July 14, 2009
Concerns about the Fed's New Balance Sheet
That's the title of a chapter I contributed to a new book edited by John Ciorciari and John Taylor entitled The Road Ahead for the Fed. The book grew out of a conference held at Stanford University in March.
In my chapter (a draft of which can be obtained here), I review the mechanics of what the Fed has been doing with its balance sheet, and then raise three concerns. One of my concerns is that the Fed's new balance sheet has compromised the independence of the central bank:
The decision of where public funds are best allocated is inherently political. Any risks on the Fed's new balance sheet are ultimately borne by the taxpayers. The U.S. Constitution specifies that decisions of how public funds get spent shall be up to Congress, and with good reason. Citizens have a right to vote on which risks they choose to absorb. And of course there are powerful established interests with views on which sectors should receive an infusion of public capital. The Fed is simply being naive if it thinks it can become involved in those decisions on a weekly basis and yet still retain its independence from Congress and the President.
The reason I find that loss of Fed independence to be a source of alarm is the observation that every hyperinflation in history has had two ingredients. The first is a fiscal debt for which there was no politically feasible ability to pay with tax increases or spending cuts. The second is a central bank that was drawn into the task of creating money as the only way to meet the obligations that the fiscal authority could not. Every historical hyperinflation has ended when the fiscal problems got resolved and independence of the central bank was restored.
Surely it is not far-fetched to suggest that the U.S. faces a profound political challenge in using spending cuts or tax increases to meet its current and planned fiscal obligations. Here's an observation that brought that reality home to me on a personal level: in fiscal year 2006, receipts collected by the U.S. federal government from personal income taxes totaled $1.06 trillion. Thus, to a first approximation of what an extra trillion dollars in taxes would mean for me personally, I just take the number I paid in 2006 and double it. And then I ask myself, how likely is it that Congress would actually do such a thing? With budget deficits in excess of a trillion dollars annually for the foreseeable future, it seems we are already well past the point at which the ability of the Treasury to fund the expanded liabilities through tax increases would reasonably be questioned.
Moreover, the detailed cooperation between the Fed and the Treasury in the various new credit measures seems to have arisen from precisely such pressures. Congress is, in fact, unwilling to accept explicitly the risks to which taxpayers are exposed as a result of the many new Fed-Treasury initiatives. If I were the chair of the Federal Reserve, I would want to be asking, "why was I invited to this party?" The answer unfortunately appears to be, "because you're the one with the deep pockets." That the Fed should find itself in a position where Congress and the White House are viewing its ability to print money as an asset to fund initiatives they otherwise couldn't afford is something that should give pause to any self-respecting central banker.
The book also includes a chapter by Donald Kohn in which the Fed's Vice-Chairman responded to some of these concerns. Here is what Kohn had to say about Fed independence:
Have we compromised our independence? No. Central banks all over the world and the legislatures that created them have recognized that considerable independence from short-run political influences is essential for the conduct of monetary policy that promotes economic growth and price stability. To be sure, in the process of combating financial instability, we have needed to cooperate in unprecedented ways with the Treasury. Our actions with the Treasury to support individual systemically important institutions have sparked intense public and legislative interest. As Chairman Bernanke has indicated, the absence of a regime for resolving systemically important nonbank financial institutions has been a serious deficiency in the current crisis, one that the Congress needs to remedy. Congress and the public, quite appropriately, want to know more about lending programs that have greatly increased the scope and size of the Federal Reserve's interventions in financial markets, and we will give them that information. In addition, our country, like others, is undertaking a broad examination of what changes are needed in our financial regulatory system. This examination will consider the role of the Federal Reserve in the supervision and regulation of financial institutions and the advantages and disadvantages of establishing a systemic risk authority.
