Alt-M Ideas for an Alternative Monetary Future Fri, 20 Nov 2015 12:53:13 +0000 en-US hourly 1 Rethinking Monetary Policy – Cato’s 33rd Annual Monetary Conference Fri, 20 Nov 2015 12:53:13 +0000 More than two hundred people gathered at the Cato Institute last Thursday for our 33rd Annual Monetary Conference.  Over the course of three addresses and four panel discussions, a distinguished cast of speakers — including St. Louis Fed president James Bullard, Richmond Fed president Jeffrey Lacker, and Stanford economist John Taylor...

The post Rethinking Monetary Policy – Cato’s 33rd Annual Monetary Conference appeared first on Alt-M.

monetary policy, federal reserve, plosser, miron, selgin, sumner, john b. taylorMore than two hundred people gathered at the Cato Institute last Thursday for our 33rd Annual Monetary Conference.  Over the course of three addresses and four panel discussions, a distinguished cast of speakers — including St. Louis Fed president James Bullard, Richmond Fed president Jeffrey Lacker, and Stanford economist John Taylor — covered topics ranging from the rights and wrongs of monetary rules, to the ins and outs of the Fed’s long-awaited “exit strategy” from quantitative easing and near-zero interest rates.  If you didn't make the event, here's a synopsis.

Opening Keynote

Bullard kicked things off with the keynote address, noting that while he favors policy normalization — that is, a return to the kind of monetary policy (and Fed balance sheet) that prevailed between 1984 and 2007 — there is a risk that we’ll get stuck at “Permazero” if the economy fails to take off, or suffers new negative shocks.  He speculated that inflation would stay persistently below target in such a scenario, while monetary policy would lose its power to stimulate or stabilize.  Long-run growth would continue to be driven by real factors, but asset prices could become very volatile.  Bullard stressed that this was just one possible interpretation, and that it didn’t change his view that the Fed should begin raising rates and shrinking its balance sheet.  Nevertheless, he said, we should be prepared for the possibility that things do not go according to plan.

Panel 1: What Monetary Policy Can and Can't Do

The day’s first panel, moderated by Wall Street Journal chief economics correspondent Jon Hilsenrath, focused on what monetary policy can and cannot do.  There was a broad consensus among the panelists — the Richmond Fed's Jeffrey Lacker, the Bank of Mexico’s Manuel Sanchez, and George Tavlas of the Bank of Greece — that monetary policy should focus on price stability, while steering clear of objectives it is less suited to, like boosting growth, guaranteeing financial stability, or pricking asset bubbles.  Within that discussion, Tavlas made the case for monetary rules over “constrained discretion,” suggesting that Milton Friedman might be sympathetic to the Taylor rule if he were around today.

Panel 2: Inflation, Deflation, and Monetary Rules

Monetary rules were the focus of the next panel, which featured John Taylor (he of the eponymous rule), former Philadelphia Fed president Charles Plosser, the Mercatus Center’s Scott Sumner, and our very own George Selgin.  Although all four panelists favored a shift towards rule-based monetary policy, each took a different approach.

Plosser noted that the Fed already runs five different monetary rules through its model of the economy when preparing for Federal Open Market Committee meetings.  So why not release the results of that analysis, and use it to explain how policy decisions are made?  Sumner advocated a similarly incremental approach, suggesting the Fed could be “nudged” towards his favored paradigm — NGDP targeting — with requirements that it clearly define the “stance of monetary policy” in its communications, regularly review its past policy decisions, and set “guardrails” for the maximum permissible fluctuations in aggregate demand.  Selgin drew a distinction between rules and “pseudo-rules,” arguing that the former must be strictly enforced, hard to “innocently” break, and possible to stick to during a crisis.  Taylor, meanwhile, argued that capricious monetary policy was promoting massive capital flows between emerging and developed economies, stoking exchange rate volatility, and giving rise to widespread capital controls and currency manipulation.  Rule-based monetary policy, he suggested, is a necessary complement to open capital markets and floating exchange rates — and legislation in the U.S. would set a great example for the rest of the world.

Luncheon Address

Claudio Borio, the head of the monetary and economic department at the Bank for International Settlements (BIS), delivered the conference’s luncheon address, arguing that we need to reassess “three pillars” of received monetary policy wisdom — first, that the natural rate of interest is best defined in terms of output and inflation; second, that money is neutral; and third, that deflation is always and everywhere a disaster.  Borio rejected all three premises.  He preferred to think of the “natural rate” as one which is consistent with good, sustainable macroeconomic performance.  According to this view, financial imbalances (such as asset price bubbles) are the key signifier of disequilibrium.  Borio also questioned the idea of monetary neutrality, arguing that credit-induced resource misallocation is central to an accurate understanding of the economic cycle.  This means that easy money can’t always solve our problems; you need structural and balance sheet reform after a crisis.  Finally, on deflation, Borio highlighted BIS research suggesting that there is only a weak association between deflation and economic contraction.  What link there is derives largely from the Great Depression and is more aptly attributed, in that case, to a collapse in asset prices.  In reality, said Borio, garden-variety falls in the prices of goods and services do not always portend doom — and shouldn’t always spur offsetting policy actions.

Panel 3: Monetary Policy and the Knowledge Problem

The monetary conference’s third panel discussion focused on Hayek’s knowledge problem in the context of monetary policy.  Cato senior fellow Gerald O’Driscoll suggested that the knowledge problem explains why rule-based monetary policy is superior to central bank discretion — we don’t know enough to design an optimal monetary policy, so we’re better off using rules to create a monetary order and anchor expectations.  The American Enterprise Institute’s Alex Pollock took a similar approach, asking, “Does the Federal Reserve Know What It’s Doing?”  His answer was a resounding “no” — but it’s not their fault, said Pollock; it’s fundamental uncertainty, not incompetence, that dooms the Fed to recurring failure.  Speaking last, David Malpass of Encima Global LLC added his voice to calls for monetary policy normalization, arguing that the Fed’s zero-interest rate policy is actually weighing down economic growth.

Panel 4: The Fed's Exit Strategy vs. Fundamental Reform

The prospect of monetary policy normalization provided the backdrop to the day’s final panel discussion: “The Fed’s Exit Strategy vs. Fundamental Reform.”  Alt-M contributor and George Mason University economics professor Larry White tackled the first half of that title.  He argued that quantitative easing (QE) wasn’t really a monetary policy at all: by deciding to pay interest on bank reserves held at the Fed, policymakers effectively “sterilized” QE, which meant it barely affected the broad-money (M2) aggregates.  What sterilized QE did do, however, was to preferentially allocate credit towards housing over other uses.  In this context, an “exit strategy” worthy of the name must put an end to this discretionary credit allocation — but, alas, there’s little indication that the Fed has any intention of doing that.  Jerry Jordan, former president of the Cleveland Fed, was similarly gloomy about the prospects for a meaningful exit strategy, arguing that monetary policy has lost its potency now that banks are no longer reserve-constrained, and questioning the Fed’s ability to normalize policy even if it wants to.  Kevin Dowd, an adjunct scholar at Cato’s Center for Monetary and Financial Alternatives, brought the session to a close by outlining a bold agenda for fundamental monetary and financial reform, eschewing incremental steps in favor of a re-commoditized dollar, an entirely new bank capital regime, radically reformed bank governance, and a thoroughgoing roll-back of government intervention in the United States’ monetary and financial system.

Closing Address

The closing address of the 33rd Annual Monetary Conference was delivered by Rep. Bill Huizenga (R-Mich.), who chairs the House Financial Services Subcommittee on Monetary Policy and Trade.  His remarks focused on the draft legislation he unveiled earlier this year, which would require the Fed to adopt an explicit policy rule, and grant greater auditing power to the Government Accountability Office, among other reforms.

If you missed the conference, video footage of all the sessions is available here, on Cato’s website.  The papers submitted to the conference will also be published in next year’s Spring/Summer issue of the Cato Journal.

The post Rethinking Monetary Policy – Cato’s 33rd Annual Monetary Conference appeared first on Alt-M.

]]> 1
Can Open Market Operations Save Puerto Rico? Wed, 18 Nov 2015 16:52:36 +0000 With Puerto Rico’s continuing fiscal strains, some commentators have suggested that one avenue to give Puerto Rico breathing room would be the purchase of Puerto Rican municipal debt as part of Open Market Operations by the Federal Reserve.  The most prominent proponent of this plan is Renssalaer Tech Economics Professor...

The post Can Open Market Operations Save Puerto Rico? appeared first on Alt-M.

puerto rico, federal reserve, bailout, debtWith Puerto Rico’s continuing fiscal strains, some commentators have suggested that one avenue to give Puerto Rico breathing room would be the purchase of Puerto Rican municipal debt as part of Open Market Operations by the Federal Reserve.  The most prominent proponent of this plan is Renssalaer Tech Economics Professor Arturo Estrella.  His proposal can be found here.  The governance of Open Market Operations, which is the buying and selling of securities by the Federal Reserve System, is found in Section 14 of the Federal Reserve Act.

