George Selgin on the Productivity Norm, Deflation, and Monetary History

George Selgin is the director of the Cato Institute for Monetary and Financial Alternatives and is a former professor of economics at the University of Georgia. He is widely published in monetary and banking theory, monetary history, and macroeconomics. George joins David to discuss what the Fed got wrong in the lead-up to the recent financial crisis. He makes the case that central banks, rather than focusing on the price level or inflation rate, should instead allow inflation to reflect changes in productivity growth. Selgin examines the Great Deflation of the late 1800s and dispels some of the popular myths surrounding that period.

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David Beckworth: George, welcome to the show.

George Selgin: Thanks, David. It's nice to be here.

Beckworth: It's always good to have my former instructor back, just like the good old days of Monetary Economics with George Selgin.

Selgin: I'll try not to give you such a hard time.

Beckworth: I appreciate that. Let's begin by talking about an idea you've developed. That is the productivity norm. Can you tell us what it is and what it implies for monetary policy?

Explaining the ‘Productivity Norm’

Selgin: Sure, David. The productivity norm, the name is somewhat misleading. It actually refers to a norm for how the price level ought to behave. What it means is that contrary to the very conventional and still very popular view that ideally the price level or at least the inflation rate ought to be as stable as possible, a constant, whether it's two percent or some other number.

Zero used to be the favorite. Contrary to that, under productivity norm, the rate of inflation is allowed to reflect the economy's underlying rate of productivity growth, specifically by adjusting opposite with adjustments to the rate of productivity growth.

In a more rapidly growing economy where productivity is growing more than usual, you would allow a lower inflation rate. In some proposals like my own original one, even a modest rate of deflation to reflect the fact that the economy's getting more productive.

That's another way of saying to reflect the fact that the average unit cost of production of many goods and of goods in general is falling. So if goods get cheaper, prices should generally fall.

Conversely, if you have an adverse supply shock, the rate of inflation should be allowed to go up. The reason for advocating this norm is that I believe if inflation is kept constant despite fluctuations in productivity growth that itself can be a source of trouble. The productivity norm has a link to proposals for market monitorists in that they all involve treating stability of nominal spending rather than of the price level is what's really desirable for overall macroeconomic stability.

Beckworth: Many economists would agree with your point that if there's a negative supply shock so there's sudden reduction in supply of oil, some natural disaster, that prices should temporarily be allowed to go up because you wouldn't want to tighten policy in a situation like that.

They have a hard time with the flip side of that argument, that if there's a positive supply shock, then maybe some disinflation, maybe even mild deflation should be allowed. Why is there this asymmetry in probably most economists thinking?

Understanding Inflation

Selgin: Economists are spooked by deflation generally. That spooking seems to have mainly come about as a result of what happened in the 1930s.

It's important to acknowledge, because some people don't, that, yes, deflation can be very spooky, but it's spooky when it is a consequence of a collapse of spending in the economy or NGDP or whatever metric you want to use to measure spending. In that case of course, when spending collapses, it's impossible for the average firm to recoup its historical expenditures and to make profit.

We have the average firm losing money, which is not a good thing because it's not a useful signal to the economy. It just signals that there's a shortage of money in the economy. That's what happened in the '30s, both at the beginning of the decade and later on, in '36, '37, and '38.

There is such a thing as bad deflation. However, there's also such a thing as good deflation, which is the kind of deflation you were just referring to, which is the flip side of adverse productivity shocks or supply shock where you have positive productivity shocks.

Actually, people are perfectly happy to tolerate good deflation if it's limited to a few goods. But what that means in practice is they're only willing to tolerate it if some other goods are getting more expensive so that the price index or inflation rate measured with conventional price index is not changing.

It's OK for the price of computers to fall, but by gosh something else had better go up to keep the overall price index or the inflation rate from changing.

The reality is, more often than not, productivity improvements are happening in many sectors of the economy at once, affecting many goods at once, with the improvements outweighing or outnumbering situations where unit costs of production are rising. In that case, why not let the general rate of inflation and the general price level reflect the overall changing state of productivity?

Because they've been spooked by the '30s and some other episodes, economists are very reluctant. They tend to speak of deflation as if it was always demand driven. Ben Bernanke routinely does that. He seems to be incapable of recognizing this other kind. He does once in a while very grudgingly.

In fact, if I may add, now there have been quite a few studies of historical deflation. Kito and Atkinson, Boreo, and others, Claudia Barre, they all come to the same conclusion, that in fact the good sort of deflation I was just describing has historically been more common than the other sort.

Therefore, we have more examples of that kind of deflation, the sort that there's really no reason for the authorities to prevent than we have of the bad kind.

