David Beckworth argues that the U.S. Federal Reserve should stop running a floor system and adopt a corridor system, say like the one that the Bank of Canada currently runs. In this post I'll argue that the Bank of Canada (and other central banks) should drop their corridors in favour of a floor—not the sort of messy floor that the Fed operates mind you, but a nice clean floor.
Floors and corridors are two different ways that a central banker can provide central banking services. Central banking is confusing, so to illustrate the two systems and how I get to my preference for a floor, let's start way back at the beginning.
Banks have historically banded together to form associations, or clearinghouses, a convenient place for bankers to make payments among each other over the course of the business day. To facilitate these payments, clearinghouses have often issued short-term deposits to their members. A deposit provides clearinghouse services. Keeping a small buffer stock of clearinghouse deposits can be useful to a banker in case they need to make unexpected payments to other banks.
Governments and central banks have pretty much monopolized the clearinghouse function. So when a Canadian bank wants to increase its buffer of clearinghouse balances, it has no choice but to select the Bank of Canada's clearing product for that purpose. Monopolization hasn't only occurred in Canada of course, almost every government has taken over their nation's clearinghouse.
One of the closest substitutes to Bank of Canada (BoC) deposits are government t-bills or overnight repo. While neither of these investment products is useful for making clearinghouse payments, they are otherwise identical to BoC deposits in that they are risk-free short-term assets. As long as these competing instruments yield the same interest rate as BoC deposits, a banker needn't worry about trading off yield for clearinghouse services. She can deposit whatever quantity of funds at the Bank of Canada that she deems necessary to prepare for the next day's clearinghouse payments without losing out on a better risk-free interest rate elsewhere.
But what if these interest rates differ? If t-bills and repo promise to pay 3%, but a Bank of Canada deposit pays an inferior interest rate of 2.5%, then our banker's buffer stock of Bank of Canada deposits is held at the expense of a higher interest elsewhere. In response, she will try to reduce her buffer of deposits as much as possible, say by reallocating bank resources and talent to the task of figuring out how to better time the bank's outgoing payments. If more attention is paid to planning out payments ahead of time, then the bank can skimp on holdings of 2.5%-yielding deposits while increasing its exposure to 3% t-bills.
Why might BoC deposits and t-bills offer different interest rates? We know that any differential between them can't be due to credit risk—both instruments are issued by the government. Now certainly BoC deposits provide valuable clearinghouse services while t-bills don't. And if those services are costly for the Bank of Canada to produce, then the BoC will try to recapture some of its clearinghouse expenses. This means restricting the quantity of deposits to those banks that are willing to pay a sufficiently high fee for clearing services. Or put differently, it means the BoC will only provide deposits to banks that are willing to accept an interest rate that is 0.5% less than the 3% offered on t-bills.
But what if the central bank's true cost of providing additional clearinghouse services is close to zero? If so, the Bank of Canada should avoid any restriction on the supply of deposits. It should provide each bank with whatever amount of deposits it requires without charging a fee. With bankers' demand for clearing services completely sated, the differential between BoC deposits and t-bills will disappear, both trading at 2.5%.
There is good reason to believe that the cost of providing additional clearinghouse services is close to zero. It is no more costly for a central bank to issue a new digital clearinghouse certificate than it is for a Treasury secretary or finance minister to issue a new t-bill. In both cases, all it takes is a few button clicks.
Let's assume that the cost of providing clearinghouses is zero. If the Bank of Canada chooses to constrain the supply of deposits to the highest bidders, it is forcing banks to overpay for a set of clearinghouse services which should otherwise be provided for free. In which case, the time and labour that our banker has diverted to figuring out how to skimp on BoC deposit holdings constitutes a misallocation of her bank's resources. If the Bank of Canada provided deposits at their true cost of zero, then her employees' time could be put to a much better use.
As members of the public, we might not care if bankers get shafted. But if our banker has diverted workers from developing helpful new technologies or providing customer service to dealing with the artificially-created problem of skimping on deposits, then the public directly suffers. Any difference between the interest rate on Bank of Canada deposits and competing assets like t-bills results in a loss to our collective welfare.
Which finally gets us to floors and corridors. In brief, a corridor system is one in which the central bank rations the number of clearinghouse deposits so that they aren't free. In a floor system, unlimited deposits are provided at a price of zero.
When a central bank is running a corridor system, as most of them do, the rate on competing assets like t-bills lies above the interest rate on central bank deposits. Economists describe these systems as corridors because the interest rate at which the central bank lends deposits lies above the interest rate on competing safe assets like t-bills and repo, and with the deposit rate lying at the bottom, a channel or corridor of sorts is formed.
