Should central banks do emergency lending?

A barnstorming new paper from the Richmond Fed, written by its President Jeffrey Lacker and staff economist Renee Halter, argues that the Federal Reserve has drifted into doing too much credit policy to the detriment of its traditional goal of overall macroeconomic stabilisation.

In its 100-year history, many of the Federal Reserve’s actions in the nameof financial stability have come through emergency lending once financial crises are underway. It is not obvious that the Fed should be involved in emergency lending, however, since expectations of such lending can increase the likelihood of crises. Arguments in favor of this role often misread history. Instead, history and experience suggest that the Fed’s balance sheet activities should be restricted to the conduct of monetary policy.

The first step in their case is attacking the idea that the Fed was created to be a lender to specific troubled institutions or sectors:

Congress created the Fed to “furnish an elastic currency.”…In other words, the Fed was created to achieve what can be best described as monetary stability. The Fed was designed to smoothly accommodate swings in currency demand, thereby dampening seasonal interest rate movements. The Fed’s design also was intended to eliminate bank panics by assuring the public that solvent banks would be able to satisfy mass requests to convert one monetary instrument (deposits) into another (currency). Preventing bank panics would solve a monetary instability problem.The Fed’s original monetary function is distinct from credit allocation, which is when policymakers choose certain firms or markets to receive credit over others.

They go on to explain further the difference between monetary policy (providing overall nominal stability; making sure that shocks to money demand do not lead to macroeconomic instability & recessions) and credit policy (choosing specific firms to receive support and funds—effectively a form of microeconomic central planning):

Monetary policy consists of the central bank’s actions that expand or contract its monetary liabilities. By contrast, a central bank’s actions constitute credit policy if they alter the composition of its portfolio—by lending, for example—without affecting the outstanding amount of monetary liabilities. To be sure, lending directly to a firm can accomplish both. But in the Fed’s modern monetary policy procedures, the banking system reserves that result from Fed lending are automatically drained through off setting open market operations to avoid driving the federal funds rate below target.

The lending is, thus, effec-tively “sterilized,” and the Fed can be thought of as selling Treasury securities and lending the proceeds to the borrower, an action that is functionally equivalent to fiscal policy.

They go on to explain why Walter Bagehot provides “scant support” for the creditist approach to crisis management, while the facts of the Great Depression do not fit with the creditist story.

Finally, they note that even if there are inherent instabilities in the financial system—something far from proven—many of these are made substantially worse by central bank intervention in credit markets.

Financial institutions don’t have to fund themselves with short-term, demand-able debt. If they choose to, they can include provisions to make contracts more resilient, reducing the incentive for runs. Many of these safeguards already exist: contracts often include limits on risk-taking, liquidity requirements, overcollateralization, and other mechanisms.

Moreover, contractual provisions can explicitly limit investors’ abilities to flee suddenly, for example, by requiring advance notice of withdrawals or allowing borrowers to restrict investor liquidations. Indeed, many financial entities outside the banking sector, such as hedge funds, avoided financial stress by adopting such measures prior to the crisis.Yet, leading up to the crisis, many financial institutions chose funding structures that left them vulnerable to sudden mass withdrawals. Why?

Arguably, precedents established by the government convinced market participants of an implicit government commitment to provide backstop liquidity. Since the 1970s, the government has rescued increasingly large fi nancial institutions and markets in distress. This encourages large, interconnected fi nancial fi rms to take greater risks, including the choice of more fragile and often more profi table funding structures. For example, larger financial firms relied to a greater extent on the short-term credit markets that ended up receiving government support during the crisis. This is the well-known “too big to fail” problem.

I apologise for the length of the quotation, but the paper really is excellent. Do read the whole thing.

Voxplainer on Scott Sumner & market monetarism

I have to admit that I usually dislike Vox. The twitter parody account Vaux News gets it kinda right in my opinion—they manage to turn anything into a centre-left talking point—and from the very beginning traded on their supposedly neutral image to write unbelievably loaded “explainer” articles in many areas. They have also written complete nonsense.

