Waldman: Halt the Fed’s Mission Creep

Steve Waldman has a typically top notch post at Interfluidity,”Let’s not write the Fed a blank check,” in which he dissects the implications of the Fed’s request to Congress to pay interest on bank reserves.

Waldman explains the technical workings and the pros, and gets to the real issue. This represents a change from a fractional reserve banking system to a so-called channel or corridor system. Fixed reserves become incidental and might be dispensed with, since the Fed would manage interbank rates directly by setting what amounts to a bid and offered price (a bit simplified, see Waldman for details).

Now the Fed did not just wake up and decide in a fit of housekeeping to adopt this practice, which has been road tested by other central banks. The problem, as has been clear from the when this idea first surfaced, is that its main objective is to allow the Fed to circumvent its balance sheet constraints in salvaging the financial system. The method open to it now, of simply issuing liabilities so it could take on more dodgy assets, is tantamount to printing money and inflationary.

Aside: you thought the credit crisis was over? This proposal says the Fed is afraid it isn’t. Per Waldman, the Fed has already used $475 billion of balance sheet capacity and has another $300 billion to go. As he points out, the amount already loaned to Wall Street equates to $1500 per person in the US; use of the additional $300 billion would bring it to $2500. Don’t kid yourself; if these loans go bad, they come out of the public purse. The Fed wants approval for a mechanism that allows it to go even higher.

The Fed’s mission creep is yet another sorry Greenspan era development. Earlier central banks understood their mission: to provide a stable price of money, preserve the soundness of the banking system, and promote full employment. Greenspan took an unprecedented interest in the stock market, which has never been any central bank’s responsibility (a May 8, 2000 Wall Street Journal cover story discussed this at some length, although predictably not in disapproving terms). Even worse, Greenspan’s predilections seemed a prescription for moral hazard: minimal regulation and a “let a thousand flowers bloom” approach to new products, no matter how geared, combined with aggressively backstopping the industry at any whiff of trouble.

Much has been written about the Greenspan put; less has been said about his Fed’s other moves that extended the Fed’s purview without any formal approval. The biggest, the one that set the stage for the Fed’s current expansive view of its role, was the bailout of LTCM. Although the Fed did not broker the deal, it did review LTCM’s books before calling 24 firms, most of which it did not regulate, to meet at its offices. While that intervention has in retrospect been presented as a success, it wasn’t clear then, and cannot be determined now, whether a LTCM failure would have been a systemic event. However, at the time, it was quite controversial, precisely because the Fed was extending its reach to areas that were not part of its charter.

The problem, as Richard Sylla points out in the Palgrave Dictionary of Money and Finance, is that

…..the Fed was a compromise between two central banking traditions in America. Each was tried for extensive periods and then rejected. The first was the tradition of the corporate central bank, chartered by the State but owned wholly or in great part by private investors…After the corporate central bank was rejected, the US flirted for seven decades with a second central banking tradition, namely having the the government’s fiscal authority, the US Treasury Department, serve also as the central bank…..The Federal Reserve Act rejected the earlier traditions of monetary policy controlled by bankers or the Treasury, but it gave each of these interests a voice in central bank policy formation.

Fast forward 95 years, and we are coming to the limits of this model. Not only have private interests managed to co-opt the central bank, as opposed to have a voice in monetary policy, but they have the Federal government apparently ready and willing to give the industry an unlimited, unconditional guarantee. Retail deposit insurance is capped; why should professional investors, shareholders (who unless they work for Bear, know to diversify their holdings) and incumbents, who created this mess, get a far more generous deal?

Remarkably, and sadly, Congress had the chance to rein in the Fed during its hearings on the Bear rescue. Indeed, I thought that was the point of that exercise. But having given the Fed a free pass, there is zero possibility that the legislature will leash and collar the Fed as Waldman recommends below.

From Waldman:

As long as the Fed is conducting ordinary monetary policy, switching to a channel system offers modest benefits at a modest cost to taxpayers. But the Fed’s monetary policy has not been ordinary at all lately. In fact, it’s been quite extraordinary….and it is in the context….that we must consider the change.

