When Federal Reserve officials first announced in 2008 their plan to engage in
quantitative easing, many believed that inflation would soon follow. The Feds rapidly
expanding balance sheet, the argument went, would cause the money supply to balloon
and the price level to skyrocket. Yet in the years since the plan was instituted, inflation
has remained relatively mild. Why did the predictions of these dire warnings never come
to pass? In Floored! How a Misguided Fed Experiment Deepened and Prolonged the Great
Recession, George Selgin argues that these outcomes failed to materialize because Fed
officials adopted a new operating framework in the midst of the financial crisis that
fundamentally transformed the U.S. monetary system.
Selgins book is a comprehensive analysis of the Feds new operating framework
known as a floor systemthat provides an overview of its origins and an examination of its
macroeconomic consequences. Selgin argues that the floor system not only is illegal but also
has had several deleterious effects on the U.S. economy and raises serious political economy
problems that threaten to further politicize the Fed. Selgins goal is to convince policy
makers and the general public that rather thanmaking the floor system permanent, as some
have suggested, the Fed should return to a more conventional operating framework.
As Selgin explains in the books early chapters, a floor system is an operating
framework wherein the central banks primary instrument of monetary policy is the
interest rate that it pays on bank reserves. In a floor system, there is no longer a link
between the quantity of reserves in the banking system and the overall stance of
monetary policy, which means that increases in the size of the central banks balance
sheet need not lead to increases in the money supply and the price level. By contrast,
prior to the financial crisis, the Feds primary policy instrument was the federal funds
rate, which it influenced by varying the quantity of reserves in the banking system via
open market operations.
In 2006, Congress authorized the Fed to pay interest on reserves in order to offset
the implicit tax that minimum-reserve requirements impose on banks and their depositors.
According to Selgin, the original intent behind the law was not to alter
fundamentally the way in which the Fed conducts monetary policy. Rather, as Selgin
shows, Fed officials argued that they would use this newfound authority to reinforce
their traditional means of monetary control by using the interest rate paid on reserves to
establish a lower bound on the federal funds rate such that the latter would remain the
central banks primary policy instrument.
That changed in 2008. In response to the worsening financial crisis, Congress
authorized the Fed to begin paying interest on reserves three years prior to the date
stipulated by the law from 2006. Rather than using this newfound authority to fix the
lower bound of the federal funds rate, as originally intended, Fed officials set the interest
rate paid on reserves above the federal funds rate to prevent the central banks
emergency lending from loosening the stance of monetary policy. By setting the interest
rate paid on reserves above the federal funds rate, Fed officials hoped to induce banks to
hold onto the newly created reserves rather than lend them. In so doing, Fed officials
were able to flood the banking system with reserves without risking inflation.
Other than authorizing the Fed to pay interest on reserves three years earlier than
initially authorized by Congress, however, the law passed in 2008 left the original law
intact, which required the rate paid on reserves to be set at or below the general level of
short-term interest rates. Selgin notes that this requirement was at odds with the Feds
efforts to sterilize its emergency lending. To prevent its emergency lending from
influencing the stance of monetary policy, the Fed would have to break the law by
paying a rate that exceeded that paid on other comparable assets to ensure that banks
would not lend their excess reserves. As Selgin shows, the Fed did exactly that.
How was the Fed able to circumvent the law? When Fed officials interpreted the
2008 law, they concluded that the primary credit ratethe rate at which it lends directly
to bankscounted as a short-term interest rate. Unlike other short-term interest rates,
however, the primary credit rate is not a market rate; it is set directly by the Fed. Under
this interpretation, the law no longer serves as a binding constraint because any rate paid
on reserves is legal if it is below the Feds chosen primary credit rate.
