Comments Before International Strategy and Investment Group’s
Inaugural Macro Conference
May 14, 2008

Thank you, Tom, for your kind invitation to speak at ISI’s Inaugural Macro Conference. It is an honor to be here, and especially an honor to appear on the same stage as Vince Reinhart. Your timing is spot on, Tom, and when it comes to thinking and talking about monetary policy, these are intensely interesting times, which I believe warrant the label of watershed.

Conventional wisdom holds that while fiscal policy should be made directly by democratically-elected legislators, monetary policy should be made by technocrats nominated by the democratically-elected president, and confirmed by democratically-elected legislators. The rationale for this conventional wisdom is that democratically-elected leaders inherently are given to inflation proclivities, giving to the citizenry more than it is willing to tax the citizenry and running perpetual budget deficits that would be monetized, if such leaders kept monetary policy decisions to themselves. Thus, it is argued, democratically-elected leaders are doing the citizenry a huge benefit by bestowing operational political independence to the Federal Reserve, essentially protecting themselves – and, thus, the citizenry –  from their inflationary selves.

There is a great deal to be said for conventional wisdom on this front. I have zero doubt that policy and operational independence for the monetary authority is a bulwark against inflation over the long run. I support it. At the same time, I think conventional wisdom is too dogmatically religious about this. The Fed is, in fact, a political institution, as the legislative branch delegates to the Fed its constitutional right to “coin money (and) regulate the value thereof.” Thus, the Fed is a legislated monopoly, given the legal power to issue liabilities on itself at a zero interest rate and buy interest-paying assets on the other side of its balance sheet.

What a wonderful business, I’ve long thought. But alas, I can’t enter the business, because it would be illegal. And even if it weren’t, I still would have a struggle, because no one would want to hold my zero-interest paper liabilities. The Fed doesn’t have to worry about that because its paper liabilities – currency in circulation and bank reserves – are supported by law. The currency of the United States is defined by law as “legal tender for all debts, public and private.” Regrettably, I don’t think the public would consider any currency I might issue to be nearly so valuable.

Legislation similarly creates statutory demand for bank reserves – called reserve requirements on depository institutions. Thus, the Fed is indeed in a really cool business – it pays nothing on its liabilities, yet the public and the banking system must hold such liabilities.

In turn, it is useful to think of the Fed as being owned by the citizenry. To be sure, it is technically owned by its member banks. But that is a technicality without substance. We the people own the Fed because we the people, through our democratically-elected representatives, bestowed something very valuable to the Fed. Indeed, there is a simple measure of just how valuable in traditional “profit” terms the Fed’s franchise is: the amount of “profits” that the Fed makes, which it must by law return to the U.S. Treasury, is displayed in the graph below.

Wow, $40 billion plus, you say. How does the Fed make all that money? Very simple: its pays no interest on its liabilities, while it receives interest on its assets, notably holdings of U.S. Treasury debt and loans at its discount window (as well as all the other lending facilities opened since last year). Thus, the Fed is – mechanically if not by statute – a subsidiary of the United States Treasury, which implements the expenditure and tax legislation of the Congress.

Accordingly, the Fed is a quasi fiscal policy institution. Conceptually, it could simply print up money unlimitedly to buy the debt issued by the Treasury. As a legal matter it cannot, because Congress enacted legislation that prohibits the Fed from buying debt directly from the Treasury (except for rolling over maturing debt).  The Fed can grow its balance sheet only by buying Treasury debt in the secondary market or making loans through its lending facilities.

And under the law, the Fed is ordinarily prohibited from lending to any institution that doesn’t hold reserve deposits at the Fed. But there is one huge, huge exception: Section 13(3) of the Federal Reserve Act of 1932. Here’s what it says:

“In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.”

The provision provides for the Fed to explicitly act as fiscal authority, lending to anybody against anything, as long as five governors declare the need for such lending to be the result of “unusual and exigent circumstances.” The power granted to the Fed by this law sat unused for over 75 years. And then it was used the weekend of March 14-16 to facilitate the rescue of Bear Stearns and to open the Primary Dealer Credit Facility to investment banks – who don’t hold reservable deposits at the Fed and, thus, are not regulated by the Fed.

That was a watershed moment in U.S. monetary history. In particular, the $29 billion loan the Fed made to facilitate the Bear Stearns merger with JPMorgan was unambiguously a fiscal policy action. Don’t get me wrong here. I am not, like Vincent, criticizing the Fed for making this loan, or for opening the Primary Dealer Credit Facility for investment banks.

