Money and Finance Policy Priorities

Flexible OMOs, IPO on ramp, NGDP targeting, Sarbanes-Oxley, Too Big To Fail
Cato Handbook for Policymakers

Flexible OMOs, IPO on ramp, NGDP targeting, Sarbanes-Oxley, Too Big To FailThe Cato Institute recently released the 8th edition of its Handbook for Policymakers. Compiled by Cato scholars, it provides advice for the new administration and Congress on key domestic and foreign policy issues.

The CMFA’s George Selgin, Thaya Brook Knight, and Mark Calabria (now Chief Economist to VP Pence) contributed chapters, writing on monetary policy, securities regulation, and financial regulation, respectively. You can find all three chapters here. A synopsis of their recommendations follows.

Monetary Policy

Selgin proposes a series of legislative reforms to the Fed’s operating framework that would improve financial stability and the  efficient allocation of credit. He recommends that Congress replace the Fed’s dual mandate with a single, stable-spending mandate. The dual mandate, by containing two potentially contradictory goals, price stability and full employment, often serves as a cover for the Fed to justify any policy it chooses. A single mandate would define a clear goal for the Fed and allow Congress and other overseers to easily discern whether a given Fed policy is furthering that goal. A stable-spending mandate would have the Fed conduct monetary policy in a way that would avoid both liquidity shortages and unsustainable booms. To make the Fed’s commitment to a single stable-spending mandate credible, Selgin recommends that Congress require the Fed to follow an explicit, straightforward, monetary rule.

Selgin also recommends a more efficient process for the Fed to use in distributing newly created liquidity in both ordinary times and times of financial market stress, a reform he calls a “flexible open market” framework, or Flexible OMOs for short. This new framework replaces the Fed’s primary dealer system with auctions open to almost all financial firms. It also broadens the range of securities eligible to serve as collateral in a fashion similar to the “product-mix” auctions the Bank of England uses.[1] Increasing the assets eligible for purchase and the firms able to participate would ensure that new credit created by the Fed is put to its most efficient use — while also limiting the Fed's footprint on allocating credit. Moreover, Flexible OMOs would rid the Fed of any need or justification to engage in direct lending, as any solvent financial institution could purchase the credit it needs during a liquidity crunch. So long as the Fed follows its proposed stable-spending mandate, it would automatically create the credit needed to meet emergency liquidity needs.

Securities Regulation

Overly restrictive securities regulation deters innovation, economic dynamism, and investment opportunities for ordinary people. Thaya Brook Knight provides policymakers with concrete steps towards more robust and fairer capital markets. To reduce burdens on firms pursuing an initial public offering (IPO), Congress should extend the 2012 JOBS Act IPO on-ramp to all firms pursuing an IPO, not just those with less than $1 billion in annual revenues. The IPO on-ramp provides five years of forbearance from certain reporting requirements, the ability to advertise to institutional investors before filing SEC paperwork, and relief from some Dodd-Frank and Sarbanes-Oxley rules. Knight also proposes that Congress revise Sarbanes-Oxley’s Section 404, which requires companies to report on the adequacy of internal controls and accuracy of financial information. Due to the costly nature of satisfying Section 404 requirements, Knight suggests that these requirements only apply to companies that have histories of internal control or accounting problems.

While easing public market restrictions will go a long way towards improving investment opportunities, Congress should go further and toss out the rules that restrict private offerings only to the rich. In 1982, the SEC promulgated Regulation D, which exempts private placements from state level regulations if the offerings meet certain requirements. Most private placements today are offered under Rule 506 of Regulation D, which essentially restricts individual investment in these offerings to people who earn more than $200,000 annually or have assets, excluding primary residence, valued in excess of $1 million. As fast growing young companies are staying private for longer, these restrictions are steadily becoming more pernicious. Congress should recognize that wealth-based investment restrictions are at odds with a liberal democratic society, and are a driver of income inequality. If lawmakers are hesitant to allow all people to purchase securities without the the full set of regulations imposed on public offerings, then at the very least the legal criterion for financial competence should be updated and based on something more objective than wealth.

