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.

Inside the Adam Smith Institute

Now that the new Adam Smith website is up, with an exciting plethora of activities and reports scheduled, new readers might like to take stock of what the ASI does, and what motivates us.

If labels are used, they might be “free market” and “libertarian,” but these are big tents under which disparate people are grouped. The crucial thing is that our free market libertarianism is both consequentialist and empiricist, combining an essentially Hayekian economic outlook with a deep optimism about the world.

In our view actions that enable individuals to advance their happiness by pursuing their own goals are worthy of support, and those that restrict their ability to do that should be opposed. We are more concerned with what results from actions than with the intentions or attitudes of those who initiate those actions. And we are more concerned with changing the world for the better than with promoting theories about it.

As empiricists we make conjectures about the world and its future, and we test their value against experience of real world outcomes. Where the two conflict, it is the conjecture that has to be rejected or modified. We take the view that “an ounce of practice is worth a pound of theory.”

While economics and public policy are complex fields that make experiment and testing difficult to perform, we do attempt to test proposals by their results. Several times we have proposed small-scale trials of larger ideas in order to validate the ideas and ascertain any unforeseen drawbacks before they are rolled out more widely.

We recognize, of course, that poor people do not have access to the choices and chances accessible to the rich, and this is why many of our policy initiatives are directed to improving the lot of poorer people in society. We have advocated for many years that the income tax and national insurance thresholds should be set at the level of the minimum wage and indexed to it, so we would not be taxing people on the bottom income level.

Some of our research studies and policy suggestions derive from our recognition that poor people are hurt most by things such as restrictions on international trade and migration, planning controls that prevent cheap housing from being built, education policies that condemn poor children to bad schools and regulatory policies that protect established market players from new entrants.

We propose and back policies that give all parents choice over where their children go to school and which introduce competition into the school system, whether these be by education vouchers, or by allowing the allocation of state funds to schools be determined by the choices parents make. We tend to back the view that welfare is not just about providing the services the state thinks poor people should have, but about equipping people with the means to make their own choices about the mix of services they prefer. Ideas such as a negative income tax could remove the perverse incentives present in the current welfare system.

We recognize that states can cause a great deal of harm when they attempt to direct and micromanage the economy. Many regulations have damaging effects that were not anticipated, and this includes financial regulations that can make financial systems more unstable than they would be without them.

More broadly, we think that the ‘unknown unknowns’ of regulation should lead society to prefer decentralized trial and error to the risk of one big mistake that affects everyone in the same way.

We have argued that the central bank should follow the ‘Hayek rule’ – the stabilization of the level of nominal spending in times of booms and busts along a predictable path. Scott Sumner recently delivered our annual Adam Smith Lecture and explained how the failure of the world’s central banks to do this led to the Great Recession.

In the Adam Smith Institute we have always been very optimistic about technology and society. We see the world becoming increasingly open and tolerant in most (though not all) areas, with technology and entrepreneurship helping to drive that. To us, companies like Uber, Google and Airbnb deserve to be celebrated when they break down barriers to competition and disrupt the existing way of doing things in ways that give consumers a better product for a lower cost. It is this kind of innovative entrepreneurship that moves the world forward and allows today’s luxuries of the very rich to be tomorrow’s household commonplaces.

There is a dark side when new technologies are used by governments to spy on their citizens and control them. If technologies like Bitcoin and other blockchain-based innovations represent a long-term way of evading the worst excesses of government intrusion, they should be defended from government now while they are still in their infancy.

Of course the Institute is not a monolith. It consists of people who sometimes differ, but all of whom are brought together by a desire to give more power and liberty to individuals, so that their regard to their own interest can make them and us richer, freer and happier.

The eurozone is in dire need of nominal income targeting

It may well be that, in the US and UK, nominal GDP is growing in line with long-term market expectations.* It may well be that, though we will not bring aggregate demand back to its pre-recession trend, most of the big costs of this policy have been paid. And so it may be that my pet policy: nominal income/GDP targeting, is only a small improvement over the current framework here in the UK or in the US. But there is one place that direly needs my medicine.

As a whole, the Eurozone is currently seeing very low inflation, but plenty of periphery countries are already suffering from deflation. And this is not the Good Deflation of productivity improvements (can be identified because it comes at the same time as real output growth) but the Bad Deflation of demand dislocation. The European Central Bank could deal with a lot of these problems simply by adopting a nominal GDP target.

When it comes to macroeconomics, the best analysis we really have is complicated econometric models on the one side, and highly stylised theoretical models on the other. Both are useful, and both can tell us something, but they rely on suspending quite a substantial amount of disbelief and making a lot of simplifying assumptions. You lose a lot of people on the way to a detailed theoretical argument, while the empirical evidence we have is really insufficient to conclusively answer the sort of questions I’m posing.

In general, I think that very complex models help us make sense of detailed specifics, but that “workhorse” basic theoretical models can essentially tell us what’s going on here. Unemployment is a real variable, not one directly controlled by a central bank, and a bad thing for the central bank to target. But in the absence of major changes in exogenous productivity, labour regulation, cultural norms around labour, migration and so on, there is a pretty strong relationship between aggregate demand and unemployment. Demand dislocation is almost always the reason for short-run employment fluctuations.

