1,682 is the number of days that the Dow Jones Industrial Average has spent rising since hitting rock bottom back in March 6, 2009.

It also happens to be the number of days between the Dow's July 8, 1932 bottom and its March 10, 1937 top. From that very day the Dow would begin to decline, at first slowly, and then dramatically from August to November when it white-knuckled almost 50%, marking one of the fastest bear market declines in history.

Comparisons of our era to 1937 seems apropos. Both eras exhibit near zero interest rates, excess reserves, and a tepid economic recovery characterized by chronic unemployment. Are the same sorts of conditions that caused the 1937 downturn likely to arise 1,682 days into our current bull market?

The classic monetary explanation for 1937 can be found in Friedman & Schwartz's Monetary History. Beginning in August 1936, the Fed announced three successive reserve requirement increases, pushing requirements on checking accounts from 13% to 26% (see chart below). The economy began to decline, albeit after a lag, as banks tried vainly to restore their excess reserve position by reducing lending and selling securities. A portion of the reserve requirement increase was rolled back on April 14, 1938, too late to prevent massive damage being done to the economy. The NBER cycle low was registered in June of that year.


Friedman & Schwartz's second monetary explanation for 1937 has been fleshed out by Douglas Irwin (pdf)(RePEc). In December 1936, FDR began to sterilize foreign inflows of gold and domestic gold production (see next paragraphs for the gritty details). This effectively froze the supply of base money, which had theretofore been increasing at a rate of 15-20% or so a year. Tight money, goes the story, caused the economy to plummet, a decline mitigated by FDR's announcement on February 14, 1938 to partially desterilize (and therefore allow the base to increase again, with limits), further mitigated by an all-out cancellation of the sterilization campaign that April.

Here are the details of how sterilization worked. (If you find the plumbing of central banking tedious, you may prefer to skip to the paragraph that begins with ">>" — I'll bring the 1937 analogy back to 2013 after I'm done with the plumbing). In the 1920s, the supply of base money could be increased in several ways. First, Fed discounting could do the trick, whereby new reserves were lent out upon appropriate collateral. The Fed could also create new reserves and buy either government securities in the open market or bankers acceptances. Lastly, gold was often sold directly to the Fed in exchange for base money. After 1934, all but the last of these four avenues had been closed. Both the Fed's discount rate and its buying rate on acceptances was simply too high to be attractive to banks, and the practice of purchasing government securities on the open market had long since petered out. Only the gold avenue remained.

New legislation in 1934 meant that all domestic gold and foreign gold inflows had to be sold to the Treasury at $35/oz. The Secretary of the Treasury would write the gold seller a cheque drawn on the Treasury's account at the Fed, reducing the Treasury's balance. The Treasury would then print off a gold certificate representing the number of ounces it had purchased, deposit the certificate at the Fed, and have the Fed renew its account balance with brand-spanking new deposits. Put differently, gold certificates were monetized. As the Treasury proceeded to pay wages and other expenses out of its account during the course of business, these new deposits were injected into the banking system.

You'll notice that by 1934 the Treasury, and not the Fed, had become responsible for increasing the base money supply, a situation that may seem odd to us today. As long as the Treasury Secretary continuously bought gold and took gold certificates representing those ounces to the Fed to be monetized, the supply of base money would increase one-for-one as the Treasury drew down its account at the Fed.

The Treasury's decision to sterilize gold inflows in December 1936 meant that although it would continue to purchase gold, it would cease bringing certificates to the Fed to be monetized. The Treasury would pay for each newly mined gold ounce and incoming foreign ounces by first transferring tax revenues and/or the proceeds of bond issuance to its account at the Fed. Only then could it afford to make the payment. Whereas the depositing of gold certificates by the Treasury had resulted in the creation of new base money, neither the transfer of tax revenues nor the proceeds of bond issuance to the Treasury's account would have resulted in the creation of new base.

FDR's sterilization campaign therefore froze the base. Gold was kept "inactive" in Treasury vaults, as Friedman & Schwartz would describe it. The moment the sterilization campaign was reversed (partially in February 1938, and fully in April), certificates were once again monetized, the base began to expand again, and a rebound in stock prices and the broader economy followed not long after.