Financial Regulation

Mark Calabria identifies a cycle at the heart of the longstanding relative instability in the American financial system. Restrictions on entry and competition artificially weaken the financial sector, as they limit firms’ ability to diversify their assets and reduce the market incentives for prudent risk management. Weakness resulting from these restrictions serves as an impetus for prudential regulation by government, like FDIC deposit insurance, risk-based capital requirements, and the Federal Reserve’s emergency lending safety net. Prudential regulation is inferior to market discipline because it relies on knowledge regulators do not and cannot have in real-time, making the system more prone to crisis.

To fix this cycle, Calabria recommends policymakers reduce the bank safety net and remove regulations that distort risk-taking incentives and erode market discipline. The best first step would be repealing Dodd-Frank. If Congress cannot achieve a full repeal, Calabria suggests at a minimum doing away with Titles I,II, and X. Title I established the Financial Stability Oversight Council, the regulatory super council that is tasked with designating firms as systemically important, or in others words, codifying too-big-to-fail. Title II gave the FDIC orderly liquidation authority (OLA) to resolve failing banks and non-bank financial firms at its discretion, which essentially institutionalizes government bailouts. Title X established the Consumer Financial Protection Bureau, which imposes non-economic lending standards on financial companies while taking a paternalistic view of consumers and regulating financial products it deems dangerous for them out of existence — despite consumers demonstrated demand for those products.

In addition to Dodd-Frank, Calabria points to mortgage finance, deposit insurance, and community lending as areas where public policy has made the financial system less stable and efficient. Given the role Fannie Mae and Freddie Mac played in the financial crisis and the dangers they continue to pose to the stability of the financial system, they should be briskly wound down, in no more than six years. Calabria outlines the legal methods to accomplish this. Congress also should tackle the distortions caused by Federal Housing Administration (FHA) subsidies. In the long run, Congress should abolish the FHA, but interim fixes include higher down-payments, lower debt-to-income ratios, and credit rating requirements for borrowers taking out FHA loans. Regarding deposit insurance, Calabria points out that it is extensively documented in academic literature that public insurance reduces the vigilance of bank creditors, encourages risk taking, and leads to more failure. Calabria suggests reducing the FDIC per account cap from $250,000 to its pre-savings and loan crisis level of $40,000, at the very least. A $40,000 cap would still leave most American households covered — since on average  households keep well below this amount in insured accounts. Lastly, Calabria suggests Congress repeal the Community Reinvestment Act, which forces banks into making economically unsound loans and opens avenues for costly litigation.

Read More…

To delve further into the policy recommendations made by Selgin, Knight, and Calabria, read all three CMFA chapters from the Cato Handbook for Policy Makers here. Or browse the entire Handbook here.

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[1] Selgin specifically proposes that all firms that currently have access to the discount window be allowed to participate in these auctions, and that all marketable securities accepted as collateral at the discount window stand ready for purchase.

  • Understanding that everyone is trying to work within an existing framework of national monopoly money and cartelized global central banking and is, perhaps, unable to suggest even more subject-friendly policy proposals, looks like some great suggestions.

  • Ray Lopez

    Wow! Selgin and Knight propose modest, incremental reforms, hardly worth taking about, but the real star is Calabria, who proposes some radical stuff. Sadly, I doubt it will be enacted. Somebody needs to get the ear of the Donald. Then again, not much brain between those ears, and the same was said about Reagan, also a populist of limited vision, sad! Probably another crisis is needed in the future to goad people into action.

    • George Selgin

      Let's see, Ray: my reform would permanently end ALL direct Federal Reserve lending, including both discount-window and13(3) loans; and it would completely re-vamp the Fed's OMO framework, abolishing that framework's traditional twin pillars consisting of "Treasuries only" and the Primary Dealer System. It would also involve a radical new auction procedure. If that's a modest reforms, I guess I'm a much more modest fellow than I realized!

      On the other hand, Ray, when you set out to misrepresent someone's arguments, there's nothing modest about it!

      • Ray Lopez

        Sigh…George, I actually downloaded and read the three chapters, so let me re-read them and reply (and you are too modest. To raise publicity for Cato you should be getting into the public eye more, I suggest you streak through Capital Hill, that will get attention for sure!)

