145 – George Selgin on *Floored!*

Episode Summary

Executive Summary: George Selgin argues that the Fed’s post-2008 floor system—paying interest on reserves and operating with a large balance sheet—deepened the Great Recession, weakens bank monitoring, enlarges political pressure on the Fed, and worsens resource allocation. The episode contrasts floor vs corridor systems, reviews international experience, and ends with an update: in January 2019 the FOMC chose to keep the floor system.

Main Topics: Fed operating systems: corridor vs floor (Priority: 5/5): Selgin explains how the pre-2008 corridor system used scarce reserves and open market operations to steer the federal funds rate, while the floor system uses abundant reserves and interest on reserves to set short-term rates. Why the Fed adopted the floor system in 2008 (Priority: 5/5): He argues the Fed used interest on reserves during the crisis to prevent rates from falling further, effectively tightening policy when the economy needed easing. Arguments for and against the floor system (Priority: 5/5): Pro-floor claims include easier rate control and more liquidity; Selgin counters that those benefits are overstated and come with costs to interbank markets, bank monitoring, and balance-sheet size. Balance-sheet expansion and resource allocation (Priority: 4/5): Selgin says a large Fed balance sheet absorbs savings that otherwise would finance bank lending, pushing funds toward Treasuries and mortgage-backed securities instead of productive private lending. Political economy, optics, and Congressional pressure (Priority: 4/5): He warns that once balance-sheet size is detached from monetary policy, Congress and other interests may press the Fed to buy assets for non-monetary reasons, and interest payments to banks create bad optics. International comparisons and alternatives (Priority: 4/5): Selgin cites Canada’s return to a corridor system and notes tiered reserve systems abroad as ways to preserve liquidity without permanently adopting a floor system. Post-episode update: FOMC decision to stay on floor system (Priority: 3/5): The host notes that the January 19, 2019 FOMC chose to retain the floor system, despite ongoing debate about its effects and alternatives.

Key Arguments: The corridor system successfully controlled the federal funds rate for decades, so claims that it cannot deliver good interest-rate control are overstated. A floor system may be necessary when rates hit the zero lower bound, but extending it beyond that point is unnecessary and costly. Interest on reserves makes the Fed’s balance sheet a free parameter, encouraging a larger, more politically vulnerable central bank balance sheet. By eliminating an active unsecured interbank market, the floor system weakens price discovery and the incentive for banks to monitor one another for solvency risk. A bigger reserve stock is not a free lunch: it diverts savings away from bank lending and toward securities holdings, changing resource allocation. The apparent gains in Fed remittances to Treasury were temporary and largely reflected the duration of Fed assets, not a permanent fiscal windfall. The floor system creates poor optics by paying banks—especially large New York and foreign-bank branches—to hold reserves, even if it is not technically a subsidy. Other countries’ experiences, especially Canada’s, show that a corridor system can coexist with strong rate control and that floor systems need not be permanent. The liquidity coverage ratio does not force permanent reserve hoarding because high-quality liquid assets can also include Treasuries; supervisory pressure, not regulation itself, is what may lock in reserve demand.

Data Points: Episode date: January 15, 2019 - Live recording date of the interview with George Selgin. FOMC update date: January 19, 2019 - Four days later, the FOMC decided to keep the floor system. Fed balance sheet: upwards of $4 trillion - Selgin cites the post-crisis enlarged balance sheet as part of the floor system apparatus. Earlier Fed balance sheet: approximately $1 trillion - Pre-crisis balance sheet size referenced in contrast with the current level. Fed funds market trading volume: about $200 billion a day - Selgin describes the active pre-2008 federal funds market. Bank loans as share of bank deposits before 2008: approximately 100% - Used to illustrate leaner balance-sheet intermediation before the floor system. Bank loans as share of bank deposits since 2008: 80% - Selgin says more deposits are now held as reserves rather than supporting loans. Reserves as share of bank deposits since 2008: about 20% - Illustrates the much larger reserve holdings under the floor system. Interest rate on reserves: 25 basis points - The rate stayed at this level for many years under the floor system. Survey-implied reserve demand: about $900 billion to $1.2 trillion - Host cites bank survey responses suggesting a reserve level banks would hold; Selgin cautions against overinterpreting it. Current reserves cited: around $1.6 to $1.7 trillion - Comparison point for the Fed’s then-current reserve stock. Potential balance-sheet floor estimate: 3 trillion to 3.5 trillion - Selgin’s guess for how far the Fed would allow balance-sheet runoff to continue. Required-reserve timing: 2006 law, implemented early in 2008 - Selgin references the legislation granting the Fed authority to pay interest on reserves. Large bank concentration: six or seven New York banks and a handful of foreign bank branches - Used to explain why reserve-interest optics appear politically unfavorable.

Pivotal Quotes: "there's no such thing as a free liquidity lunch" — George Selgin: His critique of the claim that larger reserves are costless because they provide more safety and liquidity. "the Fed's balance sheet now amounts to a piggy bank that can be tapped without worries that it will create inflation" — David Beckworth: Host’s post-episode update explaining why the FOMC’s floor-system decision raises political-economy concerns. "the real scandal is that they were told to do what they did by government officials who then went all ethical on them" — George Selgin: His response to a question about the LIBOR scandal and government pressure during the crisis.

Implications: The episode argues that keeping the floor system entrenches a large, politicized Fed balance sheet, weakens interbank discipline, and may distort capital allocation. For listeners, the big question is whether monetary control can be preserved while restoring a leaner corridor framework.