Monetary Policy 10 Years after the Crisis—New Issue of the Cato Journal

Cato Journal, monetary policy, Cato 36th Annual Monetary Conference, James Dorn, new release

Cato Journal, monetary policy, Cato 36th Annual Monetary Conference, James Dorn, new release

The Spring/Summer 2019 edition of the Cato Journal, the Cato Institute’s interdisciplinary journal of public policy, is now available online. This issue features papers from Cato’s 36th Annual Monetary Conference held last November, ten years after the financial panic of 2008. At that conference, leading scholars and policymakers discussed new changes in the Fed’s operating framework, the impact of Fed policies on interest rates and asset prices, the lessons learned from unconventional monetary policy, and the case for a rules-based monetary regime.

In the editor’s note, James A. Dorn writes:

An understanding of the role of trust, the rule of law, and free markets in creating sound money and credit is essential to avoid policy mistakes that favor special interests and increase uncertainty. By studying the Fed’s experiment with unconventional monetary policies, lessons can be learned on how to reform the monetary regime and mitigate business fluctuations caused by the monetary mischief inherent in our current unconstrained discretionary monetary policy arrangements.

Here’s a rundown of what’s inside, with links to the full-text articles.

Monetary and Fiscal Headwinds to Sustaining the Recovery

The issue’s lead article comes courtesy of three coauthors: Phil Gramm, former chairman of the Senate Banking Committee; Thomas R. Saving, former director of Texas A&M’s Private Enterprise Center; and Michael Solon, a partner at U.S. Policy Metrics. The authors provide two unique explanations for why the Fed’s large-scale asset purchase program (also known as quantitative easing, or QE) did not immediately cause runaway inflation—as many economists had predicted it would.

First, in October 2008, the Fed began paying banks interest on excess reserves at a level above the 1-year Treasury bill rate. This maneuver encouraged banks to park their excess reserves at the Fed rather than lend them out. Second, the Obama administration’s costly regulatory policies and high capital tax rates dampened the demand for credit, slowing the economic recovery and leading to correspondingly low rates of inflation.

The authors add, however, that with the Trump administration’s lower tax rates and regulatory roll-backs finally reviving economic growth, the Fed now faces the danger of a spike in market interest rates forcing it to either increase its own target interest rate and sell assets—or succumb to inflationary pressures. They recommend that the Fed “reduce its assets, and the excess reserves of the banking system” by “let[ting] the economy grow up to the size of the Fed’s asset holdings.” They also observe that while a continued recovery will require the Fed to dial back its footprint in credit markets, the Trump administration must also continue its own deregulatory efforts, resolve trade disputes, reinstate discretionary spending caps, and increase employment.

On Money, Debt, Trust, and Central Banking

Claudio Borio, head of the Monetary and Economic Department at the Bank for International Settlements and keynote speaker at last year’s conference, argues that the economic profession has lost sight of the fundamental role that trust plays in a well-functioning monetary system. By “trust,” Borio means that the items designated as money will in fact be accepted as such, and that the monetary system will deliver reasonable price level and financial stability. Borio dedicates much of his article to defining the mechanisms that will best preserve the public’s trust in its monetary system. In the process, he discusses the relationship between money and debt, the nexus of monetary soundness and financial stability, and the opportunities on the horizon for cryptocurrency.

First, Borio describes what he regards as the three essential components of any monetary system: a unit of account (an abstract unit for measuring the value of all goods and assets); a means of payment (for settling, or “extinguishing,” obligations); and mechanisms for executing and transferring those payments. Trust, as Borio uses the term, applies to the reliability, stability, and consistency of these three components and the ways in which they interact over time.

Borio distinguishes between the necessary day-to-day aspects of a trustworthy monetary system—the elasticity of both the money supply and the means of payment—and its longer-term components—price and financial stability. He argues that neither price nor financial stability can exist independently of one another, but that tension between these two concepts often arises since each stems from a separate series of underlying processes. Although numerous monetary systems have attempted throughout history to ameliorate these tensions, Borio remains convinced that—as he paraphrases Churchill’s famous quip about democracy—“the current monetary system is the worst, except for all those others that have been tried from time to time.”

The Fed’s Operating Framework: How Does It Work and How Will It Change?”

Stephen D. Williamson, Stephen A. Jarislowsky Chair in Central Banking at the University of Western Ontario, examines the characteristics of the Fed’s new operating system. He argues that, as the Fed unwinds its balance sheet and reevaluates the unconventional policies it implemented during the Great Recession (namely, large-scale asset purchases and zero interest rates) it will move even further into uncharted territory. His article provides a series of guideposts by which the Fed might steer itself safely back to normalcy and, where necessary, improve upon its prerecession policies. First, he explains what those prerecession policies were and assesses how they might have exacerbated the crisis. Next, he describes the Fed’s recession-era policies and analyzes the extent of their damage. Finally, he outlines the lessons from both periods that can inform better policymaking in the future.

