Twelve years after the 2008 financial crisis, America’s housing finance system is once again under strain. The acute decline in economic activity that coronavirus fears and government-mandated lockdowns have caused is disrupting cash flows for millions of households and businesses. In just four weeks, 22 million people have filed unemployment claims. Many among the new jobless are homeowners who will be unable to make payments on their loans, at least for a while.

Some legislative actions have sought to help these hard-pressed households. As part of its economic relief provisions, the CARES Act requires servicers of federally-backed mortgage loans to grant forbearance of up to 180 days (extensible for another 180) to any eligible mortgage-holder who requests it, without additional documentation. Eligible mortgages include those backed by Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) currently in the conservatorship of the Federal Housing Finance Agency (FHFA), and by Ginnie Mae, which the federal government guarantees directly. Altogether, such mortgages comprise around 65 percent of outstanding mortgage credit in the United States.

These CARES Act provisions have put mortgage servicers, who collect borrowers’ monthly loan payments and pass them on to mortgage-backed securities (MBS) investors, in a bind. They must still comply with their contractual obligations, including having to make advances to some investors even when borrowers go delinquent. Yet the suddenness and extent of coronavirus-related economic distress means that many will soon face a delinquency rate far greater than they would normally plan for.

According to mortgage data provider Black Knight, more than 2.9 million homeowners have already applied for forbearance under the CARES Act, for an aggregate rate of 5.5 percent of loans. Forbearances are a higher percentage of Ginnie Mae (7.5 percent) than GSE (Fannie/​Freddie) loans (4.9 percent), because Ginnie’s portfolio focuses on borrowers with lower credit scores and smaller down payments, who tend to be more vulnerable to economic downturns. Still, these numbers are unusually high and quickly approximating the 2010 peak of 14.3 percent. Some analysts expect forbearance rates to reach as high as 70 percent for Ginnie loans and 30 percent for GSE loans.

In response to these escalating forbearances, on April 10 Ginnie Mae announced a special assistance program for servicers experiencing liquidity problems “directly attributable to the national emergency.” But that may not be enough: as the mortgage market picture worsens, and forbearances accumulate beyond Ginnie Mae loans, calls for a liquidity facility for GSE servicers grow louder. Late last week, various outlets reported Wall Street’s frustration at FHFA Director Mark Calabria’s alleged reluctance to have Fannie and Freddie, whose activity he closely supervises as conservator, offer additional relief. (Full disclosure: Calabria was formerly director of financial regulation studies at the Cato Institute, a post he left in early 2017.) Late last Monday, the Wall Street Journal reported that the FHFA was contemplating allowing Fannie and Freddie to buy mortgages in forbearance from their servicers, following “pressure from the industry and members of Congress.”

Although market participants’ concern is understandable, the virulence of their criticism is surprising. After all, Calabria’s job is to care for the safety and soundness of Fannie and Freddie, as well as the Federal Home Loan Bank system; and although mortgage servicers must follow Fannie and Freddie’s guidelines, they are not under the FHFA’s direct supervision. The situation is further complicated by Calabria’s plans, which the Trump Administration has endorsed, to prepare the GSEs for release from conservatorship by reducing their footprint and providing for capital retention that will create a buffer against loan losses. At the end of 2019, Fannie and Freddie had equity-to-asset ratios equal to 0.42 percent and 0.47 percent, respectively-–-just a twentieth of the typical bank capital buffer and below what any expert would consider prudent.

Mortgage servicers and their advocates argue that Fannie and Freddie should advance the payments for loans in forbearance on servicers’ behalf. There’s at least a superficial neatness to that approach. Because Fannie and Freddie guarantee the loans, they wouldn’t be exposed to additional credit risk by acting as servicers of last resort. By helping servicers today, they might even forestall the failure of some, sparing themselves and affected borrowers the pain of reallocating failed servicers’ assets. And because of their government sponsorship, Fannie and Freddie can borrow even in distressed markets at rates close to those on Treasury securities, whereas servicers are reportedly watching nervously as banks tighten their warehouse credit lines.

The alternative to liquidity provision by the well-placed but fragile and thinly capitalized GSEs is an emergency facility from the Treasury and Fed, which the Federal Reserve Act authorizes under Section 13(3). Under such an arrangement, the Fed provides additional liquidity through loans, while the Treasury puts up the “risk capital” to cover potential losses. Such facilities are currently in place for business relief programs enacted in the CARES Act. Ed DeMarco of the Housing Policy Council, an industry advocacy group, recently called for such an approach to GSE servicer relief as “the continued operation of the GSEs in conservatorship makes [it] understandable … that [they] cannot step in to meet this need.”

What’s been largely missing from the discussion of GSE servicer woes are attempts to quantify their likely liquidity needs. Politico recently reported that “servicers will be on the hook for $100 billion in payments,” citing industry figures. My own calculations, however, give an estimate of $8 billion to $12 billion worth of principal, interest, insurance, and tax advances. The large discrepancy hinges on certain assumptions, which I explain below. Yet arriving at a consensus estimate matters because it will determine which of the two approaches above is more appropriate. Fannie and Freddie might be able to handle emergency advances worth a few billion dollars, but for larger amounts a Fed-backed 13(3) facility would probably be better. If the shortfall is small enough, we might even manage without a special facility and instead have the GSEs transfer some servicing rights from weaker to stronger servicers.

My estimate rests on several assumptions, none of which seem to be heroic. First, I assume only nonbank servicers will face a cash crunch, as banks and credit unions have more diversified portfolios, stable deposit funding, and discount-window lending from the Federal Reserve. Second, I exclude the share of mortgage payments that servicers need only deliver if the borrower pays. This adjustment reflects the different remittance types Fannie and Freddie offer. Most Fannie servicing contracts are of the “scheduled/​scheduled” type, which require servicers to pass on principal and interest due no matter what. But a significant proportion of remittances are “actual/​actual,” meaning no servicer obligation arises unless the borrower pays. In Freddie’s case, and to further befuddle the reader, all contracts are “scheduled/​actual,” so that only the interest on the loan is due come what may.

My third assumption is a maximum length of time during which servicers will have to make advances of four months (120 days). It’s standard GSE practice to buy out delinquent loans from servicers after this period. And although servicers had warned that loans under forbearance might not trigger the 120-day countdown because they don’t qualify as delinquent, yesterday the FHFA announced that servicers will not need to advance more than four months of missed payments on loans in forbearance. Just when the GSEs will reimburse servicers for those advances remains unclear. Finally, I assume the forbearance rate will reach 20 to 30 percent, in line with the expectations of other analysts. My estimates are nonetheless robust to changes in these variables: for example, a catastrophic scenario with 40 percent forbearance lasting nine months yields a shortfall of under $36 billion. That’s because the main determinants of the shortfall are the number of servicers and loans affected.