A threshold question is: does the debt of Puerto Rico qualify as allowable investments?  There are essentially three categories of allowable purchases under Section 14:  state/local government debt in the continental United States, foreign government (or agency) debt;  and U.S. Treasury or agency debt.  Professor Estrella spends considerable effort arguing that Puerto Rico is within the definition of “continental” United States and hence qualifies.  Unfortunately his efforts are in vain, as the Federal Reserve Act, in Section 1, defines the “continental United States” to mean “the States of the United States and the District of Columbia” which obviously excludes territories like Puerto Rico.

How does Professor Estrella attempt to overcome the very clear language of the Federal Reserve Act?  He argues that “the preponderance of regulatory language in Federal Reserve regulations shows that Puerto Rico is treated in the same way as a state…”  The good Professor offers plenty of examples, such as the Truth in Lending Act, carried out by the Fed’s Regulation Z.  What he fails to mention is that the cited regulations are not carried out pursuant to the Federal Reserve Act.  For instance the Truth in Lending Act actually defines Puerto Rico as a state, which explains why Regulation Z as implemented does so.  Congress regularly chooses different definitions of the same words for different statutes, and it does so intentionally.  That, however, does not allow an agency to pick and choose.  The definitions contained in a statute govern the regulations promulgated under that statute only.

Estrella also argues that since the Fed treats Puerto Rico as part of the New York Federal Reserve District, then it must be a state since Section 2 of the Federal Reserve Act established a procedure of allocating states to reserve bank districts.  The essence of Estrella’s argument is that since the Fed treats Puerto Rico as a state in some contexts, then it must be classified as a state for purposes of Section 14.  Such a view implies that an agency, like the Fed, can simply rewrite statutes at its whim.  Such a view is of course incorrect.  Only Congress can write statutes, and while agencies can “fill in the blanks” they cannot re-write clear statutory language.

Interestingly enough, Professor Estrella also argues that Puerto Rico might qualify as a “foreign government,” since the International Banking Act of 1978 defines, for its purposes, Puerto Rican banks as “foreign banks,” although it does not include Puerto Rico under its definition of “foreign country.”  One can debate the contradictory nature of the definitions of the 1978 Act, but they clearly do not apply to Section 14 of the Federal Reserve Act.  Lastly, I believe it is obvious, and I do not know of anyone who has argued the contrary, that Puerto Rico is not part of the federal government or one of its agencies.

In summary, any plain reading of the Federal Reserve Act, along with the traditional practices of statutory interpretation, would conclude that the Federal Reserve cannot purchase Puerto Rican government debt as part of open market operations.

Even if the Fed were allowed to do so, would buying debt fix Puerto Rico’s problems?

Let us assume despite the preceding that Puerto Rico qualifies as part of the continental United States.  Section 14(2) limits any municipal purchases to maturities of less than six months at the time of purchase.  While I have not been able to find a distribution of maturities for Puerto Rican debt, reports appear to indicate much longer maturities.  Perhaps longer debt could be swapped out for six month, but such might leave Puerto Rico even more vulnerable as it would have to come to market far more often.  Just as Bear Stearn’s reliance on overnight debt was part of its undoing, shortening the maturity of Puerto Rico would likely make a bad situation worse.

Perhaps most binding of all is that Section 14 is dependent upon “anticipation of the collection of taxes or in anticipation of the receipt of assured revenues…”  In plain English, that means that lending is limited to debt that the Fed has determined there is revenue forthcoming.  As Puerto Rico’s governor stated that the debt “could not be paid,” it is hard to see how the Fed could stay within the clear language and intent of Section 14 while purchasing Puerto Rico’s debt.

Let me be clear: I do not have answers to Puerto Rico’s debt crisis.  What I do know, however, is that having the Federal Reserve purchase Puerto Rico’s debt as part of open market operations is not legal.  And if it was, it would likely be unworkable.


The post Can Open Market Operations Save Puerto Rico? appeared first on Alt-M.

]]> 1
Is Bitcoin Only Valuable to Crooks and Tax Cheats? Sat, 14 Nov 2015 12:23:54 +0000 It isn’t every day that University of Chicago economists Eugene Fama and Richard Thaler see eye to eye.  Fama, who won the Nobel Prize in 2013, is one of the best known proponents of the efficient market hypothesis.  Thaler, in contrast, champions behavioral economics.  Indeed, Thaler spends a great deal...

The post Is Bitcoin Only Valuable to Crooks and Tax Cheats? appeared first on Alt-M.

BlackMarketBitcoinIt isn’t every day that University of Chicago economists Eugene Fama and Richard Thaler see eye to eye.  Fama, who won the Nobel Prize in 2013, is one of the best known proponents of the efficient market hypothesis.  Thaler, in contrast, champions behavioral economics.  Indeed, Thaler spends a great deal of time criticizing the efficient market hypothesis in his recent book, Misbehaving.

Both economists, however, seem to be on the same side when it comes to bitcoin.  Commenting on Fama’s recent interview with the Bitcoin Uncensored podcast, Thaler tweets: “Must say I agree with Fama here. Only value of bitcoin seems to be to crooks&  [sic] tax cheats. Negative social value.”

Richard Thaler Tweet

Fama and Thaler are not alone.  Many regulators worry that, absent sufficient government oversight, cryptocurrencies like bitcoin will be used to conduct illegal transactions and transfers on a massive scale.  For example, Sen. Joe Manchin has claimed that the “clear ends of Bitcoin [are] for either transacting in illegal goods and services or speculative gambling.”  Likewise, Sen. Charles Schumer has described bitcoin as “an online form of money laundering.”  Some have even warned that bitcoin might be used to fund terrorism.  Like Fama and Thaler, many people outside the bitcoin community seem to believe bitcoin is basically for criminals.

But they’re wrong.  To date, the black market transactions that trouble Fama, Thaler, and others have been quite limited.  Consider Silk Road, the premier bitcoin-for-drugs website in operation from February 2011 to October 2013.  The best available evidence suggests there were roughly $1.2 million worth of transactions made on Silk Road each month.  More recent estimates put the figure at roughly $4.7 million per month.  That modest figure hardly made Silk Road the Amazon of drugs, as Gawker once claimed.  Amazon averaged roughly $6,204.2 million per month in 2013. That’s more than 370 times the highest monthly transactions volume estimated for Silk Road.  Silk Road was not even the Etsy ($112.32 million per month) of drugs.

One might counter that the volume of transactions on Silk Road was low because so few people were using bitcoin at the time.  But the volume of transactions on the Silk Road was also small relative to the total volume of transactions conducted in bitcoin.  The monthly transactions volume for the entire bitcoin system averaged just under $16 billion from February 2011 to October 2013.  That means that Silk Road transactions were responsible for a measly 0.03 percent of all transactions conducted in bitcoin.  In other words, it was not just that few people were using bitcoin, but that of those who did few were buying and selling illegal substances on Silk Road.

What about terrorism?  The U.S. Treasury Department itself has found no evidence of bitcoin’s widespread use in funding terrorism.  That really shouldn’t come as a surprise.  Terrorist groups have much more convenient ways to secure funding  outside of legitimate banking channels.  Moreover, to the extent that terrorists are located in developing regions, they would encounter the same hurdles to adopting bitcoin that others in developing countries face.

If they aren’t buying cocaine or funding terrorists, what are users doing with all that bitcoin? Answer: a lot of things.  They are purchasing flights, Xbox games, and, well, anything sold on They are paying college tuition.  They are ordering satellite television.  They are purchasing premium memberships on dating sites and then using Yelp! to find a romantic coffee shop or trendy bar that—you guessed it—accepts bitcoin.  They are sending remittances to family members around the world at a fraction of the usual cost.  They are donating to support art, open source projects, and foundations.  A better question would be: what aren’t they doing with bitcoin?

Contrary to popular opinion, bitcoin is not basically for criminals.  It is barely for criminals.  In that respect, it resembles ordinary cash—that is, Federal Reserve notes.  As a matter of fact, the case is probably stronger for eliminating cash than bitcoin.  Harvard economist Ken Rogoff has claimed more than half of all cash in circulation is used to hide transactions from tax or law enforcement authorities.  More formal estimates by Edgar Feige suggest roughly 48 percent of cash held by the public is employed in the domestic underground economy.  For those interested in transacting outside the law, cash—not bitcoin—is king.

In short, most bitcoin users seem to be a lot like you and me, if perhaps a bit more tech savvy.  They want to purchase legal goods and services and remit funds as cheaply and conveniently as possible. To the extent that bitcoin is more effective than traditional payment mechanisms for making some transactions, it lowers transaction costs, encouraging production and exchange.

In other words, Thaler is wrong: bitcoin has a positive social value.

The post Is Bitcoin Only Valuable to Crooks and Tax Cheats? appeared first on Alt-M.