Of particular importance to Williamson are the evolving relationship between the Fed’s IOER policy and the federal funds rate, the impact these changing dynamics have had on several market operations, and whether the FOMC should maintain its current “floor” system for setting interest rates, revert to its prior “corridor” system, or implement a revised approach.

The Fed’s New Operating Framework: How We Got Here and Why We Shouldn’t Stay

George Selgin, director of Cato’s Center for Monetary and Financial Alternatives, picks up where Williamson leaves off, beginning with a review of the factors that precipitated the Fed’s decision to switch from a corridor-based system to a floor-based one. He then critiques the inception of the Fed’s floor system, which he considers ill-advised, and forecasts its likely future, which he deems ill-fated.

Selgin argues that, by adopting a floor system, the Fed inadvertently tightened the credit market. This made the Great Recession deeper and longer-lasting. His forward-looking criticisms are threefold. First, he argues that by setting an interest rate “floor,” the Fed effectively eliminated private interbank lending, which was historically one of the most useful barometers for gauging a bank’s soundness. Second, by increasing the demand for government securities, the floor system crowded out private sector borrowers and led to less productive investment. Third, and perhaps most importantly, the Fed’s floor system turned its balance sheet into a dangerously tempting target for political meddling.

Interest on Reserves: History and Rationale, Complications and Risks

Peter N. Ireland, Murray and Monti Professor of Economics at Boston College, further discusses the risks of increased regulatory discretion associated with the Fed’s floor system and IOER policy. Both policies, he argues, allow the Federal Reserve to wield an unprecedented amount of authority over the private market for credit. At the same time, they permit the Fed to “borrow short and lend long,” using banks’ short-term deposits to fund the long-term assets that now clutter its balance sheet. Ireland points out that Fed officials have already used their new tools to bolster the market for mortgage-backed securities. By depressing long-run interest rates, these Fed policies have also encouraged more private-market risk-taking.

Despite his concerns, Ireland is not fatalistic: he traces out several possible paths forward for the Fed, one of which is to shift the responsibility for setting the IOER rate from the Federal Reserve Board of Governors to the Federal Open Market Committee. A more aggressive proposal would be that the Fed stop paying interest on excess reserves altogether. He also recommends that the Fed address the maturity mismatch on its balance sheet by reverting to a policy of purchasing short-term Treasury bills only.

Assessing Global Financial Stability

Tobias Adrian, financial counsellor and director of the IMF’s Monetary and Capital Markets Department, directs readers toward a puzzling discrepancy between the U.S. and the world economy: while the rest of the globe seems to be in the middle of a monetary tightening cycle, U.S. monetary policy remains relatively easy. His article explores whether the U.S. financial cycle is approaching a turning—or tightening—point. Using the IMF’s Growth-at-Risk approach to forecast the distribution of future U.S. economic growth, he concludes that our economy will soon fall back with the world average. Adrian also outlines some of the most significant risks that will likely affect U.S. economic growth over the coming years. These include trade policy concerns, political instability, diplomatic tensions, and fallout from current global controversies like Brexit.

Unconventional Assessment of Unconventional Monetary Policy

Vincent Reinhart, managing director, chief economist, and macro strategist at BNY Mellon Asset Management North America, challenges the conventional wisdom that QE played a major part in lowering Treasury yields in the years following the crisis. While QE had some effect, Reinhart argues, it was neither the only nor the most significant cause of the post-crisis reduction in Treasury yields. Instead, he finds that the major effects of QE did not coincide with the timing of the policy. He writes: “QE mattered, but not that much.” By exaggerating the contribution of QE, Reinhart argues, the Fed also signals its lack of confidence in the recuperative ability of capital markets. He argues that even market volatility itself can be beneficial: Reinhart argues that a higher risk of capital loss will lead investors to be more discriminating, which in turn will prompt greater discipline from financial institutions. He notes that QE also lowered the level of accountability that a market economy demands of both institutions and investors. “How can we expect traders and investors to react reliably to shocks in the future,” he asks, “if their past is one in which they have been protected by a benevolent central bank?” He closes by warning that the Fed’s refusal to acknowledge the threat its experimental monetary policies posed to our capital market (and its participants) makes it all the more likely that the Fed will continue to intervene in unnecessary—and unhelpful—ways going forward.

Political Economy of the Fed’s Unconventional Monetary and Credit Policies

Scott A. Burns, assistant professor of economics at Ursinus College, and Lawrence H. White, professor of economics at George Mason University, examine the motives behind the discretionary bailouts the Fed granted to systemically important financial institutions, including primary dealers, during the Great Recession. Their article looks at the connection between that decision and the Fed’s decision to limit its monetary policy normalization.

