Minutes of the US Federal Reserve’s monetary policy committee meeting on Jan. 29 and 30 and other recent statements by Fed officials reveal a vigorous debate within the central bank about the effects of monetary policy stimulus on financial markets. Most strikingly, the minutes indicate that Kansas City Federal Reserve Bank president Esther George “…dissented from the committee’s policy decision, expressing concern that loose credit increased the risks of future economic and financial imbalances….” In the same vein, Cleveland Fed president Sandra Pianalto expressed in a Feb. 15 speech her worry that “… financial stability could be harmed if financial institutions take on excessive credit risk by “reaching for yield” —that is, buying riskier assets, or taking on too much leverage—in order to boost their profitability in this low-interest rate environment.”
These worries are not without some foundation. For example, in a Feb. 20 Wall Street Journal article “Fed Split Over How Long to Keep Cash Spigot Open,” reporters Jon Hilsenrath and Victoria McGrane show graphs of dramatic flows of money into junk bonds, junk loans, and real estate investment trusts. Nevertheless, Boston Fed president Eric Rosengren is quoted as saying:
…that it wasn’t the central bank’s job to halt every episode of financial excess. Individual financial institutions regularly fail without bringing down the economy, and financial bubbles don’t always wreck financial systems. When the tech bubble burst in 2000, for example, the U.S. experienced a relatively brief and shallow recession. It didn’t lead to the same cascade of market collapses and a deep downturn as in 2008.
And they report Dallas Fed president Richard Fisher saying that although he is alert to possible dangers, “These robust markets are part of the Fed’s policy intent.”
In an extended question and answer session at the University of Michigan on Jan. 14, Federal Reserve Board Chairman Ben Bernanke revealed his philosophy about dealing with financial stability: “… we will, obviously, be working very hard in financial stability. We’ll be using our regulatory and supervisory powers. We’ll try to strengthen the financial system. And if necessary, we will adjust monetary policy as well but I don’t think that’s the first line of defense.” Although Bernanke does not want fears about financial stability to constrain monetary policy too much, he is more concerned about the effects of quantitative easing (buying long-term Treasury bonds and mortgage-backed securities) and forward guidance (making announcements about future short-term interest rates) than he would be if the Fed could just push the current short-term interest rate below the near-zero level it is at now:
… we have to pay very close attention to the costs and the risks and the efficacy of these non-standard policies as well as the potential economic benefits. And to the extent that there are costs or risks associated with non-standard policies which do not appear or at least not to the same degree for standard policies then you would, you know, economics tells you when something is more costly, you do a little bit less of it.
I find wisdom in the words of Rosengren, Fisher and Bernanke. In my view:
- It is almost impossible for monetary policy to stimulate the economy except by (a) raising asset prices, (b) causing loans to be made to borrowers who were previously seen as too risky, or (c) stealing aggregate demand from other countries by causing changes in the exchange rate.
- Quantitative easing is likely to have unprecedented effects on financial markets—effects that will look unfamiliar to those used to what the standard monetary policy tool of cutting short-term interest rates does.
- It is not risk-taking we should be worried about, but efforts to impose risks on others—including taxpayers—without fully paying for that privilege.
1. Monetary Policy Works Through Raising Asset Prices, Loosening Borrowing Constraints, or Affecting the Exchange Rate. It doesn’t make sense for firms to produce things no one wants to buy. Aggregate demand is the willingness to buy goods and services that determines how much is produced in the short run. Aggregate demand is the sum of the willingness of households (meaning families and individuals) to spend and build houses, of firms to buy equipment, build factories, office buildings, and stores, and spend on research and development, of government purchases, and of net exports: how much more foreigners buy from us than we buy from them (an area where the US is now in the hole).
To analyze household spending, it is a useful simplification to think of households as divided into two groups: (i) those who either don’t need to borrow or can borrow all they want at reasonable rates, and (ii) those who are borrowing as much as they can already and can’t borrow more. Economic theory suggests that those who don’t need to borrow or can borrow all they want at reasonable rates will look at the value of their wealth—including the asset value of their future paychecks—and spend a small fraction that full wealth every year. The size of that fraction depends primarily on long-run factors, and is mostly beyond the Fed’s control. So, by and large, the only way the Fed can get those who don’t need to borrow to spend more is by increasing the value of their full wealth. If the full wealth goes up because they expect fatter paychecks in the future, no one gets worried, but otherwise that increase in wealth has to come from an increase in highly visible asset prices.
