May 18, 2020

Lev Menand on the Fed’s Lending Facilities and the Legal Concerns Surrounding Them

The Fed and Congress have deployed a number of important lending facilities in response to the current economic crisis, but various legal concerns continue to loom.
David Beckworth Senior Research Fellow , Lev Menand

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Lev Menand is a legal scholar at Columbia Law School and has previously worked for the New York Fed, the US Treasury Department, and the Financial Stability Oversight Council (FSOC). Lev Joins Macro Musings to talk about his new paper, *Unappropriated Dollars: The Fed’s Ad Hoc Lending Facilities and the Rules that Govern Them*. Specifically, David and Lev discuss opening up public Fed bank accounts, the importance of liquidity and credit facilities, and how Congress is using the CARES Act to skirt the Fed’s current legal mandates.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Lev, welcome to the show.

Lev Menand: Thank you David, for having me.

Beckworth: It's nice to have you on. And a little interesting story how I first met Lev. I was at Reagan National Airport. I'd been in D.C. for a week, doing my job, visiting people on Capitol Hill, forwarding papers, probably recording a podcast or two and I'm getting in line to go to the airport and there is Morgan Ricks, my fellow Nashvillian, if that's such a word. We both had been doing the same thing effectively that week and then along with him was Lev. Lev, you were there. That's where we first met, right?

Menand: Yeah. That's where we met.

Beckworth: Yeah. I believe you were probably in town talking about the Fed accounts and I was probably talking about nominal GDP targeting.

Menand: Yeah, that's exactly right. Morgan and I had some meetings on the Hill about Fed accounts.

Beckworth: Okay. Well, tell our listeners a little bit about your stuff. You've got an interesting background. You've worked at the New York Fed, US Treasury, you now are a scholar, you focus on the legal issues of financial regulation. This paper you've written is pretty remarkable paper on the legality of the Fed's actions during this crisis. So walk us through how you got to this point in your career and why are you working on it?

Menand: Yeah, so I mean like many things in life, I came to all of this by accident. I was lucky enough back in 2009 to land a job at the New York Fed in the research division. I got assigned through no fault of my own to work on bank stress testing. It was a really fascinating time to work on bank stress testing and I got to work on the first CCAR and I got to go down to D.C. and work on the Financial Stability Oversight Council as you mentioned and work on the first FSOC annual report. It seemed to me that financial instability was a big problem that we needed to address and that we hadn't sort of figured out yet. And so I started to work and focus more on financial stability. Over the intervening years I've come to believe increasingly that macroeconomic policy and monetary architecture are driving forces in modern history and that money is perhaps the quintessential technology of modern society and yet we don't study it very much in economics departments or law schools.

I've come to believe increasingly that macroeconomic policy and monetary architecture are driving forces in modern history and that money is perhaps the quintessential technology of modern society and yet we don't study it very much in economics departments or law schools.

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Menand: People in Washington are pretty confused about how it works. In fact, Congress knew more about how money worked in 1864 than most policy experts do today. So we're getting a lot of stuff wrong in my view in terms of how we structure our monetary system and I think the consequences are pretty serious and that's why I sort of study and work on these issues. In terms of the current paper, the Fed's current activities are great demonstration of the ways in which Congress I think has a lot of work to do to build a better monetary system. I wanted to explain what the Fed was doing, so that we can start to work on a better framework that won't sort of create the sort of turmoil we saw in March and put the Fed under the sort of pressure that it is now.

Beckworth: Yeah. This paper is really interesting because it really gets into the legal justifications for what the Fed is doing and as you know, I've had a number of guests on their show talking about these programs, very timely topic obviously, but we really haven't delved as deeply into The Federal Reserve Act as we're going to do today with you. So this is great to have you on kind of, I think fill in a void… we've had a lot of philosophical discussion, should Congress be doing more? Have we blurred the line between fiscal and monetary policy? What things could the Fed to be doing better? But we need to look at, what is the Fed doing and is it legal according to The Federal Reserve Act and what Congress has prescribed.

Beckworth: Now, before we do that though, I want to get one more update from you. So you and Morgan I know have been very active on the Fed account, you have this paper, we'll provide a link to it. My understanding was that in an initial draft of the CARES Act, at least the democratic version of it, there was a place for the Fed account, but it got struck out in the final version. So what is the latest you can tell us about Fed accounts?

The Latest on Creating Fed Accounts for the Public

Menand: Yeah, so Fed accounts is this idea that Morgan Ricks and John Crawford and I put out a paper on a couple of years ago, where we recommended that basically The Federal Reserve give people a public option to have a bank account at one of the 12 Federal Reserve banks. And so if you look at the Fed's balance sheet, it issues two types of monetary liabilities. One are Federal Reserve notes better known as cash and the Federal government has a monopoly on issuing cash. That wasn't always the case, but it's true today. The other are bank account balances, deposits which are also known as reserves. Right now, reserves are only available to an exclusive clientele, basically banks and governmental entities.

Menand: Our proposal is to open that up. We no longer see a principle basis for maintaining that exclusivity. We think that allowing people to have accounts at the Fed and hold sovereign non-defaultable money in account form as opposed to only in physical form would have a lot of benefits for a lot of people. In the last few months as the government has found itself in a position of having to distribute a large amount of money to a lot of different people, the fact that in this country there's a lot of un-banked households has come to the forefront in a way that it hasn't in previous years. One of the obvious benefits of Fed accounts is it would allow lower income households to maintain bank accounts with the government, that would not be a for-profit accounts. And so the government would cross-subsidize and affect the lower income households, the way they cross-subsidize in the post office and in all sorts of other public infrastructure.