It is natural and appropriate for our unusual actions in combating financial instability and recession to come under intense scrutiny. However, increased attention to, and occasional criticism of, our activities should not lead to a fundamental change in our place within our democracy. And I believe it will not; the essential role for an independent monetary policy authority pursuing economic growth and price stability remains widely appreciated and the Federal Reserve has played that role well over the years. The recent joint statement of the Treasury and the Federal Reserve included an agreement to pursue further tools to control our balance sheet, indicating the Administration's recognition of the importance of our ability to independently pursue our macroeconomic objectives.
My chapter also discusses two other concerns about the Fed's new balance sheet. The first is whether, insofar as the goal is to allocate capital to particular targeted categories, the Fed and Treasury have formed the correct vision of what we really want capital markets to be doing at the moment. A second concern is that the Fed's new balance sheet has handicapped the Fed's ability to fulfill its primary mission of promoting price stability. Specifically, I worry that the Fed's new actions have made it harder both to avoid deflation and to assure the public that the Fed will prevent a resurgence of inflation.
The book also includes contributions from a number of other prominent individuals. I particularly recommend the thoughtful analysis by Andrew Crockett (president of J.P. Morgan Chase International) on whether the Fed is the logical institution to be given broader regulatory functions given the desirability of maintaining central bank independence.
Posted by James Hamilton at July 14, 2009 09:08 PMdigg this | reddit
"The U.S. Constitution specifies that decisions of how public funds get spent shall be up to Congress..."
BINGO! What the Fed is doing is unconstitutional. The problem is that our congress is either not bright enough or not courageous enough to actually take back their OWN power.
And by the time they do it may be too late ...lord knows what kind of toxic garbage the Fed bought with our money ...or who they even bought it from ...or if they can ever unwind this mess! What is happening is an OUTRAGE and I thank you for being one of the few to comment...
Posted by: Jim Hancock at July 14, 2009 10:55 PM
"The reason I find that loss of Fed independence to be a source of alarm is the observation that every hyperinflation in history has had two ingredients. The first is a fiscal debt for which there was no politically feasible ability to pay with tax increases or spending cuts. The second is a central bank that was drawn into the task of creating money as the only way to meet the obligations that the fiscal authority could not."
seems like this is exactly the solution Bernanke is advocating:
Posted by: GreenAB at July 15, 2009 12:03 AM
Very thoughtful post. There is an old saying that "there is no problem when there's no problem".
What Dr. Kohn seems to be saying is "We were in a crisis so we did what we had to. Now we are telling Congress to take this off our plate." However, as you say:
"And then I ask myself, how likely is it that Congress would actually do such a thing? ... Congress is, in fact, unwilling to accept explicitly the risks to which taxpayers are exposed as a result of the many new Fed-Treasury initiatives."
In other words, Congress is long a sort of option, and the Fed is short that option. The Fed is perhaps trying to close that position, but since it has value Congress is not going to do that willingly.
Posted by: Robert Bell at July 15, 2009 05:22 AM
You comments are very important and I fear - becuase no one will listen to the warning - are more predictions of our future than prescriptions to cure our ailments.
Kohn's comments actually contain a number of oxymorons.
Kohn writes, "Central banks all over the world and the legislatures that created them have recognized that considerable independence from short-run political influences is essential for the conduct of monetary policy that promotes economic growth and price stability." If monetary policy is mandated to "promote economic growth" then the central bank will always be pulled into an unholy alliance with the Executive that will spend and spend in a futile attempt to achieve "economic growth" through monetary policy. In other words it is impossible for the CB to be independent with such a mandate.
Another oxymoron from Kohn is, "...increased attention to, and occasional criticism of, our activities should not lead to a fundamental change in our place within our democracy." Most central banks are far removed from the democratic process so to speak of its place in "our democracy" is almost cynical. How many of us voted for Ben Bernanke, and who many have the ability to vote him out?
A central bank as envisioned by Alexander Hamilton can be a great tool in maintaining monetary stability, but the modern central banks create havoc at every turn with their incessant monetary manipulations.
Posted by: DickF at July 15, 2009 06:07 AM
Thanks, Professor, for joining the fight to corral The Fed.
