Thursday, August 21, 2014

A Few Things the Fed Has Done Right

WSJ Oped, here.
As Federal Reserve officials lay the groundwork for raising interest rates, they are doing a few things right. They need a little cheering, and a bit more courage of their convictions  ...
I like the large balance sheet and market interest on reserves. I just want them to be permanent, not additional tools for Fed discretionary policy.

I'll post the whole thing in 30 days.

The Oped builds on a new paper, Monetary Policy with Interest on Reserves, and on Toward a Run-Free Financial System. In the latter, I advance the idea that the Fed and Treasury should first offer interest-paying money, and then stamp out private substitutes, just as the US first offered banknotes and then stamped out run-prone substitutes in the 19th century. Interest on reserves, a big balance sheet,  and opening reserves to all are a first step.


There are some big unknowns which I don't touch on in the oped. (That's what the cryptic last paragraph refers to.) Will the Fed really be able to control interest rates just by raising the rate on reserves? And while also controlling the size of the balance sheet? Will interest rates thus controlled have the expected effect on the economy? The first paper spends a lot of time on the latter question.

It's not so obvious the Fed can control interest rates and the balance sheet. If the Fed said, tomorrow, interest rates shall be 5%, and started paying 5% on reserves, would Treasurys, mortgages, credit cards, bank deposits, etc. all really rise 5 percentage points instantly? If you pay your nanny $50 per hour, will all nannies suddenly get $50 per hour?

If the Fed said "5%, come and get it, give us your Treasurys and we will give you 5% reserves'' it would be clearer. But then the Fed would lose control of the balance sheet, and would likely expand -- a lot -- a reversal of the usual sign for a tightening.

Now, there is an arbitrage argument that the Fed can raise rates while keeping the balance sheet unchanged: Banks try to steal each others' depositors by offering more interest on deposits. Then Treasury holders try to hold bank deposits. I read the reverse repo program as a lack of faith that banks are anywhere near that competitive any more. In the reverse repo program, if a non-bank financial institution gets reserves, bank-held reserves and bank deposits have to go down dollar for dollar, a little noticed consequence and incentive to competitive behavior.

But then the question goes to another level. If Treasury rates rise 5%, and expected inflation doesn't jump 5% in neo-Fisherian delight, capital would flow in from abroad.

To see it more clearly, suppose the Treasury said "ok, the Fed wants rates to be 5%. So rather than auction debt, we'll set the price. 5%, how much do you want?'' The answer would be "a lot!'' But the end result is no different.

It's easy to set a price if you let quantities adjust. It's a lot harder if you also want to control the quantity.

My bet: The Fed will seem fine to be in control of loudly-telegraphed 0.25% bp rises, as open-mouth operations rather than actual open market operations seemed to provoke previous rate hikes. They will never try 5% overnight and we find out if they really control interest rates.

29 comments:

  1. Okay, Cochrane recently posted that QE seems to have little effect on inflation and interest rates. Now Cochrane argues for a large Fed balance sheet.

    Of course, that begs the question: Why not maintain QE until the entire federal debt is on the Fed's balance sheet?

    Would this have an impact on inflation or interest rates--and if so, could the Fed mitigate such impacts by increasing IOER?

    Is it some sense of (misplaced personal) morality that the US should not monetize its debts? It doesn't "feel" honest? Or a fear that eliminating the national debt so easily and costlessly would encourage our Congressmen and Presidents to spend even more? (This strikes me as a very legitimate fear, even if it results in bad monetary policy. Boy, it gives a whole new meaning to "Deficits Don't Matter!")

    It seems to me the Fed QE program could wipe out the national debt, providing a tremendous boon to productive citizens and businesses that bear onerous taxes, and we need not fear from inflation or higher interest rates, if Cochrane is correct.

    But we would need some sort of iron ceiling on federal spending as a percentage of GDP.

