A Rejoinder to Andolfatto

"Overloaded Truck," modified, from ThinkStock: age/stock-illustration-overloaded-truck/170884039/popup?sq=M|Images%20similar%20to:%20170884039|170884039/f=CPIHVX/s=DynamicRank

David Andolfatto has thoughtfully replied to my critique of his "A public finance case for keeping the Fed's balance sheet large.” Here I respond to his reply (despite his Twitter plea to me not to!). I thank him for taking the time to address my criticisms. I think our exchange has at least helped to identify where the interesting questions lie.

To recap, David’s original blog post proposed that one good reason not to normalize the Fed’s balance sheet (which has been swollen by the QE programs) is that the big balance sheet is a bigly profitable undertaking, reducing the cost of financing the public debt. I argued here on Alt-M that David’s case as stated rested on a non sequitur because it ignored duration risk. The Fed is earning a large spread only by taking on duration risk (borrowing short and lending long). We can’t assume that the return is worth the risk. David in reply now acknowledges the issue of duration risk (neither “duration” nor “risk” appeared in his original blog post), so our remaining disagreement is about the risk-return tradeoff.

In his reply, David restates “the gist of [his] story” with the following hypothetical:

Suppose that the Fed makes a one-time purchase of a 10-year treasury bond yielding a risk-free 2.5% annual nominal coupon … financed by "printing" reserves. … Suppose further that the interest paid on reserves remains below 2.5% for the duration of the bond. Then the Fed makes a profit off the rate of return differential in each of the 10 years it holds the bond on its books. If I understand my critics correctly, none would dispute the financial benefit associated with this Fed intervention as far as the public purse is concerned; at least, as long as it is somehow known ex ante that the short rate will remain below the long rate in the manner assumed.

It’s true that this is a story of unambiguous benefit. I can restate my critique of it by saying that it is not, however, a coherent story. Supposing that it is known ex ante that the short rate will remain below the long rate is tantamount to supposing zero duration risk. A story supposing zero duration risk is incoherent if it simultaneously supposes that the long rate remains persistently above the short rate. Why wouldn’t investors arbitrage away the supernormal profits from a risk-free operation? In any case the relevant question, granted that the Fed is undertaking duration risk, is whether the return is worth the risk being borne.

As I see it, we have to choose one of three ways to think about how it is possible for the Fed to earn profits from borrowing short and lending long. (a) Markets are efficient and so the Fed is earning at most a normal return to bearing duration risk. We cannot infer from experience since 2008 (see below) that the risk is so negligible that the returns surely more than cover the risk. (b) The Fed has grasped a profit opportunity that market arbitrageurs (e.g. private hedge funds or other financial intermediaries) have failed to grasp for no good reason. Private arbitrageurs are persistently leaving money on the table. (c) The Fed has grasped a profit opportunity not available to market players because the Fed is the most efficient maturity-transformer in the economy. I reject (b) as implausible, and I presume that David does too. I find (a) more plausible than (c), absent evidence of the Fed’s efficiency advantage over private firms as a profitable intermediary. The Fed’s ability to shift losses to taxpayers does not constitute an efficiency advantage in the relevant sense.

David helpfully advances the discussion by pointing out that we can more directly analyze the question at hand by consolidating the Fed and the Treasury balance sheets. Doing so, I believe, reinforces my point that shortening the maturity structure of the consolidated debt (whether the Fed does it or the Treasury does it) reduces current interest paid but at the cost of increased interest-rate risk. (We now switch from duration to refinance risk because the Fed by itself is a net lender to the Treasury, but the Fed+Treasury is a net borrower from the public.) David acknowledges the point:

if the point is that financing short-term at low rates entails risk relative to financing long-term at high rates, then I agree. The question, however, is not whether QE exposes the taxpayer to duration risk. Of course it does. The same would be true if the Treasury was to shorten the average duration of its debt on its own.

Whether it is net-beneficial for the Fed to shorten the duration of the consolidated debt compared to the duration of the debt the Treasury has issued then depends on whether the Treasury’s debt is overly long in duration. Like David, I confess that I don’t know how to answer that question, how to compute the optimal public debt duration. But this means that the assessment whether the Fed’s duration-shortening action is net-beneficial is up in the air. It is not settled by the Fed’s apparent profits.

