Typography

David Andolfatto and Larry White have been having an interesting debate on the public finance case for having a large (or small) Federal Reserve balance sheet. In this post I'll make the case that American taxpayers are better off having a large Fed balance sheet, perhaps not as big as it is now, but certainly larger than in 2008. To explain why, we're going to have to go into more detail on some central banky stuff. The chart below illustrates the growth of the Fed's balance sheet. Prior to the 2008 credit crisis, the Fed owned around $900 billion worth of assets (green line), these being funded on the liability side by $800 billion worth of banknotes (red line), a slender $10-15 billion layer of reserves (blue line), and a hodgepodge of other liabilities. The Fed now owns an impressive $4.5 trillion in assets. These are funded by around $1.5 trillion worth of banknotes and $2.3 trillion worth of reserves. So the lion's share of the increase in the Fed's assets i...

Remember when shadow banks regularly outcompeted stodgy banks because they could evade onerous regulatory requirements? Not any more. In negative rate land, regulatory requirements are a blessing for banks. Shadow banks want in, not out. In the old days, central banks imposed a tax on banks by requiring them to maintain reserves that paid zero percent interest. This tax was particularly burdensome during the inflationary 1970s when short term rates rose into the teens. The result was that banks had troubles passing on higher rates to savers, helping to drive the growth of the nascent U.S. money market mutual fund industry. Unlike banks, MMMFs didn't face reserve requirements and could therefore offer higher deposit rates to their customers. To help level the playing field between regulated banks and so-called shadow banks, a number of central banks (including the Bank of Canada) removed the tax by no longer setting a reserve requirement. While the Federal Reserve didn't go as f...