>> Let's bring this back to the present. Before 2008 the Fed typically increased the supply of base money as it defended its target for the federal funds rate. The tremendous glut of base money created since 2008 and the introduction of interest-on-reserves has given the Fed little to defend, thus shutting the traditional avenue for base money increases. Just as the gold avenue became the only way to increase the base in 1936, quantitative easing has become the only route to get base money into the banking system. With that analogy in mind, FDR's 1936 sterilization campaign very much resembles an end to QE, doesn't it? Both actions freeze of the monetary base. Likewise, last September's decision to avoid tapering is analogous to the 1938 decision to cease sterilization (or to "desterilize") —both of these decisions unfreeze the base.

Who cares if the base is frozen? After all, in 1937 and today, any pause in base creation won't change the fact that there is already a tremendous glut in reserves. A huge pile of snow remains a huge pile, even after it has stopped snowing.

One reason that desterilization and ongoing QE might be effective is because they shape expectations about future monetary policy, and these expectations are acted upon in the present. For instance, say that the market expects the glut of base money to be removed five years in the future. Only then will reserves regain their rare, or "special" status. While a sudden announcement to taper or sterilize will do little to reduce the present glut, it might encourage the market to move up the expected date of the glut's removal by a year or two. Which will only encourage investors in the present to sell assets for soon-to-be rare reserves, causing a deflationary decline in prices. On the other hand, a renewed commitment to QE or desterilization may extend glut-expectations out another few years. This promise of an extended glut period pushes the prospect that reserves might once again be special even further down the road. With the return on base money having been reduced, current holders of the base will react by trying to offload their stash now—thus causing a rise in prices in the present.

If the monetary theories about the 1937 recession are correct, it is no wonder then that 1,682 days into our current bull market investors seem to be so edgy about issues like tapering. Small changes in current purchasing policies may have larger effects on markets than we would otherwise assume thanks to the intentions they convey about future policy.

QE is effective insofar as it is capable of pushing market expectations concerning the future removal of the base money glut ever farther into the future. But once that lift-off point has been pushed so far off into the distant future (say ten years) that the discounted value of going further is trivial, more QE will have minimal impact.

If QE is nearing the end of its usefulness, what happens if we are hit by a negative shock in 2014? Typically when an exogenous shock hits the economy and lowers the expected return on capital, the Fed will quickly reduce the return on base money in order to ensure that it doesn't dominate the return on capital. If the base's return is allowed to dominate, investors will collectively race out of capital into base money, causing a crash in capital markets. The problem we face today is that returns on capital are currently very low and nominal interest rates near zero. Should some event in 2014 cause the expected return on capital to fall below zero, there is little room for the Fed to reduce the return on base money so as to prevent it from dominating the return on capital—especially with interest-on-reserves unable to fall below zero and QE approaching irrelevance. Come the next negative shock, we may be doomed to face an unusually sharp and quick crash in asset prices (like 1937) as the economy desperately tries to adapt to the superior return on base money.

So while I am still somewhat bullish on stocks 1,682 days into the current bull market, I am worried about the potential for contractionary spirals given that we are still at the zero-lower bound. I'm less worried about the Fed implementing something like a 1937-style sterilization campaign. Incoming Fed chair Janet Yellen is well aware of the 1937 event and is unlikely to follow the 1937 playbook. Writes Yellen:

If anything, I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery. That’s just what happened in 1936 when, following two years of robust recovery, the Fed tightened policy because it was worried about large quantities of excess reserves in the banking system. The result? In 1937, the economy plunged back into a deep recession.  -June 30, 2009 [link] 

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Other recent-ish commentary on the 1937 analogy include Paul Krugman, Francois Velde (pdf), Scott Sumner, Lars Christensen, Christina Romer, Charles Calomiris (pdf), Business Insider, and David Glasner.

This post may get a bit rambling. It's an attempt to tie together a couple of different strands that I've been thinking and reading about.