]]> 4
Happy Birthday, Anna Wed, 11 Nov 2015 20:12:27 +0000 Were she still alive, Anna Schwartz, one of the last centuries' greatest monetary economists, would have celebrated her 100th birthday today. Alas, we must commemorate the date without her.  To do so, I repost here remarks I made upon her death in 2012.  In what has become a prolonged era of...

The post Happy Birthday, Anna appeared first on Alt-M.

nna Schwartz, memoriam, birthday, economist, monetaryWere she still alive, Anna Schwartz, one of the last centuries' greatest monetary economists, would have celebrated her 100th birthday today.

Alas, we must commemorate the date without her.  To do so, I repost here remarks I made upon her death in 2012.  In what has become a prolonged era of unconventional monetary policy, the loss of her expertise and wisdom is even more sorely felt than it might have been otherwise.  Still all of us, and the economics profession especially, are much better off thanks to her straightforward and uncompromising scholarship.

Happy Birthday, Anna.


She was one of my intellectual heroes, Anna was — together with Milton and Leland, David Laidler, Sir Alan Walters, and Dick Timberlake.  Old monetarists all, come to think of it. Now only three are left; and, no, they do not make them like that any more.

I met Anna at NYU. Back then the NBER occupied the 8th floor of 269 Mercer Street.  NYU's economics department was on the 7th floor.  Of course I went to meet her.  She turned out to be very nice, so I got the bright idea to ask her to serve as an external member of my dissertation committee.  I had the impression that I was one of very few NYU Ph.D. candidates to think of doing that, which struck me as odd.  But then a lot of things about NYU, and about the economics business generally, struck me (and still strike me) as odd.

Anna gave me some good advice; indeed, apart from Larry White (who was my supervisor, and who I talked to almost daily) she was my most helpful adviser at NYU.  Naturally I don't remember much about the particular advice she gave me.  But I do distinctly remember her telling me that, once I got into the business,  I had better write about stuff besides free banking if wanted to survive.  I took Anna's advice, and still found it rough going. Had I not listened to her I'm sure I would have had to give up.

I'm also pretty sure that it was only thanks to Anna that some of the the free banking stuff that did make it into the better journals got through: she was one of the few persons who was both greatly respected by the editors of those journals and willing to give the free bankers a hearing.  Indeed, Anna was more than sympathetic: she was, or she became, one of us. I am reasonably certain that she played a very large, if not crucial, part in encouraging Milton to revise his thinking on the topic, as he did when he and Anna published their 1986 JME paper "Has Government Any Role in Money?".  That Anna's views on the proper scope of government interference in banking became progressively more radical I have no doubt.  For example, while in a 1995 Cato Journal article she and Mike Bordo took the conventional line that you couldn't have a stable banking system without some sort of deposit insurance, when I questioned her about this stand a few years ago Anna claimed that she had since rejected that view, having come to believe instead that the moral hazard arising from deposit guarantees ultimately caused such guarantees to do more harm than good.

I was lucky to be able to talk to Anna at length on several occasions during the last few years, thanks to Walker Todd, who arranged for her to visit the American Institute for Economic Research while I was there as a summer fellow.  What I remember most about those conversations was how very candid and uncompromising they were: Anna never held a punch, and when she threw one, it landed square on target.  Not that Anna wasn't generous with praise: it's just that, whatever she thought, she always came right out with it.  She'd lived long enough, I suppose, to earn that. In any event it meant that talking to her was really a blast. (If only I could repeat all that I heard!)

Now, with all the dominoes lined-up from Greece to Brussels and beyond, and ready to start toppling at any moment, how I wish that this tough and uncompromising monetarist was still among us!  No one can say just what she'd have made of it all; but whatever she made you can bet she would have served it up straight.

The post Happy Birthday, Anna appeared first on Alt-M.

]]> 1
Matt Ridley on the Evolution of Money (among other things) Wed, 11 Nov 2015 00:19:58 +0000 The gang at Cato’s Center for Monetary and Financial Alternatives is thrilled to report that Matt Ridley will visit Cato tomorrow to discuss his new book The Evolution of Everything. Ridley is the author of numerous best-selling (and excellent) books on science and society.  We especially like his 2010 book, The...

The post Matt Ridley on the Evolution of Money (among other things) appeared first on Alt-M.

evolution of money, free banking, matt ridley, george selgin, larry whiteThe gang at Cato’s Center for Monetary and Financial Alternatives is thrilled to report that Matt Ridley will visit Cato tomorrow to discuss his new book The Evolution of Everything.

Ridley is the author of numerous best-selling (and excellent) books on science and society.  We especially like his 2010 book, The Rational Optimist, How Prosperity Evolves, for which he won the Manhattan Institute’s prestigious Hayek prize.  In that work, Ridley draws on both the biological theory of evolution, and the theories of specialization and trade made famous by Adam Smith, to argue that human societies possess a natural tendency to become both more economically specialized and more prosperous.

The Evolution of Everything elaborates on the same theme, by showing how social progress mainly happens, not in response to politicians’ mandates, but because of the free activity of everyday people.  Its chapters illustrate Ridley’s “bottom up” view of history, which he contrasts with the usual emphasis upon history as shaped by bureaucrats, politicians, and armies.

Our favorite chapter of Ridley’s new book is—surprise, surprise!—the one on “The Evolution of Money,” in which he argues that spontaneously-developed monetary systems tend to be more stable, more egalitarian, and more prosperity-enhancing, than ones that are deliberately designed and centrally managed.  As evidence he refers to George Selgin’s study of Birmingham’s private coinmakers, as well as Larry White’s work on the Scottish free banking system.

Of Birmingham’s coiners, Matt writes:

Birmingham businessmen had privatized the penny.  Their coins were a vast improvement on the Royal Mint’s rivals.  This despite the fact that the new coins had been designed from scratch in just a few years, and had no legal protection against fraud, unlike the Mint’s coins.  Unprotected by monopoly privilege, the commercial coiners had not only to be cost-effective, but to attract the best engravers and strikers, and had to design their coins so they would be hard to imitate. [p. 279]

Of Scotland’s 1716–1844 free-banking era, he adds:

Scotland experienced unparalleled monetary stability, pioneering financial innovation amid rapid economic growth as it caught up with England.  It had a self-regulating monetary system, which worked as well as any other monetary system at any other time or place.  Indeed it was so popular Scots rushed to praise and defend their banks — a phenomenon largely unheard of in history. [p. 281]

Such episodes of spontaneous monetary order stand in stark contrast to recent experience, in which government guarantees and other misguided programs led to boom and bust — despite (and often with the connivance of) layer upon layer of regulatory oversight.  Ultimately, writes Ridley,

the explosion in sub-prime lending was a thoroughly top-down, political project, mandated by Congress, implemented by government sponsored enterprises, enforced by the law, encouraged by the president and monitored by pressure groups.  Remember this when you hear people blame the free market for the excesses of the sub-prime bubble. [p.  291]

But don’t settle for these little snippets.  Read the whole book.  Better still: get yourself a signed copy, and listen to the man himself, here at Cato.  That’s tomorrow between noon and 1:30.  You can sign up for the event here.  Those who can’t make it can listen to the livestream here.

The post Matt Ridley on the Evolution of Money (among other things) appeared first on Alt-M.

]]> 5
What is “Optimal” Monetary Policy? Mon, 09 Nov 2015 21:37:34 +0000 On Thursday, November 12th, Cato hosts its 33rd Annual Monetary Conference.  This year’s conference theme is “Rethinking Monetary Policy.”  I will be presenting a paper on “Monetary Policy: The Knowledge Problem.” The knowledge problem in conducting monetary policy, or any other government policy, is that the required knowledge is simply...

The post What is “Optimal” Monetary Policy? appeared first on Alt-M.

O'Driscoll, knowledge problem, monetary conference, central banksOn Thursday, November 12th, Cato hosts its 33rd Annual Monetary Conference.  This year’s conference theme is “Rethinking Monetary Policy.”  I will be presenting a paper on “Monetary Policy: The Knowledge Problem.”

The knowledge problem in conducting monetary policy, or any other government policy, is that the required knowledge is simply not available to policymakers.  The knowledge is not available in any one place, nor can it be assembled in a form that would enable policymakers to formulate an “optimal” policy.

My paper focuses on Friedrich Hayek because he first formulated the knowledge problem.  He argued that knowledge is inherently dispersed and localized across the population of economic agents.  It is not possible to assemble the totality of knowledge existing in society in any one mind or place.  Moreover, what the totality of individuals knows far exceeds what any policymaker can know, no matter his expertise and wisdom.

In order to formulate an optimal policy, a monetary authority must predict how alternative policy actions will affect the plans of millions of people.  That information is unavailable.  Assuming it exists in an economic model doesn’t make it so.

It is the conceit of central bankers (or at least most) that they can acquire the knowledge needed to conduct optimal monetary policy.  In his Nobel Prize lecture, Hayek called that “The Pretence of Knowledge.”

