...Archive for August 2010

Monday at the Treasury: an overlong exegesis

Last Monday, I had the privilege to meet up with a bunch of bloggers and Treasury officials for what might be described as a “rap session”. The meeting was less formal than a previous meeting. There were no presentations, and no obvious agenda. Refugees from the blogosphere included Tyler Cowen, Phil Davis, John Lounsbury, Mike Konczal, Yves Smith, Alex Tabarrok, and myself. Our hosts at Treasury were Lewis Alexander, Michael Barr, Timothy Geithner, Matthew Kabaker, Mary John Miller, and Jake Siewart. You will find better write-ups of the affair elsewhere [Konczal, Lounsbury (also here), Smith, Tabarrok]. Treasury held another meeting, with a different set of bloggers, on Wednesday.

It is bizarro world for me to go to these things. First, let me confess right from the start, I had a great time. I pose as an outsider and a crank. But when summoned to the court, this jester puts on his bells. I am very, very angry at Treasury, and the administration it serves. But put me at a table with smart, articulate people who are willing to argue but who are otherwise pleasant towards me, and I will like them. One or two of the “senior Treasury officials” had the grace to be a bit creepy in their demeanor. But, cruelly, the rest were lively, thoughtful, and willing to engage as though we were equals. Occasionally, under attack, they expressed hints of frustration in their body language — the indignation of hardworking people unjustly accused. But they kept on in good spirits until their time was up. I like these people, and that renders me untrustworthy. Abstractly, I think some of them should be replaced and perhaps disgraced. But having chatted so cordially, I’m far less likely to take up pitchforks against them. Drawn to the Secretary’s conference room by curiosity, vanity, ambition, and conceit, I’ve been neutered a bit. There’s an irony to that, because some of the people I met with may have been neutered, in precisely the same way and to disastrous effect, by their own meetings and mentorings with the Robert Rubins and Jamie Dimons of the world.

Obviously the headline act was Timothy Geithner. Off the record (or “on deep background”), Geithner is entirely different from the sometimes stiff character who appears on television. He is fun to argue with, very smart, good natured, and intellectually wily. As Yves Smith quipped afterwards, Geithner “gives good meeting.”

Despite that, our seminar was an adversarial affair. We began by relitigating financial reform. Officials began by talking up the buzz of activity occasioned at Treasury by the Dodd-Frank Act — putting together the Financial Stability Oversight Council, “standing up” the CFPB — with the happy implication that good and important things were happening. We peppered them with skeptical questions. Mike Konczal asked what sort of metrics they would use to judge the success of the bill. (That’s a hard problem, they said.) It’s well and good that folks at Treasury are made busy by the Act, but is it having any effect on the behavior of banks? (There’s been some movement on overdraft protection, and banks are raising capital.) As Alex Tabarrok has already reported, Tyler Cowen asked the excellent question of how the Act has changed regulators’ incentives, of why we should believe that regulators won’t intervene next time as they did this time, bailing out bankers and creditors at the expense of taxpayers. Resolution authority was their answer. Regulators’ incentives were fine the first time around, but they simply didn’t have the tools they needed to take the appropriate actions, to chart a middle course between generous bailouts and catastrophic unwinds. I’m very skeptical of that account.

I was pleased that, thanks to both Tyler Cowen and Yves Smith, we had a solid discussion of derivative clearinghouses. I am a big fan of standardized derivative exchanges and clearinghouses, and trade on them frequently. But I’m very fearful of the degree to which we will rely upon them under the new regime. Like a gas under pressure, the financial sector pushes and prods for places where high returns can be earned at someone else’s risk. During the last cycle, that included banks, shadow banks, and the GSEs, which earned profit on huge asset portfolios cheaply levered by virtue of perceived state guarantees (that were ultimately ratified). In theory, financial reform will firm up those weak spots, reducing permissible leverage and increasing its cost as resolution authority makes non-bailout of creditors credible. Suppose that actually happens. Then clearinghouses will stand out as institutions that are much too big to fail, and whose ultimate creditors (derivative traders) do not and cannot monitor creditworthiness. Clearinghouses are cleverly structured, so that the “members” through which clients trade are exposed to one another’s losses and do monitor each other’s financial health. But it is easy to imagine scenarios where it is in all members’ interest to allow a product to be undermargined. Regulated, highly leveraged financial institutions rationally accept “negative skewness“, arrangements that are profitable for them almost all of the time, but that fail catastrophically when something breaks. During long periods of stable profitability, an institution builds a track record to persuade regulators that risks are minimal and capably managed. The institution is permitted to take ever greater risks, and distribute ever greater profits to investors, while times are good. When, eventually, a catastrophic failure occurs, losses exceed the capital of the firm and are shifted elsewhere, usually to taxpayers. An undercapitalized and undermargined clearinghouse is a great vehicle for this sort of game, as low margins attract fee income from speculative trading, and members can trade on their own exchanges as a means of acquiring the cheap leverage that regulation might otherwise prevent. I’ve skimmed the relevant section of Dodd-Frank, and as far as I can tell, the hard and fast rules governing “derivatives clearing organizations” are very weak. We will be depending upon the discretion of regulators.

