A Fed for Next Time: Ideas for a Crisis‐​Ready Central Bank: Panel 1 Reforming Credit Policy

How Will the Fed Fight the Next Crisis?

In just a dozen years, the Federal Reserve has faced two severe crises. And twice it has responded by leaning heavily on emergency lending powers it seldom used before by improvising temporary lending programs and taking part in fiscal policy.

In the meantime, the Fed’s nonemergency lending facilities have hardly changed, and may well prove insufficient when the Fed faces its next crisis.

The implication of this is both obvious and ominous: while we still count on the Fed to deal with crises, we no longer know how it will deal with them. Instead of being predictable, the Fed’s crisis‐​prevention methods have become unpredictable–and controversial–adding to, instead of allaying, economic scrutiny.

Can we do better? Can we improve the Fed’s systematic response to crises, making that response both more effective and more predictable? Can we thereby limit the Fed’s entanglement in politics? What can the Fed do to promote these ends? What might Congress do?


  • Sir Paul Tucker, chair of the Systemic Risk Council and former Deputy Governor of the Bank of England
  • Kathryn Judge, Harvey J. Goldschmid Professor of Law, Columbia Law School
  • Lev Menand, Academic Fellow and Lecturer in Law, Columbia Law School

Moderator: Jeanna Smialek, Federal Reserve and Economics Reporter, The New York Times

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Introductory Remarks

George Selgin: Hello everybody, and welcome to the joint Cato-Mercatus's online conference, ‘A Fed for Next Time: Ideas for a Crisis Ready Central Bank.’ I'm George Selgin, Director of Cato’s Center for Monetary and Financial Alternatives. And this week and next we'll be exploring ideas for reforming the Federal Reserve to better prepare it for future crises while also protecting it from fiscal dominance and finally protecting ourselves and our democracy from dominance by the Fed. Today's session is on reforming credit policy, and I'm very pleased now to introduce to you the moderator for that session, New York Times' Federal Reserve and economics reporter, Jeanna Smialek. Welcome, Jeanna.

Panel Discussion

Jeanna Smialek: Hi there, and thank you so much for joining us today. As George mentioned, I'm Jeanna Smialek. I'm the Federal Reserve reporter for the New York Times. The policies are always exciting, but today's are especially well-timed to give that Chair Powell just wrapped up his Senate testimony on monetary policy about half an hour ago. A few logistics on today's panel, attendees can submit questions via the Cato web page, Facebook, Twitter, and YouTube at the hashtag, #CatoEcon. I'm going to go ahead and briefly introduce all three of our speakers, and then we are going to turn to their statements. Once they conclude with those statements, we will go ahead and do Q&A, so just getting your questions before we start that so that I can have a look at them.

Sir Paul Tucker is going to be our first speaker today. He is a fellow at the Harvard Kennedy School, chair of the Systemic Risk Council and was previously a career central banker, including deputy governor of the Bank of England, where he was a member of the Group of Twenty’s Financial Stability Board. He's the author of the book, Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State.

Our second speaker is Kate Judge, who is the Harvey Goldschmid Professor of Law at Columbia Law School. She is an expert on financial regulation and is an editor of the Journal of Financial Regulation and a member of the Financial Stability Task Force sponsored by the Brookings Institution and the University of Chicago, Booth School of Business. She has served on the advisory committee at the Treasury's Office of Financial Research.

Lev Menand is our final speaker and he is an academic fellow and lecturer at Columbia Law School where he specializes in central banking. He's a senior advisor at The Treasury between 2014 and 2016. And spent the earlier part of his career at the New York Fed where he worked on treasury market infrastructure and on stress tests and at the Financial Stability Oversight Council. So with that, I'm going to turn it over to Paul who will get us started with his statement.

Sir Paul Tucker: Thanks Jeanna, and thanks to George and David for inviting me and thanks to all of you for watching today. So the Federal Reserve faces a pretty big problem, we're seeing this again. It's become the indispensable actor in ensuring that the American economy doesn't disappear down a vortex into a repeat of The Great Depression. And in this respect, the United States is close to being a country where the very biggest decisions fall to the Supreme Court and the Federal Reserve. And one of the things I would like to underline is that although across these sessions, people will talk about the Federal Reserve, and many people will say, including me, "The Federal Reserve shouldn't do this." Or, "It should face such and such a constraint." Actually, we should bear in mind that this debate is happening because Congress and the Executive Branch failed to step up to the plate again and again, to help the American people.

What that means, I think, is that for those that want to bar the Federal Reserve from doing certain things, particularly in the area of credit policy, they need to live with either accepting the consequences of no one acting or hold the belief and have a way of getting Congress and the Executive Branch to do more than they have typically been prepared to do to support the economy during bad periods over well, more than a quarter of a century in which I've been watching these things and involved with them for many years.

For those that want to bar the Federal Reserve from doing certain things, particularly in the area of credit policy, they need to live with either accepting the consequences of no one acting or hold the belief and have a way of getting Congress and the Executive Branch to do more than they have typically been prepared to do.

I would say two to three things about a regime for the Fed itself. First of all, as an independent or authority insulated by design from day to day politics, it should be subject to a regime and the people should know what that regime is, so it should be capable of being understood by interested members of the public. We need to get away from a world in which the Federal Reserve is some kind of area of esoteric knowledge for people in Wall Street and a few people in DC and academia.