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    1. Benjamin,

      "Is it some sense of (misplaced personal) morality that the US should not monetize its debts? It doesn't feel honest?"

      It is not really a morality issue. It is a more a political separation of powers issue.

      When this country was founded, the co-founders had come from oppressive authoritarian governments ruled by kings and queens. And so, the term limited government also implies decentralization of power. We see that in our system of government today - Judicial branch, Legislative Branch, and Executive Branch with checks and balances between the three branches of government.

      When the first "independent" central bank of the U. S. was created by Congress in 1913, there was no federal open market committee. There were several previous attempts at a central bank in the U. S. (First Bank of the United States and Second Bank of the United States). These were relatively short lived and were created primarily as financing arms for the U. S. government.

      The federal open market committee was created 20 years later (1933). The power of the central bank to buy and sell government debt rests in that act.

      Prior to fairly recent events, the central bank limited the size of its balance sheet precisely because it's members wanted to preserve the separation of powers between fiscal and monetary policy members.

      It really has nothing to do with honesty or morality or any other "feeling". It is all about concentration of power.

      Why stop with the central bank monetizing the debt? Why not just have the central bank go out and buy goods (cars, televisions, houses, etc.) directly? Normally, this is regarded as the domain of fiscal policy, but since we don't care about separation of powers anymore, why shouldn't the central bank just buy up everything in the United States?

      "It seems to me the Fed QE program could wipe out the national debt."

      If the central bank (as a separate enterprise) is still entitled to repayment of interest made from tax revenue, then the debt is not eliminated. If you are taking the central bank / government consolidated view then see my argument for separation of powers above.

      "But we would need some sort of iron ceiling on federal spending as a percentage of GDP."

      You mean like this:

      http://en.wikipedia.org/wiki/Maastricht_Treaty

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    2. I agree with all that except that I don’t agree with an “iron ceiling on federal spending as a percentage of GDP.” What’s needed is strict control of the DEFICIT: i.e. how much stimulus there should be. Whether public spending takes 15% of GDP or 50%, well that’s a purely political point to be decided by voters at election time.

      The size of the deficit / stimulus is best decided by some sort of committee of economists. Indeed that is already the case in that decisions on interest rate adjustments and QE are taken by central bank committees.

      Both Milton Friedman and Warren Mosler agreed with you in that they argued for a zero government borrowing regime, and I agree with them. For links to those two individual’s works see my comment below (if it’s published).

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  2. "Now, there is an arbitrage argument that the Fed can raise rates while keeping the balance sheet unchanged: Banks try to steal each others' depositors by offering more interest on deposits. Then Treasury holders try to hold bank deposits. I read the reverse repo program as a lack of faith that banks are anywhere near that competitive any more."

    Another way of looking at it is we shouldn't expect institutions that developed over a long period of time under the non-interest-paying regime to change on a dime, especially if this arbitrage condition (reserves yielding more than repos) is expected to be temporary. Regardless, the Fed has a responsibility to fund itself at the lowest cost. As a bank they should be performing arbitrage, not getting arbitraged.

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  3. The several "Real Plans" in the Brazil of the late 1990s come to mind in matters involving interest on bank reserves. In the case of Brazil, the exchange rate was a key macro variable that we were tracking closely although the Central Bank of Brazil never explicitly talked about it. At that time, it was the most interesting central bank watching to do! Oh, how much I would have liked to read in the mid 1990s the papers that you are writing today! Super interesante... Gracias.

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    1. I was terribly wrong about the Brazilian exchange rate! The central bank had at that time a widely publicized depreciation path... and our job was to guess when would the Real become overvalued. (It's just me... the same forgetful Anonymous!)

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  4. John,

    "To see it more clearly, suppose the Treasury said ok, the Fed wants rates to be 5%. So rather than auction debt, we'll set the price = 5%, how much do you want? The answer would be a lot! But the end result is no different."