Modern monetary theory (MMT) in a nutshell, at least as far as I see it, goes something like this. Back in the 1990s a couple of clever guys came up with the idea of a government-provided jobs guarantee. They realized that this program would be seen by the public as an expensive boondoggle requiring sky-high taxes and huge debts. Could they outflank these criticisms by finding another way to fund the jobs guarantee?

To find the funds the early MMTers worked backwards through the labyrinthine relationship between the Federal Reserve and the Treasury. What they claimed to have discovered at the end of their trek was certainly shocking. The US Treasury, they said, funds itself not by the conventional route of taxes and bonds, but by creating and directly spending fiat (i.e. inconvertible) money. Furthermore, it is not only the government's prerogative, but its obligation to spend this money into existence, since people need a stock of fiat money to pay their taxes. Bonds, contrary to what most of us think, are not a sign of government indebtedness—rather, they drain spending.

This bit of monetary jiu-jitsu is powerful because it has the ability to disarm people's instinctual aversion to expensive social programs. If all it takes to fund a jobs guarantee is that the government spend money, and debt and taxes are not the great evils we have been trained to think, then why resist it?

Most governments don't create fiat money—their central banks do. For a government to have this power, it needs to be able to force its central bank to add new money to the government account. One way to do this is for the government to print up a bond and give it to the central bank. The central bank then credits the government's account for the full amount of the bond, and now the government can spend, say on a jobs guarantee. Alternatively, the transaction can be completed without the transferral of the bond—just have the central bank automatically credit the government's account prior to spending. When the government can require its central bank to create money on its behalf, we say that they are effectively consolidated into one entity.

The earliest MMT tome, Wray's Understanding Modern Money, is very insistent on the consolidated nature of the Fed-Treasury:

"The important thing to notice is that the Treasury spends before and without regard to either previous receipt of taxes or prior bond sales."

"...permanent consolidated government deficits are the theoretical and practical norm in a modern economy... Further, government spending is always financed through creation of fiat money - rather than through tax revenues or bond sales."

"While it appears that the Treasury 'needs' the tax revenue so that it can spend, that is clearly a superficial view... The government certainly does not need to have its own IOU returned before it can spend; rather, the public needs the government's IOU before it can pay taxes."

Now as their critics were quick to point out (see Lavoie, for instance), the relationship between Fed and Treasury is such that the two are not consolidated. The Treasury cannot ask the Fed to credit its account, nor can the Treasury print up a bond and give it to the Fed in exchange for spending power. The only way the Treasury can spend is by moving previously acquired funds that are held in the private banking system into its Federal Reserve account—and the only way it can acquire these funds is through taxes and bond issues. Using the Fed to print money and fund a jobs guarantee program is impossible.

The MMT wish, it would seem, was the father to the thought—Wray's 1998 tome was too hasty in consolidating the Fed and Treasury. MMTers are left with an intriguing theory of how modern money works, yet their theory corresponds to no underlying reality. That doesn't mean that MMT is without some merits. MMTers are hackers. In their efforts to reverse engineer the Fed-Treasury nexus in order to fund their pet project, they've come across plenty of interesting minutiae about monetary operations. MMT papers and blogs go into these details and are worth reading if you want to hone your understanding of the monetary system [just take anything they say about consolidation with a grain of salt].

Has the lack of overlap between Wray 1998's theory and reality stopped MMTers? Not at all. When your theory doesn't describe reality, don't bother changing your theory—change reality so that it conforms to your theory. Enter the platinum coin.

The idea of issuing a trillion dollar platinum coin rose to prominence with the onset of yet another US debt ceiling crisis. The MMT blogs hummed about the coin, a huge coin crescendo grew on Twitter, and the issue went all the way to the White House, which demurred. My hunch is that beating the debt ceiling is only a tertiary motive for MMTer excitement over the platinum coin. Far more important to them is that the platinum coin, if implemented, will effectively consolidate the Fed and Treasury, finally redeeming Wray 1998. This opens to door to their beloved jobs guarantee.

