Reforming Last-Resort Lending: The Flexible Open Market Alternative

credit allocation, OMOs, open market operations, lender of last resort, Flexbile OMOs, money supply, fed, federal reserve, Term Auction Facility
https://commons.wikimedia.org/wiki/File:StateLibQld_1_128043_Bidding_at_the_Wool_Exchange_in_Brisbane,_ca._1935.jpg

biddingHaving spent the last month or so poring over writings on last-resort lending,* and especially writings dealing with the recent crisis and its aftermath, with the particular aim of discovering the best means for supplying last-resort credit when it's called for, and for not supplying it when it isn't, I've reached a number of tentative conclusions that seem worth reporting. I report them despite their tentative nature so that I might be convinced sooner rather than later that I'm barking up the wrong tree, and also because, if I'm actually on to something, I might get others to help me flesh-out my ideas.

I hasten to add that I regard any need for last-resort lending as reflecting, not the inherent shortcomings of private financial markets, but the debilitating effects of misguided regulatory interference with the free development of those markets. Some of the least regulated banking systems of the past, including systems that lacked central banks, were also famously crisis-free, or close to it.

Modern banking systems are, sadly, a far cry from those ideal arrangements. It's quite impossible, for that reason, to suppose that we might safely dispense altogether with central bank last-resort lending, without first undertaking other, major reforms. In the meantime, we can strive to  reform last-resort lending arrangements, so that they might lower the risk of future crises, instead of making them more likely by contributing to moral hazard, or by otherwise misallocating credit.

A False Dichotomy

Conventional wisdom has it that contemporary central banks must perform two fundamentally distinct duties. According to it, they are, first of all, responsible for implementing monetary policy, meaning that they must manage the aggregate supply of liquid reserves so as to reach various short- and long-term macroeconomic targets. But they must also serve as sources of "last-resort" credit when doing so serves to prevent or contain financial crises.

This established dichotomy of central bank duties has in turn informed a corresponding division of central bank facilities, with one facility or set of facilities serving for the implementation of "ordinary" monetary policy, and the rest devoted to supplying last-resort credit. In the United States, until the recent crisis, ordinary monetary policy was implemented by means of open-market operations conducted with a limited set of counterparties, known as primary dealers, and administered by the New York Fed. Last-resort credit, in contrast, took the form of discount-window loans, administered by each of the twelve Federal Reserve Banks, for which most depository institutions were eligible. Separate ordinary and last-resort liquidity-provision facilities were also standard in other systems.

Although the recent crisis witnessed extraordinary modifications of central bank liquidity-provision facilities, both in the U.S. and elsewhere, and although some of these modifications have become permanent, the conventional dichotomy of duties and facilities has survived, if indeed it has not been reinforced. The most obvious consequence of the crisis consisted of the creation of various new, though mostly temporary, last-resort lending facilities, aimed at supplying emergency credit to institutions that could not or would not get it from established facilities. The new facilities were sometimes open to counterparties to which established facilities were closed; or they were prepared to accept collateral that those facilities would not.  In some instances, such as the Fed's Term Auction Facility (TAF), the new facilities dealt with the usual counterparties and collateral, but did so in a manner calculated to avoid the "stigma" attached to ordinary last-resort borrowing.

But for all the ingenuity that went into these novel lending facilities, and all the good they may (or may not) have accomplished, I fear that their establishment may cause the wrong conclusion to be drawn from the crisis, namely,  that more or perhaps broader but nonetheless specialized last-resort lending facilities are needed if future crises are to be avoided. The proper lessons to be drawn, IMHO, are dramatically different. They are, first and most fundamentally, that the conventional dichotomy of central bank duties is a false dichotomy ; and,  second, that the problem with traditional central banking arrangements is, not that they lack adequate facilities for emergency lending, but that they rely on such facilities at all, instead of having properly designed facilities for the implementation of "ordinary" monetary policy.

To be more specific, the conventional dichotomy, though it may have had some merit in the now-distant past, when implementing "ordinary monetary policy" meant little more than maintaining the gold standard, while last-resort lending was a largely independent matter, is false when applied to modern fiat-money arrangements. A fiat-money issuing central bank has but one fundamental duty to fulfill. That duty consists of supplying cash, meaning currency and bank reserves, in amounts sufficient to meet macroeconomic targets, and doing so efficiently, that is, so that newly created cash is assigned to those parties that are willing to pay the most for it.

Special Last-Resort Lending Facilities are Inherently Inefficient

Does it really matter whether we think of central banks' fundamental responsibilities as consisting of two separate duties, or of a single duty performed efficiently? It matters a great deal, because supposing that central banks have not one but two duties to perform, and then encouraging them to employ separate facilities for each, actually makes the achievement of an efficient allocation of credit, including efficient last-resort lending, highly unlikely, if not impossible. This follows from the fact that, taking its "ordinary" monetary targets, and the amount of new reserve creation needed to achieve them, as given, a central bank operating multiple facilities, each catering to different sets of counterparties or dealing in different sorts of collateral, and offering credit on different terms, must allot specific portions of the credit to be created (some of which may be negative, as when last-resort loans are "sterilized" by open market sales) among the various facilities. Such allocations are bound to be somewhat arbitrary, if not flagrantly so. And even if the allocations were somehow correct, the facilities themselves, in so far as they offer credit on implicitly (if not explicitly) distinct terms, would likely favor certain eligible counterparties over others. Finally, because counterparties do not all compete with one another for the same pool of funds, the ultimate allocation of those funds may be inefficient even when all face similar terms.  Think of holding the Olympics at two facilities, with half the teams competing at one and half at the other, and you get the idea.