    I don't think so. Currently Treasury says we have 1 year notes, what interest rate will you accept? Either Treasury would instead say we have 5% notes / bonds, what duration will you accept OR Treasury would say we are done selling notes and bonds.

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  5. I set out 17 reasons for thinking interest rate adjustments are not a good way of regulating demand here – section 1.6 here:

    http://mpra.ub.uni-muenchen.de/57955/1/MPRA_paper_57955.pdf

    Plus Warren Mosler opposes interest rate adjustments. See 2nd last paragraph here:

    http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

    Plus Milton Friedman thought the same. See:

    http://0055d26.netsolhost.com/friedman/pdfs/aea/AEA-AER.06.01.1948.pdf

    Now with Friedman and Mosler on my side I’ve just got to be right…:-)

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    1. Ralph,

      From:

      http://0055d26.netsolhost.com/friedman/pdfs/aea/AEA-AER.06.01.1948.pdf

      "Under the proposal, government expenditures would be financed entirely by either tax revenues or the creation of money, that is, the issue of non-interest-bearing securities."

      I disagree here. I would substitute the issuance of government equity in place of the creation of money for precisely the reasons that Friedman outlines further below.

      "Government would not issue interest-bearing securities to the public; the Federal Reserve System would not operate in the open market."

      I agree here. Friedman is referring to open market operations by the central bank (interest rate / bond price adjustments) here. Friedman does not discuss in this paper administration changes in the interest rate the central bank is willing to lend at.

      "The proposal has of course its dangers. Explicit control of the quantity of money by government and explicit creation of money to meet actual government deficits may establish a climate favorable to irresponsible government action and to inflation."

      I agree here.

      "Now with Friedman and Mosler on my side I’ve just got to be right…:-)"

      I presume you are on Friedman's side in recognizing the dangers and limitations of his proposal?


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    2. Frank,

      I think you are quite right to draw attention to the “danger” inherent in Friedman’s proposal (as indeed was Friedman himself). That’s actually a danger I’m well aware of as indeed is Positive Money (and others) who advocate the same system.

      But that danger only becomes serious when POLITICIANS get their hands on the printing press.

      The solution to that problem advocated by PM, which I fully agree with, is to have decisions on stimulus (i.e. how much additional base money is created and spend (net of changes to tax)) taken by some sort of independent committee of economists.

      And that’s not actually much different from our EXISTING SYSTEM, in that decisions on interest rate adjustments and QE (i.e. stimulus) are taken by committees of economists in central banks. At least the relevant committee in the Bank of England is made up almost entirely of independent economists. In the Fed I think there are quite a few private bankers, which I suspect gives rise to conflicts of interest.

      Note that the latter "committee" system in no way stops politicians or voters determining strictly POLITICAL matters, like what proportion of GDP is allocated to public spending or how that spending is split between education, defense, etc.

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    3. Ralph,

      "Note that the latter committee system in no way stops politicians or voters determining strictly political matters, like what proportion of GDP is allocated to public spending or how that spending is split between education, defense, etc."

      Or to spend the money at all. The committee can allocate funds all it likes. It is a political decision to spend it or not spend it. Committee allocates, $1 million, politicians decide only $1 thousand is to be spent.

      Friedman also mentions in the article that you reference that such a system may be totally insufficient.

      From Friedman,

      "The fluctuations in the government contribution to the income stream under the proposed monetary and fiscal framework are clearly in the "right" direction. Nonetheless, it is not at all clear that they would, without additional institutional modifications, necessarily lead either to reasonably full employment or to a reasonable degree of stability."

      "Now with Friedman and Mosler on my side I’ve just got to be right…:-)"

      Friedman had enough modesty to recognize that even if he was "right", the outcomes of implementing his proposal may not be what you desire.


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  6. John,

    "If the Fed said "5%, come and get it, give us your Treasuries and we will give you 5% reserves'' it would be clearer. But then the Fed would lose control of the balance sheet, and would likely expand -- a lot -- a reversal of the usual sign for a tightening."