Selgin makes five claims about the macroeconomic consequences of the Feds new
floor system. First, it contributed to the recession and slow recovery by keeping
monetary policy excessively tight. Selgin argues that Fed officials failed to recognize that
the source of the financial crisis was a shortage of liquidity and in consequence contributed
to the collapse in nominal spending by essentially paying an above-market rate
on reserves that incentivized banks not to lend. Moreover, Selgin argues, there is a builtin
overtightening bias in a floor system because it is extremely sensitive to the interest
rate paid on reserves; if the rate is set too low relative to other rates, central-bank officials
may inadvertently revive the traditional monetary transmission mechanism, causing
prices to skyrocket.
Second, the floor system caused a collapse in the federal funds market as the rate
paid on reserves exceeded that which banks could earn by loaning to one another.
According to Selgin, this change has had two negative effects: it drastically reduced an
important source of bank liquidity, which has caused banks to hold larger precautionary
quantities of reserves, and the collapse of the federal funds market reduced the incentive
for banks to monitor other banks because they are no longer lending to one another,
subjecting the financial system to increased systemic risk.
Third, the floor system has undermined the effectiveness of the Feds open market
operations such that larger asset purchases are now required to achieve the same level of
monetary stimulus. As Selgin explains, the reason for this change is straightforward:
banks are opting to hold a substantial quantity of excess reserves rather than exchange
them for other types of assets because the former offers a better return under the Feds new operating framework. As a result, the ratio of bank reserves to total bank deposits
has increased from basically zero before the financial crisis to 20 percent, leading to a
substantial decline in retail lending.
Fourth, the fall in retail lending has increased the Feds role in the allocation of
scarce credit, which, Selgin argues, has contributed to the postcrisis slowdown in
productivity. In his view, the Fed has become an extremely large financial intermediary
that borrows from commercial banks at interest and then channels the
funds so acquired to those institutions whose assets the Fed is purchasing. As Selgin
explains, however, Fed officials lack both the knowledge and the incentives necessary
to employ the economys savings more effectively than their private-sector counterparts.
Thus, there is little reason to believe that the investments the Fed is making
are superior to those that would otherwise be made by commercial banks. As a
consequence, the Feds increased role in financial intermediation has reduced the
efficiency of the banking system.
Fifth and finally, Selgin claims that the floor system has severed the link between
the size of the Feds balance sheet and the stance of monetary policy. Under the new
regime, the balance sheet has become a free parameter, which may lead to Congress
using the Fed to fund off-budget programs. In Selgins view, this effect is particularly
troubling because increases in the Feds balance sheet no longer lead to increases in the
price level, and thus there will be little pushback on politicians from the public to limit
the Feds size, which may ultimately undermine the Feds independence.
Selgin concludes the book by outlining a process of policy normalization whereby
the Fed could eventually return to a version of its precrisis operating system. Recognizing
that Fed officials may be unwilling to do so, Selgin also calls on Congress to
nudge the Fed in this direction by holding the bank accountable to the spirit of the 2006
law. If Fed officials want to make the floor system permanent, Selgin argues that such a
change should be explicitly authorized by Congress rather than be founded on the Feds
dubious legal interpretation.
It remains an open question as to whether there is the political willpower to reform
the Feds operating framework in the manner that Selgin suggests. If the floor system
enables Congress to fund off-budget programs, then reforming the Feds policy
framework may be quite difficult. Selgin does not delve deeply into the political
economy of the current system. Identifying the interest groupsincluding politicians
and Fed officialsthat benefit from the floor system will, in my opinion, be crucial to
successful reform. This point is not so much a criticismof Selgins book as it is an area for
One of the books many strengths is Selgins summary of the basic monetary
concepts in the books early chapters. His discussion brings clarity to what can
sometimes be a dry and impenetrable topic to those unfamiliar with monetary theory
and policy. In consequence, the book should be accessible to both the general public
and economists whose expertise lies in other areas. More importantly, however, Selgin
has made an important contribution to our understanding of the causes and consequences of the Great Recession that vividly illustrates the important influence
monetary institutions can have on economic performance.