Gap risk and liquidity risk are kryptonite to clearinghouses. Yves Smith pointed out that clearing credit default swaps in particular could prove very challenging. These contracts sometimes “jump to default”, creating large losses very quickly for the protection sellers. If a clearinghouse were to insist on margins large enough to cover sudden jumps to default, the contracts would probably become unattractive to investors. If it does not, then a systemic shock that impairs many credits simultaneously could take down the clearinghouse.

Treasury officials had clearly thought about these issues. They pointed out, correctly, that despite formally concentrating risk, clearinghouses are better than bilateral trades, because in practice derivative markets engender systemic, not just bilateral, risk anyway and at least with a clearinghouse one can track, manage, and regulate that. Ultimately, their answer was that once we put this extra transparency in place, we just have to trust regulators to regulate well. In response to Yves’ skepticism of clearing CDS, one official suggested that regulators will insist on adequate margins, and if that renders some products uneconomical then so be it. I’ll believe that when I see it.

A disappointing moment in the conversation on financial regulation was when several officials suggested that increased capital requirements in and of themselves would do much of the work of solving bank incentive problems. I hope they were just trying snow us with this, because if they believe it, it suggests that they haven’t thought very carefully about how well aligned the incentives of equityholders, bank managers, and traders are at highly levered institutions. All three groups benefit by putting creditors’ resources at risk and earning outsize profit against limited costs (loss of equity value or loss of a job). Under the new regulation, our “strong” capital requirements will probably permit banks to be levered at least 15 times poorly measured common equity. That’s not nearly enough to tilt shareholder incentives decisively towards capital preservation. Shareholders would have to work very hard to oppose the interests of managers and traders. One official wondered aloud why bondholders failed to discipline banks, in order to prevent this sort of misbehavior. I’ll leave that one dangling as an exercise for readers.

The conversation next turned to housing and HAMP. On HAMP, officials were surprisingly candid. The program has gotten a lot of bad press in terms of its Kafka-esque qualification process and its limited success in generating mortgage modifications under which families become able and willing to pay their debt. Officials pointed out that what may have been an agonizing process for individuals was a useful palliative for the system as a whole. Even if most HAMP applicants ultimately default, the program prevented an outbreak of foreclosures exactly when the system could have handled it least. There were murmurs among the bloggers of “extend and pretend”, but I don’t think that’s quite right. This was extend-and-don’t-even-bother-to-pretend. The program was successful in the sense that it kept the patient alive until it had begun to heal. And the patient of this metaphor was not a struggling homeowner, but the financial system, a.k.a. the banks. Policymakers openly judged HAMP to be a qualified success because it helped banks muddle through what might have been a fatal shock. I believe these policymakers conflate, in full sincerity, incumbent financial institutions with “the system”, “the economy”, and “ordinary Americans”. Treasury officials are not cruel people. I’m sure they would have preferred if the program had worked out better for homeowners as well. But they have larger concerns, and from their perspective, HAMP has helped to address those.