Instead of suggesting the need for multiple liquidity-provision facilities, the view that central banks have no responsibility save that of implementing "ordinary" monetary policy, but doing so efficiently, points to the desirability of assigning as large a role as possible to the price mechanism as the means for allocating newly-created cash among competing applicants. That goal is best accomplished by means of a single facility for auctioning credit, at which numerous eligible counterparties could compete for available central bank credit on equal terms. Under this arrangement, the central bank, once having set the terms of the auction, would have no other duty to perform save that of determining the aggregate amounts of credit to be auctioned. "Last-resort lending," instead of being a distinct central bank duty, would become an incidental counterpart of ordinary monetary policy, consisting of that part of auctioned credits taken up by liquidity-strapped counterparties that choose to take part in auctions only as a last-resort. In short, there would be last-resort borrowers, but no last-resort lending operations as such.

Achieving "Flexible" Open-Market Operations

So much for the theory. Can the ideal I've sketched-out be achieved in practice?  I believe that it, or something very close, can be achieved, and without any great difficulty, both in the U.S. and elsewhere. As the present Federal Reserve System is in many respects among those furthest removed from the sort of system I think desirable, I'll outline the basic steps required to move from the present system to what I'll call a system of "flexible" open-market operations (or Flexible OMOs, for short). Some of the proposals are very similar to ones I originally suggested several years ago, so I encourage readers to consider the arguments I offered in defense of that earlier plan.

First, the Primary Dealer System — the system that confines the Fed's ordinary open-market dealings to a small set of counterparties — should be abolished. Instead, all commercial banks presently eligible for discount window loans, and all Money Market Mutual Funds, should be able to take part along with existing Primary Dealers in the Fed's ordinary credit auctions.

Second, while continuing its traditional practice of confining its outright or "permanent" open-market purchases to U.S. Treasury and agency securities, the Fed should stand ready to accept other sorts of collateral, including all collateral that is presently accepted as security for its discount-window loans, while assigning appropriate "haircuts" to riskier collateral, in its temporary open-market purchases or repos. (A "repo" or "repurchase agreement" is essentially a security purchase accompanied by a commitment of the seller to repurchase the security for an agreed-upon price after a specific  — and generally quite brief — period of time.)

Third, the Fed should offer "term" (30 or even 60-day) repos as well as the more usual overnight repos, as the former are more helpful in tiding-over liquidity-strapped firms during financial emergencies.

Fourth, to allow counterparties to bid for credit using different sorts of collateral, the Fed should adopt a version of the "product mix" auction originally developed several years ago by Paul Klemperer, and  employed since by the Bank of England in its indexed long-term repo operations (ILTRs). Klemperer's procedure allows bidders to submit multiple mutually-exclusive "sub" bids for a desired amount of credit, each offering different sorts and amounts of collateral. Then, as an article in The Economist explains,

Having received a set of bids for different goods, at various prices and quantities, the auctioneer in Mr Klemperer’s set-up then conducts a proxy auction on bidders’ behalf to see who should get what, and what the price should be. Because nothing is revealed to the bidders and they know they cannot influence this process, their best bet is to tell the truth. What is more, since the auctioneer has price information for a range of quantities, it is possible to see how prices change as supply does.

For details, including explanations of how the auction avoids adverse selection problems, readers should consult the linked sources. The bottom line, though, is (in The Economist's words again) that the auction design serves to "provide accurate information on individual banks’ demand for liquidity and the prices they are willing to pay for it." What's more, the Bank of England has discovered that it can "use the pattern of bids in each auction to assess the extent of stress in the market," and to thereby "inform its decisions on the size and maturity of future operations." In other words, Flexible OMOs serve, not only to make last-resort lending facilities redundant, but to help guide ordinary monetary policy, making it less likely that monetary authorities will err by incorrectly gauging the aggregate demand for liquidity, as Federal officials did, with tragic results, in 2008.

Finally, the Fed should permanently close its discount window, which will have become redundant once Flexible OMOs are provided for.

Flexible OMOs, and Central Bank Discretion

Superficially, the changes I've proposed may appear to award the Fed more powers than it has enjoyed in the past, by allowing more counterparties to engage in open-market operations with it, using previously unacceptable collateral. But the impression is mistaken, for a number of reasons.

First of all, as I've already noted, Flexible OMOs are meant to render all "emergency" lending operations and facilities, whether actual or potential, redundant. That means that they eliminate the rationale, not just for ordinary discount window lending, but also for lending targeted at specific banks deemed too "Systematically Important" to fail, as well as direct lending to non-banks under the Fed's current 13(3) authority. By opening access to the Fed's ordinary credit auctions to numerous counterparties, including all those institutions, whether banks or non-banks, that play a prominent role in the payments system, Flexible OMOs should make it possible for any of these counterparties that is for any reason unable to secure needed liquidity from private sources to apply directly to the Fed for it, and, by outbidding rival applicants, to get it. What's more, by dealing with the Fed's ordinary credit-creation facility, rather than with any facility explicitly devoted to last-resort or "emergency" credit provision, firms will avoid any risk of finding themselves stigmatized, and therefore worse off, than they might be if they refused central bank credit altogether.

Second, by having all counterparties compete for credit offered through a single facility, according to common terms, the reform eliminates opportunities for favoritism that arise when different counterparties must deal with different facilities operating under different rules.

