On November 12th I wrote a longish post explaining how growth fluctuations in two of the Federal Reserve’s less-familiar liabilities—the foreign repo pool (FRP) and the Treasury General Account (TGA)—had contributed to a shortage of bank reserves that in turn caused repo rates to spike. I followed that post with a November 14th post describing steps the Fed, the Treasury, and Congress could take to reduce and otherwise tame those liabilities. Finally, in December, I wrote a third post noting that Congress had already implemented one of the reforms I’d suggested (allowing the Treasury to lend its surplus cash on the private repo market), while pointing to further information reinforcing the case for other changes I’d proposed.

Among those other changes, my November 12th post recommended that the Fed take steps to discourage heavy use of its foreign repo pool (FRP), noting that it might do so by

adjusting the FRP rate formula to make the facility less attractive. At the very least, it could quit making its own rate better than corresponding private market lending rates, as it appears to have been doing lately by basing that rate on the SOFR (Secured Overnight Financing Rate). Since the Fed is a uniquely risk-free counterparty, it arguably should make its FRP rate not higher but lower than corresponding private market rates. For example, it might set a rate equal to SOFR minus 10 basis points.

Well, it so happens that as I was preparing my December follow-up post, the FOMC released the minutes of its December 10–11 meeting, buried within which is a brief paragraph noting that

the Federal Reserve Bank of New York communicated to its customers that the remuneration rate on the foreign repo pool will be revised to be generally equivalent to the overnight reverse repo rate. This action may reduce activity in the pool to some extent and increase the level of reserves.

More details on the current workings of the Fed’s foreign repo pool service can be found by clicking here and scrolling-down to the “investment services” section.

As many of my readers will know, the “overnight reverse repo rate” the Fed now pays on foreign repo pool investments is also the lower limit of the Fed’s interest rate target range. As such, it is typically below the effective federal funds rate that’s supposed to fall somewhere within that range, and also below other overnight rates, including the SOFR. Consequently, and as can be seen from the chart below, there isn’t all that much difference between what the Fed has chosen to do (the new policy went into effect just before the minutes were released) and what I had suggested it do, except that by providing for a more certain and stable FRP rate “penalty,” my proposal would have constituted a somewhat more reliable means by which to discourage the pool’s overuse.

Although in recent weeks the overnight-reverse repo (ON-RRP) rate has generally been only 3–7 basis points lower than the SOFR, to judge by the decline in the FRP since the Fed announced its new policy, the change seems to have made a difference, though a late-December jump makes one wonder whether the trend will continue:

But let us not look a gift horse in the mouth! The step is certainly one in the right direction. Now we can only hope that the Fed and the Treasury will work together to come up with a plan for reining-in the TGA, which so far shows no signs of tapering.

If they need advice on how to do it, I refer them to the links at the top of this post!

[Cross-posted from Alt‑M.org]

Back in the spring of 2018, yours truly responded at length to a speech then New York Fed President Bill Dudley gave, defending the Fed’s “floor” system of monetary control. In that speech, Dudley claimed that “the case for retaining the current floor system is very compelling.” A floor system, Dudley said, “is operationally much less complex than a corridor system” since “the setting of IOER is largely sufficient to maintain the federal funds rate within the FOMC’s target range.”

Mr. Dudley retired a couple months after giving that speech; and since 2019 he has been a senior research scholar at Princeton’s Griswold Center for Economic Policy Studies. I have no idea exactly what such a research scholar does; but unless those duties included hiding under a rock, Mr. Dudley is surely aware of goings on in the money market of late. Yet in a recent Bloomberg op-ed, he once again claims that the post-2008 floor system “is much simpler to carry out” than a corridor arrangement. Only he now adds that this is so, “provided there are sufficient reserves in the system.”

But that proviso is hardly the minor qualification Dudley makes it out to be. Instead, after more than a decade the Fed has yet to determine how many reserves are “sufficient.” And despite what Dudley claims, it is far from obvious that adding more reserves to the system will prove capable of smoothing what he blandly describes as “a few bumps in the road” toward a floor system that works in practice the way it’s supposed to work in theory. Instead, as Bill Nelson observed at a December Brookings event, the Fed could well end up discovering, as Norges Bank did a few years back, that under a floor system the demand for bank reserves tends eventually to catch-up to the supply, making the effort to satiate the banking system with reserves once and for all as futile as a dog’s effort to catch its own tail.

Nor is that all that’s wrong with Dudley’s claim. In theory, as he notes in 2016, setting the central bank policy rate under a floor system is a simple matter of flooding the system with reserves and then setting the rate of interest on reserves at the desired policy rate. But even when reserves were presumably abundant, the Fed’s floor system never worked as planned. From the first the fed funds rate sagged below the IOER rate, compelling Fed officials to switch from a single-valued rate target to a target “range.” Then, to keep the rate below the lower limit as that limit was raised above zero, they had to establish an overnight reverse-repurchase facility. Next, as the funds rate tended to creep up within the designated target range, they had to keep adding space between the IOER rate and the target upper limit. Finally, as they encountered those “bumps” along the road, they had to undertake (“forward”) repo operations amounting to hundreds of billions of dollars—operations that are likely to continue for some time, if not indefinitely, despite the Fed’s concurrent, permanent additions to the stock of bank reserves. In short, there appears to be a lot more to the U.S. money market than Mr. Dudley and other proponents of the floor system dream of in their philosophy.

And now the Fed is contemplating—and Mr. Dudley is himself championing—a standing repo facility which, whatever its merits, will add still another layer of complexity to an already far from simple operating system.

Finally, to pick one last nit, whether it was chosen by Mr. Dudley or not, the title of Mr. Dudley’s op-ed (“The Fed Should Keep Looking Forward, Not Retreat to the Past”) does critics of the Fed’s floor system an injustice. The alternative most expert critics of the Fed’s floor system have in mind isn’t a “retreat” to anything. They aren’t recommending a return to the pre-October 2008 status quo. Nor are they suggesting that the Fed should dispense with interest on reserves. Instead, they’d like to see the Fed move toward a standard “corridor” operating system, with interest on reserves determining the corridor’s lower limit, and a standing lending facility—repo or otherwise—setting the upper limit. This is a tried-and-true system employed by many of the world’s central banks. Yet the Fed itself has yet to try it.

Finally, as for which group is being more forward looking, ask me again when the Fed’s balance sheet hits $6 trillion or, better still, after we witness the first round of Green QE.

[Cross-posted from Alt‑M.org]

In a post published here in mid-November, I traced the Fed’s repo-market troubles to post-2008 changes in the importance and volatility of two of the Fed’s non-reserve liabilities: TGA balances and the foreign repo pool. Then, in a companion piece, I made some suggestions for reining-in those liabilities, as an alternative to having the Fed continue to increase the size of its balance sheet–one that could actually allow that balance sheet to shrink further. The proposed reforms would even make it relatively easy for the Fed to switch from its present floor operating system to a corridor system, with a correspondingly slim balance sheet.

Since I wrote those posts, I’ve come across further, relevant information. Besides reinforcing my confidence in the proposals’ merits, the new information also suggests that implementing them will be even easier than I’d previously supposed.

Direct Treasury Repos

In the second of my November essays, I suggested two reforms aimed at reducing the Treasury’s TGA balance. Congress, I wrote,

should (1) revive the Treasury’s direct repo borrowing program, expanded (as per the GAO’s September 2007 recommendations) to allow all primary dealers to take part and also to allow the Treasury to offer any of its securities as collateral, and (2) restore the Treasury’s “direct draw authority,” or grant it permission to make use of the Fed’s Standing Repo Facility.

When I wrote this, I knew only of a pilot program, begun in March 2006 and lasting just one year, allowing the Treasury to experiment with lending on the private repo-market. I noted that, though it was judged a success, the program “was extremely limited in scope and scale, with the Treasury’s average of $4 billion repos a day comprising but a miniscule share of what was then a $1.8 trillion per day repo-market.” Reviving and expanding the program, while making it permanent, would, I said, give the Treasury an alternative to holding large TGA balances that would yield it a higher return while being almost as safe.