Even with these adjustments, my central forecast of $8 billion to $12 billion may be an overestimate of the cash crunch, as the larger nonbanks appear to have enough liquidity to handle accumulating forbearances for a few months. Ginnie’s assistance program will give further relief to nonbanks servicing both GSE and Ginnie loans, allowing them to focus their own funds on meeting GSE advance obligations. As borrowers begin to refinance their mortgages in response to declining rates, nonbank servicers could also use prepayment income to fund their short-term advance obligations. On the other hand, should some bank and credit union servicers run into trouble despite their apparently easy access to emergency liquidity, or should nonbanks find themselves completely shut off from bank warehouse loans, my estimates will fall short of servicers’ actual funding need. Nonbanks’ condition may also worsen if forbearance requests on new loans cause the GSEs not to guarantee repayment, encumbering their sale.

The rapidly evolving public health situation, and the consequent uncertainty regarding its macroeconomic effects and impact on mortgage borrower cash flows, should not preclude a cool-headed analysis of mortgage servicers’ problems. Although the Treasury and Fed may well decide to set up an emergency facility on their behalf, such a facility shouldn’t be a blank check. Instead, regulators and servicers should publicly disclose their forecasts so policymakers and others may properly assess them. Any other approach would risk creating an unnecessary taxpayer subsidy, with the associated moral hazard, and could also have the unintended effect of turning Fannie and Freddie into servicers not merely of last resort, but for all rough seasons.

One year ago the U.S. economy was robust with unemployment at historically low levels and real incomes rising. No one would have predicted that a year later the economy would come to a halt and more than 20 million people would be applying for unemployment benefits. This reversal was not due to monetary instability, which has been the primary cause of most recessions, but rather to a decision by government officials to mandate business closures to battle a pandemic. The initial sharp supply-side effect of COVID-19 quickly turned into a strong demand for cash and a corresponding decline in the velocity of money.

Fed’s Response to the Pandemic

The Fed responded rapidly and dramatically to keep the U.S. economy from descending into depression. Monetary policymakers reduced the benchmark fed funds rate to near zero; promised to more than double the size of the Fed’s balance sheet by engaging in large-scale asset purchases of Treasuries and mortgage-backed securities, with the intent of reducing longer-run interest rates; and restarted or created a number of special purpose vehicles (SPVs), which are off the Fed’s balance sheet, to stabilize a broad array of financial markets.[1] The U.S. Treasury has worked closely with the Fed to backstop lending and increase leverage, providing $454 billion to cover potential losses from the Fed’s lending programs to private firms under the CARES Act (an acronym for Coronavirus, Aid, Relief, and Economic Security). With leverage estimated at 10 to 1, the Fed may lend as much as $4.54 trillion—none of which would show up as part of the federal deficit (see Ip and Torres).

Risks to Monetary Control and Independence

By monetizing much of the new federal debt and engaging in credit allocation, the Fed risks sacrificing monetary control and its independence. Of course, the Board of Governors could increase the rate of interest it pays on excess reserves to keep inflation at bay. However, in so doing, it would deprive the Treasury of revenue to help reduce budget deficits.

The more serious issue for the Fed’s credibility and independence is the drift into fiscal space. As Charles Plosser, former CEO and president of the Federal Reserve Bank of Philadelphia has warned: “Independence is drifting away and after this [Covid-19] crisis it will be easier and easier for politicians to seek Fed participation in off-budget fiscal actions.”[2]

The Fed’s decision to set up SPVs to purchase corporate and municipal debt opens the door for all sorts of mischief (see Timiraos). Likewise, the Term Asset-Backed Securities Loan Facility (TALF) now accepts more risky assets, including commercial mortgage securities and collateralized loan obligations. As such, the Fed will be buying “the worst shopping malls in the country and some of the most indebted companies.” Consequently, “the opportunities for losses will be that much greater,” according to an editorial in the Wall Street Journal.

In 2001, J. Alfred Broaddus and Marvin Goodfriend, warned that expanding the Fed’s portfolio beyond Treasuries poses risks to the Fed’s credibility and independence:

The Fed’s asset acquisition policies should support monetary policy by protecting the Fed’s independence.… First, the Fed’s asset acquisitions should respect the integrity of the fiscal policymaking process by minimizing the Fed’s involvement in allocating credit across sectors of the economy. Second, assets should be chosen to minimize the risk that political entanglements might undermine the Fed’s independence and the effectiveness of monetary policy.

The Fed’s decision to pay interest on excess reserves, in October 2008, means it can separate its balance sheet size from the stance of monetary policy. As Goodfriend explains:

Central banking is understood in terms of the fiscal features of monetary, credit, and interest on reserves policies. Monetary policy—expanding reserves by buying Treasuries—transfers all revenue from money creation directly to the fiscal authorities. Credit policy—selling Treasuries to fund loans or acquire non-Treasury securities—is debt-financed fiscal policy. Interest on reserves frees monetary policy to fund credit policy independently of interest rate policy.

He argues that “An ambiguous boundary of responsibilities between the Fed and the fiscal authorities contributed to economic collapse in fall 2008.”

Charles Plosser made a similar argument in his 2018 article, “The Risks of a Fed Balance Sheet Unconstrained by Monetary Policy”:

A large Fed balance sheet that is untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed and use its balance sheet to conduct off-budget fiscal policy and credit allocation.

The Fed’s response to COVID-19 has increased the chances that the Fed’s balance sheet will stay immense for a long time. Returning to “normal” would require shrinking the balance sheet and returning to a corridor-type operating system that restores the link between the balance sheet and monetary policy (see Selgin).

Insulating Monetary Policy from Credit Policy

Long ago, Clark Warburton saw the inherent danger in “too close a linkage of monetary expansion and contraction with expansion and contraction of indebtedness” (p. 301).[3] From the experience of World War II, he warned: “Whenever the federal government wishes to borrow money in large amounts, the Federal Reserve Board ceases to be an independent agency” (p. 309). He attributed that to

the combination of (a) emphasis on the accommodation of borrowers rather than maintenance of a suitable quantity of money in the economy, and (b) a specific provision that, in case of any apparent conflict between the powers of the Board and those of the Secretary of the Treasury, the Board shall exercise such powers under the supervision of the Secretary of the Treasury [ibid.].

Warburton wrote that passage in December 1946, prior to the Treasury-Federal Reserve Accord in 1951, which led to the end of the Fed’s obligation to support the prices of government securities, by pegging interest rates at artificially low levels, in 1953. The “specific provision” he was referring to still exists in the Federal Reserve Act and is relevant for the current war on COVID-19. Section 10 of the Act states:

Nothing in this chapter … shall be construed as taking away any powers heretofore vested by law in the Secretary of the Treasury which relate to the supervision, management, and control of the Treasury Department and bureaus under such department, and wherever any power vested by this chapter in the Board of Governors of the Federal Reserve System or the Federal Reserve agent appears to conflict with the powers of the Secretary of the Treasury, such powers shall be exercised subject to the supervision and control of the Secretary [italics added].[4]

Today, we are in danger of returning to a state of affairs before the famous Accord. Indeed, there has been discussion at the Fed about pegging longer-term interest rates under a program called “yield curve control” (YCC). The idea is to have the Fed commit to buy longer-term bonds to support their prices and thus peg their yields at whatever rate is decided upon, most likely under consultation with the Treasury. Although the Fed may see this as a way to “stimulate” the economy, it could also be a way to fund fiscal deficits at an artificially low rate. Sage Belz and David Wessel of the Brookings Institution have examined the YCC proposal’s benefits as well as its downsides. With respect to the latter, they write:

Like other unconventional monetary policies, a major risk associated with yield-curve policies is that they put the central bank’s credibility on the line. They require that the central bank commit to keep interest rates low over some future horizon; this is exactly why they can help encourage spending and investment, but it also means that the central bank runs the risk of letting inflation overheat while holding to its promise. If the Fed, for example, were to commit to a 2‑year peg, they would be betting on the fact that inflation will not run well above its 2 percent target in that period. If it does, the Fed may have to choose between abandoning its promise about the peg or not holding to its stated inflation objective—both bad options in terms of its credibility with the public.