Third, by eliminating distinct last resort lending operations, Flexible OMOs make it unnecessary for authorities responsible for such operations to coordinate their efforts with those of separate central bank authorities charged with conducting ordinary monetary policy operations. The elimination of multiple authorities also reduces the risk of shirking, by placing responsibility for adequate aggregate liquidity provision firmly on the shoulders of a single decision-making authority — here, the FOMC.

Fourth, Flexible OMOs should rule-out any future resort to ad-hoc emergency lending facilities, establishing instead a stable and predictable arrangement for central bank liquidity provision, meant to meet both ordinary and extraordinary liquidity needs. The existence of fixed arrangements for liquidity assistance, combined with the competitive pricing of such assistance, allows prospective borrowers to prepare themselves in advance for potential liquidity shocks, while ruling-out moral hazard.

Fifth and finally, Flexible OMOs simplify central bank decision making, by reducing it to two components, namely (1) the determination of aggregate credit amounts to be auctioned, and (2) the setting, and occasional re-adjustment, of various auction parameters, including collateral haircuts. Credit allocation, including its allocation to solvent firms faced with a liquidity shortage that have sought funding from the Fed only as a last resort, is otherwise automatic. There would be no practical distinction, indeed, between the Fed's conduct during episodes of financial distress and its conduct on other occasions. The only changes would be in the unusual counterparties taking part in the Fed's auctions, the wider range of collateral types offered, and the higher-than-usual interest rates implicit in winning bids.

The relatively automatic nature of last-resort credit provision under a system of Flexible OMOs makes such a system a natural counterpart to rule-based, if not fully-automatic, systems for determining the scale of central bank aggregate credit creation, such as the proposals of Scott Sumner, David Beckworth, and others for targeting nominal GDP.

Precedents

Although my proposal may seem radical, its various elements are far from being without precedent.  As I've noted, the Bank of England already employs product-mix auctions to allocate funds among competing bids involving different sorts of collateral. The ECB, for its part, has always accepted a relatively wide range of collateral in its ordinary (short-term) open-market operations; it also conducts those operations with numerous counterparties. The ECB was, for both of these reasons, able to cope with the first year of the financial crisis without having had to make any changes to its operational framework. The Fed itself has, finally, occasionally and temporarily resorted to unorthodox open-market operations, involving a larger number of counterparties, a wider range of securities, and different repurchase terms. To supply liquidity in connection with Y2K, it extended the term of its its repurchase agreements, while also offering to purchase a wider range of securities. More recently, in September 2013, it established a special overnight reverse repo (ON-RRP) facility, through which it deals, not with its usual set of primary dealers, but with money market mutual funds, GSE’s, and a broader set of commercial banks. More recently still, it began undertaking sizable term (as opposed to overnight) reverse repos using that facility. During the late 1990s and early 2000s, when confronted with what was then a looming shortage of Treasury securities, the Fed also gave serious thought to the possibility of permanently expanding the list of securities it might purchase, both in its repo operations and outright.

What distinguishes my plan for Flexible OMOs from these precedents is that it envisions a single facility only, supplying both ordinary and last-resort credit, and doing so in a way that relies to the fullest extent possible upon market forces, rather than decisions by bureaucrats, to achieve an efficient allocation of liquidity among competing applicants. By allowing a broad set of potential applicants, using a wide range of eligible collateral, to compete for available funds, not only in private markets, but, when necessary, at a single Federal Reserve facility, Flexible OMOs actually serve to minimize the Federal Reserve’s credit footprint, and to thereby prevent it from taking part in deliberate credit-allocation exercises for which fiscal rather than monetary authorities ought to be responsible.

Back to Bagehot

At first blush, the reforms I've proposed may also seem inconsistent with received wisdom regarding the principles of last-resort lending. But they are actually far more faithful to that wisdom, particularly as formulated by Walter Bagehot, than existing arrangements. Consider Bagehot's seminal statement of now conventional last-resort lending principles, as found in Lombard Street:

First. That [last-resort] 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… .

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. … 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.

Allowing that there is only a trivial difference between repos and securitized loans, there is after all little difference between what Bagehot recommends and what Flexible OMOs would provide for. Indeed, they make for a more certain commitment to the principle of making last-resort credit available both "largely" and at suitably "high" rates, for the auction procedure itself assures that, in times of extraordinary need, high rates are bound to prevail. If you ask me, it's not my proposed reform, but the dizzying array of emergency lending facilities seen in the course of the recent crisis, with all the opportunities for inefficient credit allocation they entailed, that would have struck Bagehot as odd.

***

Such are my thoughts, so far, on reforming last-resort lending.  Like I said, I may be barking up the wrong tree. For that reason, I especially welcome critical comments pointing out how my proposed reform might go wrong. If those comments come with alternative suggestions for improving on what I've proposed, all the better.

____________________________

*Apart, that is, from a portion spent pouring port in Porto, Portugal.

  • Walker Todd

    The key insight is as follows:

    A fiat-money issuing central bank has but one fundamental duty to fulfill. That duty consists of supplying cash, meaning currency and bank reserves, in amounts sufficient to meet macroeconomic targets, and doing so efficiently, that is, so that newly created cash is assigned to those parties that are willing to pay the most for it.

    [Back to me] To accomplish the "high rate" effectively and without central bank interference, might one want to allow others not necessarily needing the liquidity to come to the Fed and bid for it, bidding credit away from the more insolvent lot by driving up the price? Bankers and investment bankers do this daily in commodities markets, thereby squeezing farmers, miners, and end users who might be short.