In my paper, I also detail Milton Friedman’s contribution to the knowledge problem in monetary policy.  That contribution has been under-appreciated in the literature.

Some problems cannot be solved.  The knowledge problem is one such.  But it can be mitigated, and I conclude my paper by discussing how that might happen.  I suggest, as did Hayek and Friedman, that a monetary rule works best.

(If you would like to see O'Driscoll present his paper at the November 12th monetary conference, you can register here.  With several central bankers on the distinguished line up, including St. Louis Fed President James Bullard, Richmond Fed President Jeffrey Lacker, and Bank of Mexico Deputy Governor Manuel Sánchez, this year's conference is a particularly interesting place to discuss the knowledge problem in the context of central banking.  If you cannot attend, the conference papers will appear in a forthcoming edition of the Cato Journal. — Ed.)

The post What is “Optimal” Monetary Policy? appeared first on Alt-M.

]]> 3
The Monetary Base and Total Reserves: Fed Confusions and Misreporting Sat, 07 Nov 2015 12:11:23 +0000 The monetary base is the only magnitude that the Fed directly controls.  It consists of currency held by the general public (including both Federal Reserve notes and Treasury coin) and the total aggregate reserves of banks and other depositories (whether held in the form of vault cash or deposits at...

The post The Monetary Base and Total Reserves: Fed Confusions and Misreporting appeared first on Alt-M.


The monetary base is the only magnitude that the Fed directly controls.  It consists of currency held by the general public (including both Federal Reserve notes and Treasury coin) and the total aggregate reserves of banks and other depositories (whether held in the form of vault cash or deposits at one of the regional Federal Reserve banks).

Some would translate this control over the base into direct Fed control over total reserves, but that is not strictly correct.  Even though the Fed initially increases (or decreases) the base by increasing (or decreasing) reserves, the general public and the banks determine how much of the base is ultimately held instead in the form of currency in circulation.  Thus, it would seem desirable to have the Fed report the base and its two components accurately.  Yet the Fed’s reported measures of total reserves exclude significant amounts of bank vault cash.  Even with changes in the Fed’s monthly releases implemented in July 2013, the problem has not been rectified.  Moreover, there also remains a minor omission from the total base that while not yet serious could become so in the future.  More important, once the Fed began paying interest on reserves in 2008, it dramatically altered the monetary relevance of its base and reserve measures.

Misreporting Total Reserves

Several different measures of total reserves exist.  Both the St. Louis Fed and the Board of Governors have reported total reserves adjusted for changes in reserve requirements.  Although the St. Louis Fed continues to do so, the Board of Governors discontinued its adjusted series in July 2013.[1]  But these series, especially when seasonally adjusted as well, are not the raw numbers.  While allegedly (but dubiously) useful for conducting monetary policy, adjustments for changes in reserve requirements grossly distort the historical record.

Only the Board of Governors in its weekly H.3 Release reports total reserves unadjusted for reserve requirements.  But this series excludes any excess reserves held in the form of vault cash, and before July 2013 all required clearing balances and Fed float, and therefore under reports the total.[2]  For some idea of how massive the resulting misrepresentation can be, consider December 2007.  The Board of Governors reports total reserves (monthly, not seasonally, adjusted, and not adjusted for changes in reserve requirements) of $42.7 billion.  If you add in vault cash not covering reserve requirements, that number jumps to $60.3 billion.  And when you bring in required clearing balances and float, the number rises to $72.6 billion, 70 percent greater than the Board’s estimate.[3]  If the distortion were consistent across time, the Board’s reserve totals would still tell us something.  But the distortion is not close to consistent across time, in part because banks used increasing amounts of vault cash in their ATMs.

Consequently, to arrive at an accurate series for total reserves, one has to take the Board of Governors Monetary Base (not seasonally adjusted and not adjusted for changes in reserve requirements) and subtract the currency in circulation component of M1 (not seasonally adjusted).[4]  Or alternatively, one could make the same subtraction of M1 currency from what the St. Louis Fed calls the Source Base (monthly and not seasonally adjusted), which is virtually identical to the Board’s measure of the base.[5]  And just to add to the potential confusion, one must not use the so-called “currency in circulation” reported in the Board’s H.3 and H.4.1 Releases.[6]  That measure includes not only currency in the hands of the public but also the vault cash of banks and other depositories.  Subtracting it from the monetary base would yield the same misleading measure of total reserves as that of the Board.  Only the currency component of M1, reported in the Fed’s weekly H.6 Release, confines itself to currency held by the public.

In July of 2013 the Board made a few changes.  It introduced a new measure of the monetary base in the H.3 Release at the same time that it eliminated the small clearing balances banks were required to hold and revised Regulation D to simplify the administration of reserve requirements.[7]  Although the Board has calculated this new, modified version of the monetary base going back to January 1959, its differences with the old version are so minor as to be hardly noticeable.[8]  The elimination of the requirement that banks hold clearing balances, however, offers a third way of calculating total reserves from mid-2013 forward.  One can simply add “Surplus Vault Cash” to “Total Reserves” in Table 2 of the H.3 Release.  Yet this remains probably the least accurate of the three ways because it excludes the small amount of vault cash held by depositories whose total checking accounts fall below the level subject to reserve requirements.

It goes without saying that none of three ways of correctly determining total reserves is directly available on the St. Louis Fed’s interactive FRED website.  Curiously, the St Louis Fed considers the Board’s “narrow” definition of total reserves less than satisfactory for “modeling the role of depository institutions in the economy.”[9 ]  As far as I can tell, it uses the broader definition that includes all vault cash, rather than the Board’s narrow definition, as the basis for its series of total reserves adjusted for reserve requirements.  Yet it has nowhere reported its preferred unadjusted broad measure.[10]  Figure 1 illustrates how significant were the differences in these various measures of total reserves between 1979 and 2008.


Misreporting the Monetary Base

Less serious are some peculiarities in the Fed’s reporting of the total monetary base, but they have the potential of becoming more misleading in the future.  They arise because banks and other depositories are not the only institutions that can deposit reserves at the Federal Reserve Banks.  The Board’s weekly H.4.1 Release divides these additional deposits into two categories: “foreign official” and “other.”[11]  Foreign official deposits are balances of foreign central banks and monetary authorities, foreign governments, and other foreign official institutions.  The deposits labelled “other” include balances of international and multilateral organizations such as the International Monetary Fund, the United Nations, and the World Bank, along with such government-owned agencies or government-sponsored enterprises as Fannie Mae, Freddie Mac, and the Federal Homes Loan Banks.  Neither of these two categories of deposits at the Fed has ever been included within measures of the monetary base.

The case for excluding foreign official deposits seems straightforward.  Being held by institutions abroad, these deposits are not part of the domestic monetary base.  But this does create an odd asymmetry; large amounts of U.S. currency are also held abroad, presently at least half of that in circulation, by most estimates.[12]  Currency in circulation, in turn, is a large component of the reported monetary base: about 90 percent prior to the financial crisis and today, after quantitative easing and the huge increase in banks reserves, still about 30 percent.  It would be nice to have two consistent estimates of the monetary base, one including all currency and all reserves, whether held domestically or abroad, and the other including only domestically held currency and reserves.  But estimates of currency held abroad are quite unreliable.  Fortunately, the total amount official foreign deposits have been and remain small.[13]

None of these mitigating factors, however, holds as strongly for the category of deposits listed on the Fed balance sheet as “other.”  To begin with, Fannie, Freddie, and other government-sponsored enterprises are domestic institutions.  We could debate exactly where their Fed deposits belong in the monetary base.  Because these institutions do not create money, one could argue that their deposits at the Fed are really only an alternative form of currency and should be counted as such in the base.  On the other hand, Fed deposits allow these institutions to participate in the Federal funds market.  Indeed, because these institutions do not currently earn interest on these deposits, they have become the major players keeping the Federal funds rate below the interest rate on reserves.  Few banks are going to loan out their reserves at less than what the Fed is paying them.  As a result, the introduction of interest on reserves in October 2008 and the resulting accumulation of reserves by banks not only caused a collapse of Federal funds lending from over $200 billion to nearly a third of that, but the Federal Home Loan Banks became the dominant lenders in this market.[14]  This would suggest that their deposits should be counted in the base as total reserves.

Wherever in the base these “other” deposits should be categorized, they were as insignificant as “official foreign” deposits prior to the financial crisis.  Yet since then they have risen as high as $107 billion in December 2011.  (See Figure 2.)  Although that amount, if counted in the base at that time, would have increased the total base by only 4.1 percent, the same $107 billion would have increased the pre-quantitative base by more than 10 percent.[15]  There is no guarantee that a Fed exit strategy that decreases the monetary base will pari passu decrease these non-interest earning deposits.  In fact, it is likely that access of government-sponsored enterprises to Fed deposits will expand in the future.