The odds are that, given large fiscal deficits and high unemployment, there would be strong pressure by the Treasury to maintain the peg and have the Fed accept a higher inflation rate—at least in the short run. Section 10 would give the Treasury the authority to do so. There is no doubt that the credibility and independence of the Fed would suffer in the process.

Under the CARES Act, Congress appropriated nearly $500 billion for the Treasury to cover potential losses from the Fed’s lending programs—designed to support businesses, households, states, and municipalities. Consequently, Fed independence is already compromised.

Warburton wanted to insulate monetary policy from credit policy. He recognized that the goal of the Fed should be to provide for monetary stability and allow markets to determine the allocation of capital via freely determined interest rates, which are relative prices indicating preferences for current versus future consumption, as well as the productivity of capital. In a free enterprise system and monetary equilibrium, the natural rate of interest will coordinate the plans of millions of savers and investors, bringing about a voluntary allocation of resources between capital goods and consumer goods. Because time preferences and capital productivity are normally positive, the natural rate of interest should also be positive.

Writing in 1948, Warburton (p. 290) argued:

The rate of interest must be free to respond to real changes in the demand and supply of loan funds, in order to avoid producing monetary maladjustment, and there is no method of judging accurately the “correct” level of interest rates except when monetary maladjustment is avoided.

By not having a monetary rule aimed at a stable, noninflationary growth of nominal income and instead trying to use interest rates to guide monetary policy, the Fed has followed what Warburton called “upside-down” monetary policy. In his opinion, this practice is a “fatal error.” As Warburton (p. 233) explained in his June 1947 article in the Journal of Political Economy:

Interest-rate regulation came into vogue as the chief instrument, and later as the objective, of monetary policy. The latter was a fatal error—for it turned the quantity-of-money interest-rate relationship upside down. Central banks tried to use variations in the interest rate both as a technique and as a guide for the provision of a suitable quantity of money in the economy, whereas they should have used provision of a suitable quantity of money as a technique for achieving price-level stability and freedom of the rate of interest.

He goes on to say, “This upside-down monetary policy, under the circumstances of the late 1920’s and early 1930’s, proved to be as disastrous as an attempt to build a sky-scraper’s foundation from the architect’s plans for its tower.”

When the Federal Reserve was established in December 1913, it adhered to the “convertibility principle” of monetary control. That principle no longer applies, but the Fed has never adopted what Warburton calls the “responsibility principle” of monetary control, which applies to a pure fiat money regime. Under such a principle, there would be a rules-based regime aimed at safeguarding the value of money and avoiding what Warburton called “erratic money”—that is, variations in the quantity of money that are either excessive or deficient, bringing about inflation or depression. Warburton thought “the most suitable guide for the exercise of monetary power” would be to maintain “a rate of growth in the money supply equal to the combined rates of growth in population and production of final products per capita, adjusted for trend in the circuit velocity of money” (p. 396). Based on historical data, he suggested a growth rate of 5 percent per annum (pp. 358–59).

Warburton (p. 316) criticized the state of monetary law in the United States, arguing that it is “ambiguous and chaotic, does not contain a suitable principle for the exercise of the monetary power held by the Federal Reserve System, and has caused confusion in the development of Federal Reserve policy.” He distinguished between “monetary control” and “loan control,” with the former dealing with “the creation of money” and the latter with “the borrowing of money already in existence” (p. 298). The proper function of the Fed, according to Warburton (p. 401), is to “regulate the supply of money and leave interest rates on various types of loans, including United States government obligations, to be determined by the forces of supply and demand impinging upon the market where money is borrowed.”

Warburton’s historical insights are worth considering in thinking about the future path of monetary policy and Fed independence. The wide discretion and power the Fed has been given is a far cry from that envisioned at its founding. The financial crisis led to unconventional monetary policies that were to be “normalized” after the crisis. Yet the sudden onset of the COVID-19 crisis has compounded those policies and added new powers. The case for monetary control is still relevant, even though the proper monetary rule is debatable. Given the size of the Fed’s balance sheet and the fiscal deficit, it will be hard for the Fed to limit its credit policies and let market forces determine interest rates. Thus, its independence is likely to remain compromised for some time, just as it was during World War II until the Accord.

Broaddus and Goodfriend would agree with Warburton. Monetary policy must be kept separate from fiscal policy. “To formulate and carry out monetary policy effectively, the Fed must maintain a high level of independence within the government, and its asset acquisition practices must support and reinforce that independence.” That means “precluding the use of the Fed’s off-budget status to allocate credit across various sectors of the economy” and insulating “the Fed from political entanglements that could undermine its independence.” Those objectives would be realized if the Fed restricted “its asset portfolio to Treasury securities.” The authors warn that straying from a Treasuries only policy “would present significant risks to the integrity of fiscal policy and to the Fed’s independence, and hence to the quality of U.S. monetary policy.”

The Fed, of course, has moved in the opposite direction. Turning back may be very difficult and politically untenable, so long as there is little fiscal rectitude and interest rates must be kept near zero to fund massive government debt. Knowing that the Fed will “do whatever it takes” to prop up asset prices and keep rates low, there will be a continued reach for yield, an increase in risk taking, and a fleecing of risk-adverse savers. Capital formation will suffer and prospects for economic growth will diminish. The desired wealth effects from “easy money” will end up being a mirage. Taxpayers will ultimately bear the burden of the debt—either through higher future taxes or inflation. There is no free lunch.

Conclusion

The COVID-19 pandemic has led to an unprecedented expansion of Fed power and discretion. It has led to the transfer of fiscal responsibility to the Fed and weakened the Fed’s independence. The drift into fiscal policy and credit allocation—as opposed to pure monetary policy (i.e., allowing the size of the balance sheet to influence money, prices, and nominal GDP)—places the Fed in a precarious position. The lack of a rules-based monetary regime increases uncertainty and opens the Fed to further politicization. Too much is asked of monetary policy and too little responsibility is placed on Congress for difficult fiscal decisions.

After the 2007-09 financial crisis, the Fed failed to fully normalize its balance sheet and, in setting its policy rate, it stuck with the “floor system” that was first instituted in October 2008. That system has allowed the Fed to respond to COVID-19 by massively expanding its balance sheet without fueling inflation. Meanwhile, the Fed’s off-balance sheet lending programs, created under the authority of Section 13 (3) of the Federal Reserve Act, have been dramatically expanded in response to the pandemic.

