I really appreciate the comments on my recent post on QE3 and developmental central banking, particularly the detailed piece by Thomas Grennes and Andris Strazds (Can The Fed Kill Two Birds With One Stone?). I would like to clarify some points of my original blog that probably were not that obvious.
I would summarize the criticisms, perhaps too simplistically, as:
“a) The Fed has already put too much liquidity in the system; b) becoming a developmental central bank would increase that already excessive level of liquidity; and c) almost by definition, a developmental central bank, does not have independence and will be under political influence.”
First, I did not say that the Fed should become a developmental central bank (DCB). What I said was that “if the conditions continue to be “unusual and exigent” … it may be useful to study the instruments and lessons of developmental central banking in greater detail…” The key words here are “study” and “instruments.” I was particularly thinking about those instruments that can be used to target areas of private sector activity that are in distress (or as I put it in the previous blog “to focus the interventions more directly on the private sector related to the three headwind issues mentioned”).
Regarding lending to the non-banking private sector, David Fettig has a fascinating short history of Section 13-3 of the Federal Reserve Act (The History of a Powerful Paragraph). He notes that “When describing the Federal Reserve’s response to the Bear Stearns episode, observers have used words like “extraordinary” and “unprecedented.” And that’s true, to a point; namely, this is the first time the Federal Reserve has used this power since the Federal Reserve Act was amended in 1991…. But it’s not the first time that Federal Reserve banks have made loans to businesses—all types of businesses, not just those related to the financial services industry. It won’t surprise you to learn that these loans began during the Great Depression, but they also continued for nearly 20 years.”
Well, the US is going now through the worst economic conditions since the Great Depression. Still, I am not saying that the Fed should lend directly to non-bank firms because of the current “unusual and exigent” circumstances (which the Fed did during the Great Depression and afterwards, as Fettig shows). I am just noting that there are other instruments, and that the Fed used them in the past and during the current crises as well (in this case, loans to banks, such as JP Morgan and others). But, again, rather than direct loans to specific firms, which may leave the Fed open to political pressures (or the perception of politically motivated lending), it would be better to consider more general instruments, such as sectoral or specific-purpose rediscounts, which have been widely used by DCBs. Usually, it is longer term funding for banks to on-lend for specific general purposes and with pre-determined conditions.
Gillian Tett (October 11, 2012 “Looser rules won’t get banks lending more”) quotes a presentation by Phil Coffey, the chief financial officer of Westpac, on the reasons why banks are not lending, and one of the three reasons is funding. According to the article “Before 2007, CFOs presumed that they could always meet rising credit demand from their customers by tapping wholesale markets… But during the financial crisis, wholesale markets suddenly closed, cutting off that source of credit for banks, and prompting groups such as “Northern Rock, HBOS, Dexia, Countrywide, Washington Mutual and so on” to collapse….That sparked a cognitive shift: suddenly credit was no longer viewed as a bottomless pit… Or, as Mr Coffey says, the days of “tapping endless wholesale funding to meet all comers are behind us”. And while central banks have tried to replace those wholesale markets, few CFOs trust that this central bank money will always be there.”
A specific-purpose rediscount line to finance, for instance, small and medium business (one of the areas generating headwinds to the economic recovery according to Ben Bernanke’s Jackson Hole speech), would alleviate the funding problem mentioned above.
So far I argued that it was useful to look at some instruments of the DCBs. But even if we accept the distinction (that I admit that for some people may be splitting hairs) between becoming a DCB or using some instruments of a DCB, would not the latter cause further increases in levels of liquidity that for some critics are already too high? That leads me to the second point. In fact, the wholesale provision of liquidity hoping that it gets to the places that need it may be too broad an approach creating more and not less liquidity than the more targeted approach. All comparisons are imperfect, but it would be the difference in agriculture between carpet irrigation and precision irrigation. If it is true that the headwinds of the economy are the ones mentioned by Chairman Bernanke at Jackson Hole (small businesses, housing, and state and local governments; he also cited Europe, which is an altogether different issue), then you can tailor rediscount instruments to those problems. The overall levels of liquidity needed can be defined as to be equal or less those generated by the current approach. In other words, those rediscount lines can be structured to ensure macroeconomic compatibility with the monetary program.
I already referred to financing of small and medium firms. The Fed is already targeting the housing market. The third problem area is state and local governments, but as I argued in the previous blog it may be better to fund public-private partnerships for investment in infrastructure instead of buying state and local debt. There is a fourth area now being covered by the Fed, which is funding of the Federal government. This also is important to avoid a national fiscal contraction and a negative debt dynamics for the Federal public sector. In other words, the Fed is now targeting two sectors (Federal government and housing) but not the two other sectors that the Chairman identified as important headwinds for the economy. My suggestion is to analyze whether it is possible to target better the funding to the problem areas, and whether this approach may generate less liquidity than the current approach. And for that, looking at the instruments and experiences of DCBs may be useful (including the bad ones, which may be more relevant for this analysis). That is all.
The counter arguments that those instruments may generate distributive effects (“winners and losers”) and may leave open the Fed to “political interference,” need to be considered, but my guess is that these problems are already present, and more targeted instruments would not change the substance of the issues involved. Regarding distributional effects, although monetary policy is supposed to be distribution-neutral it does not seem that to be the case in practice (see, for instance, this IMF paper on monetary policy and inequality). Money always gets into the economy through specific actors, not by equally endowing each citizen with some amount of currency (and in the latter case, even if allocated equally per capita, there may still be distributional effects). If sectoral rediscounts are utilized, the money enters the economy through the sectors that are holding it back, as defined by the Fed, which seems appropriate. And the political pressures involved will not be different from the ones already present to reactivate the economy. In any case, whatever the political pressure, the Fed reaction has been, appropriately, to look at economic conditions, and based on that, exercise its authority under Section 13(3), arguing that there were “unusual and exigent circumstances” (as required by the Federal Reserve Act) and working with the Fed of New York and Boston to establish the new lending facilities’ policies, terms and conditions now in operation. The creation of new instruments, if needed, should follow the same procedure.