The second thing I would say, and this goes for all independent agencies, is that where the Federal Reserve steps in as an emergency actor, it needs to be clear what their objective is. I would say that over the past few months, it hasn't always been clear, even in the last 24 hours, when the Fed is acting to support liquidity in the banking system, when it's acting to support the liquidity in the shadow banking system, when it's acting to support liquidity in capital markets, when it's trying to prop up asset price levels, which it says it isn't doing, but I don't think that it's operations fit neatly under other categories. And finally, when it's trying to get cash to members of the public or to businesses around the continent of America or to the government or to foreign governments. And those are all different objectives, and every time they do something special, we need to know what it is they're trying to achieve so that we can track, and you, the people of America can track whether or not they are achieving what they said they were trying to achieve.

Another feature of a good contingency plan is that the conditions for the exit and the method of exit should be reasonably clear in advance. To make that concrete, the Federal Reserve is going to hold a lot of private sector paper, a lot of municipal paper, perhaps some state government paper. Is this paper that they will sell eventually or run off, or will they swap it with the United States Treasury, making clear that it's The Treasury that take the risk on behalf of the people?

The third thing I would say is that it's important that the Federal Reserve does not get into the business of favoring some sectors over others. Households over businesses, some business sectors over others, some regions over others, and how it needs to be able to articulate criteria in advance so that everybody can be assured of that.

And finally, I would say it needs to be clear who takes the risk. And the answer to that question actually is always that it is the American taxpayer who takes the risk because if the Federal Reserve loses money on emergency operations, that means that they will pay a smaller dividend seigniorage to the Treasury. And that ultimately gets reflected in lower public spending or higher taxes, but it's symmetric if they make profits as well. Those are just a few things that I want to put on that table. I mean, actually behind that lies a kind of more higher level set of issues about, what is the place of unelected authority in constitutional democracy? We have drifted into a world where, as I said at the beginning, they are the crucial actors.

I think that's lamentable, but it's plausibly where we will be in the years and decades to come, and therefore there needs to be a much more careful design. And probably that means by the Federal Reserve itself, who typically are overly cautious about articulating constraints on themselves but actually I think in the long run they would serve themselves well and the American people well, and actually what I care about, the cause of independent central banking around the world well, if they were to do that and to do that in a way that is comprehensible to ordinary people. Thanks Jeanna.

Behind that lies a kind of more higher level set of issues about, what is the place of unelected authority in constitutional democracy? We have drifted into a world where, as I said at the beginning, they are the crucial actors. I think that's lamentable, but it's plausibly where we will be in the years and decades to come, and therefore there needs to be a much more careful design.

Smialek: Okay, great. And Kate, do you want to go ahead and take it off?

Kathryn Judge: Of course, and I think my comments should follow very nicely on Paul's. So first I do want to thank George and Cato and all of his colleagues there for sponsoring this series of discussions. It has never been more important for the public, at least the engaged public, to really be a part of these conversations to understand what the Fed is doing, why they are doing it and what they potentially should be doing that they're not yet doing. And so this type of dialogue is a great foundation for that type of conversation, which is one of the ways you're going to get the type of accountability that Paul is talking about.

So as a starting point, I think Paul's point, which is key, so I just want to reiterate it, is it's far from obvious that you need a central bank to play a meaningful role in credit policy, at least in the type of credit policy that we're seeing the Fed currently engage in. The Fed is currently having to play that role because of decisions made by other actors within the Executive Branch. And by Congress, a central bank clearly has a very important role to play during periods of systemic distress with accommodative monetary policy, with providing short term liquidity and helping to stabilize short term markets, but when we shift over to credit policy the Fed and other central banks don't have a long history of playing a strong and productive role in these spaces, so there's a lot more work to do to figure out what the Fed is doing and ought to be doing as it moves into these domains.

So I want to start with one thing that I think is actually going quite well, but won't always go well, so we need to make sure we give credit where credit is due and then think about some of the challenges ahead. So one of the things that's happening right now, which I think is really important, is we have great leadership and we also have a very skilled body of actors throughout the Federal Reserve system. So as a practical matter, every emergency is going to have its own unique contours.

So no matter how well prepared the Federal Reserve is for the types of roles we want a central bank to play, there's always going to be the need for judgment to be exercised in the face of the particular challenges the bank is facing. There's no substitute for leadership, but also kind of deep institutional capacity to address in creative and productive ways the challenges that are at hand. So I think right now, the Fed both at the leadership level and in deeper into the institution, does have meaningful diversity challenges. And I think that's important for their thinking about both the types of problems that they recognize and the creativity or lack of creativity they are sometimes demonstrating over how to best achieve their objectives. So I do think on the diversity front, and I mean that broadly speaking, there's room for improvement.

So I think right now, the Fed both at the leadership level and in deeper into the institution, does have meaningful diversity challenges. And I think that's important for their thinking about both the types of problems that they recognize and the creativity or lack of creativity they are sometimes demonstrating over how to best achieve their objectives.

On the other hand, Powell, Rich Clarida, we have a great group of people who are very well intentioned and very capable who are currently leading the Fed and I'm very grateful that we have the team in place that we do. But moving from personnel to the Fed as an institution, I think if it's going to continue to play a meaningful role in credit policy, there are at least three different challenges that we're going to want to address.

First, we're going to want to make sure that they actually have the institutional competence, that is the tools available, the skills inside the institution, not just from external providers like BlackRock, for the types of aims we want them to achieve. So one of the things we're going to have to do is to make sure that if we want them to play these roles in times of emergency, that we are building up the appropriate set of skills and institutional capabilities during times of peace.

