Mark Thoma offers a very thoughtful rejoinder to my post on whether the Fed should be given authority to pay interest on deposits. Mark's comments range from specific, technical points to broad questions about governance. What follows is a quick response to some of the issues he raises. Do read his piece, The Fed Already Has a Blank Check.
My bottom line remains the same. Although the central bank does have the capability to unilaterally expand its balance sheet, it is subject to a variety of constraints that restrain it in practice. I am opposed to relieving the Fed of those constraints unless hard limits are placed upon the scale of its direct investment in the financial system, both to protect taxpayers from absorbing losses, and to support the long-term ability of financial markets to allocate real economic capital well.
I address some of Mark's points specifically below.
Mark suggests that "the Fed already has a blank check", because it could increase reserve requirements, rather than borrow funds, to sterilize the inflationary effect of printing cash. This is true in theory, but I think it would be very difficult in practice for the US central bank. The Fed has not used reserve requirements as an active instrument of monetary policy for a long time, and has allowed (encouraged) them to atrophy, with an eye towards eliminating them entirely. (See here and here.) Reserve requirements could be reinvigorated, of course, but not easily or quickly. They would have to be restored over time and in careful consultation with banks, whose enthusiasm for the project would be less than overwhelming.
You'll hear no argument from me when Mark suggests that the Fed already has the power to do great harm. Poor monetary policy can lead to unnecessary recessions, or to credit and mis-investment booms that leave the economy structurally crippled. That an institution already has great and terrible power is no argument for handing it yet another means of mischief-making.
While central banking has always entailed risk, customary and statutory constraints usually reduce the likelihood of harm. Any asset can lose value, but restricting Fed purchases to short maturity Treasury securities limits the risk of capital losses, and importantly, distributes gains from seignorage to all taxpayers. Purchasing or lending against more speculative assets provides a subsidy to particular sectors and institutions (undermining legitimacy), puts taxpayer funds at risk, and privatizes the gains of seignorage in the event of nonperformance. (Central bank cash that otherwise would have retired public debt are instead distributed to private parties and never returned.) Fair allocation of seignorage gains is one of the prime virtues of fiat money central banking. Lending against questionable collateral imperils that advance.
Mark correctly points out that the potential upside of the Fed's bank investments is not merely, as I suggested, "about what [taxpayers] would have earned investing in safe government bonds". The purpose of the central bank's activism is to prevent harms to the public that might result from turmoil in the financial sector, and these foregone harms should be included in our calculus. But if we include nonfinancial benefits, we must also consider nonfinacial costs, such as the long-term effects of the "moral hazard", a loss of information in asset prices (assets must be valued as complex bundles of economic claims and options on potential government support), and impaired political legitimacy of the central bank and the financial system as a whole. We must weigh these costs and benefits against alternative policies, not only a straw-man scenario under which all government agencies stand completely aside and watch helplessly as the world falls apart. Of course, in "real time", the Fed did not have the luxury of reflection. But we do have it now. Mark and I would come to very different judgments about the nonfinancial costs and benefits of Fed policies. I assure you that, in general, Mark's judgment is much better than mine. Nevertheless, cranks like me will aver that the long-term costs due to moral-hazard and information loss are inestimably large, that questions of legitimacy and favoritism will haunt financial capitalism for a generation, and that it would be possible (even now!) to adopt uniform procedures for managing the collapse and reorganization of institutions that could not survive without life support from the Fed. Who should be empowered to decide these issues? Ben Bernanke? Hank Paulson? I vote for the people that I voted for, warts and all.
I want to make clear that I don't actually disagree with Mark on the technical question of whether an interest rate corridor is a good idea. So long as the Fed restricts itself to traditional monetary policy — that is, so long as it buys only Treasury debt with borrowed funds — I would support this change (mostly because an interest rate corridor is easier for non-experts to understand than open market operations).
Unfortunately, not only has the Fed resorted to unorthodox tools during an acute emergency, but all indications are that the central bank plans to expand its innovative practices and continue them indefinitely. The "unusual and exigent circumstances" under which the Fed's extraordinary actions have been justified specifies duration about as precisely as the "global war on terror". Mark has great confidence in the Federal Reserve, and sees little hazard in granting it more freedom to maneuver. I view the central bank as prone to catastrophic error, and wish to see its capabilities clipped, not enlarged. I think the consequences of centralizing private sector risk on public sector balance sheets will turn out be grave, and must oppose any tool that would make it easier for the Fed to continue to do so.
Finally, Mark writes regarding the occasional need for fast action in a crisis:
This is an old problem — how much authority should be centralized thereby allowing quick and immediate response during a crisis, and how much should be retained in slower, deliberative bodies like the House and Senate? The War Powers Act reflects this compromise — we want the ability to respond quickly to an attack or other military developments, but we worry about the concentration of power in the hands of a single individual. Centralization has the benefit of allowing a quick response to a crisis, but it risks being out of step with the democratic process. In the case of financial market emergencies, however, I have more faith in the Fed than in congress to act quickly and correctly. That's partly because I have little faith in the ability of congress to quickly comprehend what the problem is and attack it directly and effectively — many of them admit to not having a clue about economics, and more worrisome are the ones who think they have a clue but don't — but congress should not give up its oversight role.
I have little faith in Congress, and even less faith in the Fed. (That's not, by the way, a reflection of the individuals running the place. Ben Bernanke is quite brilliant. But culture and ideology saddle the Fed with both blind spots and hubris.) I like Mark's idea, though. I'd support a financial "War Powers Act" that would authorize emergency extensions of secured credit by the Fed to private actors deemed systemically important. But here's my deal-breaker: That support would have to be withdrawn within 180 days, and would not be renewable. Six months is long enough for solvent institutions to counter a "liquidity panic" with full disclosure, for modestly troubled institutions to secure new capital, and for regulators to arrange an orderly unwinding of firms that cannot be made solvent and liquid within the statutory timeframe. Whaddaya say?
By the way, we'll have our six-month anniversary of the first $40B in TAF financing in June.
|Steve Randy Waldman — Tuesday May 13, 2008 at 1:11pm||permalink|