David adds some humor but not any greater clarity when he writes:

Larry's argument implicitly assumes (possibly correctly) that the Treasury has structured its debt optimally. If it has, then there is no "free lunch" for the Fed. If this is the case, then I would have to agree. (And it's heartwarming to see Larry thinking so highly of a government agency's ability to run its operations!)

Logically, to judge that Fed action to shorten the consolidated debt fails a cost-benefit test (which is a stronger claim than my saying that the Fed’s profits don’t settle the question, but the stronger claim might be true) does not require one to judge that the current Treasury debt duration is optimal, but only that it doesn’t need shortening. It could be just right, or it could already be too short.

David goes on to suggest that the market is over-estimating the risk of a rise in interest rates: “An ex ante gamble that pays off ex post is not a justification. Sure. But billions in remittances [from Fed to Treasury], year after year, one fluke after another?” My answer to that question, given a presumption of financial market efficiency, is: yes. Suppose that a rise in interest rates that would punish the consolidated Fed+Treasury is a relatively rare event, like spinning one of two green numbers (0 or 00) on a Las Vegas roulette wheel. Ten non-green spins in a row doesn’t mean that the risk is over-estimated. This is of course the well-known “peso problem”: How can Mexican peso bonds pay higher returns than US dollar bonds year after year, over a period when the peso never devalues against the dollar? Because the risk of devaluation is still there. I think David is ignoring the peso problem when he writes: “But the fact of consistently positive and sometimes very large remittances from Fed to Treasury for years (and even decades) might lead one to question that assumption.”

My reference to the historical plight of U.S. thrift institutions when interest rates spiked in the late 1970s and early 1980s, by the way, was not to warn about a Fed bankruptcy (it seems likely that a technical Fed insolvency would in fact force no change to its ongoing operations), but rather to emphasize that interest rate run-ups do happen once in a while, and when they do those carrying big duration risks or refinance risks pay heavily. That is why I described the consequences as they would be felt by taxpayers.

Finally, I noted that normalization of the Fed’s balance sheet calls for making bank reserve scarce again. David protests that this is contrary to Milton Friedman’s “optimum quantity of money” prescription, which he says aims at “eliminating all liquidity premia.” I wouldn’t characterize the OQM prescription that way. It rather calls for ending inefficient price discrimination on consolidated government liabilities by paying the same return on Fed liabilities (bank reserves and Federal Reserve Notes held by the public) as on Treasuries of the same duration and default risk. It does not imply that reserves are non-scarce in the sense that banks indifferently hold excess reserves. While there would be no cost of holding reserves relative to overnight Treasuries, there is still a cost of holding reserve relative to a well-chosen portfolio of business loans that inframarginally pays a higher return (net of defaults). The OQM does not imply the end of banks’ comparative advantage in making loans.

  • Mattyoung

    Markets may be efficient but they re institutionalized. So the is bearing duration risk against a secret plot by the large public sector unions to set the 'dot plot' going forward. At any given moment, when the ten year gets up to 2.6, we get an instant change in duration as the pensions switch from stocks to reliable safe rate investments. Currency banks do not bet time, they bet probability. Central banking has no consistent theory when time plotters are large and on the move.

  • Very educational. Thank you.

    David's original thesis is built upon a presumption that all possible outcomes are known ex ante. Thus, maximum leverage does not bear the risk we might otherwise think it does. This is exactly how LTCM ran in to problems. They thought they had every possible scenario built in to their models, it was highly profitable for a while, but subsequent events would clearly show that they did not (have every possible scenario built in to their models).

    The Fed has played a very dangerous, distorting credit allocation, game to this point. It has been profitable to the Treasury, but the risks to the overall economy and financial system are, most likely, far greater than perceived. That ignores the privilege and benefits bestowed on one class to the detriment of another class, by altering the scarcity of bank reserves. (Per Larry's prior post)

  • Dan Thornton

    I’ve read the interesting exchange between Larry White and
    David Andolfatto. Their discussion the Fed’s bloated balance sheet neglects
    entirely the most dangerous aspect of the Fed’s bloated balance sheet, namely,
    that it has caused a massive increase in the money supply. Moreover, the money
    supply will continue to increase rapidly until the balance sheet is reduced to
    the point where banks’ holdings of excess reserves are tertiary, as they were
    in August 2008.