I'm not sure how MMT will evolve, but one thing we'll probably see more of is platinum coin-style activism. Though the rest of world has moved on from the coin, the MMT blogs are still buzzing about it. I'm sure more clever ways to hack the Fed-Treasury nexus will be found, thereby giving the Treasury other routes by which to force Bernanke or whomever follows him to print dollars on demand. These hack-arounds will be publicized. Perhaps a political movement will form. This wouldn't be unique. All sorts parties have formed around monetary ideas—Greenbackism, Free Silver, and Social Credit.

I've always wondered why MMTers ignore Canada. Of all the major central banks, the Bank of Canada conforms most fully to the MMT ideal. Consider this—the Bank of Canada routinely buys bonds directly from the government. The Fed, ECB, and other central banks can only buy government debt on secondary markets. This degree of consolidation goes beyond the ability to participate in bond auctions. The BoC is permitted to lend directly to both the Federal and provincial governments without requiring any security whatsoever. Section 18(j) of the Bank of Canada Act says that the Bank may

make loans to the Government of Canada or the government of any province, but such loans outstanding at any one time shall not, in the case of the Government of Canada, exceed one-third of the estimated revenue of the Government of Canada for its fiscal year, and shall not, in the case of a provincial government, exceed one-fourth of that government’s estimated revenue for its fiscal year, and such loans shall be repaid before the end of the first quarter after the end of the fiscal year of the government that has contracted the loan. 

The US Treasury was once allowed to go into overdraft at the Fed, but this hasn't been permitted since 1981. And even when it could have its account credited, overdraft loans were quite limited in size and duration.


The Bank of Canada is engaged in a very MMT-like operation right now. As I wrote in an earlier post, the Federal government is currently implementing what it calls a prudential liquidity management plan. The BoC typically buys 15% or so of bonds auctioned off by the government. It does so on a non-competitive basis, meaning that it pays the average of all competitive bids submitted to the auction. The traditional 15% allocation is enough to ensure that maturing government debt held in the BoC's portfolio is replaced. In late 2011, the government asked the Bank to fund its prudential liquidity plan by raising its allocation at government bond auctions to 20%. Because this larger allocation is more than enough to make up for maturing debt, the BoC's balance sheet has been growing quite fast. At the same time, the government's account at the BoC, which usually hovers at around $2 billion, now clocks in at $11.5 billion, and by 2014 or so, should rise to $20 billion. Below is a chart of the Bank of Canada's balance sheet. Note the large jumps in government bond holdings (red) and deposits (bottom green).


MMTers might not agree with the prudential liquidity plan, but it surely represents the sort of consolidation they are so anxious to see in the US.

So what happens when the Federal government begins to spend down its prudential balances held at the BoC? Private banks will quickly realize that they have far too many clearing balances and will try to get rid of them. Canada's overnight lending rate will collapse below its target rate. In order to bring the rate back up to target, the BoC can do any number of things.

1) Sell assets from its existing portfolio, thereby withdrawing excess clearing balances.
2) Issue Bank of Canada sterilization bills, which banks will purchase directly from the BoC with excess clearing balances.

Alternatively, the BoC can work together with the government:

3) Ask the government to issue more bonds, depositing the proceeds at the Bank of Canada. Bonds here are fulfilling the money-draining purpose that MMTers like to emphasize.
4) Ask the government to increase taxes, depositing the proceed at the BoC. Just like bonds, taxes would be draining previously spent money.

Finally, the BoC can simply leave this spending unsterilized.

5) Rather than withdraw (i.e. sterilize) balances, let the excess supply drag the overnight rate to the deposit rate. All clearing balances now earn the deposit rate.

The BoC currently maintains a corridor system. During the day, private Canadian banks make and receive hundreds of thousands of payments. By lunch time on a normal day there will be a number of debtor and creditor banks. Debtors can settle with a creditor by borrowing clearing balances from the BoC on a collateralized basis and transferring these balances to their creditor. By the end of the day, the BoC will have typically swallowed up large amounts of collateral as it creates and lends whatever quantity of intraday clearing balances that deficit banks require.