Me, I hope, and think, we will end The Fed.
But, a tightly leashed Fed -- not creating credit bubbles, not trying to bail out its bankster owners via taxpayer funds and commitments -- works for me as an alternative.
Go get 'em, sir!
Posted by: jg at July 15, 2009 08:25 AM
We are simply moving towards a "command economy". The Federal and public's deficits are too large relative to the savings available in the market place.
Credit allocation will become ever more targeted.
The FED doesn't have near enough power. It's power should be commensurate with it's responsibilities.
Regulatory and supervisory decision-making processes should lie entirely with the Board of Governors, and that the Board should be reconstituted to include the Secretary of the Treasury, the Comptroller of the Currency, the Chairman of the Federal Home Loan Bank Board, the Director of the Federal Deposit Insurance Corporation, the Director of the Office of Thrift Supervision, the National Credit Union Administration, the Securities Futures Commission, and the Chairman of the Securities and Exchange Commission, etc.
Posted by: flow5 at July 15, 2009 09:09 AM
I disagree with the following explanation in your chapter, which I'll quote in full:
"Nevertheless, it was still the intention of the Fed that these operations should not affect the total currency in circulation. The Fed took two steps to prevent any consequences of the new facilities for the total quantity of currency in circulation. The first action was to request that the Treasury borrow some funds directly and simply leave the funds deposited in an account with the Fed. This operation by itself would have been equivalent to an open-market sale of Treasuries by the Fed. When the buyer of the T-bill delivers funds to the Treasury's account with the Fed, those reserves are drained back out of the private banking system. The reserves so drained by the Treasury accounts (which totalled $256 billion as of March 25) were in fact the same reserves created by some of the Fed's new facilities. To fund the rest of the expansion of the Fed's assets without impacting the volume of currency held by the public, the Fed adopted a policy of promising to pay the same interest rate on reserves as its target for the fed funds rate itself. In effect, this makes reserve deposits (now an interest-bearing liability of the Fed) similar to T-bills themselves (an interest-bearing liability of the Treasury), and potentially eliminates the need to get the Treasury involved in raising the funds needed for the assorted new Fed facilities. Given that lending reserves to another bank on the fed funds market involves some risk, whereas simply holding them as deposits with the Fed does not, paying interest on reserves greatly increases the demand for reserves. Indeed, most of the new reserve deposits created by the Fed ended up simply being held as excess reserves, the magnitude of which was $818 billion as of March 25. As a result of the Treasury borrowing and ballooning excess reserves, the more than doubling in the size of the Fed's balance sheet has so far had limited effect on the total currency in circulation."
I don't understand why you focus centrally here on the issue of currency in circulation. The primary point is the level and characteristic of excess reserves and the effect that might have on commercial bank balance sheet and deposit expansion. Accordingly, the initial mechanism was the prevention of excess reserve build up by Treasury's issuance of bills and deposit of money at the Fed instead. The follow up mechanism was the payment of interest on reserves, which discourages "overzealous" commercial bank balance sheet expansion and conversion of excess reserves to required reserves. Undesirable increases in currency in circulation would only be a proportionate issue relative to the undesirable expansion of bank deposits. I think the focus on currency is potentially confusing and misleading.
And later you say:
"We arrived at the current situation because the Fed was deliberately trying to insulate any consequences of its actions for the quantity of currency in circulation."
Posted by: JKH at July 15, 2009 09:48 AM
I read through your paper at lunch and it is both profound and courageous. You are laying it out for anyone with eyes to see.
This paragraph is by far the most important.
We thus find ourselves in a situation where half the public fears we're about to experience a severe deflation, and the other half believes we're about to experience an unstoppable hyperinflation. While the powers of a central bank are fundamentally limited, the destabilizing consequences of such fears should be the one thing that the central bank unambiguously has the power to prevent. What we need above all else in the current situation is a Federal Reserve on which the world can count as a bulwark of stability, and the dollar itself as an asset of reliable value.