Of course we have to be wary of the latter. We certainly don't want risk, allowing it when we shouldn't, when we don't want to, but that alertness should not be allowed to translate into an absolute refusal to allow prices generally to ever fall even when that means you have got to artificially expand nominal spending to prevent that fall.

Beckworth: Let's give a concrete example of this benign deflation. The post‑bellum deflation period, right after the Civil War up until 1896, before they had the big gold discoveries, was a period in US history where we saw on average rapid economic growth as well as a consistent one to two percent deflation a year, yet the world didn't end.

Can you speak to that experience and what it says about benign inflation?

Selgin: Sure. I will. It's a very important experience. It has been widely misunderstood. In fact, deflation of the sort you describe was roughly occurring not only in the United States but in all of the gold standard countries at the time, so it was a phenomenon that was linked to the gold standard and obviously was due to the fact that the gold standard was allowing for.

In general, just enough money growth to offset extensive expansion in production but roughly not enough to meet the expansion in production that was related to productivity improvements, I say roughly because we should not pretend that the gold standard exactly got the productivity norm right. It certainly didn't. But it came pretty close.

A lot of people have based on US experience said, "This was terrible. We had all these crashes, etc." Some even have treated the whole period from the 1870s to the 1890s as one big slump because prices were falling as if deflation were identical to depression, which is certainly not true.

As a matter of fact, of course, the US had many severe downturns, mostly relating to financial crises. These were a peculiar result of problems with the US banking system that weren't repeated in the other gold standard nations.

During those episodes, we tended to have some bad deflation mixed in with the good. That has also been a source of confusion.

As for the general background secular deflation, there's no link in the US any more than in any of the other countries between that and any general slump. We know that people were not unemployed generally at high rates. We know that people didn't feel depressed for most of these periods. Only during those financial crises and for some time after did you really have a slump.

Beckworth: People confuse those crises, 1873, 1893. They were really sharp, but, as you said, they were tied to this faulty national banking system which was very conducive to financial crisis. A good counterexample is the panic of 1907. If you 1907, you go to an inflationary regime.

The panic in 1907 was the worst financial crisis of that post‑bellum period. It speaks to the fact that the financial crisis wasn't a product or a function of the deflation. It was a product of the system because it occurred in an inflationary environment as well as the deflationary environment.

Selgin: That's absolutely right. In fact, there are all kinds of evidence you could bring to bear on this point because you could look at different countries. You could look at Canada.

Canada had the same gold dollar. They had the same secular deflation. They didn't have the crises though because they had a different monetary and banking system without a central bank for what that's worth.

If they had all those elements in common, it can't have been one of these elements they had in common with the United States that was responsible for those crises that did occur.

It had to be something peculiar to the United States. Indeed, after the Klondike and other discoveries, South Africa and especially of the 1890s, the deflationary trend ended. It was replaced by an inflationary trend, but this change had essentially no bearing on the incidence of crises in the US or anywhere else.

Beckworth: One thing we probably need to stress is...This is a question that I often encounter is, "How would the central bank know when it's good deflation or bad deflation?" The productivity norm, correct me if I'm wrong, you don't have to worry about that. It will take care of itself. All you have to do is focus on stabilizing demand. Is that right?

Selgin: That's exactly right. In fact, it's a widespread misconception, by which I mean widespread among the relatively small number of people who have ever heard of a productivity norm, that it calls upon the central bank, assuming that you have a central bank, to take account of productivity changes and react appropriately to them. But that's exactly wrong. That's exactly the opposite of the truth.

It's when the central bank is determined to maintain a constant inflation rate that in principle it has to try to anticipate productivity changes because those changes will affect the rate of inflation unless it takes counter monetary policy actions.

Every central bank that's determined to keep a stable price level target, say the ACB trying to keep two percent, is obliged to inform itself to try to forecast productivity innovations in order to offset them.

Under a productivity norm, those innovations are among the things the central banks should not pay any attention to and should not respond to. So it's one piece of information less that they need to anticipate. Indeed, when you look at the factors that determine output...Because a stable price level...

Let's just speak of stable price level. People can adapt what I'm saying for the case of a stable rate of inflation. What it really calls for in famous formulation is having the amount of money that's chasing goods only adjust as the total amount of goods adjusts, which means you're anticipating changes in total output in trying to have a money supply expansion allowing for changes. Velocity keeps up with that.

The component of output change that's hard to predict is the productivity component. All the others are relatively stable, population or labor force growth, the growth of capital, stock, that sort of thing. But intensive changes in productivity, total factor productivity, those are the ones that are the most difficult to forecast.

If central banks are going to make mistakes in attempting to keep prices stable, they're going to make mistakes with respect to their forecasts of total factor productivity growth. The productivity norm says, "Don't bother. You don't need to offset those. Therefore you don't need to take the risk of doing it incorrectly."