        OK, the most radical idea would be to permanently end all direct FR lending: "At present, the Federal Reserve can add to the nation’s monetary reserves in two ways. One is by purchasing financial assets in the open market (“open-market purchases”). The other is by directly lending money to banks or (using its emergency lending powers) to nonbanks.". I see. But the distinction is not that radical: instead of printing money and giving it to a failing institution in trouble ('direct lending'), the Fed will do OMO comprising buying any sort of junk paper (even junk bonds) that this failing institution has to offer ("product mix" auctions). Big deal? Hardly. Recall what the USA did in the Civil War: print money and just give it to the Treasury to spend. Buying junk paper for good money is akin to just giving money to a failing institution to spend. Essentially a bailout as done with the automakers, AIG, etc in 2008.

        As for "Twin Pillars" that is rhetoric (many if not most economists, even those that believe in money non-neutrality, as I do not, say that the Twin Pillars cannot be realized in practice, they are incompatible, hence it's like squaring a circle impossible, hence rhetoric only).

        Your last paragraph "Establish a Level Currency Playing Field" was radical but hardly emphasized, perhaps not to scare policy makers (private money). I thought your piece, and Knight's piece, were intended to be 'mild' so not to shock policy makers. Calabria's piece was more radical as it called for abolishing Fannie Mae, and cutting back FDIC insurance (bonus trivia: Greece had a modest 20k Euro deposit insurance scheme then raised it AFTER the 2008 crisis to 100k Euro, retroactively, showing even modest deposit insurance is malleable and contributes to moral hazard, but I digress).

        Blog on George! I'd like to see another article on fiat money backed by gold, see "Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?", Author(s): Maurice Obstfeld and Kenneth Rogoff, Source: Journal of Political Economy, Vol. 91, No. 4 (Aug., 1983), advocates using gold or some other hard asset behind fiat money to prevent hyperinflation, sound logic, math model presented.

        A call for fixed exchange rates might also be helpful for price stability, though wild swings in exchange rates don't seem to have real effects (Marianne Baxter, Alan C. Stockman 1989 paper) (Nevertheless, it's hard to hedge the dollar /euro cheaply long term, for a retail customer like me, does anybody know how to hedge the dollar/euro ratio to keep the dollar from getting stronger, Euro from getting weaker, for say a three year period? I need to do it as I have Euros in Greece I'd like to hedge. Fx markets have a six month duration, too short for me and expensive to roll over)

        • George Selgin

          "the Fed will do OMO comprising buying any sort of junk paper (even junk bonds) that this failing institution has to offer." Not at all, Ray. The auction doesn't allow the Fed to target funds to any particular institution, and the collateral involved is limited to securities already on the discount window collateral list, which includes no junk. Failing institutions need not apply.

          Details here: http://www.heritage.org/markets-and-finance/report/reforming-last-resort-lending-the-flexible-open-market-alternative

          • Ray Lopez

            OK, you got me George. Your answer is "textbook" and I have to accept it, but, snooping around on the web, where you can find any kind of information if you search long enough, I found some people who think the Fed does de facto (not de jure) hold junk paper on its books. And btw the US Treasury by extending deposit insurance in 2008 to stem the September 2008 panic in the defaulted money market fund "Reserve Fund" effectively insured even potentially junk paper. See here (internet articles):

            "To stop the run on money market funds [like the defaulting "Reserve Fund"], on September 19, 2008, the U.S. Department of the Treasury announced … a temporary deposit insurance covering all money market investments. …This announcement stopped the run on money market funds … and redemption requests promptly receded"

            "…as this Bloomberg article points out, the "Fed Made Taxpayers Unwitting Junk-Bonds." According to Bloomberg, "more than 88 percent of Maiden Lane’s CDO bonds and 78 percent of its non-agency residential mortgage-backed debt are now speculative grade… as of Jan. 29 [2010]." The classification, speculative grade, refers to a rating of BB or less. With respect to bond ratings, a rating of BB or below corresponds to "low credit-quality (non-investment grade), or 'junk bonds' [as well as] bonds in default for non-payment of principal and/or interest." "

            So there. De facto the Fed during panics arguably does buy 'junk' paper of BB or below and pretends it is "BB rated". However, you are correct that this is not the formal Fed policy, and your proposals would make this de facto rule more de jure, and under your proposal the Fed could even buy junk bonds with complete legal authority. Thanks for this clarification.

          • George Selgin

            Geez, Ray: I never said the the Fed holds no junk (for many of the MBS it now holds are just that); what I said is that my own proposed reform wouldn't allow it to acquire such! Again, the assets the Fed could acquire under it are limited to marketable securities now eligible as collateral for discount-window lending, that is, ones that are at or above investment (BBB or Baa) grade. You really must read more carefully than you do!

