All Your Base Are Belong To Us: What Is the Question? by Krugman

My questions involve whether interest on excess reserves changes any of the fundamentals of monetary policy and its relationship to the budget. That is, does IOER change the fact that the Federal Reserve has great power over aggregate demand except when market interest rates are near zero, and the related fact that when we’re not in a liquidity trap there is an important distinction between debt-financed and money-financed deficits?

Reading Izabella Kaminska with Krugman's focus in mind:

For the record, FT Alphaville has long argued that IOER’s role as a sterilisation tool is under appreciated. (This, by the way, is why we believe it’s naive to argue that ECB liquidity operations are somehow less inflationary than Fed operations. Both are in reality sterilized.) 

It’s the icing that entices banks to hold excess liquidity rather than chasing secured loans or safe assets. This is needed to compress rates during a crisis — that is, to bolster secured (collateralised) rates so that they don’t plunge below zero and therefore distance themselves from positive, near-zero unsecured rates. 

This is important because banks that are frozen out of the unsecured market depend almost entirely on private collateralised markets for funding. 

If a bank can’t borrow unsecured for less than 5 per cent even when official rates are at zero, it has three options: 1) seek emergency funds (with the associated stigma) at a punitive rate from the Fed, 2) pawn its liquid collateral at the going repo rate, or 3) in the event it doesn’t have good enough collateral, either borrow the correct collateral from the Fed or (as happened in 2008) exchange poor quality collateral for better collateral via an emergency programme.
But the problem that really struck markets in 2008 wasn’t one of insufficient liquidity. Rather, it was the problem of collateral market bifurcation. 

Banks which previously had adequate amounts of collateral for use in repo markets suddenly found their collateral unusable. This led to genuine liquidity shortfalls in some quarters, which propagated fear in the unsecured funding markets, which subsequently froze the entire market.
Banks with plenty of liquidity, on the other hand — scared of lending to potentially insolvent banks — turned entirely to secured markets instead. But here they were presented with a different problem. There were suddenly not enough safe assets to lend against, at least not at rates comparable to or better than the Fed Funds rate. 

As healthy banks began to crowd each other out for any chance to lend against a diminished pool of safe assets, and/or just opted to keep excess reserves at the Fed for zero, repo rates understandably began to tank well below target. 

The following chart from the New York Fed illustrates the story well:

[graph] 

In short, the problem wasn’t insufficient liquidity, per se. It was too much liquidity in some quarters and not enough in others. 

The challenge for the Fed was how to equalise the distribution of liquidity in the system, without putting further pressure on an already stressed-out repo market, on the verge of taking the “risk-free” funding rate negative. 

Offering interest on excess reserves was seen as an effective solution. Not only would IOER ensure that all banks holding excess liquidity could now benefit from a stable and positive rate — thus suspending the panicky capital destruction process — it would allow the Fed to continue adding liquidity until all shortfalls were covered, and more importantly all fear of potential shortfalls was removed from the market. 

In short, IOER was the key factor that compressed the spread between the risk-free and risky rate. But not because the risky rate was being suppressed. Rather, because the risk-free rate was being propped up with the IOER floor. 

Going back to Waldman’s argument, it’s at this point that “base money” became fully substitutable with short-term US debt. But, we would add, interest-bearing reserves even became preferable in some cases. 

Nevertheless, the entire debate really relates to liquidity preferences. 

The way we would put it is that IOER skewed the usual preferences in play. It’s the key reason why the proportion of reserves to currency in “base money” suddenly skyrocketed. The situation would undoubtedly reverse quickly if IOER was ever to drop to zero (or negative territory), since an opportunity cost would immediately be associated with holding reserves over zero-yielding currency. 

In fact, we would go one step further and argue that IOER was the key factor that stopped private rates turning negative, and in so doing suspended a process that could otherwise have led to a money market fund breaking the buck or even stacks of physical banknotes being hoarded and vaulted all over the United States. 

In this way, we agree with Waldman that the moment IOER created a preference for excess reserves over short-term debt assets or cash, was the moment excess reserves became a new type of safe asset security in their own right. 

Excess reserves became the equivalent of state debt. But, very importantly, a state debt taken with the intention of never being spent, but rather for the purpose of creating safe assets instead.

 On the exit strategy:

But there are other problems associated with unwinding such a huge position on the market, too. Especially if you view this as tantamount to either “spending” the money borrowed, or paying it off. 

Consequently Waldman’s argument is essentially: why bother if you don’t have to? Let the excess reserves, just like state debt, roll on:

Why go to the trouble of unwinding the existing surfeit of base money, which might be disruptive, when doing so solves no pressing problem? 

And since not moving quickly enough poses too great a risk, the alternative would be committing to IOER as a long-term rate-steering alternative instead. 

As Waldman sums up:

If the Fed adopts the floor system permanently, then the Fed will always “sterilize” the impact of a perpetual excess of base money by paying its target interest rate on reserves. As Krugman says, this prevents reserves from being equivalent to currency and amounts to a form of government borrowing. So, we agree: under the floor system, there is little difference between base money and short-term debt, at any targeted interest rate! Printing money and issuing debt are distinct only when there is an opportunity cost to holding base money rather than debt. If Krugman wants to define the existence of such a cost as “non-liquidity trap conditions”, fine. 

But, if that’s the definition, I expect we’ll be in liquidity trap conditions for a very long time! By Krugman’s definition, a floor system is an eternal liquidity trap. 

Krugman, for now, remains unconvinced. 

Waldman has opted for the cunning use of apple analogies in one final attempt to explain. But we think we’ll leave it here.

Krugman's point is that the Fed's sterilization amounts to a form of government borrowing. And in non-liqudity trap conditions there's is a limit on borrowing. He seems to be arguing against the MMT position while Kamiska and Waldman are predicting we'll be in a liquidity trap for a long time.