Unemployment rose everywhere in 2008-9. But it nudged down only marginally post-crisis in the Eurozone, whereas in the UK and US it soon began to steadily fall toward its pre-crisis rate (the red line, though not on this graph, has tracked the green one very closely). In the meantime the Eurozone rate has risen up to 12%. This is not at all surprising, given the almost complete flattening off of aggregate demand in the Eurozone—this means a constantly-widening gap with the pre-recession trend (something like 20% below it now).

Although intuitively we’d expect expectations to steadily adjust to the new likely schedule, three factors mean this takes a while: firstly the ECB is very unclear about what it is going to do (and perhaps unsure itself), secondly some plans are set over long horizons, and thirdly the lacklustre central-bank response to the 2007-8 financial crisis is unprecedented in the post-war period.

1. We have a huge literature on the costs of policy uncertainty—the variance of expected outcomes has an effect on firms’ willingness to hire, invest, produce, independent of the mean expected outcome.

2. Many firms invest over long horizons. It may have become clear at some point in 2011, when the ECB raised interest rates despite the ongoing stagnation and weak recovery, that the macro planners, in their wisdom, were aiming for a lower overall growth path and perhaps a lower overall growth rate in nominal variables. And so, after 2011 firm plans started to adjust to this new reality. But many plans will have been predicated on an entirely different 2009, 2010, 2011, 2012, 2013, 2014, and so on. And as mentioned before, the gulf between what was expected for the mid-2010s back in 2007 and what actually happened is actually widening.

3. Thirdly, and finally, the period 2008-2010 is unprecedented and will have slowed down firm adjustment substantially. As mentioned above, even if firms set plans with a fairly short-term horizon (a few years) they wouldn’t have been able to adjust to the new normal in 2008, 2009 and 2010 unless they really expected the ECB’s policy of not only not returning to trend level, but not even return to trend rate!

All of these three issues are convincingly resolved by nominal income targeting. It’s very certain—indeed the best version would have some sort of very-hard-to-stop computer doing it. It promises to keep up to trend. And it is very stable over long horizons.

Recent evidence reinforces the view, implicit in our models, that (unconventional) monetary policy is highly effective at the zero lower bound, even through the real interest rate channel (!) All the ECB needs to do is announce a nominal income target.

*This reminds me: isn’t it about time we had an NGDP futures market so we could make claims here with any kind of confidence?

QE boosts equities by boosting fundamentals

Many people suggest that the recovery in equity prices since 2009-2010, seen around round the world but particularly in the American NasdaqS&P500 and DJIA, does not represent a general economic improvement. Instead, they believe that these numbers are simply being buoyed by new money pumped into the system. I don’t think this argument holds, and I will attempt to explain why.

First let’s consider why we think people hold equities. Essentially, people hold equities because they expect a given real return for a given risk profile. In our simplest model, people hold portfolios of assets based on their risk tolerance, their subjective judgements over probabilities, and their preferences. Adding in banks, insurers, pension funds and so on makes the overall picture more realistic, but doesn’t change our theory much. People pick financial intermediaries that hold the assets according to our preferences—the intermediaries add value through scale, or through providing a payments system and settling accounts.

Why might electronic money printing (which we call “quantitative easing” or QE) affect equity prices?

Well, firstly, we might not expect an effect from quantitative easing under one circumstance. QE increases the amount of narrow money we have—that is the number of notes, coins and bank reserves in the system. Generally we think broad money—which includes bank accounts people can debit or write checks on, and is much, much larger—is what interacts directly with the real economy. The ratio of broad money to narrow money is called the money multiplier, and usually a rise in narrow money leads to an even bigger rise in broad money—but this multiplier is not stable. It’s at least possible (although not historically typical) that a rise in narrow money could be completely counteracted by a fall in the money multiplier.

But assuming this doesn’t happen, there are three reasons why QE might boost equity prices. First would be because it increases inflation and the future price level. If prices rise, cash is worth less, so relative to a given nominal amount of cash, all things being equal a given equity is worth more. In other terms, the firms’ nominal expected returns would rise.

The second reason is that in a depressed economy monetary easing like QE may boost real growth, which we would expect to raise any given company’s expected real returns. It might also reduce the risk of very bad economic outcomes. Since equities are riskier than bonds, gilts and cash they pay a risk premium to those who hold them—a higher return (lower price) to compensate for this. If risky outcomes in general become less likely, these risk premia might narrow, making equities more desirable and expensive.

The third reason QE might raise stock prices is because it increases overall social wealth, and thus may lead to greater risk-tolerance overall, if people are willing to bear more risk as they get wealthier, and thus shift towards riskier assets like equities.

In each of these three, the jump in equity prices comes from fundamental factors. One could certainly drive up stocks by creating lots of inflation, but we can easily check if that’s what’s happening by looking at inflation. Any real/relative growth in equities would refute that explanation. In contrast, real growth, reduced risk and shifted preferences due to extra wealth are all legitimate reasons for higher equity prices.