We no longer see a principle basis for maintaining that exclusivity. We think that allowing people to have accounts at the Fed and hold sovereign non-defaultable money in account form as opposed to only in physical form would have a lot of benefits for a lot of people.

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Menand: As part of the CARES Act drafting process, there was interest on the Hill in possibly doing something around Fed accounts. As you've mentioned some legislative texts that would have implemented the idea, in a sort of a two phase transition. In phase one, it would've used the banks as sort of agents of the Fed to set up the accounts. Then in phase two, the Fed would have established its own retail operations in order to manage these accounts. Some of this legislation was in the bill, but ultimately, obviously it was not in the final CARES Act legislation. Although Maxine Waters and Sherrod Brown have both introduced bills that would create Fed accounts and there are ongoing discussions on the Hill about incorporating a version of Fed accounts in some of the future legislation that Congress is considering, because one of the things that we've seen is our current money and payments infrastructure is really unprepared and inadequate for dealing with the current crisis.

Beckworth: Okay. So we may hear back from you and Morgan Ricks about Fed accounts in the near future as things continue to develop on this front. I want to transition into your paper now and again, the title is *Unappropriated Dollars: The Fed's Ad Hoc Lending Facilities and Rules that Govern Them.* So we'll have this paper linked on our website and it's a great read and as I mentioned earlier, it deals with legality and you use this term stretching the legality, a lot of it I think is very clever.

Beckworth: And what I liked about this kind of from the get-go was your framing, Lev, of the different facilities. So I had to do a webinar a few weeks ago mostly to people on Capitol Hill and explain all these facilities to them. I felt like I was doing just a list of facilities, this alphabet soup as you know. I didn't feel like I had categorized them or put them in a way, different buckets that made it make more sense. I mean, I did give it my best shot, but you have done a great job here doing that.

Beckworth: You have separated these out into two broad buckets, facilities that are liquidity facilities and facilities that are credit facilities, and you use this outline in your paper and then you get into the legality based on whether they fall under 13(3) or Section 14 of The Federal Reserve Act. So why don't we start with these two broad categorizations in terms of the facilities. There's the liquidity facilities and then there's the credit facilities and I believe there's probably seven in each of those buckets. Is that right?

Menand: That's about right. Yeah.

Beckworth: Okay. So walk us through the liquidity facilities. What is the characteristic that defines the liquidity facilities and what are they trying to do?

The Basics and Importance of Liquidity Facilities

Menand: Right. So in order to understand the liquidity facilities, I think it's helpful to take a step back briefly and explain to the listeners, how the discount window works. The discount window is the ultimate liquidity facility and it's not an ad hoc facility. It's sort of a statutory facility. The discount window is operating right now, it's always operating. Although banks may or may not be taking out discount window loans, the liquidity facilities are all designed to extend the discount window to firms that cannot access it.

Menand: So let me talk a little bit about the discount window. The discount window is designed to allow banks to borrow cash in the form of reserve balances, from the Fed when they need it. When the Fed was created in 1913, the idea was that the Fed would use the discount window to control the amount of money that banks are able to create. In other words, to control the amount of deposits that banks are able to create. Because banks will need to get cash, to back up those deposits if there are withdrawals. And so the rate at which the Fed is willing to lend them cash will determine their ability to increase the amount of deposits on their balance sheets.

Menand: Over the course of the 20th century, the Fed transitioned to conducting its monetary policy, using section 14 in open-market operations and now the discount window is not as big of a part of how the Fed controls the ability of banks to create deposits. But the Fed always has a rate that it is quoting for borrowing from the discount window for banks. That rate is sort of, banks are aware of it and it's sort of the outside spread. They know that they can always get cash from the Fed at that rate.

Menand: Now, the thing is, the Fed was established to be a bank for banks, to be a central bank. One of the things that's happened over the last several decades is lots of shadow banks have emerged. Firms that engage in a similar business to banks but they lack the regulatory status of banks. They don't create deposits because they're not legally allowed to do that, but they create deposit substitutes, similar instruments. Like repurchase agreements and Eurodollars and money market mutual fund shares and commercial paper. These firms are also a really important part of the monetary system.

Menand: The Fed doesn't have the same ability to control the money that they create, that it has, to control the money that banks create. But when these firms get in trouble, the Fed needs to do something about it and they can't borrow from the discount window. And so all of the liquidity facilities are basically set up to be ersatz discount windows for these shadow banks, for these deposit substitute products and to accomplish the same goals that the central bank is trying to accomplish with respect to bank deposits. So, the goal of the discount window is to ensure that all of the deposits in the economy trade at par with cash, that there's one-for-one. That nobody has to worry, that their deposit is not going to be equivalent to a piece of paper, physical currency.

All of the liquidity facilities are basically set up to be ersatz discount windows for these shadow banks, for these deposit substitute products and to accomplish the same goals that the central bank is trying to accomplish with respect to bank deposits. So, the goal of the discount window is to ensure that all of the deposits in the economy trade at par with cash.

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Menand: The Fed wants to ensure the same thing for the deposit substitutes, for the repos, for the commercial paper, for the money market, mutual fund shares for the Eurodollars, which are foreign dollar denominated deposits, largely. In order to do that, it has to set up these ad hoc facilities. There are seven of them and it looks like an alphabet soup, but the way to sort of think about it is they're all for one or another of these deposit substitutes. They're all special discount windows that are being created for different shadow banks that are creating different types of deposit substitutes.