Phil Davis, who made clear that his remarks were from the perspective of bank investors, thought Treasury was doing far too little to defuse the housing problem. He pointed out that even if the financial reform bill is beautifully crafted, its full implementation will take up to three years, during which the banking system will remain in peril, largely because of tenuous mortgages. He suggested that Treasury help pay down the mortgages of struggling homeowners until the remaining loan was solid. In exchange, Treasury would retain an equity claim on the home, from which in a good scenario taxpayers might be able to recover much of the cost of the program when the houses are eventually sold. A senior Treasury official gave the proposal a sympathetic hearing, but opined that exchanging a government claim against a homeowner for a bank’s claim against a homeowner in order to solidify bank balance sheets was not the best use of limited budgetary and policy implementation capacity. (For a change, I agreed with the Treasury official on this one.)

From HAMP, we segued briefly to a discussion of the GSEs. I got excited when one Treasury official explained that his inclinations were “minimalist”. I imagined winding down the GSEs, eliminating the mortgage interest rate deduction, cutting away the vast web of pernicious subsidies to home-lendership. My hopes were quickly deflated. By “minimalist”, the official meant parsimonious in terms of changes to the existing system. In a nutshell, he proposed insisting, by regulatory fiat, that future GSE’s borrowing costs be kept at a level appropriate to a private firm with no Federal backstop, implicit or otherwise. He thought there would be a continuing role for some kind of government guarantees of mortgages, but suggested this guarantee could be made more limited. (I think the idea would be to put private players — the Re-GSEs or originating banks — on the hook for a first loss.) In the spirit of Tyler’s question about regulatory incentives, I thought this proposal entirely naive. Over time, regulators would not succeed at forcing a substantial above-market spread on politically powerful private actors. (Well, private with respect to the upside, not if the downside, of their activities.) Further, the suggestion reflects an inadequate view of how creditors limit firm risk-taking. In the private sector, creditors do not only charge a higher spread for risk, but they participate in governing firms and constrain behavior directly via bond covenants. The name for bond covenants when imposed by a public sector creditor is “regulation”. Ultimately, this “minimalist” approach to managing the GSEs amounts to nothing more or less than keeping the existing system and proposing that it be better regulated, including specific regulatory suggestions that are foreseeably unlikely to withstand industry pressure. No offense to its very smart proponent, but this was a non-idea dressed up as reform.

I did express my skepticism to Mr. Minimalist. Unlike some of his colleagues, he was smart enough, or honest enough, to acknowledge that even with stronger capital ratios, it is naive to rely on the private capital structure of large, complex financial firms to enforce good behavior. So what is to be done, if not to regulate them as best we can? Almost as an aside, he noted that some people thought we should limit “size”, but that he couldn’t see how that would get at the problem, and had rejected the approach. Had there been time, I would have been glad to school him. “Size”, of course, stands in for and trivializes the notion of structural rather than supervisory regulation, an approach that many of us pushed desperately, only to be met by a wall of dismissal from Treasury and Congressional leaders. [*]

Perhaps Treasury officials really can’t see how limiting “size” might help. But I don’t think that’s right. These are very, very smart people. I think they understand the merits of the structural approach to financial regulation, but view the transition costs as simply too large to bear. But that begs the question of costs to whom, and whether (per the HAMP conversation above) it is wise to conflate the health of status quo financial institutions with the welfare of the economy as a whole.

Finally, our conversation turned to the current macroeconomic doldrums. Thankfully, there was none of the “let’s look on the bright side” chipperness of Timothy Geithner’s recent New York Times op-ed. Treasury officials didn’t downplay how bad things are. They did point out that considering the headwinds the economy faces, things are a bit better than they might be. The account went roughly like this: Last year, after the doldrums of March, the economy grew faster and performed better than most would have forecast. But recently it encountered two obstacles, one expected, the other an unexpected near cataclysm. The spurt of GDP growth due to post-panic inventory restocking was always going to end. But a sovereign debt crisis in Europe strong enough to shake confidence and financial markets in the US was not expected. Taking all that into account, things are a bit better than they might have been. One Treasury official pointed out that if we could return to the path of consensus growth forecasts from just before the troubles in Europe, we would have two or three difficult years ahead of us yet, but would be on a decent path. I took this as a kind of optimistic but plausible thought experiment on where we might be going.

I’m not going to belabor the obvious critique of this account, that it focuses too much on statistical growth and financial market performance and too little on employment (which, in the optimistic thought experiment, would follow statistical growth with a lag). Also, if we are enumerating headwinds to current GDP growth, I would have included the tailing off of Federal stimulus, a factor I don’t recall officials emphasizing.