    Think about this for a second - just because a central bank is expanding its balance sheet does not imply a loosing of monetary policy. The assumption is that the central bank buys bonds at a premium or at par and sells them at a discount or at par. That need not be the case. A central bank can buy bonds from the market at a discount under certain circumstances - is this monetary tightening or loosening?

    Market: We have all these government bonds but don't trust government to raise enough tax revenue to make the payments.

    Central Bank (Solomon): What do you want me to do?

    Market: Sell us interest bearing securities where you print up the interest payments.

    Central Bank: What interest rate would you like?

    Market: 5%

    Central Bank: What interest are you currently getting on your government bonds and what is there average duration?

    Market: 2%

    Central Bank: - Fine, we will pay you 85% of face value for the government bonds that you hold and give you instead 5% interest paying reserves.

    Market: ???

    The only group that must buy government bonds at a price of par or higher is the federal government at redemption.

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  7. Let me get this straight. The Fed misses the housing bubble, the fed misses the mortgage problem, the fed saves big banks that then become even bigger, the fed screws older savers, (see Bernanke laughing about that question) the fed ignores food and energy (and don't give me the crap about hard to measure), the fed enables the large expansion of government, the fed forces millions out of the labor market, the fed engages in programs that they have no idea how they will turn out, they fed gives voice to sinecure occupying economists, numerous other externalities (As Mankiew would say this are things we know exist but difficult to measure so we ignore) i.e. freedom and rule of law come to mind, overreaching government, trashing the lower middle class etc. My point is that you have no idea how this fed experiment will work other than the already devastating effects on our government and economy.

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  8. This all seems so serene and rational. A group of solons has decided how to spin and pull the knobs and voila, we are in the best of all possible worlds. The buying power of the dollar sure seems to have dropped, an effect, seems to me, of all this "not literally" printing of money. The tone here reminds me of what I recall from classes in political science, you know, those "rational actor" models poli sci profs love to trot out. Only thing is, the models never really connect with reality (ISIS). How rational is the political world when the guys on other side of the aisle are death worshippers? How do you models help there? We had a crash in 2008 that none of the solons saw coming. I submit the men who didn't have clue back then still don't have clue. Sorry to spoil the party. Is the Fed trying hard to do the right thing? Sure. But all I need to remind me of the "bad actor" model is to look at banks and car companies and the current auto loan fiasco (bubble) to know the leopard still sports his spots.

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  9. Well said David! Full(er) marks!

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  10. Frank Restl:

    Thanks for your comments.

    Yes, the central bank can remain independent (though I prefer it to be a part of the Treasury Department), and QE can still be a boon to taxpayers.

    The Fed (as I am sure you know) merely funnels the interest payments it receives on Treasury bills back to the Treasury.

    Right now, that's about $200 billion a year---a nice little tax cut, or nearly enough to, say, eliminate corporate income taxes.

    If this strategy did not result in higher inflation or interest rates, than why not?

    As far as I can tell, this is in fact what John Cochrane is proposing, when he proposes a gigantic Fed balance sheet and huge reserves at commercial banks. We monetize debt, and keep loans from going crazy by raising IOER.

    It seems clear the Fed can monetize several trillions in debt without negative result; we have already done that. Why not try a few trillions more?

    IMHO, QE is actually having a positive effect, and comparing the US to Europe we see better growth here. Japan seems to be having some luck as well.

    Cochrane has been extraordinarily oblique on this aspect of his policy recommendations---how we get to the huge balance sheet and massive commercial bank reserves. Seems to me that the Fed QE program is the pathway there.

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    1. Benjamin,

      "If this strategy did not result in higher inflation or interest rates, than why not?"

      You are arguing from the negative. If the Fed members were to spend their time blowing up balloons and popping them, would it cause either higher inflation or interest rates? Then why shouldn't they spend their time doing it?