I think it was the right thing to do at the time; in fact, I think it was the only thing to do at the time. To be sure, I wish, as surely the Fed wishes, that circumstances had not reached such an “unusual and exigent” state. But the fact of the matter is that the weekend of March 14-16 unambiguously fit that description. And in the wake of that, if the Fed ultimately recovers less than $29 billion from the collateral it accepted from Bear Stearns (with JPMorgan taking the $1 billion “first loss” tranche of the total $30 billion that was accepted, to be placed in a Delaware LLC), then the Fed will reduce the amount that it rebates to the Treasury by the amount of the shortfall.

That’s a bail out, my friends. Plain and simple. To be sure, Bear Stearns shareholders got only ten dollars a share; but Bear Stearns debt holders and counterparties were made completely whole by the transaction. That is a fiscal policy action in no less a way than when Congress facilitated the bailout of Chrysler many moons ago, by guaranteeing that company’s debt. Again, I’m not griping about what the Fed did. I support what the Fed did. I’m just stating the facts: it was a fiscal policy operation.

In turn, this operation makes it very legitimate to ask what other type of fiscal-policy actions the Fed might take on its own or be requested to take by Congress. In for a nickel, in for a dime, as we used to say during college poker games. The Fed never wanted to be here, but it is. That’s a fact.

And it fundamentally changes the relationship between the monetary authority and the fiscal policy authority – the Fed’s monetary policy will remain operationally independent, meaning that the Fed can set the Fed funds rate as it sees fit in the pursuit of its dual mandate from Congress to pursue both price stability and maximum employment. But in regulatory matters, as well as in the size and composition of the Fed’s balance sheet, the Fed will prospectively be a lot less independent than before the Bear Stearns episode.

I’m sure that the Fed hopes I’m wrong in this forecast, that its balance sheet genie can be put back into the no-credit-risk bottle. I doubt it, because Congress has now had a dramatic example of just how powerful that genie is. In a democracy, this is not all bad, in my opinion. And as a practical matter, I don’t think its all bad for the Fed, as an institution, either.

Post opening the discount window to the investment banks, regulatory arrangements will ineluctably change – it is simply untenable for the Fed to lend to someone that it doesn’t regulate. The Fed knows this and Congress knows it, too. Thus, while the Fed may have less independence over the composition and size of its balance sheet, the Fed will have greater leverage at this watershed moment to demand and get sensible regulatory reform, aimed at counter-cyclical, rather than pro-cyclical, constraints on leverage in the financial system.

And, in fact, I think there actually may be a silver lining in the Fed’s making more loans and holding less U.S. Treasury securities on the asset side of its balance sheet, even if Congress is given to more meddling. More loans will, by definition, give the Fed more power to shape the activities of those to whom it loans, similar to the relationship between Bank of Dad and my 19-year old son. 

Hyman Minsky addressed this issue over 20 years ago, and his wise counsel is even more important now than it was then, in the wake of the implosion of the Shadow Banking system and the extension of the Fed’s balance sheet to the biggest shadow banks of all, the investment banks. So let me close these remarks with what Professor Minsky had to say (my emphasis):

"Commercial bank reserves mainly result from the ownership of government securities by the Federal Reserve. The government security/open market technique of supplying reserves to the banking system is not the only way reserves can be furnished. Prior to the Great Depression, a major part of reserves that were not based on gold were based on borrowings by banks at the discount window. The resurrection of the discount window as a normal source of bank reserves is a way of tightening Federal Reserve control over commercial banks. If commercial banks normally borrow at the Federal Reserve discount window, they will necessarily accept and be responsive to guidance by the Federal Reserve.

As long as bank reserves are mainly the result of open-market purchases of government securities, the giant banks are virtually immune to Federal Reserve pressures. If normal functioning requires banks to borrow at the discount window, then the capital adequacy and asset structure of banks will be under Federal Reserve supervision. A shift to a greater use of the discount window as a normal source of bank reserves should diminish the destabilizing influences in our economy that are the result of too rapid an expansion of bank financing of business and asset holdings.”

The Fed addressed the Minsky Moment of the last year exceedingly well. Now is the time to adopt the Minsky Solution.

Paul McCulley
Managing Director
May 14, 2008