Beckworth: Okay. That makes a lot of sense to me. You put it nicely in your paper. The liquidity facilities are created to avoid bank runs or run on money assets in the shadow banking system. So it extends the reach of the Fed’s, kind of lender of last resort role into shadow banking where it normally can't reach. You mentioned Perry Mehrling calls this ‘dealer of last resort’, but effectively it's doing what it was designed to do. It's just reaching into places it normally can't reach, giving us normal tools, the discount window. They're trying to avoid runs. I like what you mentioned also that this is a way to keep broad money stability, to avoid collapses in monetary assets.

Beckworth: I think this is a point that I think many folks overlooked. 2008, if you looked at broad money assets, not just retail money assets that we think of, like M2 money supply, but if you include institutional money assets, there was a dramatic drop in it. When there was a run on the shadow banking system, a lot of these institutional money assets disappeared and was a big reason we had a financial crisis. So what the Fed is doing here is trying to avoid that, trying to preserve all these forms of money assets out there. Is that fair?

Menand: That's exactly right. The Fed's mandate from Congress is to ensure the growth of monetary aggregates commensurate with full employment and price stability. The monetary reality we live in now, most monetary aggregates or a large portion of monetary aggregates are produced by shadow banks instead of banks. So when the Fed was created in 1913, most monetary aggregates were bank deposits and bank notes, banks still issued physical notes back then. But now the monetary reality is repo markets and Eurodollar markets are a huge portion of the monetary aggregates. If the Fed allows those markets to collapse, it's not going to be able to fulfill its mission. And so the Fed is using its other statutory authorities to get around the fact that it's discount window facility was only actually designed for banks because when it was originally designed it was a central bank and the shadow banks don't have the regulatory status to access the discount window.

Beckworth: Yeah, this is great stuff. I wish more textbooks would recognize this broader understanding of what monetary aggregates are. I think most textbooks still think of retail money assets as the money supply, when in fact you've got to look at the shadow banking money assets as well. An interesting thing that's happened so far, I shouldn't count my chickens before they all hatch. But one thing that's interesting compared to 2008 is if you look at a measure of these aggregates on a broad scale. So, one I've looked at is an M4 measures called the Divisia M4 measure, but it essentially covers retail and institutional money assets. It actually has been growing during this period. Now, in 2008 it actually collapsed. There was a drop in this measure of broad money assets.

Beckworth: I think the difference is that today, people know that these shadow banking money assets are protected or backstopped by the Fed. What they're doing is they're rushing into these safe stores of value, they're putting funds taken from riskier assets moving in there. And so the reason you actually don't see a collapse this time is because they saw what happened in 2008 and their suspicions have been confirmed by the fact that Fed has opened up these facilities again to reach into and backstop the shadow banking system. So I think, the Fed created an expectation and it's being fulfilled. And so people feel, "You know what, these broad money assets are just as safe as retail money assets. So I can park my funds there."

Menand: Yeah, that's basically right. Although I would emphasize that in March, there were a few weeks there, where the markets were pretty wobbly and the Fed had to stand up all these facilities, under a huge amount of pressure, in a very short timeframe to backstop these shadow money products, money market mutual funds that were running. Goldman Sachs had to bail out one of its money market mutual funds and you can be sure that the repo markets would have completely melted down. They were showing lots of signs of severe stress had the Fed not been able to get all these facilities up and running. You're right, the Fed saw the slide show in 2008. In 2008, they maybe weren't sure the extent to which the deposit substitutes created by these other financial firms were critical components of the money supply, but by the end they were quite clear on that.

Menand: Ben Bernanke has a great paper from a couple of years ago showing that the reason why the Great Recession was great was because of the collapse in M4, because of the collapse in monetary aggregates. Something similar happened in the 1930s and the Fed understands that now and they were not going to sit by and watch that happen again this time. But the statute has not been updated to make this any easier for the Fed. These are all these ad hoc facilities, right?

Beckworth: Right.

Menand: And so there is a moment there where everybody's wondering whether the issuers of these deposits substitutes are going to be able to maintain them at par or not. They don't wonder that about banks because they know the discount window is there, but they're not so sure about securities dealers and money market mutual funds and finance companies issuing commercial paper and foreign banks issuing dollar deposits. There was actually some real uncertainty there for a few days. The Fed just did such a great job, standing up these facilities so quickly that we've basically forgotten that things were looking kind of bleak for a few days in March.

The Fed just did such a great job, standing up these facilities so quickly that we've basically forgotten that things were looking kind of bleak for a few days in March.

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Beckworth: That's fair. So maybe I should have a more nuanced take along these lines. There was some uncertainty whether the Fed would follow through with the signal it sent in 2008. So maybe my question should be rephrased this way. Do you think going forward now that the Fed has intervened twice with these facilities, 2008, present, do you think that sends a strong signal going forward that the Fed will intervene again in shadow banking markets, should it need to?

Menand: Yes. But there's always going to be a question of how quickly and on what terms. Right now, the Fed has been able to calm money markets, in part because the shadow banks that issue these deposit substitutes appear to be solvent and this is primarily a liquidity crisis or was primarily a liquidity crisis. We should be more worried about what could happen down the line if some of these shadow banks become insolvent. Then the Fed is in the position of having to deal with sort of a Lehman brothers situation, securities dealers or other finance companies that issue money claims, but that just don't have the assets to back them anymore.

Beckworth: Okay. So just to summarize the liquidity facilities is what we normally think a central bank does, just expanded to the realities of where money is being created. In short, it's trying to avoid runs on the banking system, however broad it may be. Now, just to run through the list of facilities real quick here, I'm looking at your chart through, figure one. These would include the Expanded Repurchase Operations. These technically started last fall, but they vastly expanded them in March. The Commercial Paper Funding Facility, the Primary Dealer Credit Facility, the Money Market Fund Liquidity Facility, and also the dollar swap lines. Is that the list?