Beckworth: Some people might wonder, "Then do we have a nominal anchor?" But the answer is yes. We were still tied to a nominal measure. In the long run, that anchors down trend prices. But in the short run, there can be deviations. Maybe I should step back a minute.

The Fed was if it were the Fed doing a productivity norm, it would keep spending growing at a stable growth path or growth rate. The question would be how that growth rate was broken down into real growth versus changes in prices. One year it might be higher real growth, lower prices. The next year, it might be the opposite. Is that fair?

Selgin: That's right. A lot of people are hung up on that because they say this would mean that if you're stabilizing nominal spending, this means you're allowing output and the price level to vary more than they would if you were perhaps trying to stabilize some weighted average as in a Taylor rule, for example.

That misses the point because the goal of monetary policy in my opinion and that of market monitors as I take it is not to aim for any absolute stability of either P or Y but rather to avoid monetary influences on Y, deviations from the natural rate we might say. That's a question of stabilizing demand, which is to say total spending.

You can think the amount of NGDP as just indicating the position of the aggregate demand schedule and aggregate supply demand space. In that case, to the extent that the natural is changing and shifting, particularly in response to productivity gains and losses, then that should be reflected in changes in the price level or inflation rate.

I make an analogy or rather respond to an analogy in talking about this where some people say, "Having a price level that varies is like having a thermometer that isn't measuring the temperature correctly or a yardstick made of rubber," and so on. But it's not correct.

Under a productivity norm, it's true that the price level varies, but it's also true that in the world, the temperature varies. The thermometer registers different temperatures that are a good thing.

Similarly, let's say we have a ruler, and we're measuring the average height of people. Sometimes the average height of the entire population changes. We wouldn't want to change our rulers so that average is always constant. Five feet in the Victorian era so it must be five feet today.

Similarly, when the price level changes under productivity norm, it's not telling you that you've got a broken yardstick or rubber on or bad thermometer. It's telling you that the goods are getting cheaper to produce or getting more expensive to produce. Very useful, informative signal.

Then there's another side to the argument which is remember when we're stabilizing output prices or rather allowing output prices to change under productivity norm. What we are stabilizing is an index of factor prices in principle.

Conversely, those who would stabilize output prices in the face of productivity innovations are destabilizing factor prices. They think that they're stabilizing the price level and imagining that this is all prices.

They're forgetting what price level stabilization or inflation targeting involve in practice is looking at one set of prices and not looking at the other. You can make all kinds of good arguments. Economists through the ages have made them, that it's more important that factor prices be kept stable than final good prices.

Beckworth: This speaks to a criticism that I often hear or at least recently have heard. That is that the nominal GDP target. That's what the productivity norm is to be very clear. It's a special kind of nominal GDP target.

Selgin: One of the earliest types.

Beckworth: One of the earliest. Now I stand corrected. But it's basically a nominal GDP target. I believe Marvin Keene had a paper that made this point that is we have a nominal GDP target every so often, we have to out and estimate potential GDP and adjust the target.

That kind of defeats the whole purpose of a nominal target, the whole point of that. Along those lines, could you also speak to this idea that when we're measuring the effect of monetary policy or the stance of it, there's this idea that you've got to decompose nominal measures into the real and inflation as opposed to measuring the actual observed nominal measure.

Selgin: On this question of what the central bank, let's remember that if you have a central bank targeting the inflation rate, what that means is that setting fluctuations in velocity aside which all of these norms the central bank would have to offset changes in velocity. So let's set that aside.

Then, under an inflation targeting regime, what the central bank has to do is try to forecast uncertainty to be aware of current changes in total output. That's little y in the equations. That means that it has to know about both intensive and extensive changes in output where extensive changes are changes based on increased factor input.

Intensive are based on changes increased factor productivity. As I said earlier, it's a factor of productivity that's the hard one to anticipate. It bounces around a lot as we know. From recent experience, we know that very well.

The other one, the factor input, doesn't change that much. It's relatively easy to forecast that. If you're a baseline central banker trying to make sure you hit a fixed inflation rate target, you've got a big forecasting challenge.

If you're just trying to anticipate, to fix an AGDP growth target, you have a considerably easier challenge because you're only having to anticipate that input factor. That is relatively less volatile and easier to guesstimate. They'll get it wrong, but they're not as likely to get it wrong as the other component.

Beckworth: Maybe another way of saying that is if you're an inflation targeting central bank like most are, they have to divine what's causing the changes in inflation to get it right. If it's a velocity change or demand change, they need to respond to that. But if there are supply changes, productivity driven changes, they need to ignore those.

Selgin: Under my regime, they need to ignore the productivity changes, but the point is that's just a matter of not bothering to forecast those.

Beckworth: Right, it's far easier.