Second, we're going to want to make sure that the legal authority of the Fed maps well onto what it is we want them to achieve through their credit policy. And I expect Lev is going to speak further about this, so I won't go into detail, but there are reasons to be concerned. I have addressed this elsewhere, I've been quite concerned about whether or not The Fed's legal constraints are well mapped on to where we most need credit support in the economy, and in particular, the small and midsize businesses and even businesses that might be going through or emerging from bankruptcy. So I think that there are reasons to think both in terms of institutional competence and in terms of legal authority that we're going to have to make some changes.

But I want to focus on a third component today, and this builds really nicely on Paul's comments, which is not surprising considering the great work he has done on the importance of accountability in the context of central banks. So I don't see the law as being the most important mechanism through which we get accountability here. Part of the reason we need really good personnel is, as I said, each challenge, each emergency, each systemic threat is going to be a little bit different and it's very hard to craft legal rules that map perfectly on to the various exigencies that might arise in the future. There is no way Congress was thinking when it revised 13(3) last, "Okay. Well, in the face of a global pandemic, here's what we want the Fed to be able to do, and here's what we don't want the Fed to be able to do." Instead, I think it's appropriate and healthy for the law to allow some meaningful flexibility. We want the Fed to be able to have the flexibility to do what they need to do, and we also don't want the Fed to be able to hide behind the law, as personally, I'm somewhat skeptical they might have done in the case of Lehman Brothers in 2008. I think the legal constraints matter and should be updated, but they're not going to be the primary constraint. Really, one of the key components that is missing is, "What is it we're trying to achieve through credit policy, and how is it we're trying to achieve it?"

I don't see the law as being the most important mechanism through which we get accountability here. Part of the reason we need really good personnel is, as I said, each challenge, each emergency, each systemic threat is going to be a little bit different and it's very hard to craft legal rules that map perfectly on to the various exigencies that might arise in the future.

Again, as Paul has written about beautifully, when we talk about a central bank going in as a lender of last resort, we have a paradigm over what central banks are trying to achieve and how they're trying to achieve it. We want central banks to be lenders of last resort, and we use Bagehot's dictum, which has actually been modified quite a bit from Bagehot's original work, to say, "Here's when and how a central bank ought to intervene." There's a lot of reasons to be worried that this dictum is at times used opportunistically, again, by central bankers, to justify certain actions or to avoid taking others. On the other hand, the fact that we have an agreed-upon set of standards provides a framework through which lawmakers in Congress, academics, other commentators, the public at large can assess, "Is the Fed doing what they're supposed to be doing, or are they not doing it?" We want to have a set of principles that say, "Here's when they ought to act." There also should be limiting principles over, "Here is where they ought not to act."

We also want to make sure we understand how they are trying to achieve their particular goals. While we definitely need to make progress in terms of those built-in institutional capacity, which was lacking this time around, we want to make progress in the law. I don't think we can make progress on either of those fronts until we come up with a broader agreed-upon set of principles over, "Here is what a central bank ought to be doing when it's engaging in emergency lending directly to non-bank institutions, from nonprofits to municipalities to nonfinancial firms, and here's how we think that they are going about achieving that." Again, that might emerge over time, but I think trying to develop a largely, even if not perfectly, agreed-upon paradigm, is how we're going to get the reference point that we're going to need to help to create that meaningful accountability without trying to resort to tools like the law that might be imperfect relative to what we want to achieve. Thank you.

Smialek: Great, Kate. Thank you very much. Then Lev, do you want to go ahead with your comments?

Lev Menand: Yeah, sure. Thank you, Jeanna, and thank you, David and George, for inviting me to be on this amazing panel. So much of what I know about this subject, I've learned from Kate and from Sir Paul and their critical work on these issues. I think we all agree that the Fed's actions so far this year have staved off a monetary collapse and kept credit flowing to businesses and municipalities. What I want to focus on is that almost none of the 14 ad hoc lending facilities that the Fed has hastily thrown together to do this are actually authorized by the Federal Reserve Act taken along. Instead, these facilities rely on the CARES Act, which does not amend the Federal Reserve Act directly, but suspends various of its requirements sub silentio, in other words, by implication. On its own, I think this suggests we ought to consider legal changes, but the difficulties go deeper. Most, if not all, of the Fed's ad hoc facilities I think are necessary in the first place only because of serious design flaws in our monetary architecture and dysfunction that Sir Paul has alluded to within the political branches of our government.

I think this suggests we ought to consider legal changes, but the difficulties go deeper. Most, if not all, of the Fed's ad hoc facilities I think are necessary in the first place only because of serious design flaws in our monetary architecture and dysfunction that Sir Paul has alluded to within the political branches of our government.

I see two distinct problems. The first is that firms that are not regulated like banks, so-called shadow banks, have gotten into the business of banking, that is, the business of creating money and money substitutes. This is the business that the Fed is supposed to manage and control, but the law assumes that only banks do it, and so the Fed can't manage it using its normal tools. The second is that the political branches lack the capacity to extend grants, conditional grants, or subsidized loans to individuals, businesses, and municipalities in an emergency, and they haven't agreed on a set of rules to guide the Fed in providing such assistance. We're facing the first problem for the second time in 12 years, and the problem goes to the heart of what it means for the Fed to be a monetary authority or a central bank. Central banks administer two-tiered monetary systems, in which the vast majority of the money is created at the second tier by privately owned and operated banks.