Indeed, a change introduced by the Board of Governors on February 18, 2014, portents such an expansion of non-bank deposits at the Fed.  The Dodd-Frank Act permits the Fed to provide financial services to what are styled Financial Market Utilities (FMU’s), and the new Financial Stability Oversight Committee has so far designated eight such FMU’s.  They are the Clearing House Payments Company, CLS Bank International, Chicago Mercantile Exchange, the Depository Trust Company, Fixed Income Clearing Corporation, ICE Clear Credit, National Securities Clearing Corporation, and the Options Clearing Corporation.[16]   All FMU’s now lodge deposits at the Fed and may eventually earn interest on them.  Some of these entities previously had Fed deposits, but before February 2014, their deposits, along with those of banks, were counted in the monetary base.  Now all FMU deposits are in the “other” category and have been dropped out of the the base.  In other words, this represent still another omission that could in the future more seriously distort reported measures of both total reserves and the monetary base.[17]

Monetary Relevance of the Base and Reserves

Up to this point, I have focused on statistical inconsistencies in the Fed’s reported measures of both the monetary base and total reserves.  But once the Fed began paying interest on reserves, it created a theoretical problem with the reported versions of these measures.  Monetary economists distinguish between outside money and inside money.[18]  Checking accounts and other deposits at banks qualify as inside money because they have both an asset and liability side; they are an asset of the depositor and a liability of the bank.  Redeemable for Federal Reserve notes, they therefore entail financial intermediation in which the depositor can be thought to lend cash to the bank, which then relends part or all of it.  Federal Reserve notes, on the other hand, are outside money.  While nominally a liability on the Fed’s balance sheet, this paper fiat money is not a genuine liability and not redeemable for anything other than an equal amount of more of the same.  Federal Reserve notes therefore are an asset only; like gold coins in a commodity money system.  Prior to the financial crisis, the monetary base consisted entirely of outside money.[19]

This changed when the Fed began paying interest on reserves.  Through these interest payments, these reserves have become a genuine liability on the Fed’s balance sheet.  They are just like interest-earning Treasury securities.  The Fed is now in effect borrowing money from banks in order to relend it on the asset side of its balance sheet.  In short, the Fed is now involved in financial intermediation, doing the same thing as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.  Interest-earning reserves therefore cease to be outside money and become another form of inside money.  Or to put it another way, the Fed in essence is conducting fiscal policy just like the U.S. Treasury.  When the Treasury borrows money, even with short-term Treasury bills, those securities are not considered part of the monetary base.  There is no good reason why Fed borrowing should be any different.[20]

The Fed’s Term Deposit Facility(TDC), created on April 30, 2010, helps highlight this logic.  The TDC is a mechanism through which banks can convert their reserve deposits at the Fed (which are like Fed-provided, interest-earning checking accounts for banks) into deposits of fixed maturity at higher interest rates set by auction (making them like Fed-provided certificates of deposit for banks).  The Fed so far has only tested term deposits, which peaked at $404 billion in February 2014, with maturities ranging from 14 to 84 days.  But for obvious reasons, this form of Fed borrowing is quite correctly excluded from Fed measures of both total reserves and the monetary base.[21]

Not all bank reserves earn interest—only those reserves held as deposits at the Fed.  A bank’s vault cash earns nothing, but vault cash currently amounts to a little less than $70 billion, about the same as total reserves before the Fed began quantitative easing.[22]  Thus, at least $2.5 trillion of the post-crisis explosion of the monetary base constitutes interest-bearing inside money that in substance is government debt merely intermediated by the Fed.[23]   Confining the definition of the monetary base and total reserves to only non-interest bearing, Fed-created outside money would yield the results for the period from 2001 to mid-2015 depicted in Figure 3, 4, and 5.[24]  With this adjustment, the mere $500 billion increase in what we can call the “outside base” since September 2008 represents merely a slightly more rapid rate of increase than the rate of increase in the base the decade prior, and nearly all of that recent increase has been in the form of hand-held currency.[25]

No wonder that the high inflation that so many expected from quantitative easing never materialized.

Hummel 4

Hummel 5


[1] Richard G. Anderson and Robert H. Rasche, with Jeffrey Loesel, “A Reconstruction of the Federal Reserve Bank of St. Louis Adjusted Monetary Base and Reserves,” Federal Reserve Bank of St. Louis Review 85 (September/October 2003): 39-69. The Board of Governors adjusted series is labelled as TRARR on the St. Louis Fed “FRED” website.

[2] This monthly series is labelled TOTRESNS on the “FRED” website.

[3] Required clearing balances arose out of the Fed’s check-clearing operations, paid interest, and are explained in E. J. Stevens, “Required Clearing Balances,” Federal Reserve Bank of Cleveland Economic Review 29 (1993, Quarter 4): 2–14.  Float also results from the Fed’s check clearing and is reported in the Fed’s H.4.1 Release.  It requires the smallest adjustment.  Before extensive electronic clearings, the time it took for checks to clear almost always exceed the brief hold the Fed puts on checks submitted for clearing.  So the float would be positive, and two banks would temporarily be counting the same reserves, giving a small boost to total reserves and the monetary base.  Despite being quite small, however, float usually made a bigger contribution to reserves than Fed discount loans to depositories.  For instance, on July 26, 1996, the float was a mere $769 million, or only 0.17 percent of Fed assets.  But on the same date, total discounts were even less: $258 billion.  Now with electronic clearings, the float is almost always negative.  Checks clear faster than banks receive credit for them, trivially reducing total reserves and the base.  On August 28, 2002, for example, the float was a negative $324 million, but still larger in absolute value than the $189 million in total discounts.  With the huge increase in reserves resulting from quantitative easing, the affect of the float is so insignificant as to be hardly worth bothering about.

[4] I used the monthly series in my calculations and figures, labelled BOGUMNBS and CURRNS, respectively, at “FRED.” But one can do the same manipulation with weekly series.

[5] Labelled SBASENS at “Fred.”

[6] Labelled MBCURRCIR at “Fred.”

[7] The change was announced in the H.3 Release of June 6, 2013, and implemented in the H.3. Release of July 11, 2013.  The new monetary-base series is labeled BOMGBASE at “FRED,” and the revisions of Regulation D are detailed in the Federal Register.

[8] Among the “Technical Q&As” on the H.3 Release at the Board's website, it states that the “levels and growth rates of the two series are nearly identical,” and provides a confirming graph.  But I double-checked with an Excel spreadsheet of the two series just to make sure.

[9] “St. Louis Adjusted Monetary Base Series,” Federal Reserve Bank of St. Louis Economic Research (November 18, 1996).

[10] St. Louis Adjusted Reserves are reported bi-weekly and monthly, and both seasonally adjusted and not seasonally adjusted.  The monthly not seasonally adjusted series is labelled ADJRESNS at the FRED website.  See also Richard G. Anderson and Robert H. Rasche, “A Revised Measure of the St. Louis Adjusted Monetary Base,” Federal Reserve Bank of St. Louis Review (March/April 1996).

[11] The H.4.1. Release lists these deposits in the table labelled “Factors Affecting Reserve Balances of Depository Institutions” and again in the table labelled “Consolidated Statement of Condition of All Federal Reserve Banks.”

[12] Ruth Judson, “Crisis and Calm: Demand for U.S. Currency at Home and Abroad from the Fall of the Berlin Wall to 2011,” Board of Governors of the Federal Reserve System, International Finance Discussion Papers, IFDP 1058 (November 2012).

[13] Although the amount of these deposits rose from the neighborhood of $100 million prior to the financial crisis to as high as $11.2 billion afterwards, they have never exceeded 0.4 percent of the total monetary base.  This series is labelled as WLFOL at FRED.

[14] Gara Afonso, Alex Entz, and Eric LeSueur, “Who’s Lending in the Fed Funds Market?” Federal Reserve Bank of New York Liberty Street Economics (December 2, 2013).

[15] The FRED time series for “other” deposits is labelled WOTHLB.

[16] For details on these FMU’s, see “Designated Financial Market Utilities” at the Fed Board of Governors website.

[17] The handling of FMU’s in the Board’s Releases is described at “Technical Q&As” on the H.3 Release and “Have a Question about the H.4.1?” at the Board’s website.

[18] John G. Gurley and Edward S. Shaw, Money in a Theory of Finance (Washington: Brookings Institution, 1960), first coined the terms inside and outside money.  Their distinction was between money that was issued through financial intermediation (inside), with an offsetting liability side, and money that was an asset only (outside), without an offsetting liability side.  They were challenged by Boris P. Pesek and Thomas R. Saving, Money, Wealth, and Economic Theory (New York: Macmillan, 1967), who argued that the critical distinction was between interest-bearing and non-interest bearing money.  But Pesek and Saving then leapt to the conclusion that much bank-created money over and above bank reserves counted as outside money.  The subsequent tortuous debate was best sorted out by Friedman and Schwartz, Monetary Statistics of the United States: Estimates, Sources, Methods (New York: Columbia University Press, 1970), pp. 110-118, 128-130; who argued that the bank-created money that Pesek and Saving were implicitly counting as outside money was better thought of as reflecting the valuable charters of banks, often because of the monopoly privileges that banks then enjoyed.