Selgin: The problem is that under the inflation targeting regime, they need to forecast future productivity as well as future factor input in order to make sure that changes in neither of those things result in changes in the rate of inflation because they have anticipated and offset them with monetary policy. They've adjusted their monetary targets accordingly.

Whereas with the productivity norm, you don't worry about factoring, but you do worry about if lots of people immigrate and your labor force changes. You don't want to not accommodate that.

Simple way to think of that is that that would put downward pressure on factor prices, specifically wage rates, so you want to have some monetary accommodation to avoid it. But you wouldn't worry about the fact that prices fall because of productivity gains. You would just let them. You wouldn't anticipate them.

The fact that you didn't forecast productivity net, it wouldn't concern. You wouldn't try. The price level would change. You would only have to worry about your mistakes in forecasting factor input.

Beckworth: Right, so your job would be a lot easier.

Selgin: A whole lot easier.

Beckworth: What about the history of thought on that? You resurrected this idea. I think you've done some research pointing out that this actually was a fairly common idea pre‑1930s. Is that correct?

History of Thought on a Nominal GDP Target

Selgin: Oh yeah. Of course people in those days didn't speak about NGDP targeting or anything close nor did they use the expression productivity norm.

Until the 1930s, there were more economists who subscribed to some ideal involving a stability of spending, MV or P times Y, than who advocated stability of the general price level. Mind you, most of these discussions were in the context of gold standards and that sort of thing.

Probably more than any other position, the most popular was that favoring retention of one of these standards as approximating some such ideal better than other institutional arrangements could. Economists back then I think were less naive than they are today about how central planners could implement their ideal theory.

Every economist seems to talk about...Most economists talk about central banks today as if they running them, they would do exactly what their theory says is right. In fact, of course, the central banks disappoint all of them.

Before Keynes came along, you had quite a few economists including many famous ones from different schools, offhand, Dennis Robertson, Alan Fisher in New Zealand, John Williams at Harvard, Fairduke Hayek, Coopins, a Dutch economist, Merdal. Vixel was an exception.

We all know thought that keeping interest rates at their natural levels was the same as keeping a stable price level. People didn't speak of inflation targeting back then. If they advocated a stable inflation rate, it tended to be zero rate.

There was a big debate between Vixel and other Swedes, notably a fellow named David Davidson about this.

We could trace this back much further than these neoclassicals I've been talking about to persons who spoke of a labor standard of value for example in the early 19th century which was quite a different thing from Marx's and others labor theory of value.

What they meant was their conception of an ideal standard would stabilize the price of labor, which is a kind of productivity norm. So it's an old idea.

Very interestingly, as I've written in an article for "History of Political Economy," Keynes himself comes very close to conceding the merits of a productivity norm in "The General Theory" or at least the merits of a monetary policy that would stabilize not output prices but wages or nominal wages. Then he waffles.

He's back and forth in the general theory went back and forth and finally ends up embracing a stable price level norm.

By the way, yes, I just said that Keynes favored a stable price level norm. He does in "The General Theory." It's just that in that book, he's assuming pretty much throughout that the economy is in a state where the equilibrium price level is below the actual price level.

In that situation, of course, any kind of monetary expansion doesn't raise the price level. It just gets you back towards that price level once again being in equilibrium.

Beckworth: The productivity norm is actually an old idea. You resurrected it. You've published on it. I was exposed to it.

I've talked to Ramesh Pumuru who's the writer for "National Review." He was influenced by your work on productivity norms as well, which also lend him into nominal GDP targeting. You work on that has been influential.

I want to think of a new application for it. I want you to hear me out and tell me if this makes any sense. Today there are many who argue that technology is rapidly taking off. There's increased digitization of society, more networking, more smart machines, 3D printers, driverless cars. Some are concerned this is going to accelerate. We're going to have more and more rapid technology growth. They're concerned that...

Selgin: Heaven forefend.

Beckworth: It'd be a great future. There are some, particularly on the left, who are concerned that this will be very disruptive in the short run, and capital will benefit more in the short run than labor.

There's concern about massive structural unemployment as such. Let's take that as given that that's the case. Wouldn't a productivity norm be exactly what we would need in terms of monetary policy for a situation like that?

Because labor would more directly share in those real economic gains through a lower price level. Their nominal wage would be stabilized, but the rapid technological gains would be shared with them via lower prices.

Selgin: Yeah, I think logically you could say that. I suppose you could put it more pithily by saying that if you're out of work, you'd rather be out of work with prices falling than with them staying the same. But of course this is little consolation if you're not getting any income at all which I suppose in the more dire cases might happen.

Not to be so facetious about it, anybody on fixed income benefits under a productivity norm from productivity gains along with all consumers. That includes welfare, social security recipients, and so on, presumably people on unemployment.