These banks are like mints. They issue deposit account balances to people like you and me usually when they make us loans, and they create these balances ex nihilo, out of nothing. Central banks control the ability of banks to do this through regulation and supervision and by issuing money of their own, cash or promises to pay cash, known as reserves. Banks need reserves to settle payments with each other and in case their depositors go to a teller and ask for cash. If they run out, they can borrow reserves from each other or from the central bank at what's known as the discount window. The central bank adjusts the interest rate for these borrowings to influence the amount of deposits banks create. If central banks do their job well, banks do not create too many deposits, and no one ever notices that there's any difference between a deposit account balance at a bank and cash.

But the theory assumes that only banks augment the supply of cash. The system's not designed to accommodate non-banks doing this. Nonetheless, practice has moved away from theory, and today, shadow banks supply a significant portion of the money that our economy relies on to function. When the economy slows and asset prices fall, banks tend to be unwilling or unable to backstop the shadow banks. Because of their regulatory status, shadow banks can't access the discount window. If the Fed wants to ensure that cash and cash substitutes trade at par, it's forced to set up a bunch of ad hoc facilities using Section 13(3) of the Federal Reserve Act, a special emergency authority that it got during the Great Depression. The Fed is operating six such facilities at the moment, and each functions as an ersatz discount window for a different sort of shadow bank.

Now, there are a number of reasons why this is not a good way to run a monetary system. The first is it leaves the Fed scrambling every time it looks like money substitutes created by shadow banks might break par. If the Fed drops a ball, even for a moment, a severe credit contraction can result and trigger huge job losses. This is what happened with Lehman in the fall of 2008. Second, it reduces the efficacy of monetary policy and fuels credit bubbles. The Fed can limit the power of banks to create money, but it has far less control over shadow banks. If financial markets become convinced that the Fed will backstop their money substitutes no matter what, it can lead to dangerous and opportunistic behavior. Third, it leads to rent extraction by lending cash to shadow banks at below market rates, the Fed subsidizes them. Fourth, relatedly, it undermines the statutory scheme for money and banking.

Prior to the Fed's creation, a private association called The Clearing House stemmed banking panics, picking winners and losers based on basically who J.P. Morgan and his associates liked. Congress wanted to put an end to this. It set down generally applicable rules governing what sort of banks could access emergency liquidity and on what terms, and these rules are still in place as far as banks are concerned, but they don't amount to much when it comes to backstopping shadow banks. I think the solution to all of this first problem stuff is to get rid of the ad hoc-ery and confine the activity of money augmentation that the Fed needs to backstop to the charter banking system.

The second problem relates to another eight or so facilities that the Fed has created pursuant to the CARES Act. These facilities further, essentially, fiscal policies by investing in municipalities and businesses, and the Federal Reserve Act provides no framework for these investments. Section 13(3), which Congress adopted to permit the Fed to lend to non-banks, includes a number of restrictions that are inconsistent with them. First, there's what I call the credit availability proviso, which is a restriction originally adopted in 1932 that requires the Fed, before lending to non-banks, to obtain evidence that applicants are unable to access adequate credit accommodations from existing banks. The proviso is supposed to preserve the Fed's role as a monetary authority. It prevents the Fed from bypassing banks unless banks themselves have failed or are failing and the Fed has to step into their shoes to ensure that money and credit aggregates don't collapse. Then there's also requirements that Congress added in 2010, including that the Fed ensure that its non-bank lending is, quote, for the purpose of providing liquidity to the financial system.

Congress basically bypassed both of these requirements in the CARES Act because it directed the Fed to invest money on the government's behalf in businesses and municipalities, not just to keep the monetary system running. Unfortunately, Congress didn't create a framework for these investments. Instead, it put the Fed in the unenviable position of engaging in a sort of highly-charged activity of dispensing trillions of dollars potentially of government assistance without the benefit of any guidelines to insulate it from blowback. The consequences are already apparent. In the wake of sort of substantial industry political pressure, the Fed has revised its term sheets for these facilities numerous times. The Fed's supposed to be an independent central bank, but deciding who gets government loans and on what terms is not a monetary function, and it's not a technical job. It's inherently political. Next time, I think it would be better if an executive branch agency managed these programs, or if Congress decides it should be the Fed, then Congress, not the Fed, should make the decisions about who is eligible and on what terms. Thanks.

Smialek: Great. Thank you all for those really interesting comments. Paul, I wanted to start with you on a couple of questions. One of the things that I thought was really interesting about your comments is this idea that the Fed should avoid advantaging certain sectors over others. Obviously, a big concern with the 13(3) facilities broadly has been that the Fed does not want to take on what it views to be excessive credit risk. I think part of that can end up sometimes favoring sectors. For example, hotels get left out often because they are over-leveraged relative to what the Fed programs allow. I guess, how do you balance those two things, the credit risk concern on one hand and this desire not to be playing favorites on the other?

Tucker: I would say two things. First of all, I think it's important to distinguish lending unsecured, which is what buying a bond involves, and lending secured, so by repo or whatever, because when you lend secured, you can control your risk over time and, to put it crudely, you can make a mistake at the beginning, value the paper too highly, not require sufficient excess collateral, and you can correct for that down the road, whereas lending outright at the beginning is a kind of one-shot game, and you've done it. The second thing I would say, which goes more directly to your question, is all of this, in providing any assistance, it should be relative to those that are in need.