[19] With the possible exception of the small amount of interest-earning required clearing balances mentioned in the first section and discontinued in July 2013.

[20] The Fiscal Theory of the Price Level implicitly denies that even currency in circulation is genuine outside money but, because it is payable of taxes, a form of inside money, as pointed out in Jeffrey Rogers Hummel, “Mises, the Regression Theorem, and Free Banking, Liberty Matters: An Online Discussion Forum (January 2014). Here is not the place to fully address this contention.

[21] This series is reported in the Board’s H.4.1 Release and is labelled WLTDHDIA at FRED.  Other forms of Fed borrowing that are also quite correctly not counted as reserves or in the monetary base are Treasury deposits (which during the financial crises were expanded with what was called the Supplementary Financing Account, discontinued in July 2011) and reverse repurchase agreements.  For details about these as well as the Term Deposit Facility, see Jeffrey Rogers Hummel,The Federal Reserve’s Exit Strategy: Looming Inflation or Controllable Overhang,” Mercatus Research, Mercatus Center at George Mason University, September 2014.

[22] Total vault cash is now reported in the Board’s H.3 Release and is labelled TLVAULTW at FRED.

[23] A more sophisticated approach would treat interest-bearing reserves as partly both inside and outside money that should be weighted on the basis of the difference between the interest rate paid on reserves and some higher market rate.  But then one would have to view the liquidity services of many other financial assets as making them partly outside money as well.  Although this is an enormous, if not totally insurmountable, empirical problem, it is an approach that has been frequently suggested and is similar to what Divisia aggregates try to do with measures of the money stock weighted according to liquidity.

[24] The total outside base is calculated by taking the Board’s base series (monthly, not seasonally adjusted) available at “FRED” as BOMGBASE and, beginning in September 2008, subtracting the Board’s series on Total Reserves Maintained at Federal Reserve Banks (monthly, not seasonally adjusted), reported in the H.3 Release and available at “FRED” as RESBALNS.  Currency is still the currency component of M1, reported in the H.6 Release and as CURRNS at “FRED.”  Outside reserves is the difference between the total outside base and currency.

[25] Since the crisis, the growth rate of the non-interest bearing base (outside money) has risen from less than 2 percent in mid-2008 to has high as 9 percent annually.  The irrelevance of interest-bearing base money for genuine monetary policy has also been noted by John A. Tatom, “U.S. Monetary Policy in Disarray,” Journal of Financial Stability. 12 (2014): 47-58.  One minor difference between Tatom’s analysis and mine is that his “adjusted monetary base” only subtracts excess reserves held as deposits at the Fed from the monetary base, whereas I subtract all interest-bearing reserves, whether excess or required.

The post The Monetary Base and Total Reserves: Fed Confusions and Misreporting appeared first on Alt-M.

]]> 4
The Courage to Refuse Sat, 31 Oct 2015 11:24:14 +0000 Last week I attended a talk and panel discussion at Brookings, in which Roger Lowenstein discussed his new book on the Fed's origins.  I have much to say about that book, and I eventually plan to say some of it here.  But for the moment my concern is with another...

The post The Courage to Refuse appeared first on Alt-M.

courage to act, Bernanke, Federal Reserve, Fed, bailouts, moral hazard, TBTF, too big to failLast week I attended a talk and panel discussion at Brookings, in which Roger Lowenstein discussed his new book on the Fed's origins.  I have much to say about that book, and I eventually plan to say some of it here.  But for the moment my concern is with another book, this one concerning, not the Fed's origins, but its recent conduct.  I mean Ben Bernanke's The Courage to Act.

So why bring up the Brookings event?  Because, in the course of that Federal Reserve love-fest, someone made a passing reference to those crazy people who actually want to limit the Fed's emergency lending powers.  Having seen the Fed save the economy from oblivion, such people, one of the panelists observed (I believe it was former Fed Vice Chairman Donald Kohn), are determined to make sure it can never save it again!  At this, the audience chuckled approvingly.

Well, mostly it did.  My own reaction was more like a bad attack of acid reflux.  Is it really possible, I asked myself (as I struggled to keep my gorge from rising), that nobody here takes the moral hazard problem seriously?  Do they really suppose that Senators Warren and Vitter and others seeking to limit the Fed's bailout capacity are doing so because they like financial meltdowns and couldn't care less if the U.S. economy went to hell in a hand-basket?

To his credit, Ben Bernanke does understand the problem of moral hazard.  Moreover, he claims, in his long but very readable memoir, to have struggled with it repeatedly over the course of the financial crises.  "I knew," he writes at one point, "that financial disruptions" could

send the economy into a tailspin.  At the same time, I was mindful of the dangers of moral hazard — the risk that rescuing investors and financial institutions from the consequences of their bad decisions could encourage more bad decisions in the future (p. 147).

Faced with this dilemma, what's a responsible central banker to do?  The classic answer — and one that Bernanke has long endorsed — is what he calls "Bagehot's dictum," after Walter Bagehot, the Victorian polymath (and opponent of central banking) who set it forth in Lombard Street.  According to Bernanke's own summary of that dictum, central bankers faced with a crisis should "lend freely at a high interest rate, against good collateral" (p. 45).

Did Bernanke's Fed follow Bagehot's advice?  To answer, it helps to first consider Bagehot's own elaboration of his rules:

First. That these loans should only be made at a very high rate of interest.  This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it.  The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Secondly.  That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them.  The reason is plain.  The object is to stay alarm, and nothing therefore should be done to cause alarm.  But the way to cause alarm is to refuse some one who has good security to offer… No advances indeed need be made by which the Bank will ultimately lose.  The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business… The great majority, the majority to be protected, are the 'sound' people, the people who have good security to offer.  If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security — on what is then commonly pledged and easily convertible — the alarm of the solvent merchants and bankers will be stayed.  But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.

Plainly, Bagehot's reasons for insisting on good collateral ("good banking securities") are, first, to protect the central bank itself against losses, and, second, to make sure that only "sound" institutions benefit from the central bank's protection.

The Fed's first, extraordinary use of its last-resort lending power during the subprime crisis consisted of its decision, on March 15, 2008, to assist JPMorgan's purchase of Bear Stearns by arranging for the purchase, through Maiden Lane, a limited liability company formed for the purpose, of $30 billion worth of Bear's mortgage-related securities.  Although Bernanke claims that those securities were "judged by the rating agencies to be investment-grade" (that is, rated BBB- or higher) (p. 219), their value when the Fed acquired them was anything but certain, which is why JPMorgan was determined to limit its exposure to losses on them to $1 billion — its share of the Maiden Lane purchase.

Moreover, thanks to Bloomberg's having forced the Fed to disclose the contents of all three Maiden Lane portfolios, we now know that, by April 3, 2008, when Bernanke made the same "investment grade" claim in testifying before the Senate Banking Committee, some Maiden Lane securities had already been downgraded to below investment grade.  Furthermore we know that Maiden Lane I's portfolio was chock-full of toxic securities.  Reacting to these disclosures, Ohio Senator Sherrod Brown, a member of the Senate Banking Committee, opined that “Either the Fed did not understand the distressed state of some of the assets that it was purchasing from banks and is only now discovering their true value, or it understood that it was buying weak assets and attempted to obscure that fact." 

That Bernanke should repeat the "investment grade" claim in his book, after the true nature of the Fed's purchases has been disclosed, seems pretty surprising.  So, for that matter, does his admission — offered in defense of the Fed's subsequent decision to let Lehman go under — that the Fed "had no legal authority to overpay for bad assets."  If the Fed really lacked such authority, then its purchase of Bear's assets wasn't legal.  If it did have permission to overpay, then the reason Bernanke gives for the Fed's having let Lehman Brothers fail — a reason he only started referring to when questioned by the Financial Crisis Inquiry Commission (FCIC), almost two years after the rescue — is phony.

If saying that the the Fed's Bear bailout was secured by "investment grade" collateral is a stretch,  calling the assets in question "sound banking securities" or "commonly pledged" ones requires an impossible leap:  even the Fed itself commonly accepts only AAA-rated CDOs and MBSs as collateral for its  discount-window loans.