    Anna Schwartz and I, in our 2008 article, cited here, agreed that the discount window needs to be closed. If an emergency operation is deemed required, it should be operated under open-market operations principles, like the old Term Auction Facility. Citation:

    Anna J. Schwartz and Walker F. Todd, "Why s Dual Mandate Is Wrong for Monetary Policy," International Finance, vol. 11, no. 2 (2008), pp. 167-183.

    One of the issues in the Selgin proposal is valuation of the collateral, haircuts or no haircuts. Discount windows in the System tend to rely on bank examiners to come up with those haircuts. The Open Market Trading Desk in New York is going to rely on credit rating agencies and will never listen to bank examiners. With whose judgment are you more comfortable?

    A final issue with the proposal is expanded range of access to Fed facilities that the Fed does not inspect or examine. It is more practical for the Fed to make expanded credit available to banks (whom it does examine) and for bankers then to allocate that credit (by price) to "needy and deserving" money market mutual funds (and hedge funds?).

    In a free banking environment, none of these facilities would exist. If we are stuck with them, let them be run by auction market processes. But let bank examiners opine on the credit worthiness of the collateral offered.–Walker Todd, Chagrin Falls, Ohio

  • This is a little long. Please bear with me until the end.

    "In the meantime, we can strive to reform last-resort lending arrangements, so that they might lower the risk of future crises, instead of making them more likely by contributing to moral hazard, or by otherwise misallocating credit."

    I think we can all agree the the current arrangement is 1) crises prone and, 2) by serving any macroeconomic goal, automatically benefits one at the expense of another (Debtors, equity holders and labor at the expense of creditors, money savers and consumers). It is also subject to a large degree of political influence, political pressure imposed from outside and within any given central bank, favoring the primary dealers at the expense of others and rather arbitrary decisions on whom to save, and who not to save. Along these lines, Milton Friedman made the claim that, during the Great Depression, antisemitism played a role in eligibility at the discount window, though I would not make that claim today. Certainly, in 2008, arbitrary, or perhaps even personal vendettas, were deciding factors. My concern is that, If the current arrangement, or even the modified arrangement along the lines you suggest, which I would wholeheartedly agree is an improvement, are worse than a regime without central banking, wouldn't we be better off with bigger crises occurring more frequently, than smaller crises occurring less often? IMO, the sooner we rid ourselves of all central planning boards, through crises if that's what it takes, the better off we will be.

    ""Last-resort lending," instead of being a distinct central bank duty, would become an incidental counterpart of ordinary monetary policy, consisting of that part of auctioned credits taken up by liquidity-strapped counterparties that chose to take part in auctions only as a last-resort. In short, there would be last-resort borrowers, but no last-resort lending operations as such."

    Except that the most politically favored last resort borrower may be outbid, or forced to make a bid, that would lead to its demise even if they won. Regardless of any purported public mandate, the purpose of the Fed was/is not to help "the people", it was put in place to help certain politically favored interests. Your proposal would rob the Fed, and other central banks, of their one true primary role, no different than ending privilege quotas, SBA loans for women and minorities as an example, would rob the SBA (government) of their ability to favor certain special interests over others.

    "They are, first and most fundamentally, that the conventional dichotomy of central bank duties is a false dichotomy ; and, second, that the problem with traditional central banking arrangements is, not that they lack adequate facilities for emergency lending, but that they rely on such facilities at all, instead of having properly designed facilities for the implementation of "ordinary" monetary policy."

    This presumes that the design of any central bank, and monetary policy in general, is indeed designed to achieve optimal or efficient results for the users of money and banking services, the general public. The US Department of Agriculture, and the laws, rules, regulations, it promulgates, could hardly be seen as beneficial to the general public either, but of course that was never the intention.

    "encouraging them to employ separate facilities for each, actually makes the achievement of an efficient allocation of credit, including efficient last-resort lending, highly unlikely, if not impossible."

    Yes, it does.

    "Such allocations are bound to be somewhat arbitrary, if not flagrantly so. And even if the allocations were somehow correct, the facilities themselves, in so far as they offer credit on implicitly (if not explicitly) distinct terms, would likely favor certain eligible counterparties over others."

    By design.

    "That goal is best accomplished by means of a single facility for auctioning credit, at which numerous eligible counterparties could compete for available central bank credit on equal terms."

    Assuming a central bank in place, and the only option, this would be the best solution. I would prefer that the proposed improvements, however and for the reasons I have outlined above, not be implemented; the sooner the system fails completely, the better. Second, given the entrenched special interests, implementation would be difficult, if not impossible, Third, IMO, abolishing the current system in favor of laissez-faire money and banking would require the same amount of work, and would stand an equal chance in success, compared with the proposal under consideration. Thus, the true optimal, most efficient, free market, solution should be proposed consistently and persistently, until achieved.

    "…by having all counterparties compete for credit offered through a single facility, according to common terms, the reform eliminates opportunities for favoritism that arise when different counterparties must deal with different facilities operating under different rules."

    Exactly!

    "If you ask me, it's not my proposed reform, but the dizzying array of emergency lending facilities seen in the course of the recent crisis, with all the opportunities for inefficient credit allocation they entailed, that would have struck Bagehot as odd."

    Agreed!

    "I especially welcome critical comments pointing out how my proposed reform might go wrong. If those comments come with alternative suggestions for improving on what I've proposed, all the better."

    Frankly, I think your proposal is too good to be implemented. But, if it was, my only hope would be an imminent realization that having one lender, conducting business in a manner you have described, could only be improved by having multiple.