Menand: Yes. And the Foreign and International Monetary Authority repo facility.

Beckworth: FIMA. All right. We'll call it FIMA. Alright. Let me speak to these dollars swap lines and to the FIMA facility. These facilities vastly expand the number of central banks who have access to the Fed's balance sheet so they can either deposit treasuries or their own currency at the Fed and in turn get dollars to distribute to the banks that may need them in their jurisdictions. This seems to me to be another case of the Fed sending a strong signal that in the future will use these if it needs to. So it used them in 2008. It's vastly expanded them again, this crisis. So if I'm an investor overseas, does that not send a signal to me that I should continue to use dollars or put dollars in my portfolios, all else equal and therefore expand the dollar’s reach, dollar’s dominance and therefore make this a problem the Fed’s going to have to deal with in the future even more so.

The Creation of FIMA and Dollar Swap Lines

Menand: Yeah, absolutely. I mean, so there's two types of facilities here. One is the swap line and the Fed has set up swap lines with a select group of central banks. The way a swap line works is the Fed credits on its books, amount of dollars, due to the foreign central bank and in exchange, the foreign central bank on its books, credits to the Fed, the currency it issues. So in the case of the Bank of England, the Fed gets a balance on the Bank of England's books, in pounds. The Fed has not wanted to do that with all the central banks in the world because these are sort of unsecured loans. A balance on the books of a central bank is just a promise by the central bank to pay currency.

Menand: That promise is no better than the loan promise itself to pay back the dollars and you'd have to enforce it in a foreign court. There's no physical collateral in the possession of the Fed. And so the FIMA repo facility is an attempt to expand access to dollars to central bank, the Fed doesn't feel comfortable with lending through a swap line. In the FIMA repo facility, the Fed structures the loan as a purchase of a treasury security, with an agreement to resell it. And so if for whatever reason, the foreign central bank is unable to repay the dollars, the Fed has the treasury security. Now, in the last crisis, the Fed put in place the swap lines, with a group of foreign central banks.

Menand: This played a major role in calming the basically bank runs, in dollars, going on overseas. In the wake of that, the Eurodollar markets, the foreign dollar deposit markets have grown, and they've grown a lot in Asia. The Fed has backstopped them again and you're exactly right, if you're in this business overseas, you can be fairly certain that in the future business cycle downturn, the Fed will be forced to step in as a sort of international dealer of last resort, lender of last resort to foreign central banks so that they can on lend to their own sort of banks and shadow banks. This is a problem that's calling out a need for some real governance solutions.

Beckworth: Yes. Okay, so let's walk through the implications of this. So on one hand, this is great for seigniorage, right? For the US government. I mean, this implies increased demand for dollars in the future, increased seigniorage. So that means the US government will have a higher revenue stream than it otherwise would, if the Fed hadn't done this intervention, which is great. Because, we have some big deficits on the horizon. The downside would be though that the dollar is going to remain the reserve currency of the world and all the costs that come with it for the US economy. So the dollar will tend to be overvalued, will tend to run more trade deficits. There'll be some effect on what jobs are affected in industry in the US because of that. So there are some trade-offs involved here, but I guess the silver lining would be that the US government has an extra stream of revenue coming in through higher seigniorage in the future.

Menand: Yeah. That's absolutely right. The question is how big is that seigniorage stream? Because right now only some of these dollar deposits are being invested in US Treasury securities and benefiting the United States through increasing demand for our sovereign debt. A lot of  the Eurodollar market is taking place overseas where on both sides of the ledger there are overseas dollar assets and overseas dollar liabilities and none of it is touching the United States. And so the seigniorage from that is being captured by the foreign financial institutions, not by the United States.

Beckworth: Fair point, I guess my thought was more along the lines, even if seigniorage from those particular dollars are being captured overseas, it's creating more path dependency, more dollar lock-in that maybe indirectly makes it easier for the Fed to run deficits, to issue more dollars. So it may not be a-

Menand: That's absolutely right.

Beckworth: A direct benefit. But just it's adding to dollar dominance. Again, there are a bunch of challenges that come up. I mean, I mentioned some of them for the US economy, continued trade deficits, probably continued budget deficits, but also the global financial cycle. The literature that when the dollar strengthens or when the Fed does monetary policy, it affects everyone around the world and even more so. This is a big deal. I mean, you mentioned in the paper and you just said there's a real governance issue. How do you set up these swap lines? When do you turn them on? When you turn them off? Who gets them? Under what conditions? So I think this will be a very fertile area of research going forward. One other category, you mentioned in your paper, that falls in this, you say it's a gray area, but the Term Asset-Backed Securities Loan Facility or TALF, would you consider that a liquidity facility or a credit facility?

Menand: So I've kind of lumped it here as a liquidity facility, but that's not quite right. It's basically a credit facility, but the Fed could operate it in a way, depends on how the Fed operates it, basically. The way that the TALF works is it lends to us companies with eligible collateral and account relationships with one of the 24 primary dealers and the eligible collateral are asset-backed securities like auto loans. A lot of the shadow banking markets use these securities as assets. And so backstopping these markets is geared in part, to allowing shadow bank liabilities to trade at par with cash. But the Fed used this facility in 2008 to actually support the underlying credit markets. So the auto lending market for example, and that's actually much more like a credit facility than a liquidity facility. So it sits in a sort of in between area.