The challenge, in the wake of COVID-19, will be to limit the Fed to its proper role of providing monetary stability, while allowing competitive capital markets to freely set interest rates and allocate funds. To meet that challenge, according to Plosser, means:

The Fed should not be allowed to engage in fiscal policy actions that rightly belong to the fiscal authorities. Without carefully established constraints on the size and composition of the Fed’s balance sheet, credit allocation and off-budget fiscal policy represent discretionary opportunities ripe for abuses that would undermine the case for political independence. Such authorities are likely to prove detrimental to our institutions and the economy.

In a world of scarcity and uncertainty, tradeoffs are inevitable. The pandemic was not the Fed’s fault, nor was the political decision to lockdown the economy and put millions of people out of work. In such a situation, the Fed had to act quickly and decisively to provide liquidity to prevent financial instability from leading to further deterioration of the real economy. But the Fed’s actions are meant to be temporary, not permanent. Ensuring long-run economic growth necessary to restore economic well-being will require adapting to new realities via markets, not manipulating interest rates to finance government deficits and providing cheap credit to favored groups.

Several fundamental issues will need to be addressed when the pandemic ends: Will the Fed be able to downsize along with the government? Will fiscal policy continue to dominate monetary policy? Will interest rates continue to be pegged at low levels to finance ever growing fiscal deficits? The answers to those and related questions will determine both the path of economic life and the scope of personal freedom. They are too important to be left solely to policymakers.

******

[1] For a detailed discussion of the Fed’s SPVs, see Cheung.

[2] Correspondence with author, April 18, 2020.

[3] All text references are to Warburton’s 1966 book: Depression, Inflation, and Monetary Policy: Selected Papers, 1945–1953 (Baltimore: The Johns Hopkins Press). Page numbers are indicated.

[4] See 12 USC 246.

[Cross-posted from Alt‑M.org]

Having had a lot to say on these pages concerning the Fed’s past Main Street lending efforts, I thought it proper to put in my 2 cents concerning its current plan, by responding to the Fed’s request for comments on it.

Unfortunately, “2 cents” is an all too accurate description of what I was allowed to contribute, since the Fed’s electronic comment-submission page allows me no more than 1500 characters with which to express myself.

Kindly keep that constraint in mind in reading my comment, reproduced here. You will note that my advice is similar to that offered by Hal Scott (with whom I recently exchanged thoughts on the topic) and Glenn Hubbard in their recent WSJ op-ed.

***

Thank you for this opportunity to comment on the Fed’s Main Street lending plan.

It’s notorious that many small-to-medium size businesses cannot survive the present crisis without substantial access to credit. However, such credit carries a substantial risk of default, and consequent losses. Because the Fed must guard against any unauthorized use of taxpayer funds, it can undertake such risky lending only if Congress agrees to fund those losses.

The Treasury has thus far contributed $75 billion to the Fed’s Main Street Lending programs, while limiting the Fed’s lending through them to $600 billion. That limit is modest in itself. And if the Fed or its partner banks are either too indiscriminate or too cautious in their lending, the Fed could fall well short of it.

To keep that from happening, the Fed should ask the Treasury to devote a substantial part of the remaining $215 billion in CARES Act funding for Fed lending programs to its Main Street efforts. Doing so will pose no greater burden on taxpayers: the cost is interest on Treasury debt in one case, and on bank reserves in the other. But Congress will gain through a more certain achievement of its goals.

Believe me, I would have liked to say more. Indeed, had I had 1500 words rather than 1500 characters to play with, I would have argued for keeping the Fed out of the non-bank lending business altogether, so as to not involve it in politically-charged decisions regarding which businesses get thrown a lifeline, and which ones are left to drown.

[Cross-posted from Alt‑M.org]

Just over 150 miles separate the Swiss cities of Basel and Geneva. For ten months, their distance has symbolized the gulf between the international regulators of the Financial Stability Board and the Libra Association, a corporate payments consortium led by Facebook. But this week marked a rapprochement, as the Basel-based FSB issued its recommendations for the regulation of what it calls “global stablecoins,” while Geneva-headquartered Libra announced fundamental changes to its operating model aimed at meeting the FSB’s demands.

Although these developments mark a victory for regulators, who vigorously pushed back against Libra after its initial launch in June 2019, they also bode well for Libra’s business success, which government roadblocks are now less likely to hinder. But they also raise troubling questions about the freedom to innovate. Regulators have demonstrated that they will go to great lengths to frustrate initiatives they view as a competitive threat. If Facebook and its partners, with their financial and technological heft, cannot proceed on any terms save those favored by regulators, what hope is there for challengers with less clout?

Libra did itself no favors by initially marketing the project as a “global cryptocurrency”—a label that triggered fears of volatility, money laundering, and a lack of oversight characteristic of other cryptocurrencies. But what most irked regulators was Libra’s plan to use a multi-currency stablecoin as its medium of exchange. Although each unit of that stablecoin would have been backed by assets denominated in relatively reliable national currencies, such as the U.S. dollar and the euro, central bankers worried that Libra’s wide adoption could undermine monetary policy. Prudential regulators, meanwhile, worried about the systemic consequences were a globally successful Libra to fail in the future.

I suggested at the time that these worries were probably exaggerated. The stablecoin’s full backing meant that Libra issues and redemptions could not have a disproportionate impact on the supply of money and credit. This fact alone should have assuaged fears that Libra could pose risks similar to large banks or interfered with central banks’ conduct of monetary policy. Nor could malicious actors easily have gotten a hold of Libra coins, access to which would be controlled by the Association’s members—large and financially sophisticated corporations with reputations to protect.

Valid or not, regulators’ concerns jeopardized Libra’s viability, prompting it to release this week’s updated white paper outlining significant changes. The most notable of these is the shift from reliance upon a single multi-currency stablecoin for all jurisdictions to the use of each jurisdiction’s national currency unit. There will thus be Libra-dollars, Libra-euros, and so on for each jurisdiction in which Libra operates.

This new approach offers several advantages. First, unlike the multi-currency hybrid proposed in June, the concept of electronic money denominated in established national units has longstanding legal precedents in Europe and North America. Single-currency stablecoins are also likely to be more appealing to users, who won’t have to bear exchange-rate risk. The single-currency approach will make life easier for Libra’s managers, too, as it eliminates the need to alter the stablecoin’s composition in response to user demand in different countries. Finally, because it makes Libra functionally equivalent to PayPal and other electronic payment networks with which they are familiar, the new plan should be less discomfiting to central bankers.

To address concerns about potential abuse of Libra by malefactors, the updated white paper describes several new rules to which network participants will be subject. For example, only financial institutions that follow guidelines from the Financial Action Task Force will initially be able to deal in Libra coins. Other participants will eventually be admitted, but they must undergo periodic compliance checks by external auditors and, in the case of digital wallet providers, will face size limits on user balances and transactions.