But they have some really smart and talented authors, and one of those is Timothy B. Lee, who has just written an explainer of all things market monetarism, Prof. Scott Sumner, and nominal GDP targeting. Blog readers may remember that only a few weeks ago Scott gave a barnstorming Adam Smith Lecture (see it on youtube here). Readers may also know that I am rather obsessed with this particular issue myself.*

So I’m extremely happy to say that the article is great. Some excerpts:

Market monetarism builds on monetarism, a school of thought that emerged in the 20th century. Its most famous advocate was Nobel prize winner Milton Friedman. Market monetarists and classic monetarists agree that monetary policy is extremely powerful. Friedman famously argued that excessively tight monetary policy caused the Great Depression. Sumner makes the same argument about the Great Recession. Market monetarists have borrowed many monetarist ideas and see themselves as heirs to the monetarist tradition.

But Sumner placed a much greater emphasis than Friedman on the importance of market expectations — the “market” part of market monetarism. Friedman thought central banks should expand the money supply at a pre-determined rate and do little else. In contrast, Sumner and other market monetarists argue that the Fed should set a target for long-term growth of national output and commit to do whatever it takes to keep the economy on that trajectory. In Sumner’s view, what a central bank says about its future actions is just as important as what it does.


In 2011, the concept of nominal GDP targeting attracted a wave of influential endorsements:

Michael Woodford, a widely respected monetary economist who wrote a leading monetary economics textbook, endorsed NGDP targeting at a monetary policy conference in September.

The next month, Christina Romer wrote a New York Times op-ed calling for the Fed to “begin targeting the path of nominal gross domestic product.” Romer is widely respected in the economics profession and chaired President Obama’s Council of Economic Advisors during the first two years of his administration.

Also in October, Jan Hatzius, the chief economist of Goldman Sachs, endorsed NGDP targeting. He wrote that the effectiveness of the policy “depends critically on the credibility of the Fed’s commitment” — a key part of Sumner’s argument.

But read the whole thing, as they say.

*[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16]

An unpublished letter to the LRB on high frequency trading

Lanchester, John. “Scalpers Inc.” Review of Flash Boys: Cracking the Money Code, by Michael Lewis. London Review of Books 36 no. 11 (2014): 7-9,

Dear Sir,

It is striking for John Lanchester to claim that those who believe high-frequency trading is a net benefit to finance (and by extension, society) “offer no data to support” their views. Aside from the fact that he presents such views in the line of climate-change deniers, rather than a perfectly respectable mainstream view in financial economics, it doesn’t really seem like he has gone out looking for any data himself!

In fact there is a wide literature on the costs and benefits of HFT, much of it very recent. While Lanchester (apparently following Lewis) dismisses the claim that HFT provides liquidity as essentially apologia, a 2014 paper in The Financial Review finds that “HFT continuously provides liquidity in most situations” and “resolves temporal imbalances in order flow by providing liquidity where the public supply is insufficient, and provide a valuable service during periods of market uncertainty”. [1]

And looking more broadly, a widely-cited 2013 review paper, which looks at studies that isolate and analyse the impacts of adding more HFT to markets, found that “virtually every time a market structure change results in more HFT, liquidity and market quality have improved because liquidity suppliers are better able to adjust their quotes in response to new information.” [2]

There is nary a mention of price discovery in Lanchester’s piece—yet economists consider this basically the whole point of markets. And many high quality studies, including a 2013 European Central Bank paper [3], find that “HFTs facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors, both on average and on the highest volatility days”.

Of course, we should all know that HFT narrows spreads. For example, a 2013 paper found that the introduction of an algorithmic-trade-limiting regulation in Canada in April 2012 drove the bid-ask spread up by 9%. [4] This, the authors say, mainly harms retail investors.

The evidence is out there, and easy to find—but not always easy to fit into the narrative of a financial thriller.

Ben Southwood


City Regulation and the EU

Last month Business for Britain published research on the potential damage to the City from EU financial regulation.  This is an excellent report, full of content, and deserving of careful Whitehall consideration. It did, however, call fundamentally for the City to be regulated by the UK. 54 top City figures wrote to the Sunday Times (22nd June) supporting this recommendation.  Business for Britain is right about the danger but their solution does not take enough account of the realities of the EU, whether the UK remains in or out. After explaining why their proposal is, frankly, unachievable, an alternative solution is advanced.