    • M. Camp

      Lots of good comments, thanks! But the author's job as an economist is to promote the good directly, by honest argument. Not to promote what is harmful in order to alter the balance of power. You're Samuel Adams in this to his John, IRA to Sinn Fein.

      • Thanks though I don't consider my argument dishonest or harmful in any way.

        • George Selgin

          No worries, Milton (or "Sam"). I'm sure you're quite sincere in your suggestion (though I also rather like being compared to John Adams by M. Camp!). Your view is in fact not uncommon; in some writings and talks I have referred to it, only semi-facetiously, as the "apocalyptic" approach to monetary reform. Alas, while the destructive part of the plan is all too easily achieved, it's the other part that's fraught!

          • And I certainly do not mind being compared to Sam Adams! My best to all that write, contribute and comment on this site, especially the original founders. I am thankful to have access, and be part of the debate.

        • M. Camp

          I may have worded this wrong. By "harm" I only meant to refer to your preference for "bigger, more frequent crises". I didn't mean that you intended long-term net harm to society. And I guess it was wrong to say 'honest argument', since an economist could in theory openly propose a solution on the basis that it would cause the system to fail more quickly. But if he convinced other economists, I suppose he would succeed in getting most to shift their support to the side he opposes! He'd be looked at as disingenuous, cunning. Or dumb maybe. Other economists would stop playing squash with him.

    • George Selgin

      Thanks for your thoughtful remarks, Milton. Concerning your question, "If the current arrangement, or even the modified arrangement along the
      lines you suggest, which I would wholeheartedly agree is an improvement,
      are worse than a regime without central banking, wouldn't we be better
      off with bigger crises occurring more frequently, than smaller crises
      occurring less often? IMO, the sooner we rid ourselves of all central
      planning boards, through crises if that's what it takes, the better off
      we will be?" I'm convinced that the answer is "no." History shows, first of all, that crisis tend to result in more rather than less government interference. Look at what has happened since 2008! Ditto 1930-33, and so on.

      Second and more fundamentally, I do not see my proposal as an alternative to "ridding ourselves of [monetary] central planning boards," but as one element of a set of reforms that can ultimately achieve that very goal, or something relatively close to it. Yes, many people talk the radical talk of just "getting rid" of central banks. But there is no "just" getting rid of them in practice. As I point out to Ralph Musgrave above, one has to have more than an alternative vision, or a wish, or a theory. One has to get from A to B, where A is where we are. More crises, as I've said, are unlikely to do the trick. So we must try a different, more prudent tack.

      • I have read a lot of what you, Larry and Kevin have written and respect your opinions very much. I also look forward to hearing and reading more. As always, thank you!

  • Ralph Musgrave

    Interesting and carefully thought out article, IMO. I like the idea of making last resort loans available to “a broad set of potential applicants”. I suggest that should include ABSOLUTELY ANY type of individual, firm or corporation.

    Obviously under the latter scenario, a central bank would charge extra for potential borrowers wanting to borrow relatively small amounts. But what of it? The important point is that I don’t see why commercial banks should have any sort of preferential treatment relative to car manufacturers, multinational oil corporations or anyone else.

    The main problem, I think, with George’s proposal (and my minor variation on it) is that come a credit crunch, there will still be big disruptions stemming from letting systemically important banks go under. Letting Lehmans go caused disruption.

    My solution to that is full reserve banking: a system under which it is plain impossible for banks to fail. In fact (and in line with my above point that no sort of preferential treatment should be given to banks) banks under the existing system are specially privileged in that they are allowed to create or print money, whereas other firms cannot. Richard Werner explains the latter point in more detail here:

    http://www.sciencedirect.com/science/article/pii/S1057521914001434

    • George Selgin

      Thanks for your comment, Ralph. Regarding your statement that "there will still be big disruptions stemming from letting systemically
      important banks go under. Letting Lehmans go caused disruption," we must bear in mind that the only reason for bailing out SIFIs is that it is not practical support all the solvent firms that might suffer collateral damage from a SIFI's failure. With my scheme, however, most solvent firms would have the same access to central bank credit as any SIFI. So they need never fear finding themselves threatened with failure owing to a lack of liquidity.

      Concerning full reserve banking, I continue, as ever, to regard it as both a Draconian solution, and a quite unnecessary one, to the problem of financial instability. We might just as well reduce traffic fatalities by returning to horses and buggies. But I'm sure we can do better than that.

      • Ralph Musgrave

        I agree that full reserve is not needed in order to deal with “financial instability”. A decent rise in bank capital ratios solves that problem. Certainly the sort of ratio advocated by Martin Wolf and Anat Admati (about 25%) would solve that problem.

        My basic objection to the existing bank system is that it enables commercial banks to create / print money as pointed out in the opening sentences of the Bank of England article linked to below. That constitutes a subsidy of commercial banks, and the only way to get rid of that “freedom to print” is a 100% capital ratio (as advocated by Milton Friedman and others).

        http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

  • M. Camp

    I can only criticize it as a layman. For us, enough missing knowledge of present and historical details and terms must be crisply and clearly filled in that we can make sense of the proposal. Then the proposal must be presented and defended in plain language, to allow us to be convinced or not. Then, it has to be a convincing argument.

    For me all these criteria were met.

    (Regarding the smithing of words: to most the "distant past" would imply the "now-distant past". That was the only little hiccup in the entire flow of words for me, and I've now spent fifty words to save three letters and a hyphen.)