Unbeknownst to me, Congress had already taken the step I recommended in 2008, by passing the “Fostering Connections to Success and Increasing Adoptions Act.” What have adoptions got to do with Treasury repos, you ask? I haven’t the foggiest idea. Nevertheless, it was by means of section 502 of that act that Congress chose to amend section 323 of Title 31 of the United States Code.* The revised code allows the Secretary of the Treasury to invest the Treasury’s cash in

‘‘(1) obligations of depositories maintaining Treasury tax
and loan accounts secured by pledged collateral acceptable to
the Secretary;
‘‘(2) obligations of the United States Government; and
‘‘(3) repurchase agreements with parties acceptable to the
Secretary.

The 2008 amendment further stipulates that, instead of being obliged to place funds in any particular account, the Secretary “shall consider the prevailing market in prescribing rates of interest for investments” allowed for by the amendment.

In short, the Treasury is already free to lend all it likes in the repo-market, instead of placing money in either the TGA or in still-less remunerative TT&L accounts.

So why hasn’t the Treasury ever taken advantage of this right? The answer resides in the timing of the measure granting it. That measure took effect on October 7th, 2008–one day after the Fed announced that it would begin paying interest on bank reserves. Because placing funds in the TGA reduces bank reserves, while direct Treasury repos would leave those reserves unchanged, once the Fed started paying interest on reserves, it was only worthwhile for the Treasury to prefer repos to TGA balances when repos paid less than the IOER rate. Otherwise, the Treasury would lose more through IOER payments than it could earn by supplying funds to the repo market. As the following chart shows, that was generally the case between 2008 and 2017.

Since 2017, however, repo rates have gradually risen relative to the IOER rate; and lately, they’ve been persistently higher–high enough to make direct Treasury repos more profitable than a large TGA balance.

So what’s been keeping the Treasury from making use of its direct repo option more recently? The main reason is the Treasury’s 2015 decision to keep at least a week’s worth of disbursements, and never less than $150 billion, in the TGA, as insurance against a major disruption of financial markets. $150 billion: that’s thirty times the Treasury’s pre-2008 minimum TGA balance! That seems like a case of “once bitten, twice shy,” with a vengeance. Only the Treasury has never actually found itself unable to tap the private money market for more than a day or so–not in September 2008, or in October 2012 (Superstorm Sandy), or even in September 2011.

The Treasury claims nevertheless that it has to have such a large balance as protection against the possibility of a successful cyber-attack, or other major disaster. But my other proposed reform–reviving the Treasury’s “direct draw” authority so that it can borrow from the Fed during crises– would also address the Treasury’s concerns. For almost four decades until 1981, I noted, Congress allowed the Fed to borrow directly from the Fed, so that it might safely maintain a low TGA balance.

The second bit of new information that’s come to my attention concerns this second proposal.

Providing for Emergency Treasury Borrowing

It turns out that, back in September 2006, the GAO published a report titled “Backup Funding Options Would Enhance Treasury’s Resilience to a Financial Market Disruption.” The report was written in response to the 9/11 attacks, with the aim of exploring ways in which the Treasury might continue to fund its expenditures “during a future wide-scale financial market disruption” without having to maintain a large TGA balance. In other words, the report was aimed at helping the Treasury to deal with precisely the sort of problem it chose to address in 2015 by maintaining a mammoth TGA balance. The difference is that back in 2006 the Treasury considered a large TGA balance wasteful. So it encouraged the GAO to look into more efficient options.

One option to which the GAO devoted considerable attention was that of once again allowing the Treasury to borrow directly from the Fed under certain conditions. The report refers frequently to the Fed’s former direct draw authority, devoting a lengthy appendix to it. It also notes that “primary dealers and commercial bankers generally agreed” that allowing the Treasury to borrow directly from the Fed “was the most resilient and direct way for the Treasury to ensure it met its obligations,” while stating “that they did not think this arrangement would damage the Treasury’s or the Federal Reserve’s reputation if it was used in a limited way during wide-scale disruptions.”

Fed and Treasury officials, on the other hand, worried that the Treasury might abuse its ability to borrow directly from the Fed, particularly by taking advantage of it to evade the debt ceiling. Still, rather than oppose the idea altogether, they settled for suggesting that any direct Treasury borrowing rights would have to be “very tightly” controlled, in part by having to be approved of by both the Fed Chair and the Secretary of the Treasury, if not the President.

To allay such concerns, the GAO concluded that, “Although the existence of a previous draw authority is relevant,” it would not be prudent to suggest simply restoring that authority. Instead, it recommended a “two-tiered” approach to emergency Treasury funding. The first tier would consist of lines of credit established by the Treasury with various commercial banks, and of private placements of Treasury CM (“Cash Management”) bills. Only if these options proved unavailable would the Treasury have direct recourse to the Fed, making it a truly “last resort” option. To guard against the possible use of that last resort option as a means for evading the debt ceiling, the debt limit could simply be redefined to include any direct Fed lending to the Treasury.

The Direct Treasury Lending Bugbear

As someone wary of excessive central bank power, who by no means assumes that we need never worry about inflation breaking out again, and who favors (for all its limitations) central bank independence, I might be expected to blanch at the prospect of having the Fed allow the Treasury to borrow directly from it. In fact, I’m not inclined to do so, for the simple reason that, widespread opinion to the contrary notwithstanding, so far as the risk of inflation is concerned I don’t believe the Treasury’s ability to borrow directly from the Fed matters much at all.

The extent of government spending, deficits, and inflation, is indeed a function of the ease with which the Treasury can borrow; and that ease is, in turn, a function of the Fed’s interest rate settings. But that said, whether the Fed lends directly to the Treasury, or only purchases Treasury securities on the open market, makes little difference. So long as the rate at which the Fed lends directly to the Treasury is consistent with its general rate targets, the Treasury can’t generally do better by borrowing directly from the Fed, or having the Fed buy bonds directly from it, than it might by selling more bonds on the open market. (As for the 1935 decision to prohibit direct Fed purchases of Treasury securities, Kenneth Garbade explains that there has never been any good reason for it.)

What matters isn’t whether the Fed funds the Treasury directly or indirectly, but whether the rate at which the Treasury secures funding is or isn’t consistent with the Fed’s monetary policy objectives. Although the Treasury can benefit by being able to borrow directly from the Fed, its gains consist, not of enhanced opportunities for inflationary finance, but of greater short-run funding flexibility, including the ability to borrow on short notice even when private markets seize-up.

So far as I’m aware, the Treasury has only abused its direct borrowing powers twice, in 1977 and again in 1979, taking advantage of them on both occasions to borrow in anticipation of reaching the debt ceiling. This abuse of direct borrowing, which a more carefully-worded statute (or more carefully-defined debt ceiling) could easily have precluded, was among the factors that informed Congress’s decision to end the Treasury’s direct draw authority in June 1981.

A Word from Canada

The third and last bit of new information comes from Jean-François Nadeau, Senior Economist for Canada’s Department of Finance, by way of David Beckworth. In response to David’s December 16th Macro Musings podcast, in which I discussed with him my ideas for limiting the Treasury’s use of the TGA (among other topics), Mr. Nadeau sent him an email pointing out that some of my proposals were “already taking place in Canada.” The Bank of Canada, he wrote,

achieves the near-zero settlement balance in the LVTS [Large Value Transfer System] by essentially putting Government of Canada balances on auction twice a day so as to offset any payments from LVTS members (essentially commercial banks/​credit unions) to the government that would risk creating a shortfall in settlement balances at the end of the day.

Mr. Nadeau also noted

that some of the institutional constraints that seem to plague the US system have been dealt with in Canada. In particular, the Bank of Canada regularly buys Government of Canada bonds on a non-competitive basis on the primary market, what many would call money printing. It even announces ahead of time how much it is going to buy directly.

Finally, he observed that the Bank of Canada

authorized by law to lend money directly to the Government of Canada and even provincial governments on either a secure or non-secured basis, although in the latter case there is a limit. In essence, this is the same thing as allowing the US treasury or central banks in the foreign repo pool to be counterparties to the standing repo facility that is proposed right now.

Speaking of HM Customs, Laurence Stern famously opined that “they order this matter better in France.” For my part, I maintain, regarding the U.S. government’s handling of monetary policy both today and more than a century ago, that they order the matter better in Canada. So I’m naturally encouraged by Mr. Nadeau’s remarks. The Fed and the U.S. Treasury would be wise to take a good look at Canada’s system, and to allow themselves to learn from it.

