one more way the Fed has painted itself into a corner.

  3. I think was a case for lowering IOR...maybe incrementally to see results...I thought the cause of the Great Recession was Fed tightening in a weak economy blessed with poorly underwritten leverage...BTW, Milton Friedman blamed three recessions on overly tight money: the Great Depression, the 1957-58 recession in the United States and Japan post 1992.

    Today, to say "tight money caused a recession" is not PC.


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