I have just completed the newly released version of Roy Jastram's The Golden Constant with an update by Jill Leyland for the period after Jastram ended in 1976. The most profound thing about this book is that while commodities might inflation or deflation they always were pulled back to the gold price level under a gold standard. What Jill Leyland demonstrates is that now that we have a floating currency gold actually fluctuates with the value of the dollar but commodities still center around gold.
Gold seriously is a constant when it comes to monetary policy. This is where the FED should be. Since the world has floated currencies we have had horrible inflation and Leyland breaks this into two periods, the 1970s and our current time. Since the currencies were floated the only period when there was any real stability was the period when Greenspan actually targeted the price of gold. Greenspan left gold as a target (it is reported he was convinced by Bernanke but I have not verified that claim) in the mid-1990s and that is when the currency returned to instablity.
Posted by: DickF at July 15, 2009 10:03 AM
In desperate time the Constitution really seems to read like a suggestion box. Bush ignored it, as far as I can tell Congress is unaware of its existence, and even though its written in (for the most part) clear terms, people still argue like hell over it.
I like what the Fed has been doing, but when this all turns around all of the excess power they've been granted should be immediately stripped. The interest rate is a strong weapon against recessions, one that is proven to work, and it should be trusted except in times of economic disaster.
Posted by: Dave at July 15, 2009 10:44 AM
""The U.S. Constitution specifies that decisions of how public funds get spent shall be up to Congress..."
BINGO! What the Fed is doing is unconstitutional. The problem is that our congress is either not bright enough or not courageous enough to actually take back their OWN power."
Congress also has the power to distribute the power to distribute pubic funds. Or do you think that every screw and nail the US government buys is quantified in a Congressional mandate?
In any case, the Fed's funds aren't 'Public Funds'.
Posted by: Anonymous at July 15, 2009 11:06 AM
RE the paragraph DickF cites -
Where does this power come from? If the Fed is trusted to keep future inflation in check, it fosters current deflation. As Krugman points out, to fight deflation from a liquidity trap, the Fed has to convince people it will be a bit irresponsible in combating future inflation. Doing this without getting actual inflation seems like a hard trick to pull off. I am doubtful that BB could do it successfully, and I can't see where he has the power to convince me that he can.
Posted by: don at July 15, 2009 11:29 AM
The saying "Power corrupts and absolute power corrupts absolutely" is ringing through my ears. Fed's days are numbered but it will be a daunting challenge. All that is known - the current system either needs some serious financial Darwinism or complete revolution.
Posted by: Vintage Filings at July 15, 2009 11:50 AM
Haven't read the rest of the chapter but I agree full heartedly on what the professor said here. In fact, there are still two empty seats on the BOG. Maybe Jim would be interested in the job?
By the way, that idea about Fed issuing its own currency mentioned in Kohn's comments seems dead -- the Fed doesn't want to open the door for the Congress for further scrutiny. But the Fed still lobbies hard for the systemic risk regulator's job, which is likely to impaired its independence further, I think.
Posted by: Pat at July 15, 2009 12:33 PM
Paul McCulley's (PIMCO) July "Global Central Bank Focus" doesn't directly address the Fed's independence, but his analysis does shed light on Bernanke's policy tilt in dealing with a deflationary liquidity trap. McCulley points out:
". . . he (Bernanke) advocated explicit cooperation between the fiscal authority and the monetary authority, with the latter subordinating itself to the former."
Global Central Bank Focus
Paul McCulley | July 2009
. . . Professor Bernanke became Fed Governor Bernanke the prior year, making his most famous speech in November 2002, �Making Sure �It� Doesn�t Happen Here,� detailing the Fed�s anti-deflationary toolbox. That�s the speech that the markets are using as a roadmap for Chairman Bernanke�s present anti-deflation policy path (it�s actually been quite a good roadmap!). But a speech in May 2003, �Some Thoughts on Monetary Policy in Japan,� is equally important, I think, because it provides a roadmap for what the Fed might do if present anti-deflation policies prove to be inadequate to the task. . . he (Bernanke) advocated explicit cooperation between the fiscal authority and the monetary authority, with the latter subordinating itself to the former. . .While the passage on this topic in Bernanke�s speech is a bit long, it is so powerful that I think it deserves a full hearing. Here it is:
�My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt � so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.