    • George Selgin

      I much appreciate your general approval, and accept the minor criticism as entirely valid.

      More generally, I'm always happy to have readers pay attention to my prose, even (or especially) in order to help me improve it.

      • M. Camp

        Good. I had to work hard to find something to pick on. Nice to be appreciated, but in future, a little more bad writing would make my life easier.

  • M. Camp

    Regarding the explanation of terms to lay readers.

    /*
    (A "repo" or "repurchase agreement" is essentially a security purchase accompanied by a commitment of the seller to repurchase the security for an agreed-upon price after a specific — and generally quite brief — period of time.)
    */

    This tries to explain it to us by describing the mechanics, in preference to describing the intent (the practical meaning). Which is for us very much obscured by those mechanics.

    For this part of the article, the layman mostly needs to understand the practical definition, the intent. He will then want to know the mechanics, but only to understand why the term puzzling term "repo" was chosen, instead of "loan". The only reason he wants this second level of detail is so that he will have confidence that he hasn't missed something. He won't feel confident he understands the term "repo" until he first knows what it really is, and then why the strange term is applied and why it makes sense.

    • George Selgin

      Thanks, M. Camp. Your mild reproach is deserved. My only defense is that the "intent" behind repos, as substitutes for ordinary secured loans, to which they are extremely similar in practice as well as in law, is a rather recondite matter: try as I might, I don't suppose I could convey it in a sentence or two, assuming I could explain it adequately at all!

  • Ralph Musgrave

    I have another problem with the above thesis, as follows. Far as I can see, George goes along with the conventional view that it is the job of central banks to help adjust demand and that they should continue to do that. That’s where he says central banks are “responsible for implementing monetary policy, meaning that they must manage the aggregate supply of liquid reserves so as to reach various short- and long-term macroeconomic targets.”

    Now there are big problems with interest rate adjustments (one element of “monetary policy”). One is that if demand needs to be increased (or reduced), and that is done just via interest rate cuts (increases), then demand is altered for a limited section of the economy: the investment goods sector. Thus for a given total change in demand, that will involve more dislocation than if demand is altered for the economy AS A WHOLE.

    Second, the free market’s cure for recessions actually does raise demand for the economy as a whole. That is, in a perfectly functioning free market, and given extensive unemployed resources, wages and prices would drop, which in turn raises the value of base money (and government debt), which in turn encourages spending by all holders of that money and debt. Incidentally that’s the so called “Pigou effect”. In short, helicopter drops aimed at ALL PARTICIPANTS in the economy (not just commercial banks and similar) are closer to the free market’s cure for recessions, than monetary policy.

    To summarise, I suggest the GDP maximising way out of a recession involves abandoning monetary policy and adopting helicopter drops, which are a combination of monetary and fiscal policy: they increase the stock of money held by a wide selection of households, public sector employers, etc, plus they involve a purely fiscal effect. David Williams of the Fed was hinting at some sort of fiscal / monetary mix in this recent article of his:

    http://www.frbsf.org/economic-research/publications/economic-letter/2016/august/monetary-policy-and-low-r-star-natural-rate-of-interest/

    • George Selgin

      "George goes along with the conventional view that it is the job of
      central banks to help adjust demand and that they should continue to do
      that." Well, not quite: I simply recognize that, so long as we continue to rely on fiat money, the supply of that stuff must be artificially managed so as to maintain reasonable levels of liquidity whilst avoiding excessive liquidity creation. It is all well and good to discuss alternative systems–as I have done often–and also to propose that we would be better of with them. But one mustn't confuse such hypothetical possibilities with a free-market "cure" for existing problems: a real cure must involve some specific treatment or regimen, applicable to the patient in his or her present state of ill-health, and not just a vision of the patient in a different and healthier state!

      I'm not unsympathetic, on the other hand, to the "helicopter money" argument. However, I think that having central bank's open-market-operations broadened to encompass a large number of counterparties and many collateral types is a far less cumbersome solution, and one that is both less-likely to become a political football, with various special interests conniving to influence the nature of the "drops," and more likely to approximate an efficient free-market system of financial
      intermediation, than helicopter money.

    • I don't believe George feels, at all, that it is the job of monetary policy to "help adjust demand". His proposal is based on the imperfect world of having a central bank, and trying to bring fairness, efficiency and more stability to a system which is inherently unfair, inefficient and prone to crises.

      So, you have gone from only wiping out the entire modern-day banking system with a 100% reserve requirement to a 100% reserve requirement and helicopter drops. Helicopter drops have zero positive impact on, creates zero, real wealth. The only positive thing to say about your suggestions is that they would lead to a massive crises and reset much quicker than George's suggestions.

      • Ralph Musgrave

        I agree that 100% reserve banking can well be said to involve “wiping out the entire modern-day banking system”. Advocates of 100% reserve are quite open about that. E.g. see this Bloomberg article by Matthew Klein:

        http://www.bloomberg.com/news/2013-03-27/the-best-way-to-save-banking-is-to-kill-it.html

        However the fact that a proposal involves an absolutely fundamental change to some existing system is not in itself an argument against that change.

        Re helicopter drops having zero impact on real wealth, I think most people have worked out that simply printing money does not of itself make anyone better off. However, if it’s printed in the right quantity when there’s a recession, that will bring the economy up to capacity or “full employment”, and that certainly does involve an increase in “wealth”.

    • Eric Lonergan says real helicopter money is not a fiscal exercise at all. He means it is a direct infusion to the citizens, equally, of base money from the Fed. Now, I suppose if base money was injected into the government with no sterilization, that would have a fiscal result. But it also is essentially monetary policy, not fiscal policy.

