Question

1. PUSHING ON STRINGS
   The explosion of U.S. banks' excess reserves since 2008
   illustrates the dramatic failure of monetary policy.

   BY GERALD FRIEDMAN May/June 2009; updated 2018 Dollars and Sense

   Monetary policy is not working. Since the economic crisis began in July 2007, the Federal Reserve has dramatically cut interest rates and pumped out over $1 trillion, increasing the money supply by over 15% in less than two years. These vast sums have failed to revive the economy because the banks have been hoarding liquidity rather than lending. The Fed requires that banks hold money on reserve to back up deposits and other bank liabilities. In the past, beyond these required reserves, banks would hold very small amounts of excess reserves, holdings that they minimized because reserves earn very little or no interest. Between the 1950s and September 2008, U.S. banks held over $5 billion in total excess reserves only once, after the September 11 attacks. This changed with the collapse of Lehman Brothers. Beginning with less than $2 billion in August 2008, excess reserves soared to $60 billion in September and then to $559 billion in November before peaking at $798 billion in January 2009. (They had dropped to $644 billion by the time this article was written.)

   This explosion of excess reserves represents a signal change in bank policy that threatens the effectiveness of monetary policy in the current economic crisis. Aware of their own financial vulnerability, even insolvency, frightened bank managers

   Time series graph: Bank Excess Reserves Since 1999

   
   BANK EXCESS RESERVES SINCE 1999

   responded to the collapse of major investment houses like Lehman Brothers by grabbing and hoarding all the cash that they could get. At the same time, a general loss of confidence and spreading economic collapse persuaded banks that there are few to whom they could lend with confidence that the loans would be repaid. Clearly, our banks have decided that they need, or at least want, the money more than consumers and productive businesses do.

   Banks could have been investing this money by lending to businesses that needed liquidity to buy material inputs or pay workers. Had they done so, monetarist economists would be shouting from the rooftops, or at lease in the university halls, about how monetary policy prevented another Great Depression. Instead, even the Wall Street journal is proclaiming that "We're All Keynesians Again" because monetary policy has failed. Monetary authorities, the Wall Street journal explains, can create money but they cannot force banks to lend or to invest it in productive activities. The Federal Reserve confronts a reality shown in the graph above: it can't "push on a string," as Fed Chair Marriner Eccles famously put it during his testimony before Congress in 1935, in the depths of the Great Depression.

   If the banks won't lend, then we need more than monetary policy to get out of the current crisis. No bailout, no Troubled Asset Relief Program (TARP), can revive the economy if banks hoard all of the cash they receive. The Obama-era stimulus was an appropriate response to the failure of string-pushing. But much more government stimulus will be needed to solve a crisis this large, and we will need programs to move liquidity from bank vaults to businesses and consumers. It may be time to stop waiting on the banks, and to start telling them what to do with our money.

   Update, June 2018

   Ten years after the onset of the Great Recession, sometimes called the Lesser Depression, we can better appreciate the limits of monetary policy in stimulating a depressed economy. Four years after the 2008 crash, the Federal Reserve pushed money into the economy in hopes of stimulating investment. While not a complete failure, the Fed's monetary policy did little to stimulate the economy, with investment demand in particular continuing to lag in what has been the slowest economic recovery since World War II. The failure of monetary policy, not only in the United States but in Japan and Europe as well, has led even many orthodox economists, notably Paul Krugman and Larry Summers, to warn that the United States has entered a period of "secular stagnation" where the rate of return has fallen so low that the interest rate cannot drop to a level where capitalists can profit from new investment. With the return on investment this slow, the economy has fallen into what John Maynard Keynes, and Krugman, call a "liquidity trap," a situation where there is so little demand for investment that further increases in the money supply will simply go into idle cash reserves rather than new economic activity. In such a situation, monetary authorities can do little but "push on strings" because only active fiscal policy can provide economic stimulus by substituting government spending for failing private investment. Inadequate fiscal stimulus in the United States and, even more, in Europe, accounts for the slow economic recovery from the Lesser Depression despite active monetary stimulus.

The discussion question(s) : Address both parts in your answer (questions a, and b) for full credit.

a.) Why does Friedman, like others before him, liken monetary policy to "pushing on a string"?

b.) What evidence does Friedman offer in his article to show that this analogy is an apt description of monetary policy today?

Answer 1

a) Pushing on a string means putting effort where it is not required. Friedman likens monetary policy to "pushing on a string" because monetary policy is making efforts which are not providing the expected stimulus to the economies. It is making efforts which has ultimately no results as it is doing it in the wrong way.

b) He provides evidence that even though monetary policy has pumped liquidity, lowered interest rates and wants banks to give money to the general public, banks have excess reserves so that banks don't go bankrupt, this is not addressing the real concern as banks have increased their reserves exponentially but are not lending to people, this has led to fall in investments and credit flow as banks have turned extra cautious. Without investments the economy is not growing as fast, thus this measure doesn't provide the full effort and necessary repurcussions with which it was implemented, monetary policy has to ensure people have access to credit, but instead with increase in excess reserves of banks, banks are holding back on providing credit to the businesses and individuals. Monetary policy is pushing on the string by increasing the money supply but where they really need to put in effort is force the banks to lend to the public.