Those who are already borrowing as much as they can only can spend more if they can get their hands on more money in the here and now. Tax policy matters here, but the most recent change—the expiration of the Obama payroll tax cut—goes in the wrong way, reducing what people living from paycheck to paycheck have to spend. My proposal of a $2,000 Federal Line of Credit to every taxpayer would be a way to stimulate the spending of this group without adding much to the national debt. But this is beyond the Federal Reserve’s authority under current law. The way monetary policy now affects the spending of those who face limits on their borrowing is by lowering the cost of funds to banks so much that banks start to think about lending to people they were unwilling to lend to before.
A similar division by ability to borrow helps in understanding business investment as well. For firms who have trouble borrowing, additional investment spending will depend borrowers-previously-deemed-too-risky getting loans. For firms that don’t need to borrow or can borrow all they want at reasonable rates, the key determinant is how valuable a firm thinks a new factory, office building, store, piece of equipment, or patent will be. But, by and large, the same factors that affect how valuable a new investment will be affect how valuable existing factories, office buildings, stores, equipment, and patents are. So the prices of the stocks and bonds that would allow one to buy a firm outright—with all of its factories, office buildings, stores, equipment and patents—will have to increase if the Fed is to encourage investment. The same logic holds for houses: it is hard to make it more valuable to build a new house without also making existing houses more valuable and pushing up their prices.
Aside from government purchases—which are the job of the president and the warring Democrats and Republicans in Congress rather than the Fed—that leaves net exports. There the problem is that while any one country can increase its aggregate demand by increasing its net exports, this doesn’t work when all countries try to increase net exports at the same time. The reason that monetary expansion isn’t a zero-sum game across countries is because monetary policy can increase aggregate demand by raising asset prices and encouraging lenders to lend to borrowers they didn’t want to lend to before. The big danger is that those making the decisions within the Federal Reserve will mistake the normal workings of monetary policy—acting through asset prices and risky lending—for financial shenanigans that need to be stamped out by premature monetary tightening.
2. Nonstandard Monetary Policy. That said, nonstandard monetary policy in the form of purchases of long-term Treasury bonds and mortgage-backed securities and “forward guidance” on future short-term interest rates take the economy into uncharted territory. But uncharted territory brings not only the possibility of new monsters but also the near certainty of previously unseen creatures that might look like monsters, but are harmless.
3. Facing the Real Financial Dangers Squarely. So what distinguishes the real monsters from the paper dragons? Eric Rosengren had the key when he pointed to the contrast between the collapse of the internet stock bubble in 2000 and the financial crisis in 2008, that stemmed from the collapse of the housing bubble. The difference was that, by and large, people invested in internet stock price boom with their own money, and took the hit themselves when the bubble collapsed; people invested in the house price boom—both directly and indirectly—with borrowed money, and so imposed their losses on those they borrowed from and on taxpayers through bailouts. “High capital requirements” is the name of the policy of forcing big banks to put enough of their own money at risk to be able to absorb financial losses without imposing those losses on others. Capital requirements for banks are akin to down payment requirements for individuals buying houses. The financial crisis we are still suffering from arose from too little of both. Needless to say, banks hate capital requirements, since the secret for all too great a share of financial profits is taking the upside while foisting the downside on others (often taxpayers) who don’t know they are taking the downside, and aren’t being compensated for taking that risk.
Beyond pushing for high capital requirements—especially during booms, when financial shenanigans are most likely—the Fed can do a lot to foster financial stability by continuing to make a list of possible macroeconomic risks to use in subjecting financial firms to “stress tests” as it has done in 2009, 2011, 2012 and 2013. But it can do more with this list of possible macroeconomic risks by requiring financial firms to explicitly insure themselves against these risks and imposing very tough capital requirements of those who purport to provide such insurance. Indeed, for deep pockets, the ideal provider of such insurance would be a sovereign wealth fund, as I proposed in “Why the US Needs Its Own Sovereign Wealth Fund.” The problem is not having taxpayers bear these risks, it is having taxpayers bear these risks without being compensated for doing so. The bedrock principle should be to bring as many macroeconomic risks as possible out of the shadows into the light of day, so that prices can be put on those risks. If risks are out in the open, then those who face them will them knowingly, and won’t be able to shirk the responsibility they have undertaken when those risks materialize.
Fostering financial stability by enforcing high capital requirements during booms and working toward the naming and pricing of macroeconomic risks is its own reward. But it also has the extraordinary benefit of freeing up monetary policy to pursue its main mission of protecting the economy from inflation and high unemployment. The more potential evils we face, the more tools we need. Rather than attempting to use the familiar tool of monetary policy for a task to which it is ill-suited, let us fashion new tools to enhance financial stability.
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