_________________

*I’m grateful to my friend, Alex Schibiuola, an economist at the Treasury, for discovering the amendment and making me aware of it.

[Cross-posted from Alt‑M.org]

From President Trump lobbing invectives against Federal Reserve Chairman Jerome Powell on Twitter to progressives clamoring for the Federal Reserve to use monetary policy to finance social projects, our central bank’s independence looks increasingly tenuous. Recently, Chairman Powell called for an internal “strategic review” of how Fed policymakers “formulate, conduct, and communicate monetary policy.”

At Cato’s 37^th Annual Monetary Conference in November, organized by Jim Dorn, Cato’s Vice President for Monetary Studies, current and former Fed officials, economists, monetary scholars, and experts gathered to hold a “shadow review” in tandem with the Fed’s own. Below are summaries of the panels and addresses (click the section titles for videos of each presentation). The speakers’ written remarks will be published in next year’s spring/​summer edition of the Cato Journal.

Keynote Address: Richard H. Clarida on the Federal Reserve’s Review of its Monetary Policy Strategy, Tools, and Communication Practices

Richard H. Clarida set the tone of the conference in his keynote address, which outlined three questions that the Fed also needs to ask of itself. First: are the Fed’s existing policy strategies sufficient to help it achieve its dual mandate of promoting maximum employment and price stability? Clarida noted that the Fed’s current operating framework, which measures price stability according to a self-imposed 2 percent inflation rate target, treats inflation shortfalls or excesses as “bygones.” If the annual rate of inflation rate falls below or above 2 percent, that is, nothing changes policy-wise. This has prompted several proposals for “make-up strategies”—policies that require the Fed to compensate for prior deficiencies or excesses in inflation. Clarida cautioned, however, that make-up strategies are only as effective as the public expects them to be. A successful make-up strategy depends on creating public confidence that “the make-up will be delivered when the time comes.”

Second: can the Fed combat future crises more effectively by expanding its current operating framework, or by reverting to the comparably narrower powers it assigned itself in its precrisis system? Today, the Fed attempts to regulate the economy mainly through policies that it adopted in the aftermath of the recent financial crisis. While these policies significantly expanded the Fed’s asset portfolio (and its market footprint), some data suggest that its current framework may not be sufficient to mitigate subsequent economic shocks.

Finally: how can the Fed improve its communication strategies? In a market system where central bank policy is only as effective as it is transparent, communicating policies—and achieving them in line with consumers’ expectations—is paramount.

Panel 1: Targets and Mandates

The first panel of the day, moderated by Chris Condon (Federal Reserve reporter for Bloomberg), concentrated on targets and mandates. The panel began with remarks from Peter Ireland (Murray and Monti Professor of Economics, Boston College) who emphasized the importance of central bank independence. Ireland’s presentation relied on evidence from economic models as well as real-world case studies (notably, the fiscally catastrophic “Great Inflation” of the 1970s, which Ireland attributed to the politicization of the Federal Reserve). Yet “independence” hardly means “free rein,” Ireland reminded audiences. He proposed that, in order to restore its independence and enhance its accountability, the Fed adopt a single mandate that concentrates solely on stabilizing inflation. Absent this maneuver, Ireland warned, the Fed’s independence, already waning, is at risk of eroding entirely.

Next, Jeffrey M. Lacker (former President of the Federal Reserve Bank of Richmond and currently Distinguished Professor of Economics at Virginia Commonwealth University) analyzed the Fed’s 2012 Consensus Statement on Longer-Run Goals and Monetary Policy Strategy (often simply referred to as its Consensus Statement). The Consensus Statement both clarified and rendered official the Fed’s current dual mandate. Two key features of the Consensus Statement were the targets of Lacker’s critique. First, the Fed had attempted to project a sense of continuity in communicating its statement to the public by suggesting that the statement merely formalized preexisting policies. While the aim of this maneuver may have been to quell a negative market reaction, it may have backfired, Lacker said: “with such a rollout, it’s not clear that the statement had much of a chance of improving inflation expectations.”

Second, the consensus statement deliberately neglected to specify an employment target, aiming only for “maximum employment.” This, too, may have minimized the statement’s capacity to improve market behavior. Lacker concluded by considering whether the Fed’s dual mandate was sufficient to support a stronger operating framework. “I used to think so,” he said. “I’m less sanguine right now after having conducted this review.”

Carola Binder (Assistant Professor of Economics, Haverford College) argued that the time has come to switch from inflation and employment targeting to nominal GDP (NGDP) targeting. Now would be an opportune moment, not only because the economy is relatively stable, but because the Fed has achieved the hypothetical NGDP target that it considered adopting when the measure was first introduced. In other words, had the Fed opted to target NGDP when it was suggested several years ago, the effects of central bank policy in subsequent years would have been consistent with that target. As a result, if the Fed chooses to switch to NGDP targeting now, its decision to do so is likely to promote faith in both the central bank and the market. Indeed, part of what makes NGDP targeting so attractive is that it is a smoother metric than inflation or employment targeting. It’s also one that the public can more readily grasp: consumers find it easier to think in terms of nominal income than inflation, meaning that NGDP targeting alone can improve the transparency of the Fed’s policy statements. “The informational advantage of NGDP level targeting is very strong,” Binder concluded, “especially considering the uncertainty surrounding [inflation and] unemployment targeting.”

Finally, Eric R. Sims (Professor of Economics, University of Notre Dame) emphasized that interest rates are very likely to hit or fall below zero percent again (as they did during the last financial crisis), and to do so repeatedly. He discussed the need to develop policy strategies suited to our new world of low, and possibly sub-zero, interest rates. “We’re going to need to deal with the zero lower bound in the future,” Sims impressed. “This is a reality that we have to contend with.” Since monetary policy is partly a matter of keeping policy interest rates in line with the natural rate of interest, a zero percent natural interest rate jeopardizes a central bank’s ability to conduct monetary policy effectively. After all, there isn’t much room to lower interest rates if those rates are already at zero percent, unless the central bank elects to move its policy rate below zero. Sims considered the merits of negative interest rates, but concluded that negative rates aren’t particularly effective at stimulating the economy. Equally inadvisable, in Sims’ view, was the alternate strategy of transitioning to a higher policy rate regime. Sims suggested that instead of shifting policy rates, the Fed should continue to use two of its most powerful postcrisis tools—quantitative easing and forward guidance—to combat stagnation when rates hit their zero lower bound.

Panel 2: The Operating Framework

Participants in the second panel discussed the Federal Reserve’s controversial operating framework. Heather Long (economics correspondent for The Washington Post) moderated the conversation. Charles I. Plosser (former President and CEO, Federal Reserve Bank of Philadelphia) began by arguing that the Fed’s unconventional monetary policies (especially quantitative easing, or QE) have weakened its independence. Within the Fed’s current operating framework, the Fed’s balance sheet—and therefore the overall volume of reserves—has little, if any, bearing on monetary policy. This is because the Fed’s main policy instrument is now the amount of interest that it pays other banks to store their excess reserves at Fed branches. “In adopting a framework where large excess reserves become a standing feature of the Fed’s operating regime,” Plosser explained, “there is no limit to how large the balance sheet can become.” This, he warned, invites congressional meddling, with elected lawmakers coveting the central bank’s abundant reserves for their own purposes. And lawmakers have already succeeded in funneling Fed money toward their pet projects. The crisis-era bailouts, FAST Act, and (somewhat ironically) the Consumer Financial Protection Bureau were all funded by Congress exploiting the Fed’s “power” to detach its balance sheet from the total quantity of reserves. Plosser closed by admonishing the Federal Reserve to stop undermining its own independence from congressional whims.