Under this plan, the BOJ�s balance sheet is protected by the bond conversion program,7 and the government�s concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but � because the BOJ purchased government debt in the amount of the tax cut � no current or future debt service burden has been created to imply increased future taxes.
Essentially, monetary and fiscal policies together have increased the nominal wealth of the household sector, which will increase nominal spending and hence prices. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about �broken� channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank �lacks the tools� to reach a price-level or inflation target. Isn�t it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ�s purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan�s fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.
Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ�s purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public�s expectations of future tax obligations.
Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government�s fiscal position.�
Posted by: Ted at July 15, 2009 02:47 PM
Great post as usual. Re: the prof's remark about the extra trillion dollars doubling the prof's taxes, three questions: a) what is our horizon, b) how much of this taxation is feasible by leaving the median taxpayer and below untouched, and c) what is income effect of the deficit?
Posted by: venky at July 15, 2009 04:45 PM
Small deflation and small inflation is not a problem. If the economy rights itself within this year, the fears stated above will disappear.
What is disturbing me is the consensus among the major players today that : 1) stabilizing the financial system is the first priority; and 2) correcting past mistakes is not the way to stabilize the financial system.
We know the major financial institutions created our current problem. Instead of being punished for their mistakes, they are being rewarded. Corporate profits for the first quarter of 2009 were a positive 114 billion for domestic financial institutions. That is money given to these institutions by agencies of the Federal government. In the previous quarter, before the "rescue" by the Federal government they lost 179 billion.
Comperable data for nonfinancial domestic corporations show a loss both quarters - 89 billion in 2008IV and 49 billion in 2009I.
Stability can also be achieved by forcing firms to live with their losses and thereby reducing competition and reducing the size of the financial sector to a level appropriate to that needed to serve the rest of the economy.
Some of us will not trust any person in political leadership positions who makes no effort to thwart the drive for power exhibited by the financial sector.
Goldman Sacks recently reported profits shows that not all financial firms were at risk in 2008 and that Paulson and Bernrnake could have let more firms fail without all firms failing.
Posted by: ReformerRay at July 15, 2009 06:46 PM
The numbers quoted in my previous comment are numeric change from the last quarter rather than totals.
Sorry for the mistake. The 114 billion reported for financial firms in 2009, first quarter, are the change from the profit level reported in 2008IV.
Posted by: ReformerRay at July 15, 2009 06:51 PM
Many have mentioned a "deflationary liquidity trap." This may be one of the most destructive Keynesian ideas ever foisted on an economy. What this actually says is that if you attempt to save to buy something that requires more than one pay check then the government will tax away your savings and spend it. By saving to buy the bigger product you are harming the economy and the government has to step in, take your money then spend it for you.
The whold idea of the government fighting against a "deflationary liquidity trap" fosters just the problem we have today, overconsumption. There is no doubt that we had a real estate bubble and it was created by overconsumption such that false signals were sent to the market leading to a glut of housing at inflated prices. The only way out of the crisis is to build up savings so that consumption can return to normal. But the government is racing headlong over the cliff of massive consumption stealing savings and preventing the young couple from saving to buy that new home.
Keynes is a live and well in Washington DC and he is eating the seed corn faster than it can be stored. The idea of preventing a "deflationary liquidity trap" is an illusion used to waste scarce resources or more cynically to give to politically connected corporations like Goldman Sachs.
