201812

December 20, 2018 9:25AM

The Fed’s LCR Reserve Requirement: An Ace up Its Floor‐​System Defense Sleeve

Among many other advantages it enjoys when it comes to influencing the course of monetary reform, the Fed has that of being able to shift the constraints that determine whether a proposed reform is or isn't possible. If existing constraints don't stand in the way of some reform Fed officials would rather not see happen, they can always put up a new one, tailor-made for the purpose.

The Fed seems prepared to do just that as part of its campaign to keep the "floor" system of monetary control it set-up in October 2008 around for good. Considering the floor system's many disadvantages compared to a "corridor" system, should the plan work we may all live to regret it. Those disadvantages include:

  1. A considerable increase in the share of financial-institution intermediated credit that gets shunted into the Fed's coffers;
  2. A moribund interbank fed-funds market, with correspondingly reduced incentives for interbank risk monitoring;
  3. A less-reliable monetary control mechanism, as evidenced by the failure of changes in the IOER rate to result in like changes in market-determined interest rates; and
  4. A Fed balance sheet made ripe for political abuse by the fact that it's size is no longer a determinant of the stance of monetary policy.[1]

For the most part, Fed officials have tried to justify the floor operating system by ignoring its shortcomings whilst harping on its supposed advantages, including the fact that it enhances banks' liquidity by encouraging them to stockpile reserves, and the fact that the new arrangement dispenses with the need for routine open-market operations.[2] Those officials are also inclined to avoid any public discussions of the topic, which, according to some press reports at least, is not to be among those addressed during the next summer's Fed outreach program aimed at gaining public input concerning the "strategies, tools, and communication practices it uses to pursue its mandate of maximum employment and price stability."[3]

But just in case these means for assuring the survival of the Fed's floor system should prove inadequate, Fed officials have an ace up their sleeve: if hard-pressed on the matter, they can insist that switching from the current system to a corridor system is, not just undesirable, but impossible.

How so? The argument has to do with Basel's LCR (Liquidity Coverage Ratio) requirements, first applied to U.S. banks in 2015. Those requirements call for banks to keep a substantial amount of  "High Quality Liquid Assets" (HQLAs) on hand at all times, with the precise proportion depending on the extent and volatility of banks' nonoperating wholesale deposits.[4] Because excess reserves qualify as HQLAs, banks have been able to use them to meet the LCR requirements. In contrast, the floor system's champions point out, switching to a corridor system would mean not having enough excess reserves in the system with which to meet those requirements.

The wrinkle is that, although excess reserves qualify as HQLAs, so do Treasury securities, Ginnie-Mae mortgage-backed securities, other non-MBS agency securities, and deposits at the Fed's Term Deposit Facility. Because the same Fed asset sales that serve to reduce the stock of excess reserves increase the outstanding supply of Treasury securities by a like amount, even an unwind complete enough to force a switch to a corridor system would leave the banks with all the HQLAs they need to meet their LCR requirements. And though banks would rather meet their LCR requirements with excess reserves than with Treasuries so long as excess reserves earn higher returns, as they did until recently, under a corridor system excess reserves would yield less then even the shortest-term Treasuries, so that banks would prefer Treasuries. In short, contrary to what some experts have claimed, Basel's LCR requirements don't in themselves mean that we're stuck with a floor system.

It's here that the Fed's special powers come into play. For although the published LCR requirements don't themselves make it necessary for banks to stock-up on excess reserves, the Fed has been bending the rules to change that. In a Bank Policy Institute Research Note published in late November, BPIs Bill Nelson explains how:

In principle…banks could hold Treasury securities rather than excess reserves to satisfy their LCR. However, while the LCR regulation treats reserves and Treasury securities the same, Fed supervisors have reportedly instructed banks through the examination process that they must hold a certain, not publicly known, fraction of their HQLA as excess reserves. The Fed's "LCR Reserve Requirement" creates an added function that only excess reserves will be able to satisfy.