Banks who have borrowed balances to fund a deficit are free to maintain these positions overnight, but are dissuaded from doing so because the rate which they must pay to the BoC, the bank rate, is 0.25% above the market overnight rate. Nor do surplus banks wish to keep the quantities of clearing balances they have received at the BoC overnight, since the deposit rate is 0.25% below the market rate. As a result, those banks holding clearing balances are incentivized to transfer them to those banks that are in debt to the BoC. This transfer allows the deficit banks to pay back their intraday debts to the BoC and get their collateral back. In short, BoC balances are not attractive to maintain so they reflux back to the Bank of Canada. A good visual aid is to think of the central bank as a blowfish: it blows up during the day and sucks itself back in at night when it isn't needed.

If it turns to this last solution, the Bank of Canada will be throwing away its corridor system and adopting a floor system. Steve Waldman generated plenty of discussion on his recent series of blog posts on floor systems. As the Federal government spends down its $20 billion prudential balance at the BoC, all private banks will end up holding excess clearing balances. There is no way for them to contract among each other to remove this excess. Only one option remains to the banks—hold these balances overnight and receive the deposit rate. The Bank of Canada would be a permanently inflated blowfish.

If it adopts a floor, the BoC wouldn't be the first. The Federal Reserve stumbled its way into a floor system in 2008 by injecting so many reserves that it was unable to sterilize them. But a floor system is by no means universally accidental. The Reserve Bank of New Zealand chose to adopt a floor in 2006. When it maintained a corridor, the RBNZ began to notice signs of stress in the banking system that it traced to insufficient liquidity. Evidence included delayed or 'just-in-time' payments, failed settlement, collateral hoarding, and increasing use of the bank's overnight lending facility.

Between July and October 2006, the RBNZ moved to a fully "cashed up" system by injecting $7 billion worth of settlement cash on which it paid interest. Banks had typically required $3-5 billion worth of intraday credit in order to meet their payment requirements. Now that there was a permanent $7 billion worth of balances, there was no longer any need for banks to get intraday loans from the RBNZ, nor scramble for collateral to qualify for these loans. Banks ceased waiting till the end of the day to make payments. The time of day when 50% of all payments were completed was moved up by two hours compared to when the corridor system was in place. (See the RBNZ's account of this here.) Flattening out settlement over a trading day can be desirable since settlement delays, especially if they spread from participant to participant, can be costly.

The Bank of Canada has toyed with an RBNZ-style cashed up system. In response to the credit crisis, in May 2009 the BoC injected $3 billion of excess settlement balances into the clearing system, pushing the overnight rate down to the Bank's deposit rate. This excess was removed in June 2010, a year later. We know from a presentation by former Deputy BoC Governor David Longworth that much like New Zealand, Canadian payments tended to be made earlier in the day during the period between May 2009 and June 2010.  If the Federal government's prudential balances at the BoC are spent down, a decision to use the occasion to move to a floor system rather than sterilizing this spending would not be without precedent or merit.

[If you're interested on this subject, this paper relates the US experience with excess reserves. Much like Canada and New Zealand, US payments after the onset of excess reserves were more evenly distributed throughout the day.]

Back to MMT, where this whole ramble started. Much a large corporate conglomerate, MMT might benefit from being dismantled. Beholden to the jobs guarantee division, the monetary division has made unrealistic claims about the nature of consolidation. Now it is turning to monetary activism. The monetary division would be less conflicted, and therefore be taken more seriously, if it was spun off from its parent. As separate corporations, the jobs guarantee folks could focus on lobbying governments like Canada to use their central banks to fund social programs, freeing the monetary folks to focus on how monetary systems actually work. Why not deconsolidate MMT?

David Glasner and Scott Sumner have posts on Chinese monetary policy. They both inquire about the People's Bank of China (PBoC) balance sheet. I've affixed a chart of it below.

Here's a quick rundown of how the PBoC balance sheet changes. The PBoC sets the yuan-to-dollar exchange rate at some rate below what it would in a free market. Chinese exporters thereby enjoy a subsidy. The law requires that the foreign currency that exporters earn overseas be repatriated and exchanged for yuan. The PBoC prints yuan (bottom green area) or provides deposits (bottom purple area), receiving this foreign exchange in return (top green area).