      Fiscal policy is what Krugman, Summers and Kocherlakota want, a spending in deficit on the part of the government so that more bonds are created for Wall Street and for collateral. But, since these bonds are gold, the new gold, I think the government should get more from Wall Street in return, a tax on Wall Street's good fortune, since the government made bonds that are gold available to Wall Street on the cheap.

  • JoeEsty

    I understand that George Selgin is as much in favor of free-market banking as anyone. With that acknowledgement aside, it's a waste of time to attempt to reform that which is unable to be reformed. Even if his flexible OMO comes to fruition, that doesn't negate the negatives of the organization itself. I'm confident that financial crises will occur with no less frequency.

    Every central banks is a top-down, bureaucratic, backward-looking, sclerotic, moral-hazard inducing organization subject to regulatory capture and manned by delusional philosopher kings whose decisions are driven by large aggregate numbers — the macro.

    And whenever I read of someone and his "macro targets," Louis Spadaro's excellent article "Averages and Aggregates," printed in the 1956 festschrift titled On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises comes to mind. Spadaro's "Averages and Aggregates" begins as such:

    "In an interesting, though apparently neglected, aside, Professor Hayek has remarked that ' … neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning.'" How, then, can anyone derive a useful nostrum predicated on the macro? (Not surprisingly, I hold the NGDP crowd in low regard.)

    Nor do I believe that reform of the corrupt must occur because the uncorrupt — the free-market banking — option appears unattainable. History has shown us that the unattainable can arise with startling unexpectancy. If I remember correctly, iron-fisted totalitarian Soviet Union didn't gave way to a classically liberal (as compared to the Soviet Union) Russia in an evolutionary progression, the transformation was violent and immediate.

  • JoeEsty

    I understand that George Selgin is as much in favor of free-market banking as anyone. For this, I applaud him. In addition, I applaud him for his ability to convince me that fractional-reserve banking is very much a viable option in a free-market with his 2011 article titled "Capital and Cash Reserves."

    With those acknowledgements aside, I think Mr. Selgin is barking up the wrong tree. It's a waste of time to attempt to reform that which is unable to be reformed. Even if his flexible OMO comes to fruition, that doesn't negate the negatives of the organization itself. I'm confident that financial crises will occur with no less frequency.

    Every central bank is a top-down, bureaucratic, backward-looking, sclerotic, moral-hazard inducing
    organization subject to regulatory capture. Central banks are run by a minute hegemony of philosopher kings of infinitesimal knowledge (compared to knowledge reflected in free-market prices) whose decisions are driven by large aggregate numbers — the macro.

    And whenever I read of someone driven by "macro targets," Louis Spadaro's excellent
    article "Averages and Aggregates," printed in the 1956 festschrift titled On Freedom and Free Enterprise: Essays in Honor of Ludwig von Mises, comes to mind. Spadaro's "Averages and Aggregates" begins as such:

    "In an interesting, though apparently neglected, aside, Professor Hayek has remarked that ' … neither aggregates nor averages do act upon one another, and it will never be possible to establish
    necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning.'" How, then, can anyone derive a
    useful nostrum predicated on the macro? (Not surprisingly, I hold the NGDP crowd in low regard.)

    Nor do I believe that reform of the corrupt must occur because the uncorrupt — the free-market banking — option appears unattainable. History has shown us that the unattainable can arise with startling unexpectancy. If I remember correctly, the iron-fisted totalitarian Soviet Union didn't gave way to a classically liberal (as compared to the Soviet Union) Russia in an evolutionary progression, the transformation was violent and immediate.

    • George Selgin

      I appreciate your comments, JoeEsty. They remind me a bit of Milton Churchill's similar remarks below, in that Russia's transition to a relatively more market-oriented system occurred only with the collapse of the Soviet System, in a context in which other nations already had relatively free economies, the superior success of which Soviet authorities could no longer either keep secret or deny.

      As I said to Milton, I do not believe that we can expect "the unattainable" to happen simply by banging the free market drum, and no matter how loudly. That is, I do not expect a revolution to occur; what's more I do not know what such a revolution would involve if it did. What is the scenario you have in mind, that will bring about the sort of system you'd like to see, and what sort of system is that? Many people keep telling me that the reforms I recommend are too timid; but no one has yet told me what I should propose instead. A description of an alternative system isn't the same as a path leading to it, let alone a force capable of getting one going along that path.

      I have also to disagree with you about the significance of Spadaro's essay–with which I'm quite familiar from my grad-school days. No, aggregates don't work on one another. All good economics is microeconomics. Nevertheless, there is a solid microeconomic rationale for regarding a well-working monetary system as one that stabilizes some aggregate measure of spending. I spell-out the rationale both in my Theory of Free Banking and in Less Than Zero. I was, as it were, a proponent of NGDP targeting, or something very close, avant la letter. Indeed, Hayek himself, whom Spadaro refers to, treated stability of nominal aggregate spending (constant MV, to be specific) as an ideal for avoiding the business cycle I his works of the 1930s on the topic. NGDP is just a popular measure of Py which of course is = MV.

      • JoeEsty

        Mr.Selgin, I'll concede that I have no scenario that will bring about the system I seek, but neither do you. And if you did, (or if I did) the system would very well never come in the scenario you conjure. Change is so frequently Black Swan (to steal a reference from Nassim Taleb) in its arrival. In the late 1980s, I know of no one (including me) who anticipated the imminent collapse of the Soviet Union, yet the collapse was imminent. I know of no one in the early 1990s who predicted the imminent, market-changing ascension of the Internet, and yet its ascension was imminent.