The authors follow a “public-choice” approach, which assumes that because policymakers tend to favor special interests at the expense of the general welfare, they will routinely deviate from the public interest when they have the discretion to do so. For example, the Treasury, Fed bureaucracy, and rent-seeking financial institutions benefitted from the Fed’s recession-era policies even as the general public suffered. Today, Burns and White write, these same groups continue to get preferential treatment without any clear advantage to the general public. The authors note that the Fed’s balance sheet has expanded in roughly equal proportion to its discretionary budget, signaling that the Fed may have used its QE programs, at least in part, to fund or justify further unnecessary expenditures.

Burns and White caution that, without rules to check its discretion, the Fed’s future policies will become increasingly unpredictable—and increasingly hostile to the public interest. They recommend a constitutional “generality norm” that would require that all federal agency programs benefit “citizens in general, rather than providing rents to some at the expense of others.”

Improving the Monetary Regime: The Case for U.S. Digital Cash

Michael D. Bordo, director of the Center for Monetary and Financial History at Rutgers University, and Andrew T. Levin, professor of economics at Dartmouth College, also point to the inefficacy of quantitative easing, both in the U.S., the eurozone, and Japan. As an alternative way of circumventing the zero lower bound problem, they recommend that the Fed collaborate with private, supervised financial institutions to put digital cash at the helm of the monetary system. Such a digital monetary regime would allow the Fed to implement negative interest rate policies. Bordo and Levin also discuss practical considerations of implementing a digitized monetary regime and outline different approaches for establishing a digital currency.

What Have We Learned About Central Bank Balance Sheets and Monetary Policy?

Joseph E. Gagnon, senior fellow at the Peterson Institute for International Economics,  also reflects on the institutional changes necessary for improving our current monetary policy framework. He does so, however, from the premise that central bankers were too timid in using unconventional policies during and after the Great Recession. Gagnon believes this timidity led to a much slower and weaker economic recovery than we would have seen, had the Fed acted more aggressively.

Gagnon suggests several changes that would allow the Fed to more aggressively combat future crises. For example, he recommends granting the Fed the power to buy a greater variety of financial assets and to engage in “helicopter-money” transfers. He also suggests that “the Fed… raise its inflation target, either directly or indirectly by switching to a nominal GDP (NGDP) growth target of 5 percent.” (This would allow for inflation of 3 percent if real output—adjusted for inflation—is assumed to grow at 2 percent.) During severe recessions, Gagnon adds, the Fed might adopt a “level target” for NGDP, which would help make up for any shortfalls, increase inflation in the medium term, and keep the policy rate near zero for a longer period.

The Financial Stability Case for a Nominal GDP Target

David Beckworth, director of the Monetary Policy Project at the Mercatus Center of George Mason University, also believes that NGDP targeting can help to promote financial stability. He questions the efficacy of using macroprudential regulations to respond to economic shocks. He tests the hypothesis that NGDP level targeting would do a better job of promoting financial stability than our current macroprudential regulations do.

To do so, Beckworth constructs an NGDP gap measure for 21 advanced economies, which he uses to track the relationship between NGDP and other measures of economic soundness. His data confirm that there is indeed a strong case for using NGDP level targeting to promote financial stability.

Ten Lessons from the Economic Crisis of 2008

Scott B. Sumner, Ralph G. Hawtrey Chair of Monetary Policy at the Mercatus Center of George Mason University, draws ten lessons from the 2008 financial panic, the first of which is that “unstable NGDP represents a failure of monetary policy.” After diagnosing the Great Recession as a series of “nominal” problems (i.e., problems related to monetary policy rather than market failure), Sumner recommends implementing an NGDP-based policy target—one that he urges the Fed to do “whatever it takes” to meet. He emphasizes that “monetary policy is always capable of maintaining adequate NGDP growth.”

The suggestion that the Fed do “whatever it takes” is bound to raise some eyebrows. However, Sumner insists that doing “whatever it takes” to maintain “a target path for the level of NGDP” will actually help policymakers avoid extraordinary interventions like QE or negative interest rates. He also recommends that the Fed policymakers target expected NGDP using market forecasts rather than the Fed’s internal projections. Finally, he admonishes the Fed never to pay interest on reserves during a recession.

Should the Fed Be Constrained?”

Jeffrey Frankel, James W. Harpel Professor of Capital Formation and Growth at Harvard University’s Kennedy School, closes the issue with a final vote of approval for NGDP targeting. While Frankel accepts that NGDP targeting would better accommodate supply-side economic shocks than inflation targeting, he warns that unforeseen shocks can lead even the most well-intentioned policymakers to fail in meeting any target assigned to them. Because of that, Frankel suggests a more conservative reform namely, to have the FOMC include nominal GDP growth in its Summary of Economic Projections.

However, Frankel is completely opposed to politicians’ efforts to constrain the Fed. He argues that politicians, susceptible as they are to interest groups and election cycles, would likely do a poor job of regulating the regulators. Instead, he recommends that politicians “let the Fed do its job”—a verdict that, while simple in its phrasing, is perhaps less so in practice.


Co-authored with James A. Dorn, Vice President for Monetary Studies, Cato Institute.