If the hotel sector was the only sector in need, and nobody else was in need, and assuming for the moment that it's okay to do credit policy at all, then under those conditions, it would be okay just to lend to the hotel sector, but it wouldn't be okay on my criteria to lend just to the hotel sector and then the following week, it turns out there's a problem in the manufacturing sector, and they say, "Oh no, we don't lend to manufacturing." This comes back to having general criteria in the background. I think the other central banks have done that, quite frankly, and I think that the Federal Reserve has tended not to be active enough between crises in articulating what its contingency plans are.

When bringing a monetary policy, when it has done a review, as it's doing a review of its monetary regime, it's tended to be painfully slow, in that the next crisis arrived before they had completed that review. I don't know if that's cheap criticism. It is criticism. I think the lesson, which matters more, is that the Federal Reserve, like other central banks, need to be busier during financial and economic peace time in addressing and publishing how they will respond when things happen in a horrible cyber-attack, in another pandemic or whatever. Actually, can I say one other thing, which goes concretely to what you said?

When I saw that they were going to step in and rescue the private equity industry and the junk bond industry, my second thought was, "They will have to lend to municipals and states as well, and they will have to, 'Let's find a way of lending to smaller businesses as well.'" Those announcements came later from the Fed, but they were completely obvious both in terms of the kind of politics in a bad sense, but also in terms of politics in a good sense. Now, they corrected their error reasonably quickly, but it wasn't an error they particularly needed to make.

Smialek: Interesting. Thank you for that. Kate, we have question from you from the audience actually, which is, obviously, as you discussed, principles are important, but why, in the case that they are important, should they not be in the law? Otherwise, where should they be? And the contention here is that being the law would increase their democratic legitimacy.

Judge: So I come to this as a lawyer, and one of the interesting challenges, you realize when you're a law professor and you spend your time immersed in the law, and I spent some time clerking for two wonderful judges, is the law is never self-executing. And so if we could have a world where there was perfect information, where the public courts and central banks all have precisely the same information and that information was accurate relative to whatever legal standard we want to use to both say here's when they ought to act and here's when they ought not to act, then, of course, we might well want the law to map perfectly onto what we want central banks to do. But one of the core challenges, of course, is information is not perfect. And even with the benefit of hindsight, not only does it not illuminate, but that can create different biases over trying to assess what was actually known or should have been known at a particular point in time.

And so, again, going back to the example of Bagehot's dictum and lender of last resort, there's been a meaningful effort by the Fed to say the reason that they didn't rescue Lehman Brothers was, not because they made a judgment call under the circumstances, but rather that they lacked legal authority to do so. And they base that on their claims regarding the solvency of the institution. But, of course, there was incredible noise in any assessment of solvency at the time. There has been a beautiful book written showing that that actually wasn't the focus of a lot of their conversations. And of course, as a practical matter, if a central bank chooses not to rescue an institution, it's going to appear as if it wasn't solvent. Had they not rescued Bear, it would have appeared the same. And, of course, it's also contingent on a bunch of other decisions a central bank is making.

So, again, I think we want the law to roughly map, we want legal constraints to roughly map, onto the broad based principles. But to think that the law can be the perfect tool requires us to assume that courts can come in and perfectly discern whether or not a central bank was acting appropriately or not. And I think I'm very skeptical of the capacity of courts to do that and the capacity of the law to do that well. And so, again, if we want meaningful accountability, as counter intuitive as it might seem, sometimes what you actually want is say here's what we want to achieve, here how it ought to be achieved. We're going to create a lot of transparency and accountability through things like testimony.

So they really need to explain what they're doing and whether or not they're achieving what we want to achieve and how we want them to achieve it but provide a little bit of flexibility in the law because otherwise there is this ability to actually use the law as an excuse for not going in. And that actually can foreclose precisely the type of public debates that we need to have, and it can reduce accountability, providing excuses not to act without actually having to take responsibility because they can say, look, it was out of our hands. So, again, I think the law plays an important role here, but it's one of many different tools that need to be used in complementary ways to achieve the optimal level of accountability.

Smialek: Now, a follow-up question that relates closely, and I'm going to tweak it a little bit out of my own interest. To what degree is it fair to say that the Fed is lending in a way that's consistent with the Bagehot's dictum presently? And then I'll tweak that and ask can you give specific instances right now where you think they clearly departed, that maybe we need some sort of more clear overarching principle to apply to?

Judge: Yeah. There's a lot of different ways to go at this, but I don't think Bagehot's dictum is what they're using as the animating principle. And they're not invoking it. It's very different than it was in 2008 where Bernanke himself was invoking that so frequently and used that so often to say here's what we're doing and here's what we're not. And really, he was doing that, to get to Lev’s point, one of the biggest changes there is that we had liquidity transformation occurring outside of banks and in markets. And so we're using this framework to say here's why market-based intermediation also requires certain central bank backstops.

But if we look at what's going on now, look at what the Fed recently started doing in terms of the secondary corporate credit facility. So they are buying broadly a whole variety of different bonds. It's not obvious that there's any liquidity need or market functioning need, and it's not obvious that this is a situation where trying to go in is going to create this type of stabilization. So if you look at Bagehot's dictum, this isn't a collateralized lending to overcome a short-term acute liquidity issue. It's contorting credit. And it's not necessarily inappropriate, but whether it's appropriate or not is very difficult to discern because what we have right now is these two long reaching macroeconomic concerns, according to Chair Powell, where if we have too many companies going bankrupt without an appropriate scheme for reorganization or we have too many workers who are out of the workforce for too long, we end up with meaningful scars for long-term economic growth. And I think he's right to be concerned about both of those. He's also right to be concerned that if companies are shrinking because of lack of access to credit or failing to pursue opportunities because of lack of access to credit, there could be harms to workers and to the health of the broader economy. But we haven't articulated how, where they're going in and the terms that they're using in these various areas actually reflect that.