Another change from its June plans is that Libra no longer intends to eventually go “permissionless.” Instead, it will continue to limit access to its blockchain (the ledger of all Libra coin transactions) to authorized participants. This change offers much-needed clarity. Just how the transition to an open ledger like Bitcoin’s would have proceeded without forcing the Libra Association to relinquish control was never clear. Nor had Libra explained how it would avoid the large electricity requirements for which Bitcoin is infamous. The decision to remain permissioned will therefore please money-laundering watchdogs and address one of the few genuine lacunae in the original proposal.

How are regulators likely to respond to Libra’s new offer? If the FSB’s ten recommendations are any guide, their reception will be a lot warmer than last time around. Not only has Libra made structural changes that will turn it into a payments provider much like incumbent ones, but it has also agreed not to launch the new currency anywhere without first meeting local regulators’ requirements. And, like regulated banks, Libra has set out capital and liquidity management policies so users can get their money back in the event of stress or failure.

No private financial innovation has ever faced so much scrutiny before even going live. And that is precisely the problem with this ten-month saga. What began as a promising if untested plan for fast and cheap international payments quickly became the target of hyperbolic attacks. That Libra has responded so swiftly and comprehensively says more about how high the stakes are for Facebook and its partners than about the merits of the claims against them. But the precedent leaves one wondering whether other potential innovators with lower stakes will find it worthwhile to proceed at all.

Yet discouraging future payments innovation would be a great loss to us all, as recent events demonstrate. The challenge of getting relief money to households amid the coronavirus emergency has once again exposed the sluggishness of U.S. payments. Digital wallets could have accelerated the flow of funds to Americans who will be getting a paper check instead. For international transfers and the 1.7 billion people worldwide without a bank account, the high cost and slow speed of payments is an even more pressing concern. As they evaluate Libra’s new proposal, regulators should keep in mind its potential to improve on the status quo, instead of focusing only on unsubstantiated risks and the preservation of their own turf.

[Cross-posted from Alt‑M.org]

Just over 150 miles separate the Swiss cities of Basel and Geneva. For ten months, their distance has symbolized the gulf between the international regulators of the Financial Stability Board and the Libra Association, a corporate payments consortium led by Facebook. But this week marked a rapprochement, as the Basel-based FSB issued its recommendations for the regulation of what it calls “global stablecoins,” while Geneva-headquartered Libra announced fundamental changes to its operating model aimed at meeting the FSB’s demands.

Although these developments mark a victory for regulators, who vigorously pushed back against Libra after its initial launch in June 2019, they also bode well for Libra’s business success, which government roadblocks are now less likely to hinder. But they also raise troubling questions about the freedom to innovate. Regulators have demonstrated that they will go to great lengths to frustrate initiatives they view as a competitive threat. If Facebook and its partners, with their financial and technological heft, cannot proceed on any terms save those favored by regulators, what hope is there for challengers with less clout?

Libra did itself no favors by initially marketing the project as a “global cryptocurrency”—a label that triggered fears of volatility, money laundering, and a lack of oversight characteristic of other cryptocurrencies. But what most irked regulators was Libra’s plan to use a multi-currency stablecoin as its medium of exchange. Although each unit of that stablecoin would have been backed by assets denominated in relatively reliable national currencies, such as the U.S. dollar and the euro, central bankers worried that Libra’s wide adoption could undermine monetary policy. Prudential regulators, meanwhile, worried about the systemic consequences were a globally successful Libra to fail in the future.

I suggested at the time that these worries were probably exaggerated. The stablecoin’s full backing meant that Libra issues and redemptions could not have a disproportionate impact on the supply of money and credit. This fact alone should have assuaged fears that Libra could pose risks similar to large banks or interfered with central banks’ conduct of monetary policy. Nor could malicious actors easily have gotten a hold of Libra coins, access to which would be controlled by the Association’s members—large and financially sophisticated corporations with reputations to protect.

Valid or not, regulators’ concerns jeopardized Libra’s viability, prompting it to release this week’s updated white paper outlining significant changes. The most notable of these is the shift from reliance upon a single multi-currency stablecoin for all jurisdictions to the use of each jurisdiction’s national currency unit. There will thus be Libra-dollars, Libra-euros, and so on for each jurisdiction in which Libra operates.

This new approach offers several advantages. First, unlike the multi-currency hybrid proposed in June, the concept of electronic money denominated in established national units has longstanding legal precedents in Europe and North America. Single-currency stablecoins are also likely to be more appealing to users, who won’t have to bear exchange-rate risk. The single-currency approach will make life easier for Libra’s managers, too, as it eliminates the need to alter the stablecoin’s composition in response to user demand in different countries. Finally, because it makes Libra functionally equivalent to PayPal and other electronic payment networks with which they are familiar, the new plan should be less discomfiting to central bankers.

To address concerns about potential abuse of Libra by malefactors, the updated white paper describes several new rules to which network participants will be subject. For example, only financial institutions that follow guidelines from the Financial Action Task Force will initially be able to deal in Libra coins. Other participants will eventually be admitted, but they must undergo periodic compliance checks by external auditors and, in the case of digital wallet providers, will face size limits on user balances and transactions.

Another change from its June plans is that Libra no longer intends to eventually go “permissionless.” Instead, it will continue to limit access to its blockchain (the ledger of all Libra coin transactions) to authorized participants. This change offers much-needed clarity. Just how the transition to an open ledger like Bitcoin’s would have proceeded without forcing the Libra Association to relinquish control was never clear. Nor had Libra explained how it would avoid the large electricity requirements for which Bitcoin is infamous. The decision to remain permissioned will therefore please money-laundering watchdogs and address one of the few genuine lacunae in the original proposal.

How are regulators likely to respond to Libra’s new offer? If the FSB’s ten recommendations are any guide, their reception will be a lot warmer than last time around. Not only has Libra made structural changes that will turn it into a payments provider much like incumbent ones, but it has also agreed not to launch the new currency anywhere without first meeting local regulators’ requirements. And, like regulated banks, Libra has set out capital and liquidity management policies so users can get their money back in the event of stress or failure.

No private financial innovation has ever faced so much scrutiny before even going live. And that is precisely the problem with this ten-month saga. What began as a promising if untested plan for fast and cheap international payments quickly became the target of hyperbolic attacks. That Libra has responded so swiftly and comprehensively says more about how high the stakes are for Facebook and its partners than about the merits of the claims against them. But the precedent leaves one wondering whether other potential innovators with lower stakes will find it worthwhile to proceed at all.

Yet discouraging future payments innovation would be a great loss to us all, as recent events demonstrate. The challenge of getting relief money to households amid the coronavirus emergency has once again exposed the sluggishness of U.S. payments. Digital wallets could have accelerated the flow of funds to Americans who will be getting a paper check instead. For international transfers and the 1.7 billion people worldwide without a bank account, the high cost and slow speed of payments is an even more pressing concern. As they evaluate Libra’s new proposal, regulators should keep in mind its potential to improve on the status quo, instead of focusing only on unsubstantiated risks and the preservation of their own turf.

One of the more controversial provisions of the CARES Act consists of the $454 billion it allows the U.S. Treasury to devote to “backstopping” (that is, to supply partial funding for) the Federal Reserve’s emergency lending.