I was impressed that Treasury officials had a pretty good understanding of the impediments to growth going forward. They understood that the core problem preventing business expansion isn’t access to capital but absence of demand. But I got the sense that, as they see things, they are boxed-in on that front, paralyzed and hoping for the best. When someone asked about monetary policy, an official said he really couldn’t comment on behalf of the Fed, but then proceeded to comment anyway, that in a very sharp downtown the Fed would have (presumably unconventional) ways to intervene, but that we were probably near the limits of what the central bank would do on the economy’s current path. Regarding their own bailiwick, an official perceptively pointed out that the set of spending programs Congress seems capable of delivering and the set of programs the public would consider wise and legitimate seem not to intersect. All of this resonated well with me: I view the current macro-sluggishness as a function of insufficient demand, yet stand with the hypothetical public in being hesitant to support “stimulus” and “jobs” programs that strike me as haphazardly targeted and sometimes wasteful or corrupt.

What ought a Treasury official do under these circumstances? Mike Konczal suggested that Treasury had latitude to stimulate without Congressional approval, pointing out that only a small fraction of the funds allocated to HAMP had been spent, and that with some cleverness the remainder could serve as a piggy bank. He was openly astonished when he was told that despite the tiny uptake thus far, according to Treasury’s extrapolations and accountings, at least $40 of the $50 billion allocated to HAMP would be used by the program and the funds were therefore already spoken for.

My suggestion was that Treasury should take the lead from Congress and propose a “two-year guaranteed income program”. If I were writing a proposal, I’d offer a lot of detail and caveats, but during a short meeting with scarce air-time, that was the sound-bite I came up with. As regular readers know, I think the government ought to be transferring equal sums of money to all adult US citizens irrespective of tax or employment status. That’s a form of stimulus that seems fair on face, that doesn’t pick winners and losers or skew the direction of the economy, and is plainly not corrupt. “Guaranteed income program” can be interpreted in lots of different ways, though, and I have no idea how Treasury officials took this. In any case, the quick response was to say it wouldn’t pass Congress, as though that were that. Later on, I suggested officials should push it anyway, and “go down, or up, with the ship”.

Putting aside the merits and demerits of my own proposal, under the present circumstance, where things are going badly and officials believe that some forms of policy activism would be wise but are politically impossible, how ought public servants behave? Is it too much to ask, as I did, that officials choose good policy and push it, even if that means tilting at windmills in ways that could erode political capital and be harmful to their careers? One can make the case, as I suspect Treasury officials would, that policy idealism makes the best into the enemy of the good, and results in less achievement than a more pragmatic approach. Sometimes that might be true, but I think it is dead wrong right now. We are currently trapped in a political dynamic under which the contours of what is conventionally possible are so terribly straitened, and so terribly corrupt, that “achievements”, like health care reform, even when they are incremental improvements in policy, are painful blows to the public’s sense of the potency and legitimacy of government. We have a President who campaigned under the slogan “Yes we can!”, but then governed by cutting deals with status quo interest groups and limiting options to what powerful lobbies could live with. I was not lying when I said at the beginning of this piece that I like the people at Treasury personally. I have no great wish that they should lose their jobs. But for the good of the country, I do think they should come up with what they think would be the best economic policy imaginable and push it on its merits, publicly and unapologetically, even if it costs them their positions, and even though I might be horrified by what they’d choose. (Despite all the conversation, I have absolutely no idea what they would choose.)

Amid the talk about flagging demand, blogger John Lounsbury had the courage to “drop a stink bomb”, as he put it. He said that in his view, the United States needed to move from a consumption to a production oriented economy, and that we ought to use the tax system to get there, increasing taxes on consumption and reducing taxes on capital. I agree with John that the US economy needs to shift so that it produces as much value as it consumes (see below) but I’m entirely unenthusiastic about this sort of tax policy. John’s proposal amounted to a full U-turn from our how-to-inspire-demand conversation, but the Treasury official with whom we were speaking didn’t miss a beat. He nodded sympathetically, and said that while he couldn’t discuss specifics of what the deficit commission was doing, they were doing good work. I left with a serious case of heebie-jeebies about what the deficit commission might be up to, but no details at all.