EU control of financial regulation was President Sarkozy’s price for attending the London G10 Summit in April 2009. To save the Summit, or perhaps his own prestige, Gordon Brown agreed that Brussels would set future regulations, with member states (such as the UK) merely enforcing them. We highlighted the dangers of this in a letter The Times published in June 2009 and a report called Saving the City, but City bosses then seemed unconcerned.

The EU’s position is logical: a single market requires a single set of regulations, and as the main proponent of the single market in financial services, the UK should accept that. Against that, the EU’s lawmaking system is undemocratic and corrupt, and the City, the world’s second-largest financial market, will be at the mercy of 27 other states – most with no interest in its future success, and some that are openly hostile to it.  The UK with far the largest financial services market will have just one vote in 28.

The extent to which George Osborne has enabled the UK to claw back from that, and whether the claw back applies only to banks, is unclear.  As the Business for Britain report (p.19) says “Facing new regulations which it believes are prejudicial to the interests of the UK, the government is so far failing to shape regulation before it is proposed to the point where it supports that regulation; failing to stop the progress of the resulting regulations which it does not support; and then failing to win the resulting legal cases when it attempts to challenge them in the courts.”

A solution which would give comfort to Business for Britain and those of similar persuasion would be to allocate votes on the EU financial regulation committee pro rata to the skin they have in the financial game.  The UK would have about 75% of the votes but as other member states increased their financial services, they would also increased their share of votes. In effect it would still be a single EU market but the regulators would have a genuine interest in the health of the EU financial services market for the long term and its global competitiveness.

The naysayers, citing the 2008 crash, would say that the financial services people cannot be trusted with their own regulation but that is not what is proposed.  The UK financial services market has regulators independent of the traders and that would still be true for the EU.  To have regulation decided by member states that know nothing about it, as envisaged by the current arrangements, makes no sense.  One might as well have the dentistry regulator setting the rules for horse racing.

Leaving the EU is no solution as UK financial services would still be governed by EU regulation when trading in the EU (our largest customer) just as they are by the US when trading in the US.

Achieving this EU reform would not be easy but then none of the reforms we seek will be easy to negotiate.  Given the importance of the City, it should be a priority.

Apparently HFT is going to bring on the next crash or something

I confess, I do find myself a little puzzled by the coverage of finance and banking over at The Guardian at times. Are their writers actually inhabiting this same universe that we are or are they phoning it in from some parallel one? Tke this example, worrying about the perils of high frequency trading (HFT):

Cynics may conclude that Goldman's damascene conversion is a PR exercise designed to counter some of the more incendiary material that Lewis is expected to disclose. But they would be wrong. After playing a heroic role in the sub-prime mortgage scandal and Greece's economic ruin, Goldman, like all the big banks, is surely now turning over a new leaf. This is just as well. The consequences of a repeat of the 2008 financial crash, conducted at warp speed, are too terrifying for us mortals to get our heads around. History repeats itself first as tragedy, second as farce, Marx observed. But then he didn't have fibreoptic broadband.

My first confusion is that of course it wasn't trading, at high frequencies or not, that actually caused the crash. The markets that do have high turnovers, at high speed, are things like foreign currency, options, derivatives, and now moving into equities. None of these causwed the slightest problem during the crash. That was all about housing finance, the securitisation of mortgages into bonds that were then sliced and diced. Abnd, notably, very rarely traded after they have been placed with investors.Almost all of these bonds were nearly entirely illiquid, no one trading in them at all a month after issuance. And that's what caused the problems given that some banks had held onto healthy slices of these issues. How we can comare the perils of HFT with something that was hardly traded at all I'm really not sure.

As to why Goldman Sachs might not like HFT, can we at least start with the idea that GS is a greedy, profits hungry, capitalistic firm? Good, thought we could get agreement there. So, what's the effect of HFT? It reduces trading margins: reduces the difference between the buy and sell price of any particular security. Who would be unhappy if this happened? The people who make markets, the people making those buy and sell prices of course. A large part of GS's business is in making markets in things. And if margins collapse as a result of more trading and greater liquidity then GS isn't going to be happy, is it?

But over in Guardian world things seem to be different….