      "Yes, the central bank can remain independent - though I prefer it to be a part of the Treasury Department, and QE can still be a boon to taxpayers."

      And here is where we disagree. I would prefer the central bank to remain independent of fiscal matters. I would also prefer fiscal matters to be independent of central bank action (federal government never borrows).

      "It seems clear the Fed can monetize several trillions in debt without negative result; we have already done that. Why not try a few trillions more?"

      You indicate that central bank monetization has not resulted in higher interest rates or higher inflation. Nor has it resulted in higher employment or higher real economic growth.

      Why not try something else?

      "IMHO, QE is actually having a positive effect, and comparing the US to Europe we see better growth here."

      Comparing the U. S. to the moon, we see better growth in the U. S. The output gap and employment to population ratio in the United States would say that QE has had little to no effect.

      We can agree to disagree?

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    2. Frank R-

      Sure, we can disagree.

      But I still would like John Cochrane to clarify two fundamentals:

      1. Cochrane says "banks" should operate making 100 percent equity-backed loans. But he never defines a bank. Is it any organization that make loans, or only organizations that rely upon FDIC insurance? If I borrow $10 million from friends, and lend it out at 6 percent interest to a homebuilder, am I breaking Cochrane's Law?

      2. Oaky, the Fed obtains a gigantic balance sheet. But how? What does it buy to obtain a huge balance sheet? All the federal debt?

      3. i favor a balanced federal budget, btw, although one can make a side argument for a federal capital budget--especially in a world of capital gluts.

      Side note: I agree that economic performance has been subpar in the USA. The answer is much more aggressive QE that is publicly keyed on targets, such as "We will do $100 billion a month in QE until we see 4 percent unemployment in the USA for six months straight."

      The Taylor Rule fixates on instruments, not results.

      I think we also have to cut in half SSDI and VA "disability" programs, btw...

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    3. 1. Yes, especially if you borrow overnight, issue essentially money-like claims, and are pretty big.
      2. Sure, why not. If it needs to. Actually, if the Treasury would issue fixed-value floating rate debt it woudn't have to bother. Or private money market funds holding treasuries can do the same thing

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    4. John,

      I borrow $10 million overnight, I sell $10 million in equity, I make $10 million in long term loans, and I construct a new office costing $10 million - am I a bank?

      Prove that the $10 million I borrowed overnight was the same $10 million I loaned out.

      "Okay, the Fed obtains a gigantic balance sheet. But how? What does it buy to obtain a huge balance sheet? All the federal debt?"

      "Sure, why not. If it needs to."

      John,

      While we are at it why don't we eliminate the system of courts and the entire legislature and just have a king and queen announcing the laws from on high? See my argument for separation of powers above. How do free marketers feel about authoritarian governments?

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    5. I think we can clarify Prof. Cochrane's proposal using Gary Gorton's concepts. Gorton explains the previous financial crisis as a breakdown in the private production of collateral. Cochrane would shift the production of such money-like securities entirely to the US government. Because the US borrows in its own currency, its debt is information-insensitive regardless of what is happening in the rest of the financial system. If the entire world uses US debt as money, instead of using the existing hierarchy of money, we will stop having runs and monetary contraction even if a lot of investments go bad.

      US debt is already at the top of hierarchy of money, because the US produces the world's dominant reserve currency. Cochrane would flatten this hierarchy with a ban on run-prone structures.

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    6. Japan having luck with it? I'd like to see by what measures you're getting that idea from. I'm positive they will either default or devalue their currency by an insane amount within the next decade.

      Also, the US is doing better not because of QE, but because Europe is still having debt issues and the Euro currency well, was a horrible idea. What's the point of fiat money if each country doesn't have it's own central bank and it's own monetary policy? The Euro has been a complete disaster. There's also the disastrous policies put into place in countries such as France by the socialist party. I could go on and on...