So for example, in that facility, we're not seeing something like a penalty rate. And they often, of course, don't use penalty rates. But we need to at least have a conversation about that. Similarly, across all of these different new facilities where we have things labeled liquidity, they're not liquidity like we've traditionally thought about it. There's a lot of talk about building bridges. And so that suggested something akin to liquidity where it's looking longer term, but it really doesn't fit the traditional model at all of an institution or an environment where there's liquidity transformation. And what we're trying to do is stop unnecessary runs by creating the ability of a central bank to go in and to provide cash and to stop the need for institutions to sell these longer term assets at fire sale prices.

So I think there's a whole variety of ways that that paradigm just doesn't fit the nature of the challenge or the nature of the interventions. Again, when we're looking at the credit facilities, I think if we're looking at TALF and separately a lot of the shorter term facilities that we saw used previously that they rolled out again, I think those actually can fit the paradigm. But in credit policy, we're doing something that's different. And as Paul pointed out, the Fed hasn't done a great job outside of crisis periods. And I would say hasn't done a great job in this crisis to articulate with specificity what they're trying to achieve and how they're trying to approach it.

Tucker: Yeah. Yeah. I think that's exactly right.

Smialek: Actually, I wanted to follow up with a question for you, Paul, on exactly that point. And then, Lev, I'll jump to you after that. But I guess the question is obviously there is a real concern about transparency around these facilities and around what the goal of these facilities is. It's very easy to criticize lack of transparency and may be harder to be transparent in real time. I guess, if you had a couple of concrete recommendations for how they could be clear about what they're doing or what the overarching goal is, what would those be?

Tucker: Let me say, first of all, since you brought me in again, that this is a completely different crisis from anything that Bagehot contemplated. He was writing in the late 1860s and the early 1870s. I suspect that had Victorian England suffered a pandemic, the government would not have locked down the economy. And if the economy had spontaneously locked down, which is why the government mandated a lockdown, I doubt very much whether the government would have come to the rescue of families and businesses in the way that governments have now. And the economy would have been in worse shape, a lot worse shape for a lot longer afterwards I would suggest. And the point being that as societal expectations change, central banks have to prepare for that.

What would I recommend on transparency? One's default assumption and preference as a central banker should be, I am going to publish who I am lending to at some point. Is it safe to do so now? If I do so in the short run, will I deter people from taking funds from me in ways that perversely hurt the general public and the economy as a whole? If that, that may not be the case. If it is the case, then there should be publication after a lag. One could debate what the lag should be. But in between time, even if you don't publish immediately, and what I'm going to say now, we put in place in the UK back during the last crisis, frankly, after we'd made a bit of a mistake, was that the Federal Reserve should be reporting to the Chairs and ranking members of the two key committees just who they have lent to so that there's no secret about that.

Now, there may be people watching who are saying, well, actually, you couldn't trust these politicians not publish it. Well, that would be a terrible thing. And it should be disclosed on the same basis that the intelligence services and security services disclose things in camera or secretly. But if the politicians can't be trusted, which would be a symptom of a much, much greater malaise, then at least it should be reported to some kind of staff facility in Congress so that the Federal Reserve as an unelected independent insulated body isn't sitting on information which it says, we'll provide this to you only when we think it's safe, because that is a kind of self-monitoring and self-reflective accountability that just isn't consistent with the deep values of the political systems in which we're lucky enough to live in.

And so I disagree. And so I disagree with Secretary Mnuchin, why I think he's got this wrong. And I think he's probably getting it wrong because it's the first time he has been through it.

Smialek: You disagree with him in what sense?

Tucker: If I made a mistake on this, I apologize. I think he said no, that we don't think we should publish X, Y and Z about who was taking, which companies are taking money from the government or from the Federal Reserve and, well, certainly by implication from the Federal Reserve as well. And if that is his position, then it at least ought to be we will provide this to some private and Congress people or some staff in Congress and we will publish it more generally when it's safe to do so and when it doesn't affect confidence in businesses and their incentives to borrow. You can't just have the executive branch and the Federal Reserve just doing what they like and no one ever knows.

Smialek: Right. It is worth noting, just for our viewers who maybe pay a little bit less attention to this, that the Fed is putting out more information on the CARES Act facilities than it previously has put out on the other facilities. And those are all available on a landing page. So I'll tweet the link out to that after this wraps up just so everyone can find it. As all things with the Federal Reserve website, it's a bit difficult to locate on your own.

Now, Lev, I was hoping to ask you, we have a question from an audience member about your shadow banking point. As they say, it's one thing to reign in money creation and shadow banking in the United States via changes in laws and regulations, but how do you do it for shadow bank money creation outside of the United States, which the BIS says amounts to about $13 trillion? I assume that's last year. What's your response there?

Menand: This is a really important and really critical question. And I think that the answer has to involve international diplomacy. And when we think about the Basel Accords, we have three Basel Accords about bank supervision and regulation, and we really need a Basel Accord about money creation overseas. So for the United States, it's about the Euro dollar markets, which are not specific to Europe, that they're dollar denominated deposit and short-term debt markets that take place outside of the U S jurisdiction. The OECD countries and the Basel participants should reach an agreement about the ability of institutions in their country to create money substitutes and other people's currencies. And so US financial institutions creating Euro denominated deposits, for example, that would be subject to these rules, and there would be sort of some sort of reciprocity. I don't have all the answers here, but this is definitely the hardest part of constraining money creation and probably the most important. And international solution is essential.