Manhmohan Singh (Senior Financial Economist, International Monetary Fund) critiqued the effects of QE operations (whereby central banks purchase high-volume—and typically high-risk—securities from the market and reap the rate of return on those securities). Singh’s main concern was that QE removes duration risk from the market. Not only does this alter the availability of long-term bonds (the objects of QE purchases), it affects short-term interest rates as well. This is because financial institutions often use long-term bonds as collateral when conducting shorter-term transactions in securities, prime brokerage, and other lending markets. An abundance of collateral, in other words, “lubricates” the money markets. When a central bank buys up this long-term collateral and its market availability declines, short-term interest rates rise, and the money markets can dry up. Singh, therefore, urged central banks to let financial institutions use, and reuse, long-term bonds—rather than buy those bonds up to remove market risk. Andrew Filardo (Bank for International Settlements and Visiting Fellow, Hoover Institution) continued the conversation on money market instability. By “instability,” Filardo referred to the recent increase in both the rate and the frequency of repo loans—funds that central banks lend to private banks who end their business days with fewer reserves than the law requires. (In theory, a central bank is only the “lender of last resort,” and private banks should serve as one another’s primary lenders. This theory, however, has not borne out in recent practice.) The recent repo rate spike, Filardo continued, is just one of several recent indicators of higher market volatility. (Again, in theory, the volatility of the global money market should be decreasing, not increasing, the further out we are from the last financial crisis.) One hypothesis for this counterintuitive trend, Filardo said, is that “central bank intervention in the money markets is contributing to instability.” He then presented data to support his more detailed conclusion: that the Federal Reserve’s new floor system has weakened incentives for financial institutions to lend to one another. Owing to the reduction in interbank lending, private financial institutions have less of a reason to monitor one another. In the past, if a bank could not maintain a stable network of market-based lenders, this was seen as a sign of financial distress. Now, however, financial institutions depend on the Fed to pump large quantities of reserves into the market when money becomes scarce, which reduces their need to rely on one another for overnight lending. Filardo pointed to two ways that the Fed could work to re-incentivize market dynamism: first, abandon its current floor system and return to its precrisis corridor system; second, adopt a new “sequestered reserve rule” (which Filardo had developed), which requires financial institutions to “negotiate… and preannounce the amount of reserves [they intend] to hold as high-quality liquid assets.”

David Beckworth (Director, Monetary Policy Program, Mercatus Center at GMU) closed the panel by surveying some of the more critical macroeconomic lessons of the past decade. After reviewing case studies from countries that had experimented with various postcrisis strategies—interest rate policy adjustments, QE strategies, and monetary base expansion—Beckworth suggested two measures that would make our own central bank’s operating framework more robust. First, transition to NGDP level targeting; second, move toward a more expansionary monetary policy (known as “helicopter money”) when—and only when—interest rates drop below their zero lower bound. This will allow the Federal Reserve “limited access to fiscal policy,” Beckworth said, but added the caveat that, according to his proposal, such access will be “very rules-based,” and limited in both duration and scope.

Luncheon Address: Sir Paul Tucker on Central Banks and the Rule of Law

The Cato Institute was delighted to welcome Sir Paul Tucker, former Deputy Governor of the Bank of England, to deliver the day’s luncheon address. In a discussion entitled “Central Banks and the Rule of Law,” Tucker reminded listeners of monetary policy’s philosophic roots. “This isn’t about economics,” Tucker said, reflecting on the fundamental purpose of central bank policymaking. “This is about our deepest political values.” He emphasized the need for central banks to hold themselves accountable to the standards of classical republican virtue, given that elected lawmakers are often all too willing to exploit central banks’ immense power. Elaborating on his thesis that central banks should never serve as the economy’s “lender of last resort,” Tucker explained that since a lender of last resort cannot set policy independent of its own interests, central banks’ lending responsibilities must be rules-based, not discretionary. He then considered how monetary authorities could achieve their mandated policy goals without reverting to overly interventionist measures. A central bank “should monitor itself, using rules to measure its own compliance with its mandate,” Tucker argued; and “should explain publicly when it departs from those rules.” He added that central banks should keep their balance sheets as small as possible, as well as develop transparent contingency plans for would-be extraordinary circumstances, such as financial crises, in which they might need to intervene more strongly in the market. Tucker closed with the reminder that “each generation of Fed leaders carries the burden of ensuring that they apply their powers in ways compatible with their country’s deep values.”

Panel 3: Communication Practices: Transparency and Forward Guidance

Victoria Guida (Financial Services Reporter, Politico) led the third panel in a conversation about the Federal Reserve’s communication strategies. Sarah Binder (Professor of Political Science at GWU and Senior Fellow at the Brookings Institution) and Mark Spindel (Founder and Chief Investment Officer, Potomac River Capital, LLC) began by discussing the political roots of the Fed’s transparency issues. Until quite recently, Binder reminded audiences, Federal Reserve transparency came second to its unofficial policy of “strategic ambiguity” (to quote Alan Greenspan). Under the chairmanship of Ben Bernanke, however, the Federal Reserve adopted a new philosophy: the FOMC’s monthly policy statement is the policy. As Bernanke once put it: “the ability to shape market expectations through public statements is one of the most powerful tools the Fed has.” But the high premium we rightly place on Fed transparency comes at a cost. Often, the more the Fed discloses about its strategies, the more likely we are to blame the Fed when those strategies go awry. Preliminary data from Binder and Spindel suggest that U.S. Presidents are more liable to pressure the Federal Reserve during periods of greater financial distress. (When the Fed folds to such pressure, of course—as it routinely does—the economy often ends up worse for the wear.) Fear of inappropriate political pressure, the pair concluded, may make the Fed even more reluctant to adjust its communications practices: owing to importunate political jawboning, transparency can be a thankless enterprise.

Next, Andrew T. Levin (Professor of Economics, Dartmouth College) examined the efficacy of proposed “make-up strategies” through which the Fed could compensate for prior failures to achieve its policy goals. Levin cautioned that make-up strategies are inherently risky, for three key reasons. First, the public may not trust the Fed to carry through on a given make-up strategy, rendering the Fed’s policy changes impotent. Second, and relatedly, is the challenge of “imperfect credibility.” The less credible a central bank is, the less capable it will be of influencing market behavior. Finally, Levin pointed to “model uncertainty.” Any make-up strategy the Fed might adopt would rely to some degree on economic modeling. But models are not mirrors of reality, and can at best only estimate the results of policy decisions.

Charles W. Calomiris (Henry Kaufman Professor of Financial Institutions, Columbia Business School) began his presentation with what he called an “optimistic prediction”: that central bank transparency is likely to improve, rather than deteriorate, in the near future. Calomiris attributed his rosy outlook to the phenomenon of natural language processing (NLP) software, which can detect characteristic markers of obfuscation in one’s speech or writing. Using NLP techniques like Fleish-Kincaid and “prattle scores,” Calomiris showed, we can now highlight vague, meaningless, or redundant language in Fed policy statements. He also explained that our lack of a systematic policy framework disincentivizes transparency, by making central bankers shy away from accountability. As a result, many of the Fed’s policy statements are reprisals of those prior, and contain language that can be interpreted to coincide with any outcome. NLP is likely to become more popular and advanced in the coming years, Calomiris predicted, especially in a monetary system like ours where “the policy statement is the policy.”

Panel 4: Creating an Optimal Monetary System for a Free Society

The final panel of the day looked forward, with speakers considering the optimal monetary system for a free society. Bloomberg Businessweek’s economics editor Peter Coy engaged panelists in a conversation about banking regulation, monetary stability, and the path to a more efficient operating framework.