Bill goes on to note how, when directly asked about this after a panel discussion at the Hoover Institution's May 4th, 2018 Policy Conference on "Currencies, Capital, And Central Bank Balances," Fed Vice Chair Randal Quarles "acknowledged that [Fed] supervisors have indicated to banks that there is an expectation that some HQLA be held in the form of excess reserves."[5] And if you think there's any difference between what Fed supervisors "expect" banks they supervise to do, and what those banks are bound to do to avoid getting in hot water, you don't know how bank regulation really works in this country![6]

If the Fed's extra-legal maneuvers somehow made either banks subjected to them or the general public better off, those maneuvers might perhaps be justifiable. But there's no good reason to think so. On the contrary: the written rules are more than capable of keeping banks adequately stocked with reserves, and would remain just as capable were the Fed to switch to a corridor system. Indeed, the U.S. is now among a small minority of advanced economies that combine LCR requirements with minimum statutory reserve requirements particularly aimed at guarding against reserve shortages. Relatively modest IOER payments, such as would be consistent with a corridor system, would suffice to keep banks from using "sweep" accounts to evade those reserve requirements, as banks tended to do when reserves bore no interest at all. Also, in a corridor system a revived fed funds market would usually be a reliable source of extra reserves to any subset of sound banks that needed them. Finally, because Treasuries can serve as collateral for secured overnight and term borrowing, solvent banks that used them to meet their LCR requirements could also turn to secured lending markets, or to the Fed's discount window, to make up for reserve deficiencies. In short, in treating Treasuries as equivalent to reserves for meeting banks' liquidity needs, the Gnomes of Basel have (for once) gotten things right.

Make no mistake, if Fed supervisors are prepared to stick their thumbs on the HQLA scale to compel banks to meet some of their LCR requirements using reserves rather than Treasuries, it's for one reason only: to allow Fed officials to claim, with implicit reference to their self-imposed constraint, that a floor system is the only monetary control game in town. Some people may call this clever strategizing. I call it abusing the Fed's supervisory powers for the sake of thwarting worthwhile monetary reform.

___________________________

[1] For more on these and other disadvantages of the floor system see my recent Cato book, Floored!: How a Misguided Fed Experiment Deepened and Prolonged the Great Recession.

[2] While it's pleasant for the New York Fed staff not to have to expend effort on managing routine open-market operations, whether the economies that this change is supposed to achieve will be realized through either a reduction in that staff or a corresponding increase in the quality or quantity of other Fed services remains to be seen. I, for one, am not holding my breath.

[3] According to a November 15th Bloomberg report, although "Virtually everything the Fed does in pursuit of its congressionally mandated goals will be on the table" during its summer policy review, which includes a June 2-4 "research" conference to be held at the Chicago Fed, "the review is not expected to include a look at how the Fed mechanically controls short-term interest rates, which is being discussed internally."

[4] Nonoperating wholesale deposits include any such deposits apart from those held for clearing, custody, or cash management purposes.

[5] The published version of Quarles conference remarks is here. The full transcript, including the referred to question and answer, is, unfortunately, only available on the gated WSJ Pro site.

[6] I refer here particularly to how regulation works for all save the big Wall Street banks. For them, the situation is often reversed, with the bankers intimidating their supervisors rather than the other way around.

[Cross-posted from Alt-M.org]

December 19, 2018 4:59PM

Trump Is Right to Withdraw From Syria

President Trump has ordered a withdrawal of U.S. troops from Syria. This is the right decision. The U.S. military presence in Syria has not been authorized by Congress, is illegal under international law, lacks a coherent strategy, and carries significant risks of entangling America in a broader quagmire in yet another Middle Eastern country.

As I wrote in Axios:

The Obama administration first deployed U.S. troops to Syria to complement its aerial bombing campaign against ISIS with special operations forces and coordinate with local anti-ISIS militias on the ground, gradually expanding from hundreds of troops to roughly 4,000.

The mission expanded, too, from merely defeating ISIS (substantially accomplished some time ago) to ushering Syrian President Bashar al-Assad out of power, expelling Iranian forces, and edging out Russia.

...The bottom line: Absent achievable goals and a strong national security imperative backed up by congressional authorization, the U.S. presence in Syria is illegitimate and better off wound down.

One prominent criticism of Trump’s decision is that it lacks a clear public explanation and evades the carefully planned and coordinated inter-agency process that enables such a withdrawal to be executed safely and responsibly. This is a fair criticism. Indeed, Trump seems not to have consulted the Defense Department, State Department, or really any of the national security principals in his administration before making this announcement.

But the fault for evading process may lie more with the president’s hawkish advisors than with Trump himself. Trump has long expressed disapproval for the U.S. military presence in Syria, but his own officials – including National Security Advisor John Bolton, Secretary of State Mike Pompeo, Secretary of Defense James Mattis, and the current Special Representative for Syria Engagement James Jeffrey – either resisted or ignored the Commander in Chief’s clearly stated preferences on an ongoing military mission. That may have made the president feel he had no choice but to circumvent process and issue the order to withdraw on his own, via Twitter. 