Posted by: DickF at July 16, 2009 06:17 AM
My concern is with the long-run financial health of the nation and it's capacity for meeting the legitimate needs of its citizens. Every nation,like individuals and business, has a maximum capacity to carry debt and tax it's citizens. These limits should not be exceeded, and a responsible government will operate below a substantial reserve relative to these limits. Violation of this principle will lead to financial distress. Early indicators will include rising interest rates and sovereign credit downgrades. As the crisis intensifies creditors may refuse to refinance the debt. The threat of insolvency will lead to a currency crisis.The financial distress will cause tremendous social problems as the nation runs out of options to handle its financial problems. Deadlock in government becomes the norm. This scenario may not be as far-fetched as it seems. You know the old adage "as California goes, so goes the nation". California is a good example. It appears to have reached it's maximum debt capacity and its limiting ability to tax it's citizens. Financial distress is self-evident and it's ability to govern questionable. So where does the Fed fit in to this scenario. At the very least, they should not contribute to the problem. I worry about the Fed maximising short-term goals while 'kicking the can down the road".
Posted by: fwm at July 17, 2009 07:18 AM
A Fed that has not shown much independence is more likely to succumb to the short-term political pressures of the day. A Fed whose vision of Fed policy is to subordinate itself to administration goals, is very troublesome.
Posted by: fwm at July 17, 2009 08:04 AM
Where is 'Old Hickory' when you need him? The fact that Jackson's face is on the $20 federal reserve note, the most-used, must have him spinning in his grave. We need an Old Hickory to kill the Fed. Fed gone. market demand sets interest rates and money supply. Problem solved.
Posted by: Keith at July 17, 2009 07:53 PM
Be careful of what you wish for. Andrew Jackson destroyed the 2nd National Bank, but that freed his "pet" state banks to issue currency with abandon. inflation and monetary collapse spread through the western states. Jackson has created the biggest inflation our country had ever experienced. Then with the stroke of a pen, the Specie Circular, he brought the whole thing down on the heads of the American people a precipitated the greatest economic collapse our nation had experienced. The decline lasted after he left office and was still being felt after his death.
Jackson fell prey to monetary ignorance combined with political hubris (sound familiar Obama?) A constant currency is a good thing and a currency anchored to gold achieves that goal. A wildly fluctuating currency is the most destructive thing in an economy because economic transactors cannot rely on decisions. They make a decisions based on the rules of today then wakeup tomorrow and the world has changed. The result is short-term limited investment with much capital sitting idle.
Posted by: DickF at July 18, 2009 05:00 AM
It's maybe idle but still interesting to speculate on what the fallout will be for the Fed as an institution as the consequences of this episode of rapid money creation play out. The question is a bit clouded by the fact that, however formally independent the Fed is, Bernanke seems to be convinced that the crisis obligates him to fully cooperate with the administration as if he were part of it. As unintended consequences appear I expect the relationship will sour fast, and I suspect the Fed will lose much of its formal independence.
Posted by: Tom at July 20, 2009 03:49 PM
"..in fiscal year 2006, receipts collected by the U.S. federal government from personal income taxes totaled $1.06 trillion. Thus, to a first approximation of what an extra trillion dollars in taxes would mean for me personally, I just take the number I paid in 2006 and double it. And then I ask myself, how likely is it that Congress would actually do such a thing? With budget deficits in excess of a trillion dollars annually for the foreseeable future, it seems we are already well past the point at which the ability of the Treasury to fund the expanded liabilities through tax increases would reasonably be questioned."
Isn't this a little bit alarmist? Yes, deficit spending is a concern and one that seems widely acknowledged. But this year's and next year's deficits are partly due to greatly depressed economic activity which have reduced receipts, and partly from a temporary stimulus package of nearly 800 billion. These temporary factors account for more than half our current deficit. But you write as if these temporary phenomena are permanent.
I'm not worried about hyperinflation. Nor is the market. Deflation still seems the larger and more tangible threat to our economic lives. I don't see how inciting fear of hyperinflation helps the situation.
All that said, Fed independence is important. I do wish Congress would stop giving Bernanke such a hard time. He's more a public servant than any of those hacks on the Hill.
Posted by: mike at July 22, 2009 05:31 AM