George Selgin (Director of Cato’s Center for Monetary and Financial Alternatives) began by asking: can markets handle money better than central banks can? “In one sense, definitely yes,” said Selgin, but added the caveat: “when you let them.” Historically, banking has been a highly regulated sector. Yet Selgin pointed to cases—such as the Scottish and Canadian free banking eras—where deregulation of the banking sector heightened monetary stability and improved trust in the markets. Selgin also noted that many of the deregulation “horror stories” touted out today fail to mention the outsized role that misguided regulations have played in creating, or prolonging, financial crises throughout history. In many cases, over- or improperly regulated banks have been and remain “the main source of banking instability. Certainly, that’s been true in the United States,” he said. Selgin also discussed the role that our present fiat dollar should have under an ideal operating framework. While one school of thought insists that fiat currency should be eliminated outright, he cautioned that the free market does not have a particularly good track record when it comes to creating money from scratch. Instead, he suggested, the value of the dollar should be tied to a predetermined monetary rule. Tying its value to something like a gold standard would be more difficult than a quantity rule, he said. The latter at least has “the merit of being possible in an age where trust in convertibility contracts,” and the banking system in general, continues to depreciate. William Nelson (Executive Vice President and Chief Economist, Bank Policy Institute) outlined the steps necessary for returning to the Fed’s pre-2008 operating framework. Prior to the last financial crisis, our central bank regulated the money supply mainly through its purchases of U.S. Treasuries and short-term sales of government securities (repo agreements), buying those securities back the next day at a slightly higher price. Together, these tools allowed the Fed to raise and lower the money supply to adjust to changes in market demand. As a result, it didn’t engage in many day-to-day financial transactions with private banks, as it does now. Banks instead borrowed and lent among one another, with the Fed serving only as their lender of last resort. Nelson then outlined the consequences of the Fed’s crisis-era decision to house unlimited Treasury deposits at Federal Reserve banks—initially in an effort to raise interest rates—and to continue doing so well after those rates surpassed their zero lower bound. He also discussed the Fed’s misguided QE3 (or “QE Infinity”) program, which was unique in that it allowed for unlimited QE purchases—and which was unfortunately par for the course in that it extended long past its proposed duration. This, in turn, postponed the Fed’s plans to renormalize its balance sheet. It also altered those plans: rather than sell back the assets it had purchased from the market, the Fed has now opted to allow those assets to roll off naturally as they mature. Nelson ended with three steps that the Fed can take to return to its precrisis operating framework. First, discontinue its policy of allowing the Treasury to keep all of its deposits at Fed banks. In the medium and long term, he said, the majority of Treasury bills should be housed in private banks (where they will earn interest and reduce money market volatility). Second, undertake a “massive reeducation campaign” incentivizing private banks to return to conducting most of their borrowing and lending with one another, and not the Fed. Finally, the Fed should begin unwinding its asset portfolio immediately.

William J. Luther (Assistant Professor of Economics, Florida Atlantic University; Director, Sound Money Project, AIER) described the four characteristics of an optimal base money regime. First, a base money regime has a stable inflation rate—one close to zero, although economists continue to debate whether that rate should be slightly negative or slightly positive. Second, it is “demand-elastic”; that is, the quantity of base money either increases or decreases depending on market demand. Yet it should not adjust according to shocks in the real money supply, Luther said, since these generally affect only “a particular subset of markets,” and not the economy as a whole. Third, an ideal base money regime is global. Luther explained the benefits of a common global currency: it promotes exchange in both direct and indirect ways; and it lowers “information costs, transaction costs, and riskiness of cross-border production plans.” Finally, an ideal base money regime is “incentive-compatible,” meaning that those who are charged with creating and maintaining it benefit from adhering to its rules. All the money regimes that currently exist are deficient in at least one of these attributes, Luther said; “but these four principles provide a useful starting point for [improving on] the available alternatives.”

Closing the panel—and the day—was Steven H. Hanke, Professor of Applied Economics at Johns Hopkins University. In Hanke’s view, the greatest threat that monetary instability and financial crises pose to free societies isn’t the supply shock itself, but rather the fact that these shocks are “always followed by policy proposals that constrain liberties.” In his remarks, Hanke proposed three strategies for improving global monetary stability. First, there should be a formal linkage—albeit a loose one—between the U.S. dollar and the euro (Hanke recommended an exchange rate between $1.20 and $1.40). Second, we should “mothball at least 100 central banks” and establish currency boards in their stead. Currency boards, Hanke explained, have an “exchange rate policy, but no monetary policy.” They also have a far better history of promoting financial stability than central banks have, and they are far more consistent in terms of producing lower inflation, lower debt, and higher rates of economic growth. Finally, Hanke insisted that central banks should “greenlight private currency board systems” like libra and other competitors. Central banks, of course, tend to regard independent currency boards as their own competitors—and therefore as threats to their power. Yet competition is a good thing, Hanke reminded audiences; and central banks’ opposition to independent currencies is perhaps the greatest argument in their favor.

Milton Friedman (1951, 1960) provided influential back-of-the-envelope estimates of the costs devoted to extracting gold under what he called a “strict” gold standard. I have criticized those estimates elsewhere (White 1999, pp. 42–48) for exaggerating the volume of gold reserves used by actual gold-standard economies, and thus exaggerating the resource cost. Friedman’s estimates assumed a 100 percent gold reserve ratio against demand deposits (1951) or against all bank deposits (1960), whereas sophisticated banking systems in gold-standard economies historically operated on small prudential reserve ratios (as he elsewhere recognized). Plugging a historically observed 2 percent reserve ratio against all the bank liabilities in the broad monetary aggregate M2, rather than Friedman’s 100 percent, yields a resource cost estimate one-fiftieth of his 1960 figure, namely 0.05 percent rather than 2.5 percent of national income.

President Nixon closed the gold window in 1971, ushering in our present era of fiat money. As inflation rose and became more variable, people began acquiring gold and silver coins and bullion for hedging against fiat money regimes. Friedman to his credit was alert to the resource costs of the gold and silver acquisition that emerged. In a note on “The Resource Costs of Irredeemable Paper Money” he observed (Friedman 1986, p. 644):

Real resources are employed … in the production of the gold and silver absorbed into the hoards accumulated by [individuals] who have come to regard gold or silver as a prudent component of their asset portfolios. Since the end of Bretton Woods, even the direct resource cost of the gold and silver accumulated in private hoards may have been as great as or greater than it would have been under an effective gold standard. That depends on whether gold production since 1971 has been greater or less than it would have been under an effective gold standard—a promising research topic whose conclusion is by no means obvious from casual empiricism.

Recent data on gold production from the World Gold Council (2019) allow us to revisit the question with something better than casual empiricism, and to reach a conclusion.[1] Plugging recent numbers from the World Gold Council into Friedman’s own model, it is fairly clear that gold coins and bullion in recent years have been produced in greater volumes than would have been the case under a gold standard with reasonable prudential reserve ratios, and thus gold-extraction resource costs have been higher under fiat money in practice. Note that this accounting effort provides an underestimate of the total resource costs induced by fiat money, because it neglects the costs incurred in acquiring silver, collectibles, cryptocurrencies, and other inflation hedges.

Private stocks of gold coins, bullion, and exchange-traded funds have grown so much since 1971 that they now exceed official gold reserves. The World Gold Council reports that the planet’s above-ground stocks of gold at the end of 2018 totaled 193,473 tonnes, divided in the following proportions: 47.6 percent jewelry (92,043 tonnes); 21.3 percent private investment holdings of coin, bullion, and ETFs (41,279 tonnes); 17.2 percent official holdings by central banks, Treasuries, and the IMF (33,230 tonnes); and 13.9 percent “other” including mainly industrial inventories (26,921 tonnes). Data on the Council’s website go back to 2006. If we contrast 2018 figures with 2006 figures, we find that of the estimated 35,473 tonnes of gold produced overall during the period, 15,479 tonnes or 43.6 percent went into private investment holdings. Meanwhile the stock of jewelry grew 12.7 percent, and official holdings grew 16.6 percent. (Curiously, some countries have been adding to their official gold holdings despite being on fiat standards.)

The purchasing power of gold has risen substantially since leaving the US left the Bretton Woods dollar-gold-exchange standard for the fiat dollar. When President Richard Nixon “closed the gold window” to end what remained of gold redemption of the US dollar on August 15, 1971, the official par value was $35 per ounce, while the market price had floated to $44.60. In the last half of 2019, with fiat standards prevailing around the world, the price of gold has hovered above $1450 per ounce. The ratio of $1450 to $44.60 means that the dollar price of gold has risen more than 32-fold since August 1971. This increase is much greater than the increase in the dollar prices of goods and services in general, the GDP deflator index having increased about 5‑fold between 1971Q2 and 2019Q2. Thus the purchasing power of gold in terms of goods and services has risen considerably. The rise is not principally due to higher gold mining costs (as shown by production volumes rising rather than falling), or growth in the non-monetary demand for gold (coin and bullion stocks having grown much more than jewelry stocks), but is principally due to increased demand for gold bars and coins by people hedging against the uncertain future value of fiat monies.