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  11. A few responses to passages in the article:

    “Every dollar invested in reserves is a dollar that used to be invested in a Treasury bill.” Do you mean literally mean bills, as in very short obligations? The Fed cleared those out during Operation Twist and since has built a portfolio of notes and bonds with an average maturity of about ten years.

    “The interest that the Fed will pay on reserves will come from the interest it receives on its Treasury securities. If the Fed sold its government securities to banks, those banks would be getting the same interest directly from the Treasury.” Interest on reserves is 0.25%, and ten year yields are about 2.5%. Not the same.

    “The big balance sheet is a temptation for the Fed to buy all sorts of assets other than short-term Treasurys.” As I mentioned, the Fed is not buying short-term Treasurys, but perhaps they will in the future.

    “it should clarify whether it will allow its balance sheet to shrink as long-term assets, or reinvest the assets” - I agree.

    Thanks – Win Smith

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  12. In any price/supply model of economics the Fed can only have some control over interest rates with large elasticity in it's balance sheet. If markets partially behave via a supply/demand rational then the Fed has to maintain, on average, a very large balance sheet. The long end of the curve correlation with changes in the Fed Funds rate is generally very weak after an initial knee-jerk reaction. The market prices long term yields. For the Fed to be able to impact this it needs to have elasticity in it's balance sheet that is far beyond what obtains today. The facts are that long term yields have gone up during every QE cycle and down between QE cycles, the opposite of what many would have you believe.

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  13. ultimately what the FED is doing now seems to be a move of last resort.
    With low interest rates and a liquidity trap, the main monetary tool is useless.
    The QE also seems unsustainable because of its huge implications on tax burden.
    But isnt what the FED doing now simply to pass on the burden to the furture generation?
    -Sean from qeducation.sg

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    1. The burden on future generations argument is often used but mostly completely wrong. And where is the connection between QE and tax burdens? As Milton Friedman pointed out, government debt has should be accounted for in the present since the macro economy is about production and consumption and money is just an artificial creation with zero real value at the macro level. QE is essentially an asset swap and thus to first order it will have no impact. The data, which shows that yields have gone up during QE and down between QE, supports this.

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  14. Your history is more than a bit off.

    "The federal government did not issue notes on a level playing field with privately issued notes and drive the private notes out of circulation. Rather, in 1863 the federal government passed a law requiring federally chartered banks to hold federal bonds as collateral against notes issued, and in 1865 and 1866 it passed acts imposing prohibitively high tax rates on notes issued by state-chartered banks and nonbank issuers. Even after ending the state bank and nonbank notes, federally issued “greenbacks,” gold certificates and silver certificates did not drive the notes of federally chartered banks out of circulation. They remained until finally prohibited by law from circulating further, in 1935."

    http://www.freebanking.org/2014/08/24/the-grumpier-economist/

    But for someone who argues that having the government take a monopoly over note issue will magically fix any crisis. I'm not surprised. For example, during one year during the Great Depression the US lost over a third of it's banks. That same year Canada lost zero. Canada during that year had no central bank and had no monopoly over note issue. It was a free note issue system. Although unlike the US in the 1800s, they didn't have the regulations which caused the issues the US had. (ban on branch banking and the requirement to hold $2 in USTs for every $1 of note issued - the latter of which causing a shortage of notes which wasn't an issue in Canada where they didn't have such regulation)

    http://www.cato.org/sites/cato.org/files/articles/tir_14_04_01_selgin.pdf

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    1. Excellent comment. I also would be interested to see how Prof. Cochrane responds to the facts cited in Schuler's post on freebanking.org.

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    2. Yeah, I oversimplified a lot. I stand by the fact that taking over a monopoly on note creation, as you describe, ended crises in banknotes. It moved crises over to demand deposits. Alas, in the 1930s, the US missed the chance to apply the lesson and adopt the "chicago plan," and instead adopted regulation and deposit insurance. Time to fix that. More in "toward a run free financial system"

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