Whereas the standard regime that seeks and achieves a stable inflation rate tends to leave the same people out of luck when it comes to partaking of a productivity improvements that others are enjoying because they're enjoying them through increased nominal salaries and earnings. So there's a real serious distribution implication.

I think you're right. That all things considered, a productivity norm tends to be more favorable to groups that are not particularly at the high end of the food chain than price level stabilization. But I hesitate to go too far out on a limb on this because of course there are many well‑to‑do people who also live off of fixed incomes. They tend to be retirees.

There are clearly some real distributional implications of having a productivity norm versus a stable price level that ought to be taken into account with all the other consideration.

Beckworth: That approach would make someone who was much more free market friendly, someone who believes in markets over government, they would embrace that approach compared to some of the other proposals should this world come where machines are doing everything. Again, this is more of a transition story.

An alternative proposal that's often been discussed is that the government should start buying shares of S&P 500 and then take that and pay it to individuals, which would be very much an interventionist approach. Whereas a productivity norm could kind of get the same effect.

Selgin: You know, David, people think that I don't know anything about anything except monetary economics and only ask me questions about that.

At the risk of proving them right, I'd like to say something about this argument about technology because it's always struck me as something very weird, this idea that technological innovations occur in such a way as to result in a tremendous serious mismatch of available skills with available technologies.

Seems to me rather that what's more likely to occur is that innovations take place in response to the labor situation that people don't just invent machines that nobody can run and put them on the market apart from training and everything.

What I mean is that if you don't have the basic skills out there where you could at least train people and make these machines work, conversely if you do have large pools of unemployed labor, you'd innovate in a direction which take advantage of that.

Let me make a more simple example. Suppose that somebody came up with an improved machinery that relied on using some very rare element that wasn't available. That just won't fly because it's too expensive to come up with that element.

If a lot of that stuff suddenly became available, somebody finds a vast new source of some rare commodity or mineral, technology would respond. Technology is doing these things all the time.

When people come to talk about labor shortages and skills, it's as if the technology just fell from the sky willy‑nilly whee the people working on it didn't give a thought to what the actual available resources were.

This doesn't make any sense to me. I'm speaking outside of my expertise but still, somebody needs to consider then when people are doing all this R&D and coming up with these innovations, they're not simply trying to replace labor.

They're trying to replace costly methods of production with cheaper methods of production in a way that's informed by the actual scarcity of the different resources in the economy. At least people should try to argue as if they were aware of this tendency.

Beckworth: I understand. Let's talk about the implications of the productivity norm, not necessarily just the rule itself but the idea that there can benign deflation as well as malign deflation. Let's apply it to the housing boom period.

Let's talk about that period. There was a big productivity surge right after 2001, rapid gains in total factor of productivity. If you go back and read newspaper accounts, there's just all this discussion going on at that time. It really threw a curveball for the Federal Reserve.

Can you explain how it did that and why this may have been a reason the Fed blew it according to some during the housing boom period?

Applying the Productivity Norm to the mid-2000’s Housing Boom

Selgin: As I mentioned before, productivity's hard to forecast. It's also hard to measure. That's another reason why you shouldn't try if you don't have to. Policies that don't require it are better than policies that do.

Having said that, you're right, most estimates of a total factor of productivity had it growing very rapidly after the 2001 dot com crash which mud by the way involved a setback to or an interruption of what had been a similar productivity boom before the dot com phenomenon and that in fact a boom that probably contributed to the dot com boom. It was underlying the dot com boom itself. Then you had a crash.

The Federal Reserve was aware of this rapid productivity growth, but because they were committed to an ideal of stable inflation, they perceived it as supplying a grounds for keeping money easy or easing it. Because otherwise, there would be a tendency for the inflation rate to drop below target.

It's interesting that some of the economists or some of the FOMC members involved including some who were economists openly acknowledged that this probably means going in a sense setting rates below their proper equilibrium values.

Here I think they were to some extent thinking in Vixelian terms. But this was OK because it is not going to result in inflationary pressure. The idea is, ah, look, productivity is growing really rapidly. We can ease monetary policy.

We can keep interest rates lower, even lower than depending on which time in this period we're talking about. It won't have inflationary consequences. Isn't that great? Because that allows us to do more to help the economy to get back on its feet after this crash.

Productivity gains instead of being treated as a reason to modify the inflation target are treated as an opportunity to ease monetary policy or keep it easy without having to face the consequences of a higher headline inflation. This was a big mistake because in fact it involved overly easy policy according to a productivity norm standard or an NGDP growth standard.

Now the NGDP growth rates weren't phenomenally high, but they were higher than usual. They were a couple percentage points higher depending on what long run trend you look at. It would be a bad mistake of course to say that because of this you had this terrible subprime boom and consequent bust. I don't think anybody thinks that.