    As I pointed out in my forthcoming Cato Journal article, M1 has more than tripled since August 2008.
    The increase is due to the fact that banks have financed all of their lending
    out of the reserves supplied by the Fed’s bloated balance sheet rather than
    through the sale of large negotiable CDs, as they did before the FOMC decided
    to engage in large-scale asset purchases. M1 will continue to increase as long
    as the risk-adjusted rate on loans is higher than the rate the Fed pays banks
    to hold excess reserves, the IOER. The suggestion by some that the Fed can stop
    the increase in M1 by raising the IOER is simply wrong. The FOMC has increased
    the IOER by 50 basis points since December 2015. New car loan rates have
    increased by 45 basis points and the prime rate has increased 50 basis points,
    and M1 is 10.4% higher. Lending rates will continue to increase point for point
    with the IOER. Consequently, increasing the IOER will do little, if anything,
    to stem the rise in M1.

    As for duration risk, Larry White is correct
    about that. However, as I noted in a 2013 Economic
    Synopses that I published while I was at the St. Louis Fed, the likelihood
    that the Fed would suffer a capital loss is tiny. Andolfatto is correct in
    noting that the large balance sheet enables the Fed to rebate large sums to the
    Treasury thereby reducing the size of the national debt. However, he fails to
    say that this is the classic case of monetizing the debt—increasing the money
    supply for the sole purpose of helping the Treasury to finance the debt. I
    believe the $2 trillion increase in the money supply thus far hardly justifies
    the about $600 billion extra the Fed has rebated to the Treasury. Andolfatto is
    correct in noting that inflation has been well contained. But I find it hard to
    believe that the massive increase in M1 so far, and the increases that will
    continue as long as the balance sheet remains large, will not produce some
    unwelcome effects.

    • George Selgin

      "the likelihood that the Fed would suffer a capital loss is tiny." I don't get this, Dan. The Fed's own studies show very large potential losses from modest market rate increases. One recent one, for example, finds that its

      "portfolio is projected to shift to an unrealized loss in late 2017,
      before posting a peak projected shortfall of about $170 billion in late
      2020. However, the tail risk, as captured by the lower edge of the
      90-percent confidence interval, can be large, as the unrealized loss in
      the corresponding scenario peaks at about $530 billion in a simulation
      in which interest rates would move much higher than in the baseline.
      Although the modal path implies that the unrealized loss position
      narrows subsequently through 2025, as securities acquired under the
      LSAPs mature or pay down and new securities are added to the portfolio at par, under some scenarios the unrealized loss position could remain larger than $400 billion as of 2025."

      https://www.federalreserve.gov/econresdata/notes/feds-notes/2017/confidence-interval-projections-of-the-federal-reserve-balance-sheet-and-income-20170113.html

      • Dan Thornton

        Many of the securities purchased where purchased when rates were higher. Hence, rates have to increase some before they would suffer a capital loss. Because of this fact, if interest rates started to increase the Fed could sell some of these securities before the point where they would have to take a capital loss on the sale. If all they want is a big balance sheet, they could replace them with short-term securities. Furthermore, the loss is realized only if they sell. Hence, the Fed can shrink its balance sheet by first selling the shortest term securities. There would only be a big loss if interest rose a lot and quickly and if the Fed sold them. Unrealized losses are just that "unrealized." The Fed does not "mark to market."

        • George Selgin

          Dan, I should think it more correct to say that "unrealized losses are just that: losses"!

    • Spencer Hall

      "financed all of their lending out of the reserves supplied by the Fed’s bloated balance sheet rather than through the sale of large negotiable CDs"

      ——-

      Patently false. The DFIs pay for their earning assets with new money. The fact that CDs are unrestricted, like all non-M1 components, has nothing to do with it.

      And an increase in the remuneration of IBDDs induces non-bank dis-intermediation (demarcated by the NBFI’s whole-sale funding Mason-Dixon line).