Combining the price and quantity numbers, we can make a back-of-the-envelope estimate of the share of real world output that has been going to produce gold coins and bullion. We begin with the value of the coins and bullion purchased 2006–2018. One metric tonne of gold is 1000 kilograms, which is equal in mass to 32,151 troy ounces, so 15,479 tonnes meant 497,665,329 ounces added to private investment holdings of gold coins, bullion bars, and bullion ETFs. Call this “monetary gold” for short. The average gold price over the period was $1224 per troy ounce.[2] Multiplying the ounces purchased by the price per ounce, the total value of monetary gold purchased worldwide was $609 billion over twelve years, or an average of $50.8 billion per year. Average world GDP over the period, as reported by the World Bank’s website, was $77.15 trillion per year. Dividing $50.8 billion into $77.15 trillion, we find that monetary gold purchases were about 0.066 percent of the world economy’s annual output. This figure is 32 percent larger than our estimate noted above (using Friedman’s method but with a reasonable fractional reserve ratio of 2 percent) that under a gold standard some 0.05 percent of national income would go to acquiring monetary gold. And so we conclude that going off the gold standard has not reduced the flow of resources used in producing monetary gold, but has increased it something like 32 percent above what a modern gold standard requires.

Put another way, private gold acquisition over recent years have been costing the world an estimated average of $12.3 billion per year (.066 percent minus .050 percent) times $77.15 trillion) more in production of coins and bullion than an international gold standard would have cost, not even counting recent gold acquisitions by central banks (or acquisition of investment-grade gold jewelry to be stored in vaults, a common practice in India and elsewhere). In a $92 trillion world economy (as projected for 2020), the excess annual cost of 0.016 percent comes to $14.7 billion dollars per year.

These estimates indicate that the historical switch from gold to fiat standards, contrary to the sincere hopes of Milton Friedman and other advocates of the switch, has increased the resource costs associated with the production of gold coins and bullion. Perhaps this was avoidable. The establishment of trustworthy non-inflationary fiat money systems (as Friedman of course prominently advocated) might have given private citizens no reason to invest in gold coins and bars, and might have brought a resource cost saving over the gold standard. But that experiment has not been run.

Resource costs are of course not the only criterion on which to judge the relative merits of gold versus fiat money standards. Other criteria include purchasing-power stability (low inflation) and predictability (strong anchoring of inflation expectations), the amplitude of cyclical variations and proneness to financial crises, and fiscal discipline (White 2015). What the recent data tell us is that lower resource costs in practice should no longer be considered a plus on the side of fiat money.

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[1] Watts and Snyder (2015) made a similar effort using earlier data, and found that “fiat money regimes have drawn gold into quasi-monetary or investment uses at levels approaching monetary uses during the classical gold standard.” Using more recent data, I find even greater private accumulation of monetary gold.

[2] This price is the simple average of annual average gold prices, 2006–2018 inclusive, in the series reported by Statista.

[Cross-posted from Alt‑M.org]

Yesterday, Joe Nocera penned an extraordinary column expressing his bafflement at the Trump administration’s drive to release Fannie Mae and Freddie Mac, two firms that purchase and guarantee around half of single-family mortgages in the United States, from government conservatorship. Nocera argues against such a move, writing that “if it ain’t broke, don’t fix it … Fannie Mae and Freddie Mac ain’t broke.”

The piece is disconcerting from start to finish. Nocera writes that Fannie and Freddie make the 30-year fixed-rate mortgage, a product common only in the U.S., possible and thereby “help more people attain the American dream of homeownership.” Nocera neglects to mention that the U.S. homeownership rate, at 64 percent, is the same as it was in the late 1960s, long before mortgage securitization. This rate is lower than those of other Western countries (Table 1) and particularly low for minority Americans.

Table 1. Homeownership Rate, Selected Countries

Country	Homeownership Rate
Canada	67.8%
France	65.1%
Germany	51.5%
Japan	62.0%
Italy	72.4%
Netherlands	68.9%
Spain	76.3%
United Kingdom	65.1%
United States	64.8%

Source: Eurostat; Statistics Canada; Statistics Japan; U.S. Census Bureau. 2013 data for Japan, 2016 data for Canada, 2019 data for all other countries.

Nocera is correct that the 30-year fixed-rate mortgage probably wouldn’t exist without Fannie and Freddie, which are only (barely) going concerns today thanks to U.S. taxpayers. But countries without this product seem to do a better rather than worse job of promoting homeownership.

Nocera also repeats the dubious assertion that the U.S. government earned a “healthy return” on its bailout of Fannie and Freddie. Yes, since it funneled around $190 billion into the two firms in 2008, the government has collected around $300 billion in dividend payments. But those dividends are contingent on an essentially unlimited government backstop. Furthermore, Fannie and Freddie have had virtually no capital since 2008 and continue to operate merely because the government stands behind them. In short, were Fannie and Freddie private concerns, they would have been forced into receivership long ago.

The bailout of Fannie and Freddie was not a good investment. The Congressional Budget Office, in fact, estimated a return adjusted for the enormous risk Uncle Sam took on when it rescued the two firms of minus $311 billion. Other, more recent, academic evaluations also show a negative return.

Fannie and Freddie owe their continued existence to a gigantic and ongoing taxpayer subsidy. There are beneficiaries, of course, including large asset managers who deal in the mortgage-backed securities Fannie and Freddie issue. As of 2019, there are close to $10 trillion such securities outstanding, with $1.3 trillion issued in 2018 alone. Asset managers therefore have a large economic stake in our subsidized mortgage market. But claiming that this sweet deal benefits all Americans, as Nocera does, is of no service to the public interest.

“Any objective observer,” says Nocera, “would have to concede that Fannie and Freddie have done a very good job since the 2008 crisis.” Yet an examination of the evidence suggests otherwise. Conservatorship was designed to be a temporary (read: 6‑month) arrangement, not an 11-year-long commitment with no end in sight. During this time, Fannie and Freddie’s role in the mortgage market has actually increased, and they’ve expanded their purchases of high-risk mortgages as the credit cycle matures. These facts supply ample grounds for concern.

Finally, concerning what caused Fannie and Freddie to go belly-up in 2008, Nocera writes:

What got Fannie and Freddie in trouble was not the government mandate, but their public company impulses. In the years before the crisis hit, they abandoned their historically sound underwriting standards because they were losing market share to the mortgage originators that were writing all those subprime loans that came a cropper when the bubble burst. As government wards, Fannie and Freddie no longer have any incentive to act foolishly.

Famous last words, as they say. In any event, and while there’s a debate around the relative role of government intervention and speculative frenzy in the last years of the housing boom (2004–2006), Fannie and Freddie’s ill-fated lowering of underwriting standards began much earlier, in the late 1990s. The government played a key role in fomenting this decline of credit standards by steadily ratcheting up the share of high-risk mortgages that Fannie and Freddie must purchase. Fearing that failure to comply would prompt Congress to allow competitors to challenge their duopoly, Fannie and Freddie obliged, with terrible consequences for vulnerable homeowners, and the U.S. economy as a whole.

Housing finance in America is a tangled web of cross-subsidies, public guarantees, government mandates, and competitive restrictions. Those features make it exceptional around the world, but not in a good way. Those who believe Fannie and Freddie are the best invention since sliced bread might ask themselves why, after so many decades, no other country has been inclined to look to the United States for inspiration about how to run its mortgage market.

[Cross-posted from Alt‑M.org]

Thomas Philippon’s The Great Reversal is an important book in which he warns of the decline of competition in many U.S. product markets. Not having studied antitrust issues for some time, I will leave criticism of his general thesis—that competition has indeed declined and that this is owing to lax antitrust enforcement—to my Cato colleagues writing about that issue. (You can start here.)

But I do want to take issue with Philippon’s argument that finance is one of the industries in which competition has declined. Philippon devotes a whole chapter of the book to the financial services industry, giving it the punchy title, “Why Are Bankers Paid So Much?,” while Martin Wolf, in his Financial Times review of the book, called finance a “rent-extraction machine.”

There are two serious problems with this view of U.S. finance. The first is that two central pieces of evidence Philippon cites in support of his general thesis, high concentration and rising profit rates, are simply missing in the financial sector. Another popular symptom of market power, namely slowing entry, is present in banking but directly attributable to regulators’ actions following the financial crisis.