In a previous post, I argued that these Treasury backstops help to preserve the “boundary line” separating fiscal from monetary policy. I’ve since engaged in a spirited Twitter exchange with Peter Conti-Brown, Dan Awrey, and Kate Judge—all legal scholars specializing in monetary policy. That exchange inspires me to offer this more complete, but qualified, defense of the Treasury’s backstopping of risky Fed lending programs.

Leverage, Smeverage

Before I take up the legal case for Treasury backstopping, I want to clear the air of a distracting pseudo-economic rationale for it: the “leverage” argument. According to Secretary of the Treasury Mnuchin, with the help of $454 billion in CARES Act funds, the Fed can “lever up” its emergency lending by some $4 trillion. Jay Powell has also appealed to the leveraging rationale, saying that every dollar of additional Fed loss-absorption capacity is worth another $10 in Fed emergency lending.

Were the Fed an ordinary bank, this “leveraging” argument might make sense. Ordinary banks can’t operate without capital, which allows them to take risks by absorbing unanticipated losses, from bad loans or otherwise. Both economic incentives and legal requirements compel such banks, not only to stay solvent (that is, to not exhaust their capital), but to limit their lending to a finite multiple of their capital. Once it’s fully levered-up, an ordinary bank can’t lend more unless more capital comes its way.

But the Fed isn’t an ordinary bank. It’s a fiat money-issuing central bank acting on the federal government’s behalf; and such a bank can technically function with no capital at all, and even with negative capital. Unlike an ordinary bank’s liabilities, the Fed’s “liabilities” are (in John Exter’s immortal words), “IOU nothings.” The Fed never has to redeem them, except by replacing worn notes with new ones and that sort of thing. If its earnings fall short of its expenses, it can just “print” the difference. It follows that it might remain a going concern even if most of its assets weren’t worth diddley. Nor, as Nathan Tankus points out, is there a “statute, court case or any other binding legal constraint… that requires the Federal Reserve to have a positive net worth.”

In short, and speaking generally, the Fed can “lever-up” all it likes without a Treasury backstop. The sole caveat is that, if its losses are so great that the present discounted value of its future net earnings is itself negative, it can lose control of inflation. That could happen were the Fed to disburse “helicopter money” on a grand enough scale, or were it forced by the U.S. Treasury to accept a deposit of several trillion-dollar platinum coins. But it’s unlikely to happen otherwise.

Finally, from a consolidated government balance sheet perspective, there is little practical difference between $1 trillion in lending financed entirely by Congress and $1 trillion in lending financed mostly or entirely by the Fed. In one case the Treasury issues more debt to finance the lending; in the other, the Fed’s liabilities, including bank reserves on which it pays interest, increase. The necessary amounts are borrowed either way, with the Treasury ultimately bearing the interest burden. The only real difference is that, when the Treasury’s own liabilities increase, so does the federal debt, whereas when the Fed’s liabilities increase, the federal debt stays the same. In other words, to the extent that it isn’t backstopped, Fed-funded lending is “off budget.”

Dodd-Frank and Fed Risk Taking

Though no law calls for the Fed to be in the black, or otherwise limits its total lending capacity in any direct fashion, the Fed’s lending, and its Section 13(3) lending in particular, is subject to important legal limits. The most obvious of these are to be fund in Section 13(3) itself, as amended by the Dodd-Frank Act.

In answering the question, “Is Treasury investment in the Fed’s emergency lending necessary?,” Peter Conti-Brown observes in a Brookings article that “Nowhere in any part of the Federal Reserve Act does Fed lending require Treasury participation, nor did Congress prevent the Fed from taking losses in its emergency lending. ” The first part of this statement is true, so far as it goes. But the second is at best only a half truth. In defending it Peter notes that, although the law calls for the Fed’s 13(3) lending to be “indorsed or otherwise secured” to the lending Fed bank’s satisfaction, this falls short of dictating that “the Fed avoid taking first losses in an emergency lending facility.” But he overlooks another Section 13(3) clause—13(3)(b)(i)—according to which the Fed must see to it “that the security for emergency loans is sufficient to protect taxpayers from losses.” “It seems to me,” I said in our Twitter exchange, “that this can be taken to mean that the Fed isn’t supposed to lose money.”

Congress, on the other hand, is mostly free to dispose of taxpayers’ money as it sees fit. That includes appropriating funds for the specific purpose of covering losses from insufficiently secured Fed loans. The Fed can, in other words, lose money to the extent that Congress has appropriated money for it to lose, but not otherwise. Treasury backstops sanctioned by Congress are nothing other than such appropriations.

That, I submit, is the real rationale for Treasury backstopping of risky Fed lending. But to defend this view, I must trace that rationale’s roots beyond the Federal Reserve Act, to their underpinnings in the U.S. Constitution.

Constitutional Underpinnings

Because those underpinnings are very clearly explained in “Congress’ Power of the Purse,” a 1988 Yale Law Review article by Kate Stith, I need only summarize them here. Stith’s lengthy article is loaded with supporting evidence and arguments.

By stipulating that “No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law,” the Constitution, Stith observes, “places the power of the purse in Congress.” That assignment of power, she adds, “is at the foundation of our constitutional order,” for it’s by controlling the things on which public monies are spent that Congress “defines the contours of the federal government.”

Congress’ power of the purse has as corollaries two “governing principles.” The first, which Stith calls the “Principle of the Public Fisc,” “assert[s] that all monies received from whatever source by any part of the government are public funds.” The other is a “Principle of Appropriations Control” that “prohibit[s] expenditure of any public money without legislative authorization.” Together these principles imply that “Agencies and officials of the federal government may not spend monies from any source, private or public, without legislative permission to do so.” Congress, on the other hand, has not only the power but the duty to exercise legislative control over federal expenditures. “If Congress permits the Executive access to the public fisc without effective appropriations control [it] abdicates, rather than exercises, its power of the purse.”

Furthermore, Stith claims,

it is not enough for Congress to direct federal agencies to produce a better world. …Congress must affirmatively authorize the funds to do the job. …Even where the President believes that Congress has transgressed the Constitution by failing to [fund some] activity, the President has no constitutional authority to draw funds from the Treasury to finance the activity. Spending in the absence of appropriations is ultra vires.

Finally, and crucially,

Where Congress thus denies appropriations, the denial is not merely a determination that the public fisc cannot afford spending any money on that activity. By such appropriations legislation, Congress decides that, under our constitutional scheme, for the duration of the appropriations denial, the specific activity is no longer within the realm of authorized government actions.

Fitting the Fed In

What has this to do with the Federal Reserve System? Were the Fed just another government agency, the answer would be easy, for in that case it would be obliged to surrender to the Treasury, for disposal by Congress, any funds it acquired from any source, including the Reserve Banks’ earnings. It could not fritter away part of those funds unless it had Congress’ express permission to do so, in the shape of a corresponding appropriation.