Yet perhaps the biggest problem with the Bear loan was, oddly enough, the fact that its providers did not consistently maintain that Bear was being rescued only because it had plenty of good collateral.  Instead, in explaining the Bear rescue to the JEC, Bernanke argued that Bear had to be saved because its sudden failure "could have severely shaken confidence."  Tim Geithner made similar claims; and Hank Paulson, in justifying the rescue to the FCIC, actually scoffed at the suggestion that Bear might have been solvent at the time.  "We were told Thursday night," Paulson testified, "that Bear was going to file for bankruptcy Friday morning if we didn't act.  So how does a solvent company file for bankruptcy?"  How indeed.  In short, far from insisting that they were rescuing Bear because, though illiquid, it was fundamentally sound, those concerned made it clear that they were rescuing it because it was Too Big (or Too Systematically Important) to Fail.*

Peruse the pages of Lombard Street all you like.  You will find no equivalent to the contemporary notion that some firms are Too Big (or Systemically Important) to Fail.  Nor will you discover any other exception to the rule that emergency lending ought to be confined to "sound institutions." Suppose one recklessly-managed, gigantic firm to be in danger of going under, and of ruining 1000 sound firms in the process, unless the central bank intervenes.  Lombard Street offers grounds for having the central bank lend generously to the sound 1000, but none at all for having it lend to the unsound one, however gigantic it may be.

Why not lend to unsound firms, or at least to gigantic (or Systematically Important) ones?  Because, if you do, every gigantic firm will come to expect similar aid, and so will be inclined to take risks it would not take otherwise.  (Notice how this isn't the case if lending is confined to "sound" firms.)    Of course the moral hazard problem had been present before the Bear rescue.  But until then it was mainly confined to commercial banks, which had so far been the only recipients of the Fed's largesse. Although the 13(3) loophole had been present since the 1930s, the Fed hadn't dared to make much use of it even then, and made none at all for decades afterwards.

The Bear rescue  convinced surviving investment banks that they'd suddenly been moved from beyond the school-ground fence to the head of the Systematically-Important class.  As Michael Lewis put it not long after Bear was saved:

Investment banks now have even less pressure on them than they did before to control their risks.  There's a new feeling in the Wall Street air: The big firms are now too big to fail.  Already we may have seen some of the pleasant effects of this financial order: the continued survival of Lehman.  What happened to Bear Stearns might well already have happened to Lehman.  Any firm that uses $1 of its capital to finance $31 of risky bets is at the mercy of public opinion… Throw its viability into doubt and the people who lent them the other $30 want their money back as soon as they can get it — unless they know that, if it comes to that, the Fed will make them whole.  The viability of Lehman Brothers has been thrown into serious doubt, and yet Lehman Brothers lives, a tribute to the Fed's new policy.

Lewis wrote in June 2008.  And he was far from being alone in his sentiments.  (See also Joe Nocera's exit interview of Sheila Bair.)  Lehman filed for bankruptcy in September 2008.  These facts must be kept in mind in assessing Bernanke's own assessment of the Fed's action:

Some would say in hindsight that the moral hazard created by rescuing Bear reduced the urgency of firms like Lehman to raise capital or find buyers. … But in hindsight, I remain comfortable with our intervention. … Our intervention with Bear gave the financial system and the economy a nearly six-month respite, at a relatively modest cost (pp. 224-5; my emphasis).

What Bernanke calls "a six-month respite" is what some others might be inclined to call a six-month period during which failing firms, instead of either looking for more capital wherever they could get it, including from prospective purchasers, or planning for bankruptcy, could become more deeply insolvent.

Bernanke goes on to say that Lehman did, after all, raise some capital that summer, and that it ultimately suffered runs that proved that at last some of its creditors worried that it would not be rescued (ibid.).  But these facts prove no more than that the market put the probability of a Fed rescue at something less than 100 percent.  In fact they don't even prove that much, for as Bernanke observes elsewhere (p. 252), Lehman, besides refusing to consider selling itself, acquired more capital only after being heavily pressured by both the Fed and the Treasury to do so; and Lehman first confronted a broad-based run on September 12, when it finally became evident that the Fed might not rescue it after all (p. 258).  Moreover it's clear from the Fed's internal email communications, as disclosed by the FCIC, that the decision to not rescue Lehman was a last-minute one, and one that came as a surprise even to employees at the New York Fed, who reported in favor of a bailout.

Besides allowing an insolvent firm to go on placing risky bets with other people's money, the expectation of Fed support makes both troubled firms themselves and their prospective buyers unwilling to clinch a deal until the pot has been sweetened.  Had Bear been allowed to fail, or had Bernanke and company somehow been able to persuade larger investment banks that despite the Bear bailout their still greater Systematic Importance was no guarantee of Fed support, Lehman might have felt compelled to grab one of the lifelines thrown to it by CITIC securities and the Korean Development Bank, instead of waiting for the USS Fed to toss it a thicker one.  Whether any of Lehman's prospective, later purchasers were also holding out for such a deal isn't clear, although Bernanke acknowledges that at one point both Bank of America and Barclay's, having found Bear's losses to be much bigger than had previously been assumed, "were looking for the government [i.e., the Fed] to put up $40-$50 billion in new capital" (p. 263), and that he worried at the time that the firms might be "overstating the numbers as a ploy to obtain a better deal."

In the case of AIG's rescue, it's even harder to avoid seeing a moral-hazard-inspired game of chicken being played out between the lines of Bernanke's account.  "Every time we heard from the company and its potential private-sector rescuers," Bernanke writes, "the amount of cash it needed [from the Fed] seemed to grow" (p. 275).  When two firms finally made offers, AIG's board "rejected them as inadequate," and then made sure its representatives let Fed Board members know that "it would need Fed assistance to survive" (p. 276).  A day later AIG executives "were hoping for a Federal Reserve loan collateralized by a grab bag of assets ranging from its airplane-leasing division to ski resorts" (p. 127).  Would those executives have entertained such hopes if Bear hadn't been rescued, or if the Fed had been prohibited by statute from rescuing potentially insolvent firms, or ones lacking "good banking securities" in the strict sense of the term?

The $85 billion loan that the Fed ended up making to AIG was in any case even less justifiable on Bagehotian grounds than its loan to Bear had been.  As Bernanke acknowledges, the collateral for the AIG loan consisted, not of any sort of securities but of "the going concern value of specific businesses," the value of AIG's marketable securities having been "not nearly sufficient to collateralize…the loan it needed" (p. 281).  Even granting Bernanke's claim that such collateral met the Fed's own legal requirements — a claim that is one of many reasons for entertaining serious doubts concerning Bernanke's insistence that the Fed could not legally have rescued Lehman Brothers — it certainly couldn't be said to consist of "good bank securities."  On the contrary, it was so bad that when the Fed was forced to disclose its Maiden Lane holdings, those of Maiden Lane II and III, which held AIG's troubled assets, were worth 44 and 39 cents on the dollar, respectively.

Although the Fed's defenders, Bernanke among them, are quick to note that all three Maiden Lane portfolios eventually recovered, so that the Fed (or rather taxpayers) bore no losses, the fact that they did doesn't at all suffice to square the rescues in question with Bagehot's well-considered advice.  That advice simply doesn't allow central banks to place risky bets on troubled firms.  Bagehot never says that it's OK  for a central bank to set his advice aside provided that its gambles end up paying off.**  The Fed's apologists also fail to consider that, while the Fed itself may have come out of the deals it made smelling like roses, the same cannot be said for several of the private firms that took part in them.

And what about the moral hazard consequences of the AIG bailout?  Time will tell, but at very least the bailout set the dangerous precedent of having the SIFI ("Systemically Important Financial Institution") stamp applied to non-financial firms.  And although Bernanke assures his readers that the bailout's "tough" terms were such as would not "reward failure or…provide other companies with an incentive to take the types of risks that had brought AIG to the brink" (p. xiii), he fails to point out that the terms, though "tough" on AIG's shareholders, let its creditors, including Goldman Sachs, go Scot-free, instead of insisting that they accept haircuts.  The trouble is that, unless creditors bear some part of the risk of failure, they will chase after high non-risk-adjusted returns, even if that means depriving safer firms of credit.

The plain truth is that, despite his professed devotion to Bagehot, Ben Bernanke was never able to heed the principles laid down by that great authority on last-resort lending.***  Nor is it hard to see why.  When confronted by a failing SIFI, it generally takes more courage for a central banker to refuse aid than to grant it.  After all, if the SIFI survives, the central banker can claim credit, whereas if it doesn't he can at least claim to have "acted."  On the other hand, if the SIFI is left to fail, the costs are obvious and immediate, whereas the benefits are largely invisible and remote.  Bad as it was, the  drubbing Bernanke took for bailing out Bear and AIG was nothing compared to  the horsewhipping he received, even from some people whose opinions he had reason to care about, after he let Lehman fold.  The usual public choice logic applies.  In any event, no one knows how to calculate the net present value of present and future financial losses.  And who, in the midst of a crisis, would pay attention if someone managed to do it?

And that is why it makes little sense, after all, to blame Ben Bernanke for the Fed's irresponsible bailouts.  Apart from allowing Lehman Brothers to fail, he only did what just about any central banker would have done under the same circumstances.  For among that tribe, the courage to act is one thing; the courage to refuse to rescue large, potentially insolvent firms is quite another.  And that is why we need laws that make such rescues impossible.