What I think people think who believe that monetary policy was too easy at this time and what I think is that in combination with many other circumstances regulations, policies, what have you, some private market developments too of course, the excess credit that was being created here is the counterpart of the easier money, which all tended to be shunted into the mortgage market and the subprime mortgage market especially.

We had a perfect storm of conditions in which one element of that perfect storm was excessively easy monetary policy, and what was informing that excessively easy monetary policy was the view that when productivity grows more rapidly, that's not only a license for but an invitation to have an easier monetary policy.

Beckworth: The Fed in the early to mid‑2000s, they eased beyond what they should have because they saw low inflation. Is the story that they took advantage of the low inflation, said, "Hey, we can ease"? Is that the story? Or did they simply misread the inflation?

Selgin: They correctly read the productivity figures.

Beckworth: They knew that inflation was low because of productivity.

Selgin: They knew it would be low. They knew it would be lower than usual for any given monetary policy stance.

Therefore, they took this as an opportunity to have an easier monetary policy stance, saying to themselves and to each other, "We have some softening. We have some downward pressure on prices coming, so we can put more upward pressure on them to offset it," upward pressure on prices from easy monetary policy.

In that sense, they're treating the anticipation of continued rapid productivity growth as allowing them to set an easier monetary policy target than they would have otherwise. This is what was informing the decision first of all to lower the target all the way to one percent, but more importantly, to hold it there for as long as it was held there.

Beckworth: Because one of the challenges we referred to earlier is that when you're doing inflation targeting in real time, it's sometimes hard to know why inflation changes, if it's a supply shock, a demand shock. What you're saying is in this period is they did know why it was going down. They just took advantage of it. They wanted a free lunch and monetary policy.

Selgin: The point is they didn't care why it was going down, which is perfectly consistent with having an inflation target. If you believe a stable inflation rate is what you want.

I'm of course here abstracting from the fact that the Fed's mandate is more complicated than that, but in fact if you throw in the actual Fed dual mandate, you have an even more compelling reason why they would treat any opportunity to ease monetary policy during a recovery as one they should take advantage.

Here what the way they read this was we have a problem where we have recovery that's sluggish. We want it to be faster. We're under an obligation to maximize employment and not blow our inflation, not let inflation get too high. We can do that because we've got a productivity surge.

Beckworth: One of the arguments for flexible inflation targeting is that you don't hit two percent this year or next year. It's over the median term. On the average, you hit two percent, which in theory gives the central bank some flexibility in what inflation is one year to the next. It gives them the room to respond if there's some kind of shock that hits the economy.

Some argue that if they did flexible inflation targeting right, it'd be very close to a nominal GDP target. They would respond properly by ignoring supply shocks. As an example, late 2008, the Fed saw high inflation.

They were worried, so they didn't cut rates. They misread the inflation tea leaves. The ECB actually raised rates in 2008. It raised interest rates twice in 2011 because inflation was going up. I would argue those were supply shocks they should have ignored.

Selgin: That's right. Look, flexibility is vastly overrated because it's true that flexible inflation targeting could allow for, does allow for, the kind of response that you and I might like to see to productivity innovations.

It also allows for all kinds of responses that have to other things or responses to productivity innovations different from what we would like to see or opposite them. Flexibility sounds great.

If you're the kind of person who is optimistic that it'll be used the way you think it should be used, then you always favor flexibility. This gets us back to the more fundamental thing about central banks and rules versus discretion.

Beckworth: It takes us back to the knowledge problem.

Selgin: It takes a very fundamental issue. Most advocates of monetary discretion, it's rather sad to say, they favor it because it allows anything to happen. That infinite set always includes what the advocate of discretion thinks is ideal. What the advocate of discretion is saying is if the central bank could only do anything, it'll do what I would want it to do. Or it's assuming that that's the most likely outcome.

The advocates of discretion never assume that the central bank will use the discretion to do something that they think is terrible, whereas the proponents of discretion, of rules, whether it's targeting the price level or inflation rate or a productivity norm rule if you like or nominal GGB rule are assuming there's a high likelihood that if the central bank could do something else, they'd pick something worse. It's as simple as that.

Beckworth: Even now we see this as the Fed heads into 2016. There's uncertainty. Is inflation low because oil prices are low? Or is it low because the economy is weakening? We just don't know in real time. That's one of the advantages of a productivity norm, a nominal GDP rule.

Look, all you do is keep it simple. Focus on stabilizing demand and let the other pieces fall where they may. It's not the job of the central banker to play god and try to figure out what is happening to the real economy.

Let me move on to the Fed's mistakes in 2008 because I know you've been doing a lot of work on that recently. I have been very critical of the Fed during that time. You've taken a couple of interesting pieces on that period and worked through them.