Alas, things aren’t quite so simple. Although the Board of Governors is an independent government agency, the Federal Reserve Banks are so many private corporations. Because the System’s earnings come entirely from those Reserve Banks, this arrangement raises doubts concerning whether those earnings qualify as “public funds.” Until 2016, those doubts were reinforced by the fact Reserve Banks’ surplus revenues—meaning their revenues after deducting the System’s operating costs, dividends on member bank stock, and funds sufficient to keep the banks’ surplus capital equal to their paid-in capital—were remitted to the Treasury, not as a matter of law, but only in accordance with Board policy.

The passage of the 2015 FAST Act has, however, eliminated much of this ambiguity. That measure capped the Federal Reserve System’s surplus capital at $10 billion, while requiring that any surplus funds beyond those needed to maintain that amount be surrendered to the Treasury. The 2018 Economic Growth Act subsequently lowered the Fed’s surplus capital limit to $6.825 billion. These changes make it impossible to continue to regard the Fed’s Treasury remittances as voluntary contributions of “private” funds. Congress has instead asserted its right to such remittances.

By so doing, Congress asserts its right to determine the how the Reserve Banks’ earnings are employed, albeit with one important exception. That exception is provided for by Federal Reserve Act’s stipulation that any “assessments levied” by the Board upon the Reserve Banks “to defray its [that is, the Board’s] estimated expenses and the salaries of its members and employees… shall not be construed to be Government funds or appropriated moneys.” Funds so employed are considered private funds. Congress is thus denied the power to deprive the Board of an operating budget, even though that Board is a government agency. This is the (admittedly slim) legal substance of the Fed’s vaunted budgetary autonomy.*

While Congress can’t deprive the Board of its sustenance, and while it may take a generous view of what that sustenance costs, the law doesn’t seem to supply grounds by which the Board can dispose of other Reserve Bank earnings without Congress’ express permission. Seen in this light, the Dodd-Frank requirement “that the security for emergency loans is sufficient to protect taxpayers from losses,” far from being nugatory, supplies additional clarity, by specifically preventing the Board from treating such losses as a component of its ordinary expenditures and, therefore, as funds to which it’s entitled without Congress’ express permission.

Not so Novel

It remains for me to address Peter Conti-Brown’s claim that, far from being an application of long-standing Constitutional principles, the Treasury’s backstopping of the Fed’s recent emergency lending initiatives is sui generis. Peter makes this claim both in his previously-linked Brookings article and in a subsequent Macro Musings interview. In the last he says that backstops are something

we’ve never seen before in the United States, in the history of the relationship between the Fed and Treasury and the Fed and Congress. …$454 billion, not trivial money, is appropriated to one part of the government for the exclusive purpose of investing in another part of the government, this is, these are Treasury funds that can only be used as loans, loan guarantees or investments in Fed programs or facilities.

In his Brookings piece, Peter adds that backstops were not even a feature of “the vast experimentation in emergency lending that we saw in the 2008 financial crisis.”

Such claims appear to pose a serious challenge to my understanding of backstops as a Constitutionally-required accompaniment to risky Fed lending. After all, if they’re so necessary, why haven’t we seen them before?

However, a closer look at history reveals that the challenge isn’t as daunting as it seems. This is true in part because until recently the Fed simply didn’t make many risky loans. Until 2008, the Fed hardly used its 13(3) lending powers at all. The only exceptions were 123 mostly very small loans it made between 1932 and 1936, all of which were well secured.

The Fed did make potentially risky 13(3) loans during the 2007–8 crisis. But then as now it relied on either Treasury or other backstops to cover the risks it took. The TALF, for instance, involved a $20 billion Treasury backstop. JP Morgan Chase and certain AIG affiliates backstopped the Fed’s Maiden Lane loans. The government rescues of Citigroup and Bank of America, to which the Fed contributed, were also structured so that the Fed was unlikely to bear any losses. In those instances both the Treasury and the FDIC stood to lose money before it did. In fact, the Fed lost no money at all from any of its 2008-era 13(3) loans. It did incur losses on its outright agency MBS purchases, but those purchases were authorized not by Section 13(3) but by Section 14(b) of the Federal Reserve Act.

Although the Fed made no risky 13(3) loans before 2008, it made other risky loans before then, using a separate 13(b) authority granted it between 1934 and 1958. 13(b) loans were aimed not at banks or “systemically important” nonbank firms, but at smaller businesses, and as such could be secured by any sort of collateral. In practice, this meant that many were hardly secured at all, and were therefore very risky—so risky, indeed, that by 1940 the Fed’s 13(b) lending had yielded it a return of minus 3 percent.

If Peter’s view of things were correct, the Fed should have been allowed to lose that money without Congress’ express permission, in the shape of a Treasury backstop or otherwise. If, on the other hand, I’m right in thinking that the Constitution requires such permission, Congress would have had to appropriate funds to cover any such losses.

The Fed’s 13(b) loans were, in fact, backstopped by $140 million in Treasury-supplied funds, and limited to a total of $280 million, which was equal to the sum of the Treasury’s contribution and the Reserve Banks’ own surplus capital at the start of the program. The Fed might, in other words, have lent to the full limit of its 13(b) authority, and lost every nickel, without going broke. That’s taking Congress’ power of the purse very seriously indeed! For comparison, the Fed’s recently-unveiled Main Street New Loan Facility has a backstop equal to just one-twelfth of that facility’s potential lending capacity. In short, by New Deal standards Congress today is playing relatively fast and loose with its “duty to exercise legislative control over federal expenditures.”

Backstop or Back to Basics?

I said that I would offer a “qualified” defense of the Treasury’s backstopping of risky Fed lending programs. My argument is that such backstopping is justified in so far as it respects Congress’ “power of the purse,” whereas any risky lending the Fed does without such backstopping would contravene that power. When Jay Powell said on TODAY that the Fed lending was limited by its ability to take losses, whether he knew it or not, he was appealing to these Constitutional principles, not making stuff up.

BUT, Treasury backstops are only one way for the Fed to abide by both the Constitution and the specific requirements of the Federal Reserve Act. The other, more straightforward way is by renouncing altogether its authority to make loans for which adequate security is lacking. That is the course William McChesney Martin chose to take in the 1950s when, having first opposed legislation that would have strengthened the Fed’s 13(b) lending powers, he then encouraged Congress to deprive the Fed of those powers altogether, and to instead leave the task of risky emergency lending to the Reconstruction Finance Corporation and the recently established SBA. The Fed, Martin testified,

would favor neither the financing of such institutions by the Federal Reserve by purchase of stock or otherwise, nor the exercise by the System of any proprietary functions. …Basically, our concern stems from the belief that it is good government as well as good central banking for the Federal Reserve to devote itself primarily to objectives set for it by the Congress, namely, guiding monetary policy and credit policy so as to exert its influence toward maintaining the value of the dollar and fostering orderly economic growth.

Were the Fed to take a similar stand today, Congress would in turn have to establish an alternative, strictly fiscal emergency lending facility—a new RFC, perhaps. It would also have to pluck-up the courage whenever necessary to fund that facility to whatever extent it considered sufficient to avert a crisis.