The second problem is that Philippon’s argument on finance relies heavily on a 2015 paper reporting that the costs of financial intermediation had been largely unchanged for 130 years. From this, Philippon concludes that “improvements in information technologies do not appear to have led to a significant decrease in the unit cost of intermediation.” But because the 2015 paper does not break costs by category, it is not clear whether the mix of costs has also remained stable over the years, or whether (as I suspect) there has in fact been a decline in “market operating” costs, thanks to technology and economies of scale, that has been offset by rising regulatory (including lobbying) costs.

Philippon’s diagnosis of uncompetitive markets may therefore be accurate for U.S. finance, but for reasons to do with government intervention rather than the absence of competitive enforcement by government.

Concentration in Banking Has Increased but Remains Low

The United States has historically had many more banks, relative to its population, than other developed countries. As recently as 1984, we had nearly 15,000 banks and an additional 3,500 savings institutions. Several thousand credit unions also competed with these.

The primary reason for the large number of U.S. banks was states’ policy of restricting branching, which federal regulators allowed for decades. Most banks couldn’t have branches in their own state, let alone other states. Even in the early 1980s, no state allowed interstate banking and only a few tolerated intrastate branching. Things only began to change in the 1980s and 1990s, as states gradually liberalized their branching regulations, signing compacts with other states to reciprocally allow each other’s banks to enter their markets. Finally, in 1994 Congress passed the Riegle-Neal Act, allowing interstate banking throughout the country.

Branching has since ushered in an enduring cycle of consolidation: There are now fewer than 5,000 commercial banks and only a few hundred savings institutions. Small banks, in particular, have dwindled. The number of banks with (inflation-adjusted) assets under $100 million has fallen by 82 percent since 1992, while the number of banks under $1 billion has dropped by nearly half. Consolidation, however, has not resulted in a decline in bank presence or proximity. In fact, the number of bank offices (including branches), at 82,731, is near its all-time high and much higher than the 57,227 bank offices of 1984. The number of offices per capita is also higher than at any time before the passage of Riegle-Neal.

Thanks to longstanding branching restrictions, concentration in American banking has historically been exceptionally low. But that was hardly a good thing. Rather, most U.S. banks have been inefficiently small for decades. Until recently, most of them could not take advantage of economies of scale, could not adequately diversify their loans and product offerings, and therefore could not help being vulnerable to changes in their local economies. Branching restrictions impeded competition and gave banks monopoly power. So effective were these competitive restrictions at making bankers’ lives easier, that it seems bankers had lower mortality rates than other company executives of similar age! Of course, competitive restrictions made everyone else worse off.

What all this means for Philippon’s argument is that, while U.S. banking has indeed become more concentrated over the last 25 years, it is still by no means a concentrated industry. The Department of Justice, in its merger guidelines, uses the standard Herfindahl-Hirschman Index (HHI) to assess market concentration. Markets with an HHI above 2,500 are “highly concentrated,” those with an HHI between 1,500 and 2,500 are “moderately concentrated,” while those below 1,500 are “unconcentrated.” Table 1 shows bank deposit HHIs for the ten most-populated metropolitan statistical areas (MSAs) in the country as of 2019. There are values for 1994, 2018, and 2019. Out of these ten markets, only two (Houston and Philadelphia) are moderately concentrated by the DoJ standard, while another (Boston) met that criterion in 2018 but not 2019. Not a single market is highly concentrated, with most MSA HHIs well below the threshold for moderately concentrated.

Table 1. Herfindahl-Hirschman Index for the Top Five Banks by Local Deposits in the Largest U.S. MSAs

	1994	2018	2019
New York-Newark-Jersey City, NY-NJ-PA	322.40	1173.31	1175.46
Los Angeles-Long Beach-Anaheim, CA	602.22	828.81	789.16
Chicago-Naperville-Elgin, IL-IN-WI	167.15	784.70	816.85
Dallas-Fort Worth-Arlington, TX	908.11	1401.80	1402.37
Houston-The Woodlands-Sugar Land, TX	644.41	2010.78*	2177.85*
Washington-Arlington-Alexandria, DC-VA-MD	317.00	830.78	815.50
Miami-Fort Lauderdale-West Palm Beach, FL	263.17	711.57	N/A
Philadelphia-Camden-Wilmington, PA-NJ-DE-MD	270.06	1385.88	1692.36*
Atlanta-Sandy Springs-Roswell, GA	927.66	1437.40	N/A
Boston-Cambridge-Newton, MA-NH	448.59	1590.13*	1480.44

Source: FDIC, Summary of Deposits, Q2 2019. An asterisk indicates the market is “moderately concentrated,” according to the Department of Justice’s merger guidelines.

Even the European Commission, to whose approach Philippon is more sympathetic, says in its own merger guidelines that it “is unlikely to identify horizontal competition concerns in a market with a post-merger HHI below 1000 [and] in a merger with a post-merger HHI between 1000 and 2000 and a delta [change in HHI following the merger] below 250, or a merger with a post-merger HHI above 2000 and a delta below 150, except where special circumstances … are present.” The Europeans, whom Philippon holds up as a model of competition policy, tolerate much higher concentration in banking and have a policy framework that would not be concerned with the changes America has experienced since the mid-1990s.

Nationwide, the U.S. banking market has also seen a significant consolidation of deposits, with the top three bank holding companies jointly accounting for 31 percent of customer deposits in 2019, compared to around 8.5 percent in 1994 (Table 2). But those figures still point to a very unconcentrated market by the DoJ’s merger guidelines.

Table 2. Nationwide Deposit Market Share of Top 10 Bank Holding Companies

2019	2006	1992
Bank Name	Market Share	Bank Name	Market Share	Bank Name	Market Share
Bank of America	10.65%	Bank of America	9.16%	Bankamerica	3.74%
JPMorgan Chase	10.23%	JPMorgan Chase	7.17%	Nationsbank	2.70%
Wells Fargo	10.15%	Wells Fargo	4.79%	Chemical Bank	2.22%
Citigroup	4.30%	Wachovia	4.79%	Banc One	1.94%
U.S. Bank	2.67%	Citigroup	3.48%	Citicorp	1.75%
Capital One	2.55%	SunTrust	1.83%	First Union	1.63%
TD Bank	2.11%	U.S. Bank	1.82%	First Intrst	1.49%
PNC	2.10%	Royal Bank of Scotland	1.67%	Keycorp	1.40%
Charles Schwab	1.63%	BB&T	1.21%	Wells Fargo	1.29%
Morgan Stanley	1.40%	National City	1.18%	Chase Manhattan	1.17%

Source: FDIC, Summary of Deposits, Q2 2019.

Profit Rates in U.S. Banking

Philippon also points to the share of corporate profits in GDP as evidence of growing firm market power. He writes that:

over fifty years the profit share remain[ed] stable … around 6 or 7 percent, from the end of World War II to the end of the twentieth century. Over the past two decades, however, … the after-tax profit share has increased to around 10 percent. (p. 54)

But here again, as in the case of market concentration, the banking sector does not mirror the rise in profit rates apparent in other parts of the U.S. economy. Banks’ return on assets (ROA) and return on equity (ROE), two commonly used measures of their profitability, have remained remarkably stable over the last three decades (Table 3). Between 1992 and 2006, the average ROA of FDIC-insured banks and thrifts was 1.18 percent. From 2011 until the third quarter of 2019, it averaged 1.07 percent. For ROE, the respective figures are 13.54 percent and 8.8 percent. Banks of all sizes have returned less on shareholders’ capital since the end of the financial crisis than before it. Given the proliferation of new regulations, including stiffer capital requirements, after 2010, that should not come as a surprise. Post-crisis regulations may also have reduced bank risk, thereby lowering banks’ required return, but that relationship itself would suggest competitive conditions prevail in banking.

Table 3. Average Return on Assets (ROA) and Return on Equity (ROE), by Asset Size

Years	1992–2006	2011–2019
Asset Size Group	ROA	ROE	ROA	ROE
Assets > $250 Billion	1.06	14.21	1.03	9.90
Assets $10 Billion – $250 Billion	1.21	14.27	1.14	9.22
Assets $1 Billion – $10 Billion	1.27	13.84	1.10	9.30
Assets $100 Million – $1 Billion	1.14	11.90	0.98	8.79
Assets < $100 Million	1.02	9.38	0.80	6.36
All Insured Institutions	1.18	13.54	1.07	9.48

Source: FDIC, Quarterly Banking Profile, Q3 2019.