The core of the Fed’s new exuberance is a willingness to enter into asset swaps with banks…. In doing so, the Fed puts taxpayer funds at risk. If a bank that has borrowed from the Fed runs into trouble, the Fed would face an unappetizing choice: Orchestrate a bail-out, or permit a failure and accept collateral of questionable value instead of repayment. Either way, taxpayers are left holding the bag.

In December, the Fed had $775 worth of Treasury securities. That stock will soon have dwindled to $300B, give or take. The difference, about $475B, represents an investment by the central bank in risky assets of the US financial sector.

$475B is an extraordinary sum of money. It is as if the Fed borrowed more than $1500 from every man, woman, and child in the United States, and invested that money on our behalf in Wall Street banks that private financiers were afraid to touch. For bearing all this risk, if things work out well, taxpayers will earn about what they would have earned investing in safe government bonds. If things don’t work out well, the scale of the losses is hard to predict. The Fed will claim to have done “due diligence” on its loans, to have valued collateral conservatively, and will point to strength of bank guarantees and the enormous diversity of collateral assets to convince us that its actions are safe and prudent. But rating agencies made the same claims about AAA CDO tranches, and turned out to have been mistaken. Correlations often tend towards one when asset values fall sharply. Central bankers struggling to manage day-to-day crises in financial markets might cut corners when trying to value complex securities. They might find it convenient to err on the side of optimism, as the ratings agencies did, albeit for very different reasons. And even if the Fed is cautious and sober-minded, are we sure that central bankers can value these assets more accurately than private investors?

If the Fed were to blow through the rest of its current stock of Treasuries, it would have invested more than $2500 for every man, woman, and child in America. Public investment in the financial sector would have exceeded the direct costs to date of the Iraq War by a wide margin. Would that that be enough? If not, how much more? Just how large a risk should taxpayers endure on behalf of companies that arguably deserve to fail, to prevent “collateral damage”? Have we considered other approaches to containing damage, approaches that shift costs and risks towards those who benefited from bad practices, rather onto the shoulders of taxpayers and nominal-dollar wage earners? Does this sort of policy choice belong within the purview of an independent central bank?….

I don’t love the decisions that were made, but decisions did have to be made, and there weren’t very good options. But now we have a moment to reflect. If the credit crisis flares hot and bright again, how much more citizen wealth should be put at risk before other policy options are considered? That’s not a rhetorical question: We need to choose a number, a figure in dollars. My answer would be something north of zero, but not more than the roughly $300B stock of Treasuries that remains on the Fed’s balance sheet….

…..suppose Congress gives the Fed the authority to pay interest on reserves. Suddenly the Fed can print cash to buy all the Treasuries it wants to swap for troubled assets….. Since interest rates can be held to any level by adjusting the “corridor”, the Fed would retain the flexibility to respond to inflation. At the same time, it would be able print cash in any amount that it pleases — “to infinity and beyond!” — in order to fund asset swaps (or outright purchases) at taxpayers’ risk. This strikes me as a delegation of Congressional authority that would not only be undesirable, but arguably unconstitutional……

I think that Congress should grant the Fed’s request, but it should simultaneously impose constraints on the composition of the Fed’s balance sheet that cannot be violated without express legislative consent. This will be a complicated exercise, unfortunately. Besides government debt, central banks quite ordinarily hold precious metals and foreign exchange, and limitations on non-Treasury assets will have to take this into account. Plus, restrictions would have to be written carefully to apply to off-balance sheet arrangements such as TSLF, and contingent liabilities like the insidious reverse MBS swap proposal. Finally, Congress must consider restrictions on the Fed’s ability to enter into derivative positions, whether directly or indirectly via special purpose entities, including how the bank’s existing derivative book should be managed and whether the bank should or should not guarantee the liabilities of current Fed-affiliated SPEs.

Congress might also limit the quantity of reserves on which the Fed will be permitted to pay interest.

The Fed can retain full independence for the purpose of conducting ordinary monetary policy, exchanging government debt for cash and vice-versa. But if the central bank wants to put ever greater quantities of public money at risk, it will have to accept a lot more public supervision. If the prospect of intrusive oversight is too much for the Fed, then, as James Hamilton hints, perhaps the roles of central bank and macroeconomic superhero should be moved to separate boxes on the organizational chart. If we are not careful, the next bank requiring a taxpayer bailout may be the Federal Reserve system itself.