Smialek: Right. And then we had another question, actually, that I think you would be probably the right person to take, which is that bank credit is an important transmission channel of any central bank's monetary policy. The risk-weighted bank capital requirements based on perceived or decreed credit risk distorts it. Why is that ignored? Partialized, I meant.

Menand: I'm sorry. I missed the first part of that question. Could you just repeat it?

Smialek: Absolutely. Bank credit is an important transmission channel of any central bank's monetary policy. The risk-weighted bank capital requirement based on perceived or decreed risk distorts it. Why is that ignored?

Menand: Great question. I don't think it's ignored that it distorts it. It's part of the two-tiered monetary system. And so in the two-tiered monetary system, the government says we want to enlist the help of privately run institutions to create the bulk of the money supply because we do not want to make the decisions about what assets are going to be monetized. We want to outsource that responsibility to a bunch of privately managed banks for a variety of reasons. But the capital rules are a way of saying there are some decisions that the government is still going to make about how these banks exercise this delegated authority, and the rules are designed in part to reduce the amount of risk that banks can take. Recognizing that essentially the government is backstopping them and there are going to be incentives misaligned there.

But the Community Reinvestment Act is an example of another set of rules governing how banks exercise this delegated authority that doesn't really have to do very much about losses, it has to do with how the government wants to see the banks exercise this authority. So it does distort, but in a very intentional sense, it's a set of guidelines for the banks that they have to follow, if they want to be in the business of partnering with the central bank to create a workable money supply for the economy.

Smialek: Okay. Interesting. Thank you. Then for Paul, if Congress asked you how it might amend the Federal Reserve Act, so as to better limit its unelected power, what would you tell it?

Tucker: I would, first thing I would say is set an objective for the lender of last resort policy. I think that would ... and I think that's much better than the kind of ... What's tended to happen in the past is the Fed have acted in the way that they are now, and then Congress has tried to place constraints on them. Some of which have been well-designed some of which have been poorly designed in my view, but they never say what's it actually for.

Well, there is something in the 1913 act about an elastic currency, but no one alive knows what that means, and few people did when it was passed over a century ago. So I think an objective for the lender of last resort policy and putting the Federal Reserve under a duty to be the lender of last resort, subject to some constraints, including not lending to bodies that it knows or should know to be fundamentally insolvent.

Then I think there's a much more difficult question, which is, what should the objective be for credit policy of the kind that we've seen in recent weeks? And let's be completely clear about what's been going on, the Federal Reserve and the government have been acting to hold the economy in some kind of suspended animation to ensure that families are in food and shelter and businesses don't collapse and the Federal Reserve and the government end up doing this because private sector banks wouldn't willingly do it.

There's a lot of rubbish being talked about banks already being part of the solution. They may become part of the solution as the economy reopens and gradually recovers. But so far banks have just stepped up where they had a contractual commitment under committed lines of credit. They haven't been writing much new lending business and yet all sorts of people and businesses across the country who never thought they would need a loan or a cash handout have needed one.

I don't know what the answer is about framing limits around that, but I think something around that is needed because otherwise the Federal Reserve just becomes not a central bank, but in a sense, everybody's personal bank. So that all American citizens and businesses it's as if they have an account with the Federal Reserve. If that's not the model that America wants, then it needs to play some kind of reasonable constraint on the kind of activity underway at the moment, which I think is best done, this goes back to Kate's point about the law, I think.

It's best on in terms of purposes and objectives that are reasonably concrete and can be tracked rather than trying to envisage every single situation and putting a constraint on various things. So the 13(3) constraint that says you can only provide general facilities, this isn't sensible because it's not hard for central bankers to imagine circumstances where, because of concentrations of activity, particularly frankly, in the US system of custodial businesses, that the failure of one firm would be an absolute disaster and one would need a facility for just that firm.

So I don't have all of the answers to this, but I think framing it in terms of objectives is better than trying to think of very detailed constraints and the objectives should not be vague. I mean, I'm keen on resurrecting what lawyers call the non-delegation doctrine, or a variant of it for independent institutions, where there really does need to be a clear principle and a monitorable objective rather than just something that the court says is an intelligible principle, which has become a kind of Alice in Wonderland term of art.

Smialek: Interesting. Now this is a question for Kate, but I'm curious in all of your response to it. So we'll start with Kate and then move around, which is, what types of moral hazard do the new Fed facilities raise and how should the Fed manage them? Should they worry more right now about economic risks or about moral hazard?

Judge: You always have to worry about both. There's no situation in which you're going to have massive government intervention where you're not going to have some moral hazard. On the other hand, we know from experience, if you are too concerned about moral hazard during periods of systemic distress, then you have a very real risk that the government isn't going to do enough to support economic activities and support the health of financial markets. The long-term consequences can be devastating.

So I don't believe that we deal with this by just throwing moral hazard concerns completely out the window once we are facing any kind of systemic distress. But I do think that they have to be balanced the specific, and so two comments on that. One, we mitigate some of that moral hazard. The specific moral hazard we have to worry about, I think this time around, is that that institutions are too quick to take on debt because they expect the central bank to come in and to support debt markets and to really actively support lending.