By creating such large quantities of liquid currency and reserves, the PBoC will force the domestic price level  to rise. In order to prevent this inflation, the Bank must "sterilize", or mop up the liquidity it has created. It does this by issuing bonds (dark blue area at bottom) to domestic banks in exchange for currency and reserves (bottom purple and green). Thus liquid instruments are replaced by an illiquid instrument, bonds. The PBoC also forces banks to hold large quantities of required reserves (bottom purple area), which immobilizes what would otherwise be a fairly liquid instrument. In this way the rise in the domestic price level can be temporarily prevented. The PBoC could also sterilize by selling domestic assets (top pink, blue, or yellow areas) and retiring the currency and reserves it receives. But given that domestic assets held on the PBoC balance sheet haven't changed much over the years, it's likely that different means are being found to sterilize.

Normally this blog is just a comment aggregator, but once in a while I write a substantial post. Here’s one.

As a bit of a Bank of Canada watcher, I recently noticed that the Bank of Canada’s balance sheet is undergoing some interesting changes. Firstly, on the liability side of its balance sheet, government deposits held at the Bank have been growing quite quickly and are now at their highest level since the credit crisis. On the asset side of its balance sheet, BoC assets are growing at over 15% year over year after relative slow growth for the last few years.

Before exploring the reasons for these changes, as always I like to put the data into charts for context. As my first chart entitled North of 10% shows, BoC assets have only grown this fast a few times over the last few decades, mostly during crisis points like Y2K and 9/11. Giddy stuff.



The chart entitled Flight of the loon decomposes the growth of the BoC’s balance sheet into various components since 1981. If you look at the most recent twelve months, you’ll see what I mean about government deposits. Since last fall they have increased from under $1 billion to over $8 billion. On the asset side of the Bank’s balance sheet, this has been compensated by an increase in government bonds held by the Bank (the red bit).

During the first two weeks of October 2008, the Bank of Canada was selling the treasury bills that it held on its own balance sheet. The increase of term PRAs on the asset side of the balance sheet of the Bank of Canada were thus being compensated by a fall of an almost exactly equal amount of Treasury bills also on the asset side of the balance sheet of the Bank of Canada. In other words, the central bank was exchanging advances to the private sector in lieu of advances to the public sector. Thus, in this case and during the period going from July 2008 to mid October 2008, the size of the balance sheet of the Bank of Canada did not change by much.2

Two comments on The Money View. One on Perry Mehrling's The IMF and the Collateral Crunch and the other on Daniel H. Neilson's Is there an ECB?

Neilson links to the erroneous Tornell/Westerman piece. My comments on this are in a previous post. In short, Karl Whelan's Worse than Sinn clarifies the issue. Sterilization by the Bundesbank is not happening. 

Merhling and me discuss the nature of the transactions conducted between borrowing NCBs and the lending ECB.

Perry, I can't find any explicit reference to whether intra-Eurosystem credits are collateralized or not.

But I still think not. Collateral is posted by a borrower to a lender to protect the lender should the borrower default. Then the lender can collect the collateral instead.

But ECB losses are dealt with in a specific way. See bottom of http://www.ecb.int/ecb/orga/capital/html/index.en.html

In short, if the ECB suffers a loss on a loan to an NCB then that loss is allocated to all NCBs according to the ECB's capital key.

The March 2011 Bundesbank report describes this:

"An actual loss will be incurred only if and when a Eurosystem counterparty defaults and the collateral it posted does not realise the full value of the collateralised refinancing operations despite the risk control measures applied by the Eurosystem. Any actual loss would always be borne by the Eurosystem as a whole, regardless of which national bank records it. The cost of such a loss would be shared among the national banks in line with the capital key."
So it would be redundant or unecessary for an NCB to post collateral to the ECB for ECB credit, since in the case of non-payment the ECB has a claim on all NCBs to make up the loss.

That being said, I don't think this necessarily changes the thrust of your post.