Despite my disagreement with John regarding tax policy, I share his concern that the US economy has habitually failed to achieve a “sustainable pattern of specialization and trade”, as Arnold Kling likes to put it. The most obvious reflection and enabler of this, I think, is the United States’ large, structural trade deficit (which recently spiked). I asked Treasury officials what they intended to do about this, keeping in mind that the problem runs much deeper than our bilateral relationship with China, as well as the importance of avoiding distortionary protectionism, unfair discriminatory policies, or trade wars. Alex Tabarrok (who fascinates me as a writer, but spoke far too little at the meeting) pointed out that Treasury had done a good job so far at avoiding conflict over trade and resisting pressure to impose foolish barriers. He is right about that, but Treasury has also done little thus far to address the structural imbalance. The trade deficit did decline briefly during the recession, but given its quick resurgence, that seems to have been a mechanical effect of the pause in economic activity rather than a sustainable change in trade patterns.

A Treasury official agreed enthusiastically about the importance of finding more sustainable patterns of trade. But he characterized trade balance as a medium-term issue that might resolve itself over time, especially if China (which he described as the “anchor” of a whole block of trade partners) allows its exchange rate to appreciate. He suggested that although the issue is important, we could worry about other things for now and save trade balance for later if it fails to self-correct.

I disagreed. I think that the trade imbalance makes stimulus both intellectually and politically difficult to defend (including my own “guaranteed income program”), because the pattern of business expansion we would stimulate would continue to overproduce domestic services and underproduce tradable goods relative to the patterns of production we will require when unsustainable international flows cease or reverse. In Austrian terms, I think demand stimulus in the context of continuing trade deficits will lead to malinvestment and another dangerous recession when what can’t go on forever stops. Rather than reinforcing patterns of investment that will have to be reversed, we should begin to wean ourselves of unbalanced trade flows, so that investors find it profitable to bolster the sectors we will require in order to pay for current consumption with current production. Unfortunately, it did not sound as though nondiscriminatory tools for enforcing trade balance, such as capital controls or “import certificates“, were anywhere on Treasury’s radar screen.

Overall, as I said at the start, the meeting was a lot of fun. I spend a lot of time around universities, and our meeting resembled nothing so much as an unusually lively seminar. Unfortunately, just like an academic seminar, I left with the feeling that there were a lot of bright ideas and brilliant people, but nothing much was going to come of it all, at least not anytime too soon.

[*] No one claims that limiting “size” alone, defined as market cap or balance sheet assets, would be sufficient to solve any problem. One dollar of equity can pull the whole universe into a financial black hole if it is sufficiently leveraged. But proponents of structural regulation understand that status quo large financial firms simply cannot be regulated, either privately by equity and debt holders or publicly by civil servants. As discussed above, when a firm is highly leveraged, equity holders switch from sober stewards of capital to risk-loving looters of creditor wealth. When a firm’s creditors are formally guaranteed, or when as a group they are sufficiently large, interconnected, and incapable of bearing losses, creditors also switch sides, ignoring risk and seeking yield on the theory that the social costs of forcing them to eat losses would be far higher than the fiscal cost of bailing out the bank. The entire private capital structure of systematically important financial firms wants to maximize risk-taking while minimizing regulatory costs, looting the public purse and splitting the proceeds between creditors, shareholders, managers, and other employees. Relying on “market discipline” for this sort of firm cannot work. Relying on public sector supervision ignores resource asymmetry and political constraints, as well as the information and incentive problems faced by even smart, well-intentioned regulators. Large, complex, leveraged and interconnected financial firms simply cannot be regulated, by the private or public sector. Without regulation they quite rationally maximize stakeholder wealth in a manner that happens to be socially and economically destructive. The only way around this is to change the incentives of all stakeholders, and that could only happen by placing them in a different kind of firm. We have to limit the size and composition of firms’ creditor base, so we can be sure losses to creditors would be socially and politically tolerable. (We do this already, or try to, with hedge funds.) We have to limit the scale of firm exposures, including on-balance-sheet, off-balance-sheet, and synthetic exposures, so we can be sure that the cost of nonperformance to counterparties would also be tolerable. Less obviously, we have to limit the scale of economic exposures relative to the number of independently responsible asset managers, so that no asset manager manages so much money that one or a few years of performance-based compensation would leave them set for life. The incentives of managers at small, nonprestigious banks are much better aligned with the long-term viability of their firms than hot-shots at glamour banks, who flit between high-paying gigs and hope to get their “fuck you money” fast. We have to limit the scope of operations at individual banks, because a complex bank is a bank that can’t be regulated, publicly or privately.

