More on Floor Systems

The discussion of floor systems, between Steve Randy Waldman and Paul Krugman has expanded. In line with my last post, Waldman gets it, more or less, with a little confusion. Krugman is confused.

What adds to the confusion, in part, is Krugman's example:

...what happens if the US government issues a trillion-dollar coin to pay its bills?

I discussed that in this post. Krugman thinks it makes a difference whether the interest rate on reserves is close to zero, as it is now (at 0.25%), or say 5%. If there is a significant quantity of excess reserves, actually there is no difference.

Suppose, as in Krugman's example, the Treasury issues currency to pay its bills. Where the currency is deposited - at private financial institutions or the Fed - or even if the currency issued by the Treasury circulates, doesn't make a difference. What matters is the consolidated balance sheet of the Fed and the Treasury, and so there is no difference between what happens when the Treasury issues currency to finance its deficit, and what happens if the Treasury issues debt, of any maturity, and the Fed purchases the debt with reserves. It's neutral - a liquidity trap - whether the interest rate on reserves is 0%, 0.25%, or 5%. For example, if the Treasury issues currency, that will not ultimately affect the quantity of currency in circulation, with the extra outside money ultimately increasing the quantity of reserves one-for-one.

Where Waldman is confused, in part, is here:

Further, a floor system is very attractive to central bankers. It maximizes policy flexibility...

Actually, a floor system gives a central bank no more or less flexibility than does a channel system. For the Fed, the only difference is that they control the overnight policy rate in a different way.