These are challenging times for monetary economists like myself, what with central banks making one dramatic departure after another from conventional ways of conducting monetary policy.
Yet so far as I’m concerned, coming to grips with negative interest rates, overnight reverse repos, and other newfangled monetary control devices is a cinch compared to meeting a challenge that nowadays confronts, not just monetary economists, but economists of all sorts. I mean the challenge of getting one’s ideas noticed by that great arbiter of all things economic, Tyler Cowen.
Last week, however, Tyler may have given me just the break I need, in the shape of a brief Marginal Revolution post entitled, “Simple Points about Central Banking and Monetary Policy.”
Tyler’s “simple points” are these:
Central banks around the world could raise rates of price inflation, and boost aggregate demand, if they were allowed to buy corporate bonds and other higher-yielding assets. Admittedly this could require changes in law and custom in many countries[.]
There is no economic theory which says central banks could not do this, as supposed liquidity traps would not apply. These are not nearly equivalent assets with nearly equivalent yields.
Tyler isn’t one to traffic in banalities, so it’s no surprise that his claims are controversial. Why so? Because the prevailing monetary policy orthodoxy, here in the U.S. at least, insists that, rare emergencies aside, the Fed should stick to a “Treasury’s only” policy, meaning that it should limit its open-market purchases to various Treasury securities. For the Fed to do otherwise, the argument goes, would be for it to involve itself in “fiscal” policy, because its security purchases would then influence, not just the overall availability of credit, but its allocation across different firms and industries. So far as the proponents of “Treasuries only” are concerned, Tyler’s remedy for deflation would create a set of privileged or “pet” corporate securities, analogous to, and no less obnoxious than, the “pet banks” of the Jacksonian era.
All of which is good news for me, because I’m prepared, not only to side with Tyler in this debate, but to offer further arguments in support of his position. For I took essentially the same position in a paper I prepared for Cato’s 2011 Monetary Conference. In that paper, I first counter various arguments against having the Fed purchase private securities, and then proceed to recommend a set of Fed operating-system reforms involving broad-based security purchases. I figure that, with a little luck, Tyler may find those arguments and suggestions worthy of other economists’ attention.
Here is a quick summary of my paper’s arguments and suggestions.
Concerning the “pet corporate securities” argument, to give it that name, I find both it and the anti-Jacksonians’ original complaint against pet banks equally unpersuasive. If those state banks to which Jackson distributed government’s funds yanked from the second Bank of the United States were “pet banks,” just what, prey tell, was the B.U.S. itself while it held all of the government’s deposits, if not a single (and correspondingly more odious) government “pet”?
Likewise, if purchasing corporate bonds means favoring particular corporations, and venturing thereby into “fiscal” policy, isn’t “Treasuries only” not itself a means of shunting scarce credit to one particular economic entity — in this case, the federal government — at the expense of all the others? Is there not, indeed, something positively Orwellian about the suggestion that, by buying Treasury securities, the Fed steers clear of “fiscal” policy?
Though they never heard of Orwell, the Fed’s founders would certainly have considered such talk perverse. Far from seeing “Treasuries only” as a means for keeping the Fed and the fisc at arms length, they took precisely the opposite view: so far as they were concerned, to allow a central bank to purchase government debt was to risk having it become a tool of inflationary finance. Consequently they favored a “commercial paper only” rule, or rather a “commercial paper and gold only” rule, with a loophole allowing purchases of government paper only for the sake of stabilizing the Fed’s earnings at times of low discount activity. Like all loopholes in the Federal Reserve Act, this one was not left unexploited for long. Yet it was not until 1984 that the opposite, Treasuries only alternative took force. Nor is Treasuries only the rule elsewhere. The ECB, in particular, ordinarily accepts euro-denominated corporate and bank bonds with ratings of A- or better as collateral for its temporary open-market operations.
The operating system reform I recommended involved replacing both the discount window and the anachronistic and unnecessary primary dealer system with an arrangement resembling the Term Auction Facility (TAF) created in December 2007, at which the Fed auctioned off credit to depository institutions against the same relatively broad set of collateral instruments, including corporate bonds, accepted at its discount window. To assure competitive allocation of credit among bidders offering different types of collateral, the facility could make use of a “product-mix” auction of the sort Paul Klemperer developed for the Bank of England. To rule out subsidies and limit its exposure to loss, the Fed could also follow the Bank of England’s example by setting bid rates for the various types of eligible collateral, reflecting predetermined penalties or “haircuts.” Finally, to allow emergency credit to be supplied as broadly as possible, and therefore in a manner fully consistent with Walter Bagehot’s last-resort lending principles, the Fed could open its auction facility to various non-depository counter-parties, including money market mutual funds.
Besides making liquidity traps relatively easy to avoid, as Tyler suggests, adopting such an alternative system would have many other advantages. It would reduce the systemic importance of present primary dealers. It would guard against the risk of having the Fed gobble-up collateral that’s essential to private-sector credit creation. It would allow a single operating system to meet both ordinary and emergency demands for credit. Like the TAF, it would avoid the “stigma” of discount-window lending. In fact, it would dispense entirely with the need for direct lending to troubled financial (and perhaps some troubled non-financial) institutions. Most importantly, it would render any sort of ad-hoc central bank lending during financial crises otiose, and by so doing would bring the Federal Reserve System one step closer to being based on the rule of law, instead of the arbitrary rule of bureaucrats.