Other measures of bank earnings also contradict Philippon’s claim of growing market power. Listed banks’ average price-to-book-value ratio, a proxy for the market’s confidence in a firm’s future profitability, is 1.1—a figure well below the market-wide average of 2.66. For the largest U.S. retail banks by assets, which presumably have been best able to adapt to the post-crisis environment thanks to their scale and too-big-to-fail status, price-to-book measures are much lower than before 2008, with the sole exception of JPMorgan Chase (Table 4).

Table 4. Ratio of Bank Stock Prices to Book Values, 2006 and 2019

Bank Name	Price-to-Book Ratio, 2006	Price-to-Book Ratio, 2019
BofA	1.42	1.12
JPM Chase	1.07	1.57
Wells Fargo	1.88	1.17
Citigroup	1.95	0.82
U.S. Bank	2.21	1.72

Source: Macrotrends.

Philippon himself allows that value-added (profits plus wages) in the financial services sector as a share of financial assets has stayed constant, rather than increased, for 130 years. According to his own calculation, the financial services industry’s share of income in intermediated assets declined from around 1.8 percent to around 1.4 percent between the mid-1990s and the mid-2010s, and is now where it was in the mid-1970s. (Philippon’s original paper only goes up to 2012, but in his book he extends the series to 2016. The unit cost of intermediation stayed at late-1970s levels long after the recovery from the financial crisis began.)

Table 5. Philippon’s Estimate of the Unit Cost of Financial Intermediation, 1886–2012

Source: Thomas Philippon, “Has the U.S. Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation,” American Economic Review Vol. 105 No. 4 (April 2015), 1412. Author’s edit in red.

Bank profitability has been a headache for bank shareholders and managers for some years, but it should not (for now) worry antitrust regulators.

Bank Entry Has Declined, but Not Because of Market Power

Philippon also worries that low rates of entry, and high rates of incumbency, are another symptom that the market power of U.S. firms has increased, to the detriment of consumer welfare. And there has indeed been little entry into banking since the financial crisis. However, the causes of this appear to be quite different from those Philippon posits—namely, low interest rates and much tighter chartering rules by financial regulators.

Low interest rates since 2008 have squeezed bank profits by narrowing the margin that banks earn from lending funds borrowed from depositors. The net interest margin is especially significant for small and new banks because, unlike larger banks, they have few other sources of revenue. Researchers at the Richmond Fed attribute 75 percent of the decline in new (de novo) bank charters in the years after the crisis to low interest rates.

The FDIC also made it costlier to start and operate a new bank between 2009 and 2016. During that time, de novo banks were subject to higher capital requirements and more frequent examinations for their first seven years of operation, rather than the three years previously provided for. (The FDIC rescinded the seven-year rule in 2016.) Higher capital requirements, other things equal, mean a lower return to shareholders per dollar of loans, while more frequent examinations slow down business and raise compliance costs. While this extra caution may have been justified, it also impeded entry into banking.

Why Is the Unit Cost of Financial Intermediation Stable?

Philippon’s 2015 AER article finding that the unit cost of financial intermediation has remained stable for more than a century has received a great deal of scholarly and media attention. The finding puzzles those who would assume information technology, globalization, and increasing competition put downward pressure on the prices financial intermediaries can charge. It also contradicts the anecdotal evidence from retail asset managers, whose fees have dropped steadily with the advent of online trading platforms and passively managed funds.

Philippon’s methods are painstaking. His adjustments for changes in the risk associated with financial intermediation, as startups and lower-income households gained access to capital, are particularly impressive (Table 6). They suggest a moderate decline in costs since the 1990s but no long-term trend of decline.

Table 6. Quality Adjustments Lower the Unit Cost of Intermediation in Recent Years

Source: Philippon, “Has U.S. Finance Become Less Efficient?,” 1433.

My concern is with Philippon’s interpretation of his findings. In particular, he dismisses regulation as a countervailing force keeping costs from declining. “Regulatory barriers to entry,” he says, “have been reduced in banking since the 1970s and yet this is when the unit cost goes up.” In his book, Philippon does not dismiss regulation quite so laconically. But there he relates rising compensation for financial sector workers to a supposed deregulation that began in 1980. He adds: “When an industry is deregulated, wages and prices usually fall. In finance, they seem to rise.” (p. 214)

But there’s much more to regulation in banking than rent-seeking by financial firms, which may have increased in the last few decades, and branching and investment-banking restrictions, which disappeared in the 1990s. Since 1970, regulations on credit intermediation have increased rapidly. According to the Mercatus Center at George Mason University, credit intermediaries are subject to six times as many mandates and restrictions as they were 50 years ago. Rules on securities, derivatives, and fund managers have also mounted since 2000. The Dodd-Frank Act alone added more than 27,000 new regulations to the books. Other proxies for bank regulatory compliance costs, such as non-interest expenses for salaries, legal fees, and other activities have increased significantly since the financial crisis.

The basic problem with Philippon’s findings on the unit cost of financial intermediation is that he does not break costs down by type. Financial intermediaries have operating (personnel and capital) as well as financial (cost of capital) expenses. They also face significant costs of compliance with government regulation. Technological innovation can particularly lower operating costs, though better information processing and tech-enabled competition may also reduce funding costs. But innovation has a harder time lowering regulatory costs, because regulatory requirements tend to be fixed and rigid. Indeed, regulation often acts as a barrier to innovation.

What Philippon Gets Right

Although the evidence suggests that the thesis of The Great Reversal does not hold in the case of banking, Philippon is right to claim that competition in this sector is less than it might be. As Table 2 illustrates, any examination of bank rankings by deposits and assets cannot fail to show a remarkable persistence among the largest institutions. Where other sectors, such as retail, telecommunications, and even the auto industry have seen significant turnover in the last quarter-century, the leading names in banking as of 2019 would ring familiar to anyone living in 2006 and even 1992 (if not 1907!).

Here again, regulation seems to be the chief contributor to this state of affairs. The dominant firms in other sectors tend to have entered the market relatively recently. In banking, entry since 2008 has been minimal. Furthermore, regulation has encouraged consolidation because many of the costs of regulatory compliance are fixed. Finally, and more controversially, the government’s readiness to rescue large financial institutions encourages size and promotes incumbency. Citigroup would not be around today were it not for Uncle Sam.

Philippon is also right to complain about America’s unusual separation of commerce and banking, passed into law by the 1956 Bank Holding Company Act. Not only is there little logic to this legal prohibition, “as if debit cards and savings accounts were magical products that a retail firm could not provide,” (p. 216) but it helps to entrench the largest financial institutions in their dominant positions by preventing similarly sized outside firms from challenging them. When Walmart applied for an industrial loan company (ILC) charter, the one banking charter that nonfinancial companies are allowed to hold, in 2005, resistance from banks was so fierce that Walmart eventually relented two years later. Now that Japanese e‑commerce and financial services firm Rakuten has applied for an ILC charter, banks large and small have again responded with vociferous opposition.

America’s strange segregation of commercial and financial companies is also bad for financial inclusion. Contrary to the popular understanding, the reason millions of Americans lack a bank account is not that they are far away from branches, but that they find bank accounts expensive and do not trust banks. But many of these Americans recognize and regularly patronize businesses like Walmart and other retailers. Moreover, some of these businesses have specialized precisely in serving people on tight budgets. Allowing commercial companies to provide a range of basic financial services could therefore help to reduce America’s unbanked problem.

We Need a Great Reversal in U.S. Banking

Philippon’s book has rightly gained a lot of attention since its publication. He raises important questions about trends in corporate concentration and market power, and the government’s role in them, in recent decades. But U.S. banking has different problems. Regulatory accumulation has made financial intermediation costlier. America’s longstanding fragmentation due to restrictions on mergers and branching means many banks are inefficiently small. The post-crisis environment of low interest rates and increased compliance costs have made banks significantly less profitable. Regulators are not helping to increase competition when they block entry. The best legislators can do to promote efficiency and innovation in banking is tear down the wall between commerce and finance.

These changes will constitute not just a great, but a long-overdue reversal in the direction of better financial markets in America.

[Cross-posted from Alt‑M.org]