A few weeks ago I wrote about how the FED is vacuuming up liquidity by making interest payments on US commercial bank excess reserves deposited at the Fed. In that post, I noted that so long as the Fed vacuums up the excess liquidity created when they buy up additional debt (gubmnt and otherwise), I can understand why and how there will be little actual monetization of the debt and only minor inflationary pressure. [It took me too long to grasp this, if it's correct.]
But by doing so, the Fed is also probably slowing economic recovery (to the extent that demand-side restrictions or reductions are playing a role in slowing the recovery from the current supply-side Covid shock).
From the Boston Globe:
Americans are finally saving more money — at exactly the wrong time: In an economy built on conspicuous consumption, Americans never seemed to save enough. But in an economy decimated by coronavirus closures, we might be saving too much.
The pandemic has upended consumer habits, with fewer people eating out and traveling and others building a financial cushion. Economists have long worried about Americans carrying too much debt, but ironically the sudden embrace of savings comes at a time when the economy needs consumers to spend more. A prolonged period of parsimony is hampering the recovery and threatening industries that had thrived on our free-spending ways.
In a classical economy, if people try to save more (and save it with financial institutions) those savings become available for others to borrow and spend, and the insane, so-called "paradox of thrift" never materializes. People save, and consumption spending falls; but roughly at the same time, people borrow and business, consumption, and investment spending rise by roughly the same amount. The composition of aggregate demand changes (and the resulting adjustments require time, meaning there are short-term dislocations with unemployment and other losses). However these dislocations cause nothing like what the old-time Keynesian "underconsumptionists" worry about. The underconsumptionists apparently are still extant and having influence on far too much biz writing and economic policy punditry.
Nowadays, though, there's a new problem. When people consume less and save more, the increased savings still tend to end up in financial institutions. But now, because the financial institutions can earn interest income on their reserves deposited at the Fed, they have a remarkably reduced incentive to create new loans and new money based on their excess reserves when the interest rates they can earn from the Fed compete effectively with the risk-adjusted rates they can receive on loans they grant.
Instead, the gubmnt increases its deficit and the increased debt isn't monetized. The result is that there is only a minimal, if any, impact on aggregate demand.
The problem here isn't that consumers are spending too little on consumption. Rather, the problem is that the Fed is soaking up excess reserves and banks are not using them as a basis for creating new loans.
This reminds me of Fed policy at the beginning of the Great Depression in the early 1930s when the Fed explicitly implemented policies to "soak up" excess reserves and, as a result, made the depression disastrously worse.
Here's hoping the current Fed doesn't go that far... From that link in the previous sentence, we see that a decade ago, the St. Louis Fed understood the problem with the Great Depression. Do they fully grasp the situation now?
But the Fed is in a BIG box of trouble as things stand. Suppose they want to use monetary policy to stimulate aggregate demand a bit. To do so, they reduce the interest rate paid on commercial bank reserves, then what will happen? They have to fine tune this precisely so as not to dump billions of tonnes of liquidity onto the market. If they guess wrong, the excess liquidity will set off a frenzy of borrowing, house buying, business investment, and much more rapid inflation than most people are expecting.
- I'm not sure my analysis and warnings are correct. I'd love to learn more.
- I have no idea whether the Bank of Canada pays interest on chartered bank deposits, and my 5-minute Google search was inefficient and/or unproductive.
Finally, please tell me, reassure me, that the criticisms of the standard Keynesian presentation of the paradox of thrift hold sway in today's intro courses [unlike the Samuelsonian Keynesian nonsense they tried to indoctrinate us with when I was an undergraduate].