That said, I do worry about an administration that is too deferential to Trump's every whim. I was heartened, for example, that cabinet officials spent months pushing back on Trump's call to withdraw from the Iran nuclear deal. Likewise with the president's request for military options against North Korea, which the Pentagon reportedly slow-walked in the months before Trump shifted from maximum pressure to diplomatic negotiations with Kim Jong-un. And when Trump reportedly asked Mattis to assassinate Assad, it was probably a good thing that the Secretary of Defense chose not to take the suggestion seriously. 

That withdrawal is the right decision does not mean Syria will flourish in peace and security. Several undesirable contingencies may occur in the aftermath of our exit. The Turks may engage in operations against the Kurds in Syria’s northeast. ISIS may make some gains here and there. But if these things materialize, they should not be cited as proof that withdrawal was unwise. That’s exactly the flawed argument hawks employed to criticize the 2011 withdrawal from Iraq. Sure, it left a vacuum in which ISIS emerged. But ISIS itself is a product of the US invasion of Iraq. And our presence in Syria could very well be creating comparable unintended consequences, instead of preventing them.

It can’t be America’s purpose to indefinitely forestall every plausible misfortune that may or may not bedevil this troubled region. In the near term, we can engage in diplomacy to try to curb Turkish plans to target the Kurds. And with regard to ISIS, it’s not at all clear that their permanent defeat depends on maintaining a U.S. ground presence in Syria. The extremist group is already decimated, and even without an indefinite U.S. presence, it is surrounded by enemies to whom we can pass the buck (should resurgence even occur, which is not a given).

Anyone who favors a U.S. military presence in Syria should be calling for Congress to formally authorize it. That process will require making a strong public case that deployment is required to preempt an immediate threat to U.S. security and that the mission have coherent, achievable goals that clearly define what victory looks like. Otherwise, our presence in Syria is illegitimate.

December 19, 2018 7:50AM

The First Amendment Protects Boozy Talk

A restriction of free speech by any other name is still unconstitutional. No matter how much the Missouri government wants to regulate alcohol it may not do so by restricting the freedom of speech. Cato joins the ACLU and the Freedom Center of Missouri on an amicus brief supporting a challenge to a Missouri law prohibiting alcohol producers from advertising alcohol prices unless the prices are displayed inside a retailer—and they may not advertise who their retail partners are unless they list more than one. This both limits and compels speech.

The government argues that advertising is “commercial speech” and therefore not afforded the same protections under the First Amendment as every other type of speech. The “commercial speech” doctrine traces back to Valentine v. Chrestensen, an infamous case from the 1940s in which the Court arbitrarily decided commercial advertising wasn’t constitutionally protected. The Court has slowly been hacking away at this arbitrary rule, eventually creating an intermediate protection for commercial speech in under the Central Hudson Gas & Electric Corp. v. Public Service Commission (1980), where courts must balance four factors before deciding whether to nullify a restriction on commercial speech.

The Central Hudson test requires courts to determine: (1) whether the speech is false or misleading, (2) whether the government has a “substantial interest” in regulating the speech at issue, (3) whether the censorship directly advances the government’s interest in regulating the desired object, and (4) whether the government’s speech-regulation is no more restrictive than necessary. As reasonable as the words may seem in the abstract, the test has sprouted a thicket of arbitrary rulings contrary to the original meaning of the First Amendment.

What exactly qualifies as a “substantial interest” for a government has never been particularly clear. Nor has the Court been able to demonstrate where in the First Amendment some types of speech are afforded greater protections than others. Justices from John Paul Stevens to Clarence Thomas have criticized the Central Hudson test for its arbitrary factors and lack of grounding in the text of the First Amendment.

Our brief argues that alcohol advertising is just as much a form of speech as literature and political speech, deserving of protection from arbitrary government restrictions. The Central Hudson test should be eliminated in favor of the standard First Amendment protection for any kind of speech—which of course isn’t absolute, but is also not subject to government whim.

Despite the “commercial speech” doctrine’s emergence seemingly over night, and that the Central Hudson test still stands after nearly 30 years, Cato once more opposes this impediment to both the freedom of speech and economic liberty in the hope that, as Shakespeare put it in Henry VI, Part III, “many strokes, though with a little ax, hew down and fell the hardest timbered oak.”

December 19, 2018 7:35AM

FIRST STEP Passes Senate

Last night, the Senate passed the Formerly Incarcerated Reenter Society Transformed Safely Transitioning Every Person (FIRST STEP) Act, a bill which could provide relief to thousands of federal inmates and an untold number of future defendants for federal drug crimes. The Senate was widely considered to be the biggest hurdle to the bill’s success, and so activists and other supporters are celebrating in a way seldom seen in Washington criminal justice circles. With the president’s vocal support of the bill, it is likely to pass the House and be signed into law.