For instance, take the Bank of Canada's corridor, illustrated in the chart below. The BoC lets commercial banks keep funds overnight and earn the "deposit rate" of 0.75%. The overnight rate on competing opportunities—very short-term t-bills and repo—is 1%. The top of the corridor, the bank rate, lies at 1.25%. So the overnight rate snakes through a corridor set by the Bank of Canada's deposit rate at the bottom and the bank rate at the top. (The exception being a short period of time in 2009 and 2010 when it ran a
Let's assume (as we did earlier) that the BoC's cost of providing additional clearinghouse services is basically zero. Given the way the system is set up now, there is a 0.25% rate differential (1%-0.75%) between the deposit rate and the rate on competing asset, specifically overnight repo. This means that the Bank of Canada has capped the quantity of deposits, forcing bankers to pay a fee to obtain clearing services rather than supplying unlimited deposits for free. This in turn means that Canadian bankers are forced to use up time and energy on a wasteful activity: trying to skimp on BoC deposit holdings. All Canadians suffer from this waste.
It might be better for the Bank of Canada (and any other nation that also uses a corridor system) to adopt what is referred to as a floor system. Under a floor system, rates would be equal such that the rate on t-bills and repo lies on the deposit rate floor of 0.75%--that's why economists call it a floor system. The Bank of Canada could do this by removing its artificial limit on the quantity of deposits it issues to commercial banks. Banks would no longer allocate scarce time and labour to the task of skirting the high cost of BoC deposits, devoting these resources to coming up with new and superior banking products. In theory at least, all Canadians would be made a little better off. All the Bank of Canada would have to do is click its 'create new clearinghouse deposits' button a few times.
The line of thought I'm invoking in this post is a version of an idea that economists refer to as the optimum quantity of money, or the Friedman rule, first described by Milton Friedman back in the 1960s. Given that a central bank's cost of issuing additional units of money is zero, Friedman thought that any interest rate differential between a monetary asset and an otherwise identical non-monetary asset represents a loss to society. This loss comes in the form of people wasting resources (or incurring shoe leather costs) trying to avoid the monetary asset as much as possible. To be consistent with the zero cost of creating new monetary assets, the rates on the two assets should be equalized. The public could then hold whatever amount of the monetary asset they saw fit, so-called shoe leather costs falling to zero.
In my post, I've applied the Friedman rule to one type of monetary asset: central bank deposits. But it can also be applied to banknotes issued by the central bank. After all, banknotes yield just 0% whereas a t-bill or a risk-free deposit offers a positive interest rates. To avoid holding large amounts of barren cash, people engage in wasteful behaviour like regularly visiting ATMs.
There are several ways to implement the Friedman rule for banknotes. One of the neatest ways would be to run a periodic lottery that rewards a few banknote serial numbers with big winnings, the size of the pot being large enough that the expected return on each banknote as made equivalent to interest rate on deposits. This idea was proposed by Charles Goodhart and Hugh McCulloch separately in 1986.
Robert Lucas once wrote that implementing the Friedman rule was “one of the few legitimate ‘free lunches’ economics has discovered in 200 years of trying.” The odd thing is that almost no central banks have tried to adopt it. On the cash side of things, none of them offer a serial number lottery or any of the other solutions for shrinking the rate differential between banknotes and deposits, say like Miles Kimball's more exotic crawling peg solution. And on the deposit side, floor systems are incredibly rare. The go-to choice among central banks is generally a Friedman-defying corridor system.
One reason behind central bankers' hesitation to implement the Friedman rule is that it would threaten their pot of "fuck you money", a concept I described here. Thanks to the large interest rate gaps between cash and t-bills, and the smaller gap between central bank clearinghouse deposits and t-bills, central banks tend to make large profits. They submit much of their winnings to their political masters. In exchange, the executive branch grants central bankers a significant degree of independence... which they use to geek out on macroeconomics. Because they like to engage in wonkery and believe that it makes the world a better place, central bankers may be hesitant to implement the Friedman rule lest it threaten their flows of fuck you money, and their sacred independence.
That may explain why floors are rare. However, they aren't without precedent. To begin with, there is the Fed's floor that Beckworth describes, which it bungled into by accident. At the outset of this post I called it a messy floor, because it leaks (George Selgin and Stephen Williamson have gone into this). The sort of floor that should be emulated isn't the Fed's messy one, but the relatively clean floor that the Reserve Bank of New Zealand operated in 2007 and Canada did from 2009-11 (see chart above). Though these floors were quickly dropped, I don't see why the couldn't (and shouldn't) be re-implemented. As Lucas says, its a free lunch.