In a comment on this post, the DeLong who is still attached to his hinges left me with quite a reading list.
Prior to 1984, there was a clear correlation between reserves, loans, and M2. After then, while loans and M2 continued to go along in a pretty close lockstep, reserves simply have flopped around all over the place.
Rosser cites Seth Carpenter and Selva Demilrap, who write
For better or worse, most economists think of M2 as the measure of money. M2 is defined as the sum of currency, checking deposits, savings deposits, retail money market mutual funds, and small time deposits. Since 1992, the only deposits on depository institutions’ balance sheets that had reserve requirements have been transaction deposits, which are essentially checking deposits. As noted above, the majority of M2 is not reservable and money market mutual funds are not liabilities of depository institutions. Nevertheless, it is the link between money and reserves that drives the theoretical money multiplier relationship. As a result, the standard multiplier cannot be an important part of the transmission mechanism because reserves are not linked to most of M2.
After reading these and other papers on his list, Mr. DeLong writes,
All this leaves me befuddled as to what the FRB and the econ profession are using as a model of the money machine.
I think that the popular saying among monetary economists these days is that attention has shifted from the Fed’s liabilities to the Fed’s assets. The old story was that the Fed’s liabilities were currency and bank reserves, and the banks lent out a predictable multiple of their reserves. The new story is that banks hold a ton of excess reserves. Also, if you include retail money market mutual funds in M2 (when did that happen? I’m so out of it, I thought that M2 was still, you know M2), then Carpenter and Demilrap are right that the money multiplier was never so reliable, anyway.
Anyway, back to the Fed’s assets. When the Fed buys long-term Treasuries, this takes them out of the hands of private investors, who then have to find something else to buy. They bid up the prices of other bonds and drive down interest rates, or so the theory goes.
My own view is that in an enormous world capital market, the Fed is not driving long-term interest rates. I am willing to be wrong. But my null hypothesis is that the Fed is always in an asset substitutability trap. Financial markets work to create substitutability. As a result, you have Goodhart’s Law: if the Fed can control the supply of an asset class (or definition of money), then that asset class will not have much effect on the economy; if an asset class correlates strongly with economic activity, the Fed will not be able to control it.
Another way to put this is that monetary and financial arrangements are endogenous with respect to Fed procedures. The financial markets will evolve ways to insulate the economy from what the Fed does.