Also, small banks rationally allocate capital differently than very large banks. Big banks seek economies of scale to exploit. They trawl through vast streams of systemized data looking for patterns that can be widely applied to inform lending and investment decisions. Smaller banks seek out advantage based on local information and specific relationships. These are distinct strategies, and banks of different size will find different approaches adaptive. Lions and house cats are superficially similar, but thrive in different ecological niches. Large banks cannot effectively exploit local information, because local information is usually “soft” — that is, difficult to quantify and objectively verify. Lending based on soft information is inherently discretionary and prone to abuse, and large banks find it difficult to discipline the qualitative instincts of thousands of loan officers. Conversely, large bank employees find it impossible to defend inevitable failures, when, ex post, investments look to have been based on glorified hunches. (Small bank loan officers would have gotten buy-in up front from senior management, so failures get more sympathetically reviewed.) Further, most businesses will find it difficult to form credible relationships with very large banks, while small banks can have a real stake in an individual client’s success. But small banks can’t do what big banks do, as they lack sufficient data to mine client-order flow or tease out subtle relationships between FICO scores, patterns in checking and credit-card behavior, and loan performance. Small banks and large banks set about the task of allocating financial capital very differently. If you take a Hayekian view of capital allocation, small banks are likely to do a superior job.

(Small banks will do a better job in aggregate, even though those that fail will be found to have made more ludicrous and scandalous mistakes. Also, while most large-bank strategies are pathological, there is a well-known pathological small-bank strategy, “herding” or “information cascades”. In a small-bank-centric world, regulators would have to penalize copycat behavior, for example by taxing or increasing regulatory capital requirements when banks choose to invest in asset classes that are already overrepresented in the aggregate banking sector portfolio.)

Update History:

  • 22-August-2010, 10:00 p.m. EDT: Removing some excess verbiage: “less achievement overall” → “less achievement”, “in policy terms” → “in policy”. Removed some unnecessary commas. Fixed use of the word “diffuse” where “defuse” was intended, many thanks to Nemo for pointing this out!
  • 22-August-2010, 10:55 p.m. EDT: “There’s some irony to that” → “There’s an irony to that”

Monetary policy for the 21st century

Twentieth Century monetary policy can be understood very simply.

One can imagine that, prior to the 1980s, the marginal unit of CPI was purchased from wages. That made managing inflation difficult. In order to suppress the price level, central bankers had to reduce the supply of wages. But reductions in aggregate wages don’t translate to smooth, universal wage cuts. For institutional reasons, attempts to restrain aggregate wages generate unemployment. Prior to the 1980s, central bankers routinely had to choose between inflation or recession.

Then came the “Great Moderation”. The signal fact of the Great Moderation was that the marginal unit of CPI was purchased from asset-related wealth and consumer credit rather than from wages. Under this circumstance, central bankers could fine-tune the economy without disruptive business cycles. When resources, especially humans, were under-employed, expansionary monetary policy could be used to inflate asset prices and credit availability, until increased expenditures on consumption goods took up the economy’s slack. When inflation threatened, contractionary monetary policy restrained asset price growth and credit access, reducing the propensity of the marginal consumer to spend. (“Asset-related wealth” includes speculative gains, the capacity to borrow against appreciated collateral, and the increased willingness of consumers to part with wages and savings due to a “wealth effect”.)

Regular readers know that I am not a fan of the Great Moderation. Central bankers and economists found it pleasant at the time, but sustaining that comfort required that cash wage growth be suppressed, that credit be expanded regardless of overall loan quality, that asset prices be frequently manipulated, as means to a macroeconomic end. In exchange for price stability and moderate business cycles, we mangled the price signals that ought to have disciplined capital allocation, we levered and impoverished American households, we transformed our financial system into a fragile and corrupt cesspool of self-congratulatory rent-seekers. I call that a very poor bargain. (I want to emphasize, because it always comes up, that it was not central bankers primarily that suppressed wages during the period. Globalization and declining union power did most of that work. But central bankers understood very well the importance of wage suppression, and emphasized their willingness, their “credibility”, to push back hard against any increase in the share of income accruing to labor.)