Beckworth: Okay. Again, to summarize what we've discussed, there are two broad buckets here. There's the liquidity facilities, we've just covered those. The main goal there is to avoid runs on banks, whether they're traditional banks or shadow banks. The other bucket is the credit facilities. There's seven of them. So let's move into that. And what they're designed to do is to avoid bankruptcy. So you mentioned liquidity facilities to avoid bank runs, credit facilities to avoid bankruptcy. They're a very different beast than what we normally think of a central bank doing. So walk us through that.

The Basics and Potential Dangers of Credit Facilities

Menand: Yeah. So the credit facilities, they invest in what economists call the real economy. It's not a monetary, they're not performing a monetary function in the way that the liquidity facilities are, where they're trying to ensure that various monetary instruments in circulation in the economy are trading at par with cash. They are trying to make credit available to households, businesses, state and local governments. They're investing directly in the real economy. They're going around the banking system and they're doing this by buying municipal bonds, buying corporate bonds, underwriting new corporate debt, purchasing loans originated by banks, that are to medium sized businesses. This is not central banking either in the traditional sense of central banking where the central bank is a bank for banks or in this sort of modern sense where it's also a bank for shadow banks. This is sort of state banking. It's industrial policy.

This is not central banking either in the traditional sense of central banking where the central bank is a bank for banks or in this sort of modern sense where it's also a bank for shadow banks. This is sort of state banking. It's industrial policy.

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Beckworth: That presents challenges because this is a new area for the Fed to get into and it stretches its legal authority. We'll move into that in a bit. But I liked the way you framed it. You called these investment and industrial policy. So again, it's very different than traditional central banking. You can understand the expansion of the Fed into all these different liquidity facilities, but now we're getting into credit reallocation and this is where people probably have some of the biggest criticisms of what the Fed is doing. Some of our previous guests I think, would look at the credit facilities as where the Fed is being asked to do too much. Congress is leaning too heavy on the Fed to go in and effectively do industrial policy, in the real economy.

Menand: That's right. I agree with your previous guests on this point. Congress is leaning very heavily on the Fed right now. It's delegating to the Fed a new responsibility really, that the Fed has never really had before. We can talk a little bit about some of the past industrial lending the Fed has done. It's very different from the Fed's role as a monetary authority because the Fed's role as a monetary authority, the Fed is managing the money supply and it's trying to do it in a neutral way that encourages sustainable economic growth and price stability. It's trying to ensure that private money instruments trade at par with public money instruments. But when it's doing that, it's not deciding who gets access to credit and who doesn't.

Menand: I mean, in some ways indirectly its decisions do have that effect, but the goal was to try to minimize that. With these new CARES Act credit facilities, the Fed is necessarily engaged in non-neutral investment choices. It's deciding who gets access to credit and who doesn't and on what terms. That's an inherently political activity that will generate lobbying pressure on the Fed and entanglement with the political branches. It's actually technically and operationally challenging for the Fed because it requires credit underwriting expertise that the Federal Reserve banks don't really have anymore. So, it's a major undertaking to do these credit facilities and it's an experiment really. It's an experiment because we don't know exactly how it's going to work out yet and there's lots of reasons to be concerned and to think that Congress needs to do more here to help the Fed, be successful in this space.

With these new CARES Act credit facilities, the Fed is necessarily engaged in non-neutral investment choices. It's deciding who gets access to credit and who doesn't and on what terms. That's an inherently political activity that will generate lobbying pressure on the Fed and entanglement with the political branches.

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Beckworth: Absolutely. Let me add one more concern on top of all those you've already listed. That is, the Fed itself may find its independence jeopardized because of this, going into the credit facilities. If it doesn't do a great job and there's good reason to believe it won't do a great job, there's going to be political blow back and it may harm the Fed's ability to do traditional monetary policy. You want to preserve the Fed's independence so it can do lender of last resort, so it can do monetary policy and this may cause some challenges for it on that front in the future. So there are I think reasons to be worried and concerned about the Fed's growing footprint in the credit facility area.

Beckworth: So just to summarize these facilities and then we'll maybe talk about the legality of them. We have the primary corporate credit facility. We've got the secondary corporate credit facility, which is going online today. As a matter of fact, we saw the news, today's the 12th of May and we know that the ETFs at least are going to go online today, last I read. There's also the Municipal Liquidity Facility, the Main Street Loan Facility and the Main Street Expanded Loan Facility. There's also the PPP loan facility as well. Is that all of them? Did I get all the facilities under the credit bucket?

Menand: Yeah, I think you got them all. Yeah. I mean, there are a variety of different main street loan facilities. There are, I think three of them.

Beckworth: Three of them now. Okay. Well, let's talk about the legality of all these facilities. So you approach this by looking at them in terms of which ones fall under section 13(3) and which ones fall under section 14. So why don't you walk us through what you see are the legal concerns with these facilities.

Legal Concerns Surrounding the Fed’s Credit Facilities

Menand: Yeah. So why don't we start with the section 13(3) facilities.

Beckworth: Okay.

Menand: That includes several of the liquidity facilities and all of the credit facilities. So it includes the PCF, the CPFF, the MMLF, the TAHL, the two corporate credit facilities, the three main street lending facilities, the PPPLF and the municipal lending facility. Those are all set up pursuant to section 13(3) of The Federal Reserve Act. The funny thing about them is that it just has not gotten a lot of attention, is that they're not really authorized by Section 13(3) of The Federal Reserve Act, as it was on the books at the beginning of this year. Congress didn't actually directly amend section 13(3) of The Federal Reserve Act in the CARES Act.

Menand: It sort of implicitly suspended a variety of requirements in section 13(3) to permit the Fed to set up these facilities. And so it's a very unusual statutory situation, where you have the background rules taken at their sort of face value, not permitting something and Congress sort of suspending that through an act that envisions the Fed doing a variety of things. But without being clear about whether in the future the Fed would be permitted to lend in this way. So, why don't we talk about a few of the different requirements of 13(3).