*Although throughout most of his memoir Bernanke insists that the Fed's emergency lending was "guided" by Bagehot's dictum calling for "unlimited credit to fundamentally solvent financial institutions and markets " (p. 268), at one point he writes that "In a few instances, we went beyond Bagehot by using our lending authority to rescue large institutions on the brink of collapse, including Bear Stearns and AIG"  Note that "including."   (Note added 11/6/2015.)

**Bernanke himself appears to confuse loans paid in full with loans made to solvent institutions when he observes that "Nearly all discount window loans [are] to sound institutions with good collateral.  Since its founding a century ago, the Fed has never lost a penny on a discount window loan" (p.149).    Apparently he is unaware of, or has forgotten about, the House Banking Committee's study of Fed discount window lending during the late 1980s and Anna Schwartz's St. Louis Fed article on the same subject.

***The conclusions appears to hold, not just for the Fed's more notorious rescues during the crisis, but also for its lending through the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF), both of which lent on toxic and systematically overvalued collateral.

The post The Courage to Refuse appeared first on Alt-M.

]]> 19
A Green Light for Investment Crowdfunding? Thu, 29 Oct 2015 12:48:55 +0000 There’s big news in the crowdfunding world.  The Securities and Exchange Commission (SEC) announced that they are (finally) voting on final rules Friday that would make investment crowdfunding legal. Other types of crowdfunding — funding a venture with small amounts of money solicited from a large group of people — have...

The post A Green Light for Investment Crowdfunding? appeared first on Alt-M.

SEC, crowdfunding, Regulation CF

There’s big news in the crowdfunding world.  The Securities and Exchange Commission (SEC) announced that they are (finally) voting on final rules Friday that would make investment crowdfunding legal.

Other types of crowdfunding — funding a venture with small amounts of money solicited from a large group of people — have been around for a while.  The biggest crowdfunding site has even seen its name become a verb – as in “we’re Kickstarting our indie film.”  And while one typically thinks of crowdfunding as a creature of the Internet, the concept has a long history.  The Statue of Liberty stands in New York Harbor because of a successful crowdfunding effort, although in those days they called it taking subscriptions for donations, and the campaign was done door-to-door and not, of course, online.

But crowdfunding has been limited legally.  Organizations raising money through crowdfunding, including for-profit corporations, have been restricted in what they can give in exchange for funds provided through online solicitations.  Things like t-shirts have been popular thank-you gifts, while creators of innovative products, like the Pebble Watch, have offered pre-sales of their coveted inventions.

But offering any kind of return on investment, including the opportunity to buy a piece of the company, has been off limits.  That’s because securities offered for sale in the U.S. must be registered with the relevant regulators, including the SEC and any state regulator in the states in which the securities will be offered.  Any offering that deviates from this rule must fall under one of the laws’ exemptions.  For example, there is an exemption that can apply when an issuer sells only to accredited investors (broadly speaking, institutional investors and wealthy individuals).  Until now, there hasn’t been an exemption for crowdfunding.

In 2010, some entrepreneurs began thinking about an exemption for investment crowdfunding.  They wanted to allow regular people to invest small amounts of money either in start-ups or in small businesses, such as a local coffee shop, without requiring the start-up or small business to register with the regulators.  The fact is that registering an offering with the SEC is extremely time-consuming and expensive.  When companies register an offering for the first time — that is, when the company has its initial public offering or IPO — it’s a big deal.  The local coffee shop is not going to do an IPO to raise $100,000 for a renovation; nor is a start-up going to use an IPO to get seed money.

In the wake of the financial crisis, there was broad concern about capital access for small companies.  In early 2012, Congress passed the Jumpstart Our Business Start-ups (JOBS) Act with wide-spread bi-partisan support, passing 390 to 23 in the House and 73 to 26 in the Senate.  Among other provisions, the Act included a new crowdfunding exemption in securities law.  Reactions in some corners of the start-up world could not have been more enthusiastic: investment crowdfunding would “change the world.”  But the new exemption required implementing regulation, and although the Act ordered the SEC to issue rules by the end of 2012, no rules were forthcoming.  In October 2013, the SEC finally issued proposed rules, but those proposed rules sat untouched for two years.

Finally, with Friday’s vote, the SEC will likely finalize the rules, dubbed Regulation CF, making investment crowdfunding legal.

I doubt, however, that the world will change because of Regulation CF.

The problem is that Regulation CF is really not very new.  It’s an exemption built into the regulatory framework created through the Securities Act and Securities Exchange Act in the mid-1930s.  Even though legislators clearly attempted to create a workable exemption in the JOBS Act, the process was fraught with concern about investors losing all their money through risky start-up investments.  The legislation includes limits on how much any one investor can invest in crowdfunding in any given year — ranging from $2,000 or less for lower and middle income investors, to up to $100,000 for people with incomes over $100,000.

Even this limit was deemed insufficient to fully protect retail investors.  So other features of public offerings (those that are registered with the SEC pursuant to an IPO or later offering) were incorporated into the crowdfunding exemption both in the JOBS Act itself and in proposed Regulation CF.  For example, crowdfunding issuers must both make a number of disclosures about the business and its financial status to the SEC (and the public) and make annual disclosures for as long as the crowdfunding securities remain outstanding, or the company goes out of business.  Additionally, under proposed Regulation CF, issuers must follow U.S. Generally Accepted Accounting Principles (GAAP) in preparing their financial statements.  Among other things, GAAP requires accrual-based accounting, but most small businesses use the simpler cash-based accounting method.  There are reasons to use accrual-based accounting for larger businesses, but it’s not clear that financial statements prepared in accordance with GAAP provides much benefit for investors in small businesses.

The crowdfunding exemption, both as it’s written in the JOBS Act and as the SEC proposes implementing it, is built on several assumptions that underlie the federal securities laws.  While some of these assumptions may be appropriate for the kinds of companies the SEC typically regulates — the large public companies — it’s not clear they apply to the small companies the crowdfunding exemption was designed to support.  Crowdfunding is supposed to be a simple process, one that an issuer could navigate without expensive assistance from accountants and lawyers.  Under the proposed rules and underlying legislation as they are currently written, most issuers will likely need help.  With the $1 million cap on how much a company can raise through selling securities through crowdfunding, it’s unlikely that many issuers will find the process worth the expense.

Fortunately, the JOBS Act included other provisions, many of which have already begun to help companies access capital.  There is no reason why investment crowdfunding should not exist; it’s just unlikely that many issuers will find it useful without significant changes to the underlying legislation, something no rules from the SEC can fix.  And investment crowdfunding is almost certainly not going to change the world.

The post A Green Light for Investment Crowdfunding? appeared first on Alt-M.

]]> 3
A Fed Divided Mon, 26 Oct 2015 13:03:06 +0000 Markets once again are waiting breathlessly for a decision on short-term interest rates by the FOMC, the Federal Reserve’s monetary policy making arm.  All signs point to no change in interest rates.  More interesting is a possible change in how members of the FOMC are thinking about the economy. For...

The post A Fed Divided appeared first on Alt-M.

Fed divided, FOMC, rate rise, interest ratesMarkets once again are waiting breathlessly for a decision on short-term interest rates by the FOMC, the Federal Reserve’s monetary policy making arm.  All signs point to no change in interest rates.  More interesting is a possible change in how members of the FOMC are thinking about the economy.

For years, most members of the FOMC have used the Phillips Curve framework in setting monetary policy.  This is done against the backdrop of the Fed’s so-called dual mandate to promote maximum employment and low inflation.  The Phillips Curve postulates a negative relationship between unemployment and inflation.  Thus, a falling unemployment rate foretells higher inflation in the future.

Now two Fed Governors (members of the FOMC) have questioned the relevance of the Phillips Curve in separate speeches recently.  The one-two punch was delivered by Lael Brainard and Daniel Tarullo.  In Brainard’s words, “I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation.”

At the Kansas City Fed’s annual Jackson Hole conference last August, two former Fed economists questioned the Phillips Curve.  They argued the relationship between inflation and unemployment has never been tight.

The Fed Chair, Janet Yellen, who has been largely absent from public view, remains wedded to the Phillips Curve.  It is unusual for two Governors to so publicly deviate not only from the Chair’s policy guidance but also from the policymaking framework.  Is Janet Yellen losing control of the FOMC?

In reality, labor markets are not so tight and there is just no sign of higher inflation in the near-term.  I made those points in an August 24th op-ed in the Wall Street Journal.

Adding to the dilemma facing the FOMC is that markets are signaling that short-term interest rates should be lower not higher.  New issues of short-term Treasury bills have been issued with a zero interest rate (though the most recent auction produced mildly positive interest rates).  In secondary markets, bills have traded at mildly negative interest rates.  Moreover, short-term interest rates are negative in around 20 countries mostly in the European Union (HT: Walker Todd).

In sum, we have a Fed divided and markets signaling a move down not up in interest rates.  That makes for enhanced uncertainty in financial markets.

The post A Fed Divided appeared first on Alt-M.

]]> 1