Still, if Great Moderation monetary policy sucked, pre-Moderation business cycles sucked as well. Is there a better way?

It’s no good when the marginal unit of CPI is purchased from wages. That’s the bad old days. It’s no good when the marginal unit of CPI is purchased from asset wealth or consumer credit. That’s the Ponzi scheme that got us into our current troubles. So what kind of dollar should buy the marginal unit of CPI? Ideally, it should be something central banks can “fine tune” without provoking recessions or bubbles, and something that doesn’t involve a macroeconomic imperative to expanded indebtedness.

Here’s my proposal. We should try to arrange things so that the marginal unit of CPI is purchased with “helicopter drop” money. That is, rather than trying to fine-tune wages, asset prices, or credit, central banks should be in the business of fine tuning a rate of transfers from the bank to the public. During depressions and disinflations, the Fed should be depositing funds directly in bank accounts at a fast clip. During booms, the rate of transfers should slow to a trickle. We could reach the “zero bound”, but a different zero bound than today’s zero interest rate bugaboo. At the point at which the Fed is making no transfers yet inflation still threatens, the central bank would have to coordinate with Congress to do “fiscal policy” in the form of negative transfers, a.k.a. taxes. However, this zero bound would be reached quite rarely if we allow transfers to displace credit expansion as the driver of money growth in the economy. In other words, at the same time as we expand the use of “helicopter money” in monetary policy, we should regulate and simplify banks, impose steep capital requirements, and relish complaints that this will “reduce credit availability”. The idea is to replace the macroeconomic role of bank credit with freshly issued cash.

Of course we will still need investors. But all that transfered money will become somebody’s savings, and having reduced the profitability of leveraged financial intermediaries, much of that will find its way to some form of equity investing.

There are details to consider. Won’t this proposal render central banks almost immediately insolvent? After all, conventionally, currency is a liability of a central bank that must be offset by some asset, or the balance sheet will show a gigantic hole where the bank’s equity ought to be. But that’s easy to remedy. Central banks can just adopt an old accounting fudge and claim that policy-motivated transfers purchase an intangible asset called “goodwill”. But, you may object, fudging the accounts doesn’t alter economic realities. Quite so! But what are the economic realities here? Balance sheet insolvency is nothing more or less than a predictor of illiquidity. No firm goes out of business because it’s shareholder equity goes negative. Firms die when they are presented with a bill that they cannot cover. But a central bank with liabilities in its own notes can never be illiquid, since it can produce cash at will to satisfy any obligation. It is book insolvency, not intangible goodwill, that would misrepresent the economic condition of the bank. If the central bank does not pay interest on reserves (which it should not), currency’s status as a “liability” is entirely formal. Central bank accounts should be defined by economic substance, not by blind analogy to the accounts of other firms. The purpose of a central bank’s balance sheet is to present a snapshot of its cumulative interventions, not to measure solvency. Consistent with that objective, a placeholder asset that offsets the formal liability incurred from past transfers would render transparent the cumulative stock and net flow of policy-motivated transfers. [1]

Then there are more interesting problems, like how routinizing transfers from the central bank to citizens might reshape society. “Free money” would certainly carry consequences, both good and bad, foreseeable and unforeseeable. My suggestion would be that the central banks should make equal transfers to all adult citizens irrespective of income, job, or tax status. That would be simple to understand and administer, and it is “fair” on face. It has other good points. To the degree that transfers are motivated by wasteful idleness of real resources (e.g. unemployment), flat transfers are guaranteed to put money in the hands of cash-constrained people who will spend it. Flat transfers are much more effective stimulus than income tax cuts (much of which are saved), and more effective even than payroll tax cuts (because people with jobs are more likely to save an extra dollar than people without). Further, because such transfers would be broadly distributed, the information contained in the spending patterns provoked by such transfers is more likely to be representative of sustainable demand than other means of stimulus. Status quo monetary policy, in obvious and direct ways, distorts economic activity towards the financial assets and debt-financed durable goods. I hope it’s obvious by now why that’s bad. Transfers to the already wealthy (e.g. income tax cuts) amplify the influence of a relatively small group of people whose desires are already overrepresented in shaping patterns of demand.