Beckworth: Yes.

Menand: Maybe a little bit of background, about 13(3) would be helpful to start off with. 13(3) was added to The Federal Reserve Act in 1932 by Congress in midst of the Great Depression. The idea was, it would allow the central bank to go around the banking system and lend directly to the real economy and also lend to other financial institutions that didn't have the regulatory status to access the discount window. It put some restrictions on the Fed, for when it would be permissible for it to go around the banking system in this way. It said that it could only do this in unusual and exigent circumstances and it also said that it would have to make a finding that credit accommodations from other banking institutions weren't available to the institutions that the Fed was going to lend to.

Menand: The Fed did some lending under 13(3) in the '30s, but not a lot, about one and a half million dollars worth of loans, which was a pretty small amount of money even back then. 13(3) wasn't used again until 2008. It was used in 2008 largely to create these ersatz discount windows for shadow banks. In the wake of that, Congress did some pretty significant revisions to 13(3) in Dodd-Frank, in Title XI of Dodd-Frank, which was enacted in 2010. Those revisions actually dramatically scale back the Fed's 13(3) lending authorities. One of the things that they do is they limit the Fed to basically the role that it took in 2008. Setting up the ersatz discount window facilities.

Menand: The way that they do that is they require the board to promulgate rules that ensure that any lending by the Federal Reserve banks is for the purpose of providing liquidity to the financial system. So whereas under the original 13(3) back in 1930s the authority was there for the Fed to lend to anyone, if it concluded that they were creditworthy and not otherwise able to get credit from a bank, after 2010 the lending was limited to providing liquidity to the financial system. A lot of the credit facilities we just talked about, they don't really provide liquidity to the financial system. They are lending directly to the real economy. They would have been permissible under the original 13(3) provided that the Fed had evidence that the borrowers were not able to access credit accommodations from banks, but under the revised 2010 version, they seem to be clearly barred.

Menand: Nobody was too concerned about this piece of Dodd-Frank in 2010 because in 2010 nobody wanted the central bank to lend directly to the real economy. So this was done sort of without much fanfare, but now we find ourselves in a world where actually, the government needs to provide a lot of credit support or wants to provide a lot of credit support directly to businesses and the Federal Reserve Act as amended in 2010 doesn't really envision that. And so what we get in the CARES Act are these workarounds. I can walk you through-

Now we find ourselves in a world where actually, the government needs to provide a lot of credit support or wants to provide a lot of credit support directly to businesses and the Federal Reserve Act as amended in 2010 doesn't really envision that. And so what we get in the CARES Act are these workarounds.

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Beckworth: Yeah. Let me just summarize. So 13(3) was changed so that the only thing the Fed should be doing is what it did in 2008. It made it legal to do what it did in 2008, which is to lend broadly to the financial systems, to support liquidity. That was the goal, but it was not intended to lend to the real economy, but yet that's exactly what's happening with the credit facilities. So how do they find wiggle room? I'm sure they got some smart lawyers at the Federal Reserve who find these loopholes, but what did they do to get around that constraint?

Menand: Section 13(3)(b)(1) says that the board has to put in place policies and procedures to ensure that any emergency lending program or facility is for the purpose of providing liquidity to the financial system.

Menand: And so that seems like on its face to bar a facility that is for the purpose of lending to state and local governments. How did they get around that? Basically, Congress gave them a workaround in the CARES Act. In the CARES Act in section 4003 in sub part B, sub paragraph four, Congress specifically appropriates $454 billion to the Treasury Secretary and says that the Treasury Secretary shall have this money to invest in facilities established by the Board of Governors, to lend to businesses, states, municipalities, by purchasing their obligations directly, by purchasing their obligations on the secondary markets and by making loans. It says that these facilities will be for the purpose of providing liquidity to the financial system. So it basically says “You know those words, ‘purpose of providing liquidity to the financial system’, we're appropriating money for the Fed to lend to these other folks and that will be for the purpose of providing liquidity to the financial system.”

Menand: It's a very odd sleight of hand by Congress.

Beckworth: So they just redefined what liquidity means in the CARES Act?

Menand: Basically.

Beckworth: That's why you paid lawyers, I guess, to help you get things through-

Menand: Yes. You have to ask yourself, why has Congress done it this way?

Beckworth: Yes.

Menand: And some of it may be expediency. But another reason is probably because they did not want to create a new rule that would generally allow the Fed to do this sort of thing. They are trying to create a specific one time exception, whereby the Fed can do this, but only in the context of the CARES Act.

Beckworth: So they're opening up what liquidity means in this particular crisis with the CARES Act. But again, thinking in terms of precedents, this might become a more common feature going forward. So walk us through how they're using these funds to get around these rules. So I know you've mentioned the $454 billion. There's also the Exchange Stabilization Fund. Talk about that.

Menand: Yeah, there's a second problem with the background rules that Congress had to provide a work around for. That involves the Exchange Stabilization Fund. The Exchange Stabilization Fund is an account that the Treasury Secretary has with about between 50 and 100 billion dollars in it, that is available to the Treasury Secretary to stabilize exchange rates. The Treasury Secretary announced, well, the Federal Reserve announced in early March that the Treasury Secretary would draw on this fund to invest $10 billion in the CPFF, in the MMFLF and in the TALF. Presumably the Fed announced this because it determined that it couldn't otherwise comply with its obligations under Section 13(3) to ensure that there is security sufficient to protect taxpayers from losses, for these programs.