Compromises between such a strictly fiscal risky lending arrangement and the current set-up might also be considered. One such compromise has been proposed by James Nason and Charles Plosser, who suggest a new Fed-Treasury “accord” by which the Treasury would agree to trade its own securities for any non-Treasury securities the Fed acquires during an emergency after a set period of time. Congress would then have to authorize and fund the Treasury’s commitment. “With such an accord,” they say, “fiscal policy remains outside the province of the Fed, but policy has the flexibility to respond to a crisis in the short run.” A stricter version of this proposal would call for the Treasury to purchase, not only any non-Treasury securities the Fed acquires, but all of its less than fully secured 13(3) loans. As the late Marvin Goodfriend testified in 2013, emergency Fed lending, like emergency Fed asset purchases, “should be authorized before the fact by Congress in its oversight role, but only as a ‘bridge loan’ and accompanied by a ‘take out’ arranged and guaranteed by Congress.”

It is of course unfair to blame the Fed for not drawing a line in the sand in the middle of an unprecedented crisis. Back in 2008, Goodfriend says, the Fed found itself

in a no-win situation. Given its wide powers to lend, the Fed could disappoint expectations of accommodation and risk financial collapse or take on expansive, underpriced credit risk… with the implied promise of similar actions in times of future turmoil.

Today it may likewise be said that the Fed had little choice but to take on risks and responsibilities that a pusillanimous and small-minded Congress wouldn’t take on itself. Karen Petrou is nevertheless right to fear that it will end up regretting its further entanglement in the nation’s fiscal affairs. “Congress and the Administration,” she says, “now get to stand back, taking credit if the economy recovers and knowing where 20^th and Constitution Avenue is if it doesn’t.”

As for the rest of us, we must ask what point there is in giving Congress the power of the purse, if instead of defining “the contours of the federal government” itself, it gives a free hand to a coterie of unelected officials.

_____________________

*The provision designating as private funds the Board’s assessments covering its operating expenses dates from the Banking Act of 1933. Revealingly, as Peter Conti-Brown notes in his 2015 article “The Institutions of Federal Reserve Independence” (p. 280n102), a decade earlier the U.S. Comptroller General had instead expressly designated those same assessed amounts as public funds “subject to various restrictions and impositions.”

In this same article Peter appears to argue that the provision allowing the Board to fund its expenses by assessments against the Reserve Banks does not allow it to employ the System’s interest earnings from its SOMA portfolio for that purpose. Assuming that I’ve understood him correctly, I confess that I’m unable to grasp his reason for taking this view. The proceeds from the Fed’s open-market operations are part of the Reserve Banks earnings, the remainder of which consists mainly of fees they collect from member banks. The Board’s assessments are made, not against Reserve Bank fee income only, but against the fungible sum of all Reserve Bank income; and the appropriations exception appears to hinge, not on the ultimate source of funds employed by the Board, but on the way in which it employs them.

[Cross-posted from Alt‑M.org]

Earlier this week, while most of us were still trying to wrap our heads around the Fed’s emergency lending plans, consumer advocate Ralph Nader fired-off an irate letter to its Chair, Jay Powell.

Nader’s letter didn’t take issue with any of those plans. Instead, it accused Powell of having “stripped hundreds of billions of dollars of interest rate income from over 150 million savers in our country.” Returns on bank and money market accounts, Nader says, “are heading toward near zero because of the Fed’s actions.” And the Fed took those actions only because Powell “buckled under unprecedented pressure and haranguing from Donald Trump.”

I’m hardly one to suggest that the Fed can do no wrong, or that it ought to be spared from criticism, during an emergency or otherwise. But criticism can be just or unjust, and it’s hard to imagine anything more unjust than Mr. Nader’s criticism of Powell.

Savers’ Plight

The least unjust of Nader’s claims is his assertion that savers are harmed by low interest rates. But even that assertion isn’t quite as true as Mr. Nader and many others suppose. As a 2017 Richmond Fed report explains,

savers are not just savers—they are also… consumers, and lower Fed policy rates generally mean lower loan rates for goods like homes and automobiles, as well as lower interest payments on variable rate loans. Finally, many savers also hold assets whose values tend to rise in low-interest-rate environments. Low rates tend to boost housing prices, for example, and housing comprises a large majority—nearly two-thirds—of assets for households in the middle of the wealth distribution. This is especially true of older households preparing for retirement; roughly 80 percent of households aged 65 and older own their homes, compared to roughly 64 percent for the nation as a whole, according to the Census Bureau.

Interest Rates and Unemployment

Most savers are also workers, and it’s by ignoring that fact that Mr. Nader’s complaint reaches a higher plateau of injustice. The Fed’s dual mandate, as he presumably knows, charges it with avoiding unnecessary unemployment. And the surest way for the Fed to fail to meet that requirement is by keeping money too tight, that is, by setting overly-high rate targets. When people are unemployed, it is of little consolation to them to know that their dwindling savings accounts yield high returns.

Moreover, the longer-run effects of an excessively high Fed rate target include disinflation, if not deflation; and these effects end up reducing instead of raising nominal returns of bank deposits and money market funds.

Natural Rates Rule the Roost

Like all too many Fed critics, Mr. Nader misunderstands what he calls the Fed’s “extreme zero-interest rate policy.” The misunderstanding consists of the belief that the aim of ZIRP (to employ the popular acronym) is to suppress market interest rates, that is, to drive and keep them down artificially when they’d otherwise tend to rise. But while it’s true that market rates often respond to changes in the Fed’s rate settings, it’s no less often the case that the Fed responds to changes in the “natural” or “neutral” interest rate, meaning the rate consistent with stable prices or (and, I think, more accurately) the avoidance of cyclical unemployment.

That natural rates have been on the decline for some time now is one of the more notorious facts—if not the most notorious fact—the Fed has had to contend with over the course of the last dozen years. It’s owing to that decline, and not because it’s indifferent to the welfare of savers, that the Fed has had to resort twice now to ZIRP. Nor (as the FRED chart below makes clear) can there be any doubt that in each of these instances the Fed’s rate settings, far from leading market rates to zero, followed them there. Indeed, if the Fed is to be faulted, it’s for having delayed ZIRP too long, particularly in 2008.

A Trump Toady?

So far, Mr. Nader’s unjust criticisms of Powell’s policies can be blamed on his ignorance of monetary economics. But that ignorance can’t explain, let alone excuse, Nader’s suggestion that Powell went along with the Fed’s recent rate cuts only because he was too weak-kneed to stand up to President Trump’s bullying.

Trump has, of course, long favored lower, if not zero, rates, and he has criticized Powell for not delivering them. Now Powell has delivered them. This much can be said in Nader’s favor. Alas, it’s hardly enough. The whole newspaper reading world knows that until recently Powell repeatedly disappointed Trump, while publicly insisting on the Fed’s independence. The merit of Nader’s charge therefore depends entirely on whether the Fed’s recent resort to ZIRP was motivated, not by the coronavirus crisis, but by Powell’s finally having caved-in to Trump’s badgering. Alas for Mr. Nader, the recently-released minutes for the Fed’s March 15th meeting leave no room for doubt concerning the reasoning behind the Fed’s decision. Had Mr. Nader waited just one more day, he might have read those minutes, and spared Mr. Powell his groundless and ill-timed philippic.

[Cross-posted at Alt‑M.org]