          • Ray Lopez

            Oh. I see. But the part "It also broadens the range of securities eligible to serve as collateral in a fashion similar to the “product-mix” auctions the Bank of England uses" implies, to a casual reader like myself and I bet 99% of the people on Capital Hill–that the Fed will be buying more junk paper ("broadens" implies that).

          • George Selgin

            No, "broadens" just means expands or extends. (As Yogi Bera might say, you can look it up!) It doesn't mean "opens the floodgates"! And I very explicitly state what securities I have in mind. You can't ask more than that.

            The B of E auctions are themselves limited to decent collateral

  • Mattyoung

    What the dollar system needs is a way for Congress to default at opportunistic times. Congress has way more debt then any taxpayers are willing to cover, so use default to distribute inflation. It is either that or a Trump shock.

  • Spencer Hall

    Reducing the FDIC's insurance limit is the most important proposal. But that proposal isn't quite stringent enough. As Shelia Bair pointed out in "Bull By the Horns": "a married couple could have three separate accounts, each with 250,000-two individual accounts in each of their names and a joint account." "Then they could set up another 1,250,000 in coverage by setting up a trust account with five different beneficiaries."

    The problem is that banks, DFIs, do not "fund" or "finance" their loans and investments, i.e., bank credit, with bank-held savings. And it is a fact that all savings originate within the commercial banking system. Unless savings are expeditiously activated via a non-bank conduit, their payment's velocity is zero. Indeed with non-bank dis-intermediation, the savings velocity becomes less than zero. This is the singular source of stagflation and secular strangulation. The remuneration of IBDDs exacerbates this contractionary, drag and decay, phenomenon. The 1966 S&L credit crunch is the economic paradigm and precursor. The the failure of 1,043 out of the 3,234 savings and loan associations in the United States from 1986 to 1995, the S&L crisis was yet another artillery shot across the bow.

  • Mike Sproul

    "A stable-spending mandate would have the Fed conduct monetary policy in a
    way that would avoid both liquidity shortages and unsustainable booms."

    The problem is distinguishing the sustainable booms from the unsustainable ones. "Unsustainable booms" could mean that the central bank had previously been supplying enough money, but then it foolishly clamped down on the money supply, bringing a perfectly sustainable boom to an end. History is full of examples of central bankers who thought they were merely reigning in inflation and irrational exuberance, when in fact they were causing a money shortage.

    The fact is that the world has nothing to fear from central banks that explode their balance sheets, as long as both sides explode equally, thus adequately backing the central bank's new liabilities (money) with new assets.

    • George Selgin

      No Mike. The whole idea is that by stabiizing spending the CB avoids contributing to unsustainable booms. The CB doesn't have to "decide" whether a boom is sustainable or not. It keeps an eye on spending, and that's that. Booms and busts might still happen, but not as often as when spending is allowed to grow excessively rapidly. After all, what is a boom if not an general increase in apparent firm profitability, which means the average firm makes more than its costs, and then some, which means receipts are rising relative to historical outlays. Stable spending growth = no profit inflation.

  • Mike Sproul

    George:
    Consider an alternative to the stable-spending mandate: The CB expands its balance sheet (both sides) by some huge amount. Excess CB notes will at first pile up in bank vaults, but this is easily remedied by introducing new CB notes with several extra zeroes, or by converting the excess CB notes to deposits held at the CB. This would not cause inflation because the CB would have expanded its assets by enough that it could, at any time, buy back any excess CB notes or deposits. The net result is that there are a few more "billion-dollar bank notes" inside private bank vaults, and a few more billion-dollar bonds held by the CB. If a big economic boom happened, the private banks could easily exchange their $1B notes for small denomination CB notes that are easily spent at the grocery store.

    This kills two birds with one stone: (1) The huge amount of notes in private banks (and the CB's willingness to redeem them for small notes) assures that there will never be a shortage of money, no matter how big the boom.
    (2) The CB notes are fully backed by the CB's assets, so no inflation happens.

    The stable-spending mandate, by contrast, runs the risk of creating a money shortage. If a really big boom happens, the CB might wrongly conclude it is unsustainable, and refuse to issue enough money to accommodate the boom.