Can we imagine a world in which “expansionary” open market operations are in fact contractionary?

John Cochrane discusses Andy Kessler:

The usual thinking is that bank reserves are “special.” They are connected to GDP in a way that Treasuries are not.  In the conventional monetary view, MV = PY.  Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.

In Andy’s view (my interpretation), that is turned around now. Now, Treasuries supply more “liquidity” needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.

Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don’t do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don’t make a difference to anything. More treasuries, according to Andy, we can do something with.

More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can’t push on a string, as the saying goes. Much “constraint” economics forgets that once the constraint is off, the relationship doesn’t hold any more.

Andy describes the repo market and the sense in which Treasuries are “special” in providing low-haircut collateral. Lots of academic research is now viewing Treasuries as special or liquidity-providing in the shadow banking system.

The Kessler piece is here.


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