You've looked at the Fed sterilization of its bank lending program in 2007 through 2008 as well as the Fed's excess reserve policies. Could you explain what those are and how they may have contributed to the worsening of the recession in 2008?

Selgin: Throughout 2008, particularly after the crisis really started to pick up with the Bear Stearns event, the Fed was engaged in all kinds of emergency lending. They didn't call it QE anything yet.

Retroactively, they would call some of the more massive expansion after the Lehman failure retroactively, they would call that QE1. But at the time, they weren't thinking of QE. They were simply rescuing or bailing out various financial firms, etc.

Their balance sheet would have grown in the course of this emergency lending. Eventually it did grow, but the Fed was throughout this period concerned that the rescues which it perceived as being aimed solely at helping these particular enterprises would inadvertently result in an easing of general monetary conditions.

They did not want that to happen because they had their idea of where the federal funds rate target should be, and by gosh, they were going to stick to it.

This is all well and good if the targets where it ought to be. In retrospect, it's pretty clear it was higher than it ought to be, that is, that some monetary easing really was desirable at this time.

By the way, a conventional understanding of the rule of a central bank during crisis would lead one to think that providing more liquidity would have been the natural thing to do, not just to particular firms but to the economy in general.

Nevertheless, the Fed was determined not to do that. They prevented the general liquidity or monetary conditions from easing at first by sterilizing their emergency loans.

This is what they did up to Lehman and particularly up to when AIG was bailed out. That meant that they had a lot of treasuries on their books. As their emergency lending increased through various programs or directly, they would sell off treasuries, that is, buy back reserves exactly in an offsetting manner so that their balance sheet in total reserves didn't change.

The only result is a reallocation of liquidity to the firms being aided through the emergency lending, a reduction in liquidity, equal reduction everywhere else. This was sterilized lending.

If you don't think there's a general lack of liquidity if there isn't, monetary policy is just right. I guess that's the right thing to do. Except it wasn't just right, it was too tight. There all kinds of evidence of this including, most obviously from our point of view, the fact that NGDP growth had slowed down and then eventually would even turn negative for a year.

There would be an absolute decline in NGDP, a level decline. This of course by our understanding is bound to cause the adverse developments in the financial market to become a more general crisis.

After Lehman, the Fed's policy didn't change at all. It was determined to keep it. It made grudging downward adjustments to its federal funds target, but they were grudging in the sense that they were both inadequate and frankly meaningless because the equilibrium federal funds target or the natural target of the effective target, any one of those things you want to talk about had already gone down below the...

The equilibrium rates had already fallen below the target which had become therefore rather meaningless.

Nevertheless, after Lehman, the big bailouts of AIG and subsequent ones that involved even bigger loans, the Fed did not have sufficient treasuries left on its book to sterilize. Sterilization became impossible.

Incidentally, there was another program that involved issuing special bonds to the treasury and having the treasury park the money and issuing Fed bonds and parking the money in these special accounts. That was also again designed to reduce the available effective quantity of total reserves.

All of this was contractionary policy because it was felt that the emergency lending by itself would be too expansionary.

Once they were no longer able to sterilize to offset emergency lending, that's when they implemented interest on reserves. That is positive interest rate on reserves including excess reserves. The express idea, this is not me looking at things after the fact and saying, "Here's what they were really up to." This is what they say they were up to.

The express goal was to have another device, an alternative to sterilization that would again make sure that the expansion in the Fed's balance sheet.

Now it's the whole balance sheet that's growing because they aren't sterilizing anymore, that that expansion does not translate into general easing of monetary policy, a general increase in liquidity, and a lowering of the effective or equilibrium federal funds target as it would if banks took the extra liquidity that was being made available to them through these emergency programs and if some of them used it to either make loans in the intra‑bank market or to purchase securities.

When they purchase securities, that's particularly significant because that would generate a multiplier effect, that would mean that the amount of total monetary and credit expansion ultimately based on a given increment of new base money, of new reserves, would be that much greater.

Essentially the Fed has turned to interest on reserves as a way to effectively achieve what sterilization beforehand had achieved.

That means this. The sterilization means you don't really increase the total amount of the monetary base as you rescue firms. Interest on reserves allows the monetary base to expand, but the idea is to keep the multiplier down so that you have the same outcome. This was the express purpose of both.

That's I'm equally critical of both because I believe that these were the instruments by which the Fed pursued what was in fact an overly tight monetary policy that allowed nominal GDP to collapse when what it needed to have was a looser policy. Here I want to be very clear because I've been misunderstood on my writings on this in many ways. I'm only just touching on the one thing.

Beckworth: I'm aware of them.