There is also a kind of macro-level justice in combating depressions with flat transfers of cash. During booms, income inequality typically grows as workers and investors in “hot” sectors do very well. In theory, there’s a positive sum social bargain that encourages us to tolerate that inequality. If people are growing rich by performing activities that are genuinely of great value, even very unequal distribution of the new wealth may leave everybody better off, and the fact that people at the center of that production get rich provides a useful incentive for people to do great things. However, when booms are followed by great busts, it suggests that some of the apparent wealth created during the boom was in fact illusory. Ideally, we’d have a system where the producers of illusions lose their wealth when it is revealed that they had in fact produced nothing of value. But in a world where everything is liquid, where risks are easily transfered and apparent gains can be converted to cash on a moment’s notice, the relationship between quality of production and wealth-you-get-to-keep becomes murky. Episodes of illusory production end up causing aggregate pain, even while the illusionists keep their gains. Using flat transfers to combat the aggregate pain compresses the distribution of relative income, taking back some of the advantage that, in retrospect, was not well earned during the boom.

The most obvious hazards of monetary policy transfers have to do with dependency and incentives to work. If people grow accustomed to getting sizable checks from the central bank, that would change behavior. But not all changes are bad. For example, it may be true that many workers would be pickier about what jobs to take if government transfers generated incomes they could get by on without employment. Employers would undoubtedly have to pay people who work unpleasant jobs more than they currently do. But that’s just another way of saying that workers would have greater bargaining power in negotiating employment, as their next best alternative would not be destitution. That we’ve spent 40 years increasing the bargaining power of capital over labor doesn’t make it “fair”, or good economics. Supplementary incomes are a cleaner way of increasing labor bargaining power than unionization. Unionization forces collective bargaining, which leads to one-size-fits-all work rules and inflexible hiring, firing, and promotion policies, in addition to higher wages. If workers have supplementary incomes, employment arrangements can be negotiated on terms specific to individuals and business circumstances, but outcomes will be more favorable to workers than they would have been absent an income to fall back upon.

Still, it is possible that too many people would choose to “live off the dole”, or that people would come to depend upon income from the central bank, limiting the bank’s flexibility to reduce transfers when economic conditions called for that. So here’s a variation. Rather than distributing cash directly, the central bank could make transfers by giving out free lottery tickets. The winnings from these lottery tickets would constitute transfers from the central bank to the public. But the odds that any individual would win in a given month could be made small, in order to prevent people from growing dependent on a regular paycheck from government. Plus, it would be easier for the central bank to reduce the “jackpot” offered in its free lottery than to scale back payments that people have come to expect. If you buy the thesis that poor people experience increasing marginal utility to wealth, paying out large sums occasionally rather than modest sums frequently might be ideal.

I know this all sounds a bit crazy, a new normal under which central banks would print money to fund lottery payouts and then fake an asset on their balance sheets to offset the spending. But these are perfectly serious proposals. Futurama, baby.

[1] There is a theory that the value of a currency is somehow related to the strength of the issuing central bank’s balance sheet, so a currency issued against fictional “goodwill” would quickly become worthless. Suffice it to say that, with respect to non-redeemable fiat currencies, there is absolutely no evidence for this theory. There is no evidence, for example, that the purchasing power of the US dollar has any relationship whatsoever to the Fed’s holdings of gold or foreign exchange reserves. The assets of existing central banks are mostly loans denominated in the currency the bank itself can produce at will. You may argue that those assets are nevertheless “real”, because repayments to the central bank will be with money earned from real activity. But that assumes what we are trying to explain, that people are willing surrender real goods and services in exchange for the bank’s scrip. Perhaps fiat currency derives its value from coercive taxation by government, as the MMT-ers maintain. Perhaps the imprimatur of the state serves as an arbitrary focal point for the coordination equilibrium required for a common medium of exchange. I don’t know what makes fiat currency valuable, but I do know that the real asset portfolio of the issuing central bank has very little to do with it.