Menand: So that requirement was added in 2010 as well. And so in 2008, that requirement wasn't there. The Federal Reserve banks were only required to ensure that there was security to their satisfaction. But in 2010, Congress added an additional requirement on the Board of Governors to ensure that there is security sufficient to protect taxpayers from losses and the way that the Fed did that was it solicited an investment from the Treasury Secretary. Problem is, Treasury Secretary is not really authorized to invest $30 billion in the Exchange Stabilization Fund into these facilities. Because the Exchange Stabilization Fund is for stabilizing exchange rates.

Menand: So, let me quote you from the relevant statutory provision. It says the department of the treasury has a stabilization fund and consistent with an orderly system of exchange rates, the secretary may deal in gold, foreign exchange, meaning foreign currency and other instruments of credit and securities. The problem here is that the $10 billion investment in the CPFF isn't really dealing in securities and it's certainly not dealing in securities in order to ensure an orderly system of exchange rates, because it doesn't really have much to do at all with the exchange rate between the dollar and foreign currencies.

Menand: It's really about the exchange rates between dollars and dollar substitutes, deposits and deposit substitutes, domestically. It's not about the price of the dollar in Euros or Yen or your Yuan. It's not dealing in securities, it's really buying up a spoke equity instrument that's created by an LLC that the Fed sets up. It's investing $10 billion in a Fed LLC. So the Fed announced that the treasury would do this and Congress then passed the CARES Act and in the CARES Act, they basically blessed the practice in a similar way where they instructed, they appropriated in fact, $500 billion to the ESF and they said this money can be used to invest in Fed facilities. It's a similar situation where this is probably a onetime switch of the ESF, because we've left the background rule in place, which just seems totally inconsistent with this and this just raises a lot of questions about what the framework is going to be in the future.

Beckworth: Okay. So to summarize, the first set of legal questions are under 13(3). One is they redefine what liquidity is and the CARES Act. Secondly, they seem to be doing some clever use of the Exchange Stabilization Fund. Again, written up in the CARES Act. So there was some formal law that was written up, but it does push the boundaries of how we normally interpret these facilities and how we think of The Federal Reserve and the term liquidity. All right, let's move to section 14. You also note that there's some legal stretching going on there as well.

Menand: So, with the section 14 facilities, the story is a little bit different. Congress doesn't actually address section 14 facilities as far as I'm aware in the CARES Act at all. Now the section 14 facilities, this is the swap lines and the FIMA repo facility. Basically, what the Fed is doing here is it's getting around the fact that the discount window isn't available to foreign central banks by structuring loans to the foreign central banks in the form of either purchase and sale agreements of treasury securities or currency swaps, which are basically purchase and sale agreements of currencies. And so they are lending by structuring it as a purchase and a sale.

Menand: This sort of section 14 lending what I call open-market lending has been going on for a very long time. The Fed has been doing it since the 1920s, well since 1917, but it's been doing it with non-banks since the 1920s. The problem with it is it's inconsistent with the statutory design and with the text of section 14. Because the text of section 14 requires that the Fed's open market operations, its purchases and sales of assets be in the open market. A purchasing sale in the open market is a purchasing sale at a market price, whereas a secured loan is actually a purchase.

Menand: These are structured as purchases in sales at non-market prices. So in a repo, for example, the Fed purchases the treasury security at a below market price. This is the haircut and then the Fed sells it back at a higher price. So that's the interest payment and arguably even, the purchase and the sale aren't purchases and sales at all. Because the purchase, the Fed doesn't actually get all of the ownership rights. The interest that is earned by the treasury security while the Fed holds it actually ends up going to the seller and the sale is much more like the settlement of a forward transaction than an actual sale.

Menand: There are some inconsistencies here between the design of section 14 and its use for lending, that Congress has known about for a very, very long time. In the 1920s, Congress objected to this use of section 14 to lend and Congress objected again in the 1950s. Let me be specific, some members of Congress objected. Congress overall didn't do anything to change the statute, suggesting that there was actually a majority in Congress that supported allowing the Fed to do this. So Congress has acquiesced in this practice for 100 years, but the Fed is relying on it more and more. It's inconsistency with the structure of the act suggests that Congress really needs to get back to the drawing board and reform the act to better match up with the realities of what the Fed needs to do, in order to perform its monetary function.

So Congress has acquiesced in this practice for 100 years, but the Fed is relying on it more and more. It's inconsistency with the structure of the act suggests that Congress really needs to get back to the drawing board and reform the act to better match up with the realities of what the Fed needs to do, in order to perform its monetary function.

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Beckworth: So I found this about section 14 probably more surprising than I did about section 13(3). So section 13(3), we know that the Fed and Congress are trying to find clever ways to get funds to the real economy during a crisis. But section 14, what you show has been abused for a century, not just a crisis. As you mentioned, it's something that the Fed itself has been aware of.

Beckworth: You mentioned in 1920, its own lawyer, its own general counsel raised this issue. Congress has raised the issue. You mentioned in a footnote Fed chair, William McChesney asked Congress to change the law so that it would be legal, wouldn't have to be limited to open market operations. It's just staggering to think that the Fed, when it engages with repo transactions, it doesn't technically meet the letter of the law in The Federal Reserve Act and hasn't been for some time. You mentioned this is something that hasn't received a lot of attention in the legal literature. What do you think that is?

Menand: Yeah, I don't really know why that is, David. It's a good question. This is certainly a technical area. You need to understand the mechanics of the repurchase agreement and a swap agreement to recognize that they're basically loans. But I don't have a good explanation for why there hasn't been more attention in the legal academy, to the use of these instruments to lend and the sort of contortion of section 14 to do it. As I say in the paper, my view is that the Fed does have authority to lend to non-banks under section 13. And so even if it were permitted to do these purchases and sales in non-market prices, which I think it's not, it seems like it should have to comply with the requirements in section 13.