        Of course, we all want a well-working monetary system, as we all want a well-working retail system, banking system, oil-production system, medical-care system, automobile-production system, etc. But there is no reason to believe the top-down authoritative system in place for manipulating aggregate spending through money manipulation is superior to the bottom-up, organic, relatively freer-market system at work in most other markets. (Please tell me what the aggregate spending should be in the auto industry.) Please provide the names of the persons so endowed with the omniscience to ensure stable spending, one that works better than a system driven by the bottom-up organic system reflective of billions of individual transactions.

        You and I will have to disagree on the importance of Spadaro's article. Perhaps I'm incorrigible on this matter. Perhaps I've been to impressed by this quote attributed to John Cowperthwaite, former financial secretary of Hong Kong. When asked to name the one reform of which he was most proud, Cowperthwaite replied, "I abolished the collection of statistics."

        Aggregate measures demand the collection of statistics, which, in turn, spurs the bureaucrat or the academician, with no skin in the game and inoculated from all negative consequences, to act on aggregated, averaged numbers. Any target you or I (or anyone) set for nominal national GDP will be wrong, and, unfortunately, neither of us will be held accountable for our hubris. No macro-manipulating actor ever is.

        • George Selgin

          "Please tell me what the aggregate spending should be in the auto industry." This confuses me. To recommend stability of aggregate spending as a desirable goal is not to presume any knowledge of how that spending should be assigned to different sectors. Nor is it "managing" the aggregate in any way save that of preserving its stability, which involves relatively little technocratic control, because it is very straightforward. A computer could do it. Finally, the best arrangements let market forces do most of the "managing" in question. In Theory of Free Banking and elsewhere, I show how a free banking system can help stabilize spending even with an absolutely fixed stock of bank reserves. What I never show–because I can't–is how you can have a reform that consists solely of deregulating banks. In a fiat money system, the fiat standard must itself be reformed, or else no amount of banking reform can prevent future crises.

          Remember, the dollar is the established money, like it or not. Any reform that treats it as a lost cause is bound to condemn billions to the ravages of continued discretionary abuse of the dollar standard. We can regret that the dollar has become what it is, but we cannot pretend that things are different from what they are. The question is, what now?

          More generally, I believe in spontaneous order as much as anyone. But it is one thing to recognize the advantages of a freely-developed and hence spontaneous system; another to suggest some way to reform a system, such as ours today, that has been dramatically influenced by government in fundamental ways. To make an analogy, what we have isn't a normal baby to nurture, but a seriously crippled adult in need of massive rehabilitation.

          You say I have no plan, but I do. I have offered parts of it here, and others there. These parts may not be easy to put into place, but they are at least coherent and concrete. They would, collectively, reduce the discretionary component of current monetary system "management," but in a manner that would not involve any cataclysmic change. They would however include steps to allow people complete freedom to employ alternatives to the (reformed) dollar unit. I know of no other practical way by which to approach the ideal of an automatic and largely market-based system.

          • JoeEsty

            Mr. Selgin, we're on the same page in many regards. Everything related to banking is need of reform. A fiat monetary system is the source of the problem. I agree that a free, competitive banking system would lead to more stable spending. (Hell, more stable everything.)

            My problem is that rules imposed from above never work (or don't work for long), because of the nature of our money, banking, and central banks. I appreciate the thought you put into your flexible OMO idea, but on the margin, I can see it as nothing more than a fleeting panacea. The patient continues to limp along. Therefore, I would alter your analogy to animal from human. We don't have a crippled adult in need of rehabilitation, we have a crippled mare that can only be put down.

            I fully understand your criticism of my all-or-nothing position: No free-banking alternative is on offer; we have no choice but to rehabilitate. Nevertheless, whenever I hear a strategy to impart stabilization on spending, money supply, or anything, I flinch. If I may lean on Professor Hayek once more: "Monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown." — Hayek, 1932. Because you're trying to stabilize, doesn't mean the cataclysmic won't happen anyway.

            I view it as Quixotic to attempt to rehabilitate — no matter how good the intentions, how thoughtful the initiative — an intractably corrupt system.

          • George Selgin

            Even if Hayek were right, in his day "overthrowing" the influence of stabilizers was an option in so far as the alternative of leaving national monies to be controlled by gold still remained a possibility, if a rapidly receding one. So Hayek wasn't quite urging the abandonment of then-existing arrangements, or treating them as so many lost causes. Much later, of course, he championed free choice in currencies, with private suppliers challenging public ones; in that case his position was, I think, more consistent with your own.

            You may well be right that the present arrangements are ones that cannot be reformed. But I'm afraid that I must go on playing Don Quixote in that case, because I do not wish to witness another and perhaps still-more catastrophic failure of our present monetary system if there is even the slightest possibility of avoiding such. I also don't believe that such a failure would usher in an era of greater monetary freedom and order. On the contrary: I expect it would lead to the creation of a still-more aggressively "planned" monetary system, in which (among other things) private money creation would be more stringently regulated than ever, if not entirely outlawed.

  • Question, Prof. Selgin: Excess reserves are sterilized, and exist only because the banks have exchanged bonds and assets to the Fed. So, since they are sterilized, doesn't the money supply drop if they are not used for lending into the real economy? Doesn't IOR constitute a double sterilization of sorts?