Although most news stories about FIRST STEP feature the “unlikely allies” from across the political and ideological spectrum that supported this bill, such language downplays the many years of tireless effort organizations on the left and right have put into bipartisan reform. Previous efforts have come up short, in one instance painfully close to the finish line, so the relief and elation many advocates are expressing are well-earned. While Cato policy precludes its scholars from endorsing legislation, my most sincere congratulations to the many organizations and individuals who fought so hard to make yesterday’s passage happen.

All that said, the FIRST STEP Act is aptly named because it only serves a small segment of the nation’s incarcerated population and thus cannot be the endpoint in the ongoing struggle for criminal justice reform. The United States holds over two million people in jails and prisons, mostly at the state and local levels. To the eligible prisoners who will be affected by FIRST STEP, the law may be a godsend, but for the vast majority of inmates, nothing will change when the president signs the bill into law. Taking nothing away from the achievements of FIRST STEP’s proponents, so much more needs to be done at every level of our criminal and carceral system.

Law enforcement officers continue to harass and over-police neighborhoods, bringing more people into the correctional system than need to be there in the first place. Prosecutors overcharge and over-sentence offenders, particularly those that exercise their constitutional rights to jury trials. Judges are still hamstrung by mandatory minimum sentencing laws that remove discretion and mercy in favor of punishment that may do more damage than good to the community.

Again, congratulations to our friends on the left, the right, and those in between who worked so hard to pass FIRST STEP. Cato is already working with some of these organizations on the next steps to making our criminal system fairer and less punitive.

December 19, 2018 7:00AM

New Cato Report: A Border Wall Won’t Stop Drug Smuggling — Marijuana Legalization Has

President Trump has repeatedly cited drug smuggling as a reason to build a wall along the Southern border. But my new Cato policy analysis shows that, if stopping drug smuggling is the goal, a border wall is about the worst possible investment. Here are a few of the main findings:

  • Hundreds of miles of border fences built from 2003 to 2009 had no effect on marijuana smuggling.
  • Marijuana legalization starting in 2014 has cut marijuana smuggling between ports of entry (i.e. where a wall would go) 78 percent from 114 pounds per agent in 2013 to just 25 pounds per agent in 2018.  
  • Since marijuana is the primary drug smuggled between ports of entry, the total value of all drugs seized by the average Border Patrol agent fell 70 percent from 2013 to 2018.
  • As a result, the average inspector at ports of entry made drug seizures that were three times more valuable than those made by Border Patrol in 2018. In 2013—prior to legalization—the average Border Patrol agent made more valuable seizures.
  • By weight, the average port inspector seized 8 times more cocaine, 17 times more fentanyl, 23 times more methamphetamine, and 36 times more heroin than the average Border Patrol agent seized at the physical border in early 2018.

The best proxy measure for changes in drug smuggling is the amount of drugs seized by Border Patrol. To control for enforcement levels, the paper looks at seizures per agent. From 2003 to 2013, the rate of seizures per agent was virtually constant, even as the number of agents doubled and the government constructed hundreds of miles of border fences. But enforcement didn’t stop the flow—only when states, starting in 2014, started to fully legalize marijuana did marijuana smuggling decline (Figure 1).

Figure 1: Marijuana seizures and length of border fences

Because marijuana is primarily smuggled between ports of entry, the most valuable drug smuggling now occurs at ports of entry. As Figure 2 shows, Border Patrol was seizing more drugs—by value—in 2013, but by 2018, value of drugs seized at ports of entry was three times the value of drugs seized between ports of entry by Border Patrol. In other words, a border wall would not target the most valuable drugs crossing the border.

Figure 2: Value of drug seizures per agent by location of seizure

All of this should inform policymakers on how to address illegal immigration as well. Policies that make legal immigration easier undermine the incentivizes for black market activity. As Figure 3 shows, when lesser-skilled guest worker admissions increase, the number of apprehensions per Border Patrol agent declines. Since 1949, a 10 percent increase in guest workers was associated with an 8.8 percent decrease in apprehensions per agent. The current H-2A and H-2B guest worker programs for seasonal workers are already helping the situation greatly, but they could be improved and expanded on to cut illegal entries further.

Figure 3: Lesser-skilled guest worker admissions and apprehensions per Border Patrol agent

If Congress wants to address drug smuggling, it should legalize marijuana nationwide and invest in better ports of entry, not build a wall. The same lessons that drug smuggling have provided should apply to illegal immigration, cutting demand for illegal immigration by making more legal options available to immigrants.