Accounts of why QE buoys stocks without improving fundamentals (and hence part of the argument that stock indices are not good proxies for economic health) tend to rely on a narrative that QE “flows into equities”. But as explained, people try to hold their wealth in the portfolio that fits closest to their preferences. If QE money did “flow into equities” then people would now be holding more of their wealth in stocks than they wanted to—they would rapidly rebalance their portfolio. Typically people needn’t even do this themselves, because their pension fund will do so for them. QE has to improve the fundamental factors in order to boost equities.

What’s a neutral monetary policy?

The Federal Reserve Bank of Richmond alerted me to a newish paper from one of my favourite economists, Robert Hetzel, entitled “The Monetarist-Keynesian Debate and the Phillips Curve: Lessons from the Great Inflation”—needless to say it’s highly interesting and informative. One bit in particular prompted me to write this screed on neutrality in central banking and monetary policy.

In the Keynesian tradition, cyclical fluctuations arise from real shocks in the form of discrete shifts in the degree of investor optimism and pessimism about the future large enough to overwhelm the stabilising properties of the price system and, by extension, to overwhelm the monetary stimulus evidenced by cyclically low interest rates.

In the quantity theory [monetarist] tradition, cyclical fluctations rise from central bank behaviour that frustrates the working of the price system through monetary shocks that require changes in individual relative prices to reach, on average, a new price level in a way uncoordinated by a common set of expectations.

In the real-business-cycle [new classical] tradition, cyclical fluctuations arise from productivity shocks passed on to the real economy through a well-functioning price system devoid of monetary non-neutralities and nominal price stickiness.

From each of these perspectives, we can derive some sort of definition of monetary/central bank neutrality, as well as an idea of what policy the central bank should operate. It strikes me that only one view is plausible, but before I make the case for that view, I will make the case for a particular theory of “meta-neutrality”, i.e. a way that we should think about neutrality, whatever our perspective. I think this is something that everyone should be able to agree on, but I think that once we’ve agreed on it one view becomes inescapable.

Nothing is neutral with respect to everything. In one of my favourite ever essays, Scott Alexander makes a very similar point about “safe spaces” (nothing can be a safe space for everything—safe spaces for, e.g. a safe space for a disadvantaged group cannot also be a safe space for no-holds-barred rational discussion). In the same way, a monetary policy that is neutral with respect to real interest rates might conceivably have to achieve this by non-neutrality with respect to say, exchange rates. So the interesting question is what economic variables monetary policy must be neutral with respect to for us to call it “neutral” with no qualifiers.

But what we really want to be neutral to is the microeconomic working of the price system and markets generally, which is a bit more complex than any particular macroeconomic variable we could point to. One way around the question is by thinking about what might be non-neutral to the workings of the price system. One answer is: menu and shoe-leather costs, typically associated with high inflation, but more accurately linked to high aggregate demand (nominal GDP) growth.

Both impose restrictions on price adjustment, especially if they are unexpected and hence not “priced in”.Menu costs will stop firms re-pricing things as often as would be optimal, impeding price adjustment, whileshoe-leather costs (from the high nominal interest rates associated with high inflation and high NGDP growth) will stop people from holding as much cash as they otherwise would, distorting their consumption decisions.

On the other side, unexpectedly low NGDP growth, combined with “money illusion” in borrowers (“sticky debts”) and workers (“sticky wages”), could cause other microeconomic problems—markets won’t clear until people’s information, expectations and plans have adjusted, i.e. until people realise that the fall in prices/wages is not a relative price adjustment but a fall in overall prices/NGDP.

Overall this suggests we should call a policy neutral without qualifiers not when it is perfectly neutral (which is impossible) but when it is the “neutrality maximising policy”. In the words of David Beckworth “neither too stimulative nor too contractionary and is pushing the economy toward its full potential” or in the words of Alan Greenspan one that “would keep the economy at its production potential over time”.

That is, one that balances the distortionary costs of high (particularly unexpectedly high) NGDP growth with the costs of low (particularly unexpectedly low) NGDP growth. Empirically, menu cost and shoe leather problems have never been large in the USA and UK when NGDP is ticking along at about 5%. By contrast, NGDP growth less than 2.5% is almost always consonant with stagnation, while NGDP growth of less than zero always means a recession—much bigger costs. This suggests policy, far from being unprecedentedly easy in the lacklustre post-recession recovery, was if anything on the tight side of neutral.

Two crucial final points:

1. Identifying the conditions that we’d want to see in the macroeconomy for a (relatively) undistorted microeconomy does not mean endorsing a particular monetary arrangement or regime. Whether we have a central bank or not, we’d want stable NGDP growth.

2. This 5% level is contingent on society-wide expectations. If long-term expectations held by borrowers, lenders, firms, consumers and workers were for 0% NGDP growth (e.g. the 19th Century), then 0% NGDP growth would be more likely to be the neutrality-maximising monetary policy.