      • Dan Thornton

        I'm afraid we'll have to disagree on this. Financing lending out of negotiable CD is the primary reason the so-called "bank credit channel" of monetary policy proposed by Bernanke and others won't work. Indeed, Ben has recognized this and is no longer pushing the idea.

        • Spencer Hall

          Ben Bernanke should be doing time in prison. He doesn't know money from mud pie.

          • Spencer Hall

            “Monetary policy is a blunt tool”. Ben Bernanke in his book “The Courage to Act” wrote:

            "Unfortunately, beyond a quarter or two, the course of the economy is extremely hard to forecast". But according to that declaration, then in July 2008, he should have seen the 4th qtr. 2008 disaster coming.

            1) POSTED: Dec 13 2007 06:55 PM
            |
            The Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.

            10/1/2007,,,,,,,-0.47,,,,,,, -0.22 * temporary bottom
            11/1/2007,,,,,,, 0.14,,,,,,, -0.18
            12/1/2007,,,,,,, 0.44,,,,,,,-0.23
            01/1/2008,,,,,,, 0.59,,,,,,, 0.06
            02/1/2008,,,,,,, 0.45,,,,,,, 0.10
            03/1/2008,,,,,,, 0.06,,,,,,, 0.04
            04/1/2008,,,,,,, 0.04,,,,,,, 0.02
            05/1/2008,,,,,,, 0.09,,,,,,, 0.04
            06/1/2008,,,,,,, 0.20,,,,,,, 0.05
            07/1/2008,,,,,,, 0.32,,,,,,, 0.10
            08/1/2008,,,,,,, 0.15,,,,,,, 0.05
            09/1/2008,,,,,,, 0.00,,,,,,, 0.13
            10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
            11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
            12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession
            Trajectory as predicted:

            BERNANKE SHOULD HAVE SEEN THIS COMING. IN DEC. 2007 I COULD.

            (2) Some people think Feb 27, 2007 started across the ocean. “On Feb. 28, Bernanke told the House Budget Committee he could see no single factor that caused the market’s pullback a day earlier”.

            In fact, it was home grown. It was the seventh biggest one-day point drop ever for the Dow. On a percentage basis, the Dow lost about 3.3 percent – its biggest one-day percentage loss since March 2003.

            flow5 (2/26/07; 14:34:35MT – usagold.com msg#: 152672)

            Suckers Rally. If gold doesn’t fall, then there’s a new paradigm
            ————–

            The fact is that Ben Bernanke was the sole cause of the Great Recession. And then he remunerated IBDDs (the 1966 S&L credit crunch is the economic paradigm and precursor). I.e., Bernanke was responsible for our subpar economic growth and the $10trillion addition to our Federal Debt.

            – Michel de Nostredame

    • Spencer Hall

      "Lending rates will continue to increase point for point with the IOER"

      No they won't. You don't trade bonds. You're the retired Daniel L. Thornton?

      And the fact that you claim banks "finance" their loans means you don't understand money and central banking (& you worked for the Fed). Bankers compete among themselves. They pay for what they already own (as anyone who has applied double-entry bookkeeping on a national scale should already know).

      Remunerating IBDDs destroys money velocity. So M1 must grow to offset the decline in Vt. But new money can't offset a decline in savings velocity (and thus incomes decline). Thus we get secular strangulation (eventually a depression given a breach of the Mason-Dixon line).

      I'm about to exit my short bond trade entered 2/10/17. If Yellen raises the remuneration rate I will buy bonds (not just based on backwardation).

    • Spencer Hall

      Like I said: ", our factor model for discerning monetary policy surprises from the
      co-movement of different asset prices scored today's price action as the
      third-biggest dovish surprise at an FOMC meeting since 2000, at least
      outside the financial crisis. (The only two non-crisis meetings that
      were clearly bigger were the August 2011 move to calendar guidance and
      the September 2013 decision not to taper QE; the March 2015 and March
      2016 cuts in the dots were similar to today’s move." – Goldman Sachs

  • Spencer Hall

    "It rather calls for ending inefficient price discrimination on
    consolidated government liabilities by paying the same return on Fed
    liabilities (bank reserves and Federal Reserve Notes held by the public)
    as on Treasuries of the same duration and default risk"

    touché