So one of the patterns that we saw going into this unique event is that even though this was brought on by COVID-19, so by this public health crisis, and by policy responses designed to contain the public health crisis, nonfinancial corporations had been issuing record amounts of debt, which really increased their fragility going into this crisis, reduce their capacity to borrow directly from markets without that implicit government backstop. As a result, I think we should expect to see a lot of corporate debt going forward. So I think that is the big moral hazard.

I think one of the ways we traditionally deal with moral hazard is through then developing a regulatory scheme that helps address that moral hazard. For me, this is one of the challenging areas we know when it comes to banks and as Lev pointed out to particular non-banks, that given the nature of what they are doing, there's going to be externalities if they fail. So there's moral hazard there, but it arises, not just from the government intervention, but rather the broader context in which they are operating and the ability of other actors to be harmed, which is precisely why a central bank and the government are going in that rescue operation, and we deal with that through regulation.

One other thing we know from banking is it's really hard to do that well. So I think one of the concerns we've already seen is now a lot of people are wondering whether we need regulatory limits on leverage for non-banks just like we have for banks. I think it's very hard to do that well. So I think one of the interesting considerations is not just about moral hazard, but what are regulatory expectations that are going to be set up to contain sources of moral hazard. Those two can just be costly and messy. So it's reasons, again, for the government not to avoid intervening, but to think about how they are intervening and making sure they're doing so when there's really a broader systemic justification for the support they are providing interesting.

Smialek: Interesting, and Lev, it seems like this question hits on your shadow banking concerns a bit. But I wonder if you could just elaborate.

Menand: Yeah, sure. I mean, and also, I just want to tie together something that Kate said earlier about law with what Paul was just saying about lender of last resort. One way to think about, at a big picture level, the role of the law is, is that the law is about where discretion is, who gets discretion? Where are you going to house discretion? Is discretion going to be with the legislature? Is it going to be with the independent agency? Is it going to be in the courts? Who's going to get the last word to decide?

What we have right now, on the credit policies, is basically full discretion with the Fed. The way the law is structured is that Congress has said, "We're not going to exercise much discretion. We're not going to put down a bunch of rules, nor are we going to set up rules for the courts or a role for the courts here or private parties, the Fed is basically going to decide how to disperse these monies." What Paul is pointing out is that the Federal Reserve Act doesn't even set forth a guiding principle to constrain that discretion.

Now, I think Congress did give the Fed a principal in 1977 in the Federal Reserve Reform Act. This is the famous dual mandate, which is in section 2A, which is where Congress tells the Fed that it needs to run its monetary policy, it needs to exercise basically all of its authority, in a way that shall maintain long run growth of monetary and credit aggregates, that's commensurate with the economy's long run potential, and that will promote effectively the goals of maximum employment and price stability.

This so-called dual mandate, I think actually does apply to all of its lender of last resort facilities as Congress conceived of them in 1977. In other words, its 13(3) lending was really a monetary function. It was about allowing the Fed to preserve monetary aggregates and their growth consistent with the dual mandate. But this is not helping us for any of the new CARES Act facilities. So Congress needs to say something more about how those policies should be structured or else all of the discretion is with the Fed, and that's going to put the Fed as an independent nonpolitical central bank in a real bind.

Smialek: Okay. Interesting. Paul, you have the final word of our panel here. What's your thought on the moral hazard question?

Tucker: Thank you very much. Thank you again for inviting me to do this. So I'm in much the same place as Kate, I'll try and be crisp. So the junk bond industry and private equity sponsors have now been bailed out twice in a decade, just over a decade. They didn't set out to do it, they didn't cause the crises, but they have no less been bailed out. So they get the upside when things are good and the taxpayer gets the downside, potentially, when things are bad. That doesn't mean that I particularly want to regulate that industry, but I think there should be a careful look at removing the tax breaks on interest because there at the moment, the taxpayer subsidizes leverage, and the taxpayer then comes to the rescue when there's too much leverage.

Second thing I would say about shadow banking and market based activity, which both Kate and Lev have turned on. I mean, the viewer should have no doubt that it is shameful that faced with a fairly small crisis at the beginning of March, and before, that the Treasury market ceased to function well. That signals that there is a fairly deep malaise in the Treasury markets that the authorities need to come back to.

But one thing they could do is they could just, as central bankers are meant to raise capital requirements for banks during the good times, during the boom, they could raise haircuts and initial margin requirements for certain types of market-based finance during the boom so as to arrest and disincentivize excessive leverage in trading markets.

Then finally, I would just say, I completely agree with what Lev said about the need for an international regime on shadow banking, the body to pursue that is the fact G20 Financial Stability Board on which I used to serve. The reason I mentioned it is because the current Chair of the Financial Stability Board is the Vice Chair for Regulation of the Federal Reserve. Randy Quarles can do real good in this area if he Marshall's his peers around the world.

One important qualification I would add to the way Lev put this is, from the point of view of the United States, you want to make use of the dollar elsewhere in the world systemically safe. I wouldn't encourage you to deter the use of the dollar elsewhere in the world. That might be both the geopolitical mistake and make it much more expensive for you to occupy the position in the world that you have had since the Second World War.

Smialek: Okay. Interesting. Thank you all we are out of time, but thank you everyone for joining in on today's event, the video recording of this event will be available on the Cato webpage later today. Now I'm going to turn it over to George, to close out the panel.

Closing Remarks

George Selgin: Thank you everybody. I hope you all enjoyed today's session. Please join us on Thursday at the same time for our second session on defining fiscal stimulus duties. See you then. Bye-bye.