December 18, 2018 5:00PM

Bump Stock Rule Bumps Up Against the Constitution

By Ilya Shapiro and Matthew Larosiere

This morning, Acting Attorney General Matthew Whitaker signed the Trump Administration’s new regulation banning bump stocks. The final rule is largely unchanged from the one put up for notice and comment several months ago, but contains over 100 pages of responses to the tens of thousands of comments submitted both in favor of and opposition to the rule (the majority of which opposed the rule, including a comment submitted by us and Josh Blackman).

The Administration’s main contention continues to be that language of the National Firearms Act and Gun Control Act—which has not needed clarification in some 80 years—is ambiguous in regards to bump firing, a contention we dispatched back in June. Yet the government is attempting to use this supposed ambiguity to shoehorn bump stocks into a statute that regulates possession of machine guns.

Regardless of what public opinion is at this moment, the law means what it says. The executive branch has the power to interpret existing law, not write new ones. The administration argues, essentially, that because the statute did not provide a separate definition of the terms “automatically” and “function,” that it gets to insert their own meaning. That simply isn’t the case. Administrative interpretations are supposed to do just that—interpret existing law—not give new meaning to an old one.

In this case, the existing law specifically defines “machine gun”; several administrations have reviewed bump stocks and repeatedly determined that they don't fall in that category. It’s been clear for decades that Gatling guns and bump stocks were not machine guns. This regulation is not an attempt to clarify a vague law, but to seize political expediency to expand the power of the executive.

If the government really wants to regulate bump stocks, it needs to do so by passing a new law, not by assigning new meaning to an old one. The Founders weren’t short-sighted; there is a reason laws that affect the entire nation have to come through Congress, not reimagined by bureaucrats.

What’s worse is the fact that the administration’s attempt to skirt the Constitution is for something as inconsequential as bump stocks. We are talking about seriously damaging the integrity of our legal system over a novelty item. In a country as divided as ours, this seems like a squandering of political capital.

The powers of the federal government are few and defined, not open to unlimited interpretation by unelected bureaucrats. In light of this, our regulatory comment potentially gives Cato a right to intervene in the coming litigation. Stay tuned.

December 18, 2018 4:26PM

How People in 1968 Used Jury Nullification to Block Unreasonable Arrests

In a series of retrospectives on 1968, NPR reports on a sort of jury nullification that took place in Long Island and created a pre-Stonewall victory for gay rights and sexual freedom. In the summers, gay men would come out from New York City and elsewhere for sunbathing, house parties, and in some cases anonymous sex in a wooded area between the towns of Cherry Grove and Fire Island Pines. And some were arrested, fined, or even imprisoned. Then in 1968 some decided to fight back and hired a lawyer willing to fight for them:

In the autumn of 1968, close to two dozen gay men were acquitted of consensual sodomy charges in a series of criminal trials on Long Island. The trials and acquittals marked a pivotal moment in what eventually became the gay rights movement. They demonstrated to the larger gay community — then mainly closeted — that gay people could band together to resist police harassment....

In late August, 1968, police arrested 27 men in Cherry Grove. A few pleaded guilty to consensual sodomy and payed a fine of $250. But 22 men fought the charges in court.

Benedict Vuturo, a prominent Long Island criminal defense lawyer, was retained by the Mattachine Society. In the fall of 1968 Benny Vuturo, as he was known, demanded jury trials for all of the gay men he was defending.

"Benny said there's terrible crimes on the mainland of Long Island, murders and rapes, and here the cops go and they beat the bushes and try to find these gay fellas who are not harming anyone," said reporter Karl Grossman, who covered some of the trials for the Long Island Press.

"The juries, one after another, concurred, and they found the defendants not guilty, not guilty, not guilty. And that was the end of the police raids on Fire Island. To me, it really was a testament to the common sense of eastern Long Island residents who served on those juries, and to the jury system."

Vuturo was hoping to lose one of the trials so he could challenge New York's sodomy law but he won every case.

The state's sodomy law was overturned in 1980, 12 years after the Fire Island trials. 

There wasn't much doubt that the men had been doing what the law prohibited. Yet Long Island juries found them not guilty. That's a phenomenon often called jury nullification, defined by the Legal Information Institute as "A jury's knowing and deliberate rejection of the evidence or refusal to apply the law either because the jury wants to send a message about some social issue that is larger than the case itself, or because the result dictated by law is contrary to the jury's sense of justice, morality, or fairness." Read more about jury nullification in this Cato Institute book and in a Wall Street Journal article discussed here. It won't surprise you to hear that judges and prosecutors don't want juries to know their rights. I wrote about Stonewall here.

It turns out that NBC News covered the 1968 Fire Island story four months ago.