Selgin: The ultimate problem was overly tight monetary policy and a desire to maintain effectively a federal funds target that was too high and later a target range that was too high. The instruments by which this overly tight policy was implemented included sterilization and then interest on reserves.

In a sense, there's nothing wrong with sterilization. There's nothing wrong with paying interest on reserves. What is wrong is doing those things in the context in which they were done or starting to do them in the way they were done when they amounted to means for keeping monetary policy excessively tight. That's the sense in which I'm criticizing these things.

I have nothing against...Well, I better be careful. In principle, sterilization could be just the right thing to do under the right circumstances, similarly, paying interest on reserves, especially required reserves but perhaps even excess reserves.

Yes, we all know about the efficiency arguments for that. The Friedman rule and so on which were the basis for the original legislation giving the Fed this power, but it had nothing to do with the decision to implement this rule at the time.

There's something else. You're probably going to ask me about this anyway but I've been hammered on 25 basis points, how much difference can that make? I've been hammered by too many very, very knowledgeable people to by any means wish to deny that they have a point.

However, I have to be very careful what I...I want to be very careful I'm not misinterpreted here. I don't believe 25 basis points in equilibrium make much difference, certainly not too risky bank lending and certainly not if capital is restrained.

The reason bank lending is so low is because of regulation and capital requirements and all sorts of things that have nothing to do with those 25 basis points.

The 25 basis points did was to implement an overly tight policy, particularly by restraining the money multiplier that resulted in banks holding excess reserves and accumulating them instead of using them to buy treasuries, which would have given effect to the multiplier.

I think 25 basis points definitely could have this effect even though it was a small amount because what matters isn't the absolute number of basis points you're talking about but whether whatever's being done in the way of paying interest in reserves, whatever change there is in that policy results in having reserves bear a greater yield or return than many of the alternative liquid assets, specifically treasury securities that are out there.

When that happens, and that can happen because of a three basis point change in interest on reserves in principle, that's a real shift in the circumstances that can affect the total equilibrium.

The equilibrium, the real change here is in the nominal total money supply growth that comes out of any Fed expansion being a much lower number and a lower equilibrium price level than would have resulted otherwise...

Beckworth: Well, on that sobering note, we are out of time. But it's been a joy, George, talking to you and always learn something new. Out guest today has been George Selgin of the CATO Institute. George, thank you for being on the show.

Selgin: You're very welcome, David. Thanks for having me.

David Beckworth
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May 23, 2016
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George Selgin on Average Inflation Targeting and 'The Menace of Fiscal QE'

Thursday, September 17, 2020
David Beckworth

George Selgin discusses his new book in this Macro Musings transcript. Read more at Seeking Alpha

George Selgin on the Fed-Treasury Relationship, New Lending Facilities, and the Fed’s Evolving Role in Response to COVID-19

George Selgin is the Director of the Cato Institute Center for Monetary and Financial Alternatives and a returning guest to Macro Musings. He joins David to break down recent policy actions by the Federal Reserve and some of the resulting challenges, as they break down the Treasury’s recent $454 billion backstop on Federal Reserve lending, the complex array of new Fed lending facilities in response to COVID-19, and the Fed’s evolving role in the global economy.

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

David Beckworth: George, welcome back to the show.

George Selgin: Great to be back again, David, as always.

Beckworth: Glad to have you back, George, you are the reigning champ on Macro Musings in terms of show appearances. Always great to have you on the show and today is no different. We want to talk about all the activities the Fed's been engaged in. There's an alphabet soup of facilities. There's a number of things they've been doing. It seems like to me, Jay Powell would be very exhausted right now and his staff and the rest of the FOMC, they are very, very busy and Congress and Treasury is giving them a lot of responsibility to take on. I want to walk through all this with you and I'm glad you're here with us today.

Selgin: Well, I look forward to it.

Beckworth: I want to begin with a discussion or a debate that you were a part of on Twitter. This is why I love Twitter, you learn so much on Twitter following people like you, but you are engaged in a conversation, a pretty long conversation with Peter Conti-Brown, Dan Awrey, and Kate Judge, and they're all lawyers. They're also people who focus on financial regulation and the Federal Reserve, as are you. All of you got into this long conversation that lasted several days on Twitter about the purpose, necessity and legality of the Treasury's equity position in Fed operations.

Beckworth: As you know, George, Treasury has put in $454 billion in addition to the funds they put in earlier from the Exchange Stabilization Fund. So, it's going to be the entity to take the first loss if there are any losses born by these facilities the Fed have created, and we'll talk about some of them later. But what is the purpose of them? Why do we have that? Is it necessary? What did you guys determine in your debate?

Explaining Treasury's Backstop Funds to the Fed

Selgin: Well, I'm not sure I can speak for Peter's own position, but mine is that the backstops are necessary. That is, it