Menand: As far as I'm aware, it's not really compliant with those requirements. Congress doesn't seem to mind. And so it's sort of an interesting space where Congress and the Fed have worked out an arrangement where the Fed is doing lending that Congress never explicitly authorized. But Congress has also... It's been sort of open and notorious and Congress hasn't come in and said that the Fed has to stop. Now with this crisis raging, it's not like the Fed could say how we've been using this authority for the last 100 years, but we can't actually use it anymore because it's overstretching section 14. Because they have been doing it basically continuously, at least since the 1950s, with William McChesney Martin as you mentioned. That's when they ramped up using repos. That's when they did the first swap lines, in the early '60s. They've basically done open-market lending under section 14 continuously without ever having Congress sort of revise the law as Martin asked Congress to do in '57.

Beckworth: Alright, well, we're getting near the end of our show Lev and I just wanted to get to your policy implications here. What should Congress do to fix these legal questions?

How Congress Should Respond to the Fed’s Legal Gray Areas

Menand: So three things I think, David. One, Congress should think very hard about whether they want the Fed to be a state bank to be a national investment authority. If they do, they should update the Federal Reserve Act to provide authority for the Fed to do that, generally. The CARES Act is a bandaid that works for now, but it's not a great equilibrium in the long-term. Now, there are a lot of people who have put out proposals and have written articles suggesting that Congress should consider not amending the Federal Reserve Act to make this an ongoing responsibility of the Fed and instead should create some new organization or retrofit some existing organization to perform the job that the Fed is doing now and perhaps do even more than what the Fed is being asked to do now.

Menand: These include George Selgin who you've had on the show and I think has spoken about this, Kate Judge, Bob Hockett, and Saule Omarova have a great proposal for a national investment authority that would have a much broader mandate than what the CARES Act gives to the Fed. I think Congress needs to really think about this and do something, do something with the Federal Reserve Act or with some other statutes to create a framework for the credit facilities that is more stable.

Menand: Second thing that Congress can do is deal with the ESF problem. This is not the first time the Treasury Secretary has tried to use the ESF to make an investment that is inconsistent with the background law on how the ESF should operate. The Treasury Secretary did this in 2008 to guarantee the money market mutual funds and the Treasury Secretary also used the ESF in a sort of aggressive manner in the '90s, although arguably more consistent with the statute, as part of the Mexico bailout. There are really good reasons to think that there should be some standing authority for the Treasury Secretary, to make these sorts of investments in an emergency, and these investments do not have a lot to do with exchange stabilization.

Menand: So rather than have the Treasury Secretary try to use the Exchange Stabilization Fund, Congress should create some sort of fund that the Treasury Secretary can use for emergency investments and put some rules and governance around when the Treasury Secretary can use it and what sort of reporting is going to be required and what role Congress is going to have, so that we don't end up in another situation where the Treasury Secretary is trying to use the ESF even though that's not really what the ESF is for.

So rather than have the Treasury Secretary try to use the Exchange Stabilization Fund, Congress should create some sort of fund that the Treasury Secretary can use for emergency investments and put some rules and governance around when the Treasury Secretary can use it and what sort of reporting is going to be required and what role Congress is going to have, so that we don't end up in another situation where the Treasury Secretary is trying to use the ESF even though that's not really what the ESF is for.

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Menand: Then I think the third thing, and this is the biggest one, is a lot of what the Fed has been forced to do over the last couple of months, involves backstopping the shadow banking system, both domestically and internationally. The reason why it's had to create all of these ad hoc facilities to do this and the reason why it has to engage in section 14 lending to do it, is that The Federal Reserve Act was written to create a central bank for banks with the understanding that the monetary system was going to be dominated by banks, that banks would create most of the money supply. And so it was sufficient to put the Fed in charge of banks.

Menand: We've ended up in a world where banks don't create the majority of the money supply anymore. Dollar instruments are created by non-banks in huge volume and the Fed can't do its job, if it doesn't have the ability to ensure that those dollar instruments trade at par with cash. But if you're going to allow all of these dollar instruments out there, then you're really going to want to give the Fed, not just some statutory framework that doesn't require them to set up ad hoc facilities, but that would allow them to operate a discount window for these deposit substitutes all the time, you want to give the Fed, not just that, but you also want to give it some of the ex ante regulatory authority that it has with respect to banks.

Menand: Banks are not just allowed to do whatever they want in the good times and then come to the discount window when the business cycle goes bad. We're sort of veering towards that kind of arrangement with shadow banks and Congress really needs to think about how to restructure that. Or else we're going to end up in... We run the risk, let's put it this way. We run the risk of ending up in a situation where the Fed is unable to establish sufficient ersatz discount windows, in a way that quells the flames in the shadow banking system. That's really what happened in 2008 and it can be disastrous. And so far the Fed has been able to do that, in 2020. But it's the early days of this economic downturn and I think Congress should be concerned about what's going to happen when insolvencies start to mount and what's going to happen in the shadow banking system.

Menand: I think they need to start taking some steps now, to prepare in terms of structuring the Federal Reserve Act and structuring the basic banking laws to make sure we don't end up in another situation like September of 2008.

Beckworth: Absolutely. I'm hoping your paper, this podcast and follow up work will spur that conversation on and lead to the kind of changes you're talking about. Well, our time is up. Our guest today has been Lev Menand. Lev, thank you so much for coming on the show.

Menand: Alright. Thank you, David, for having me. It's been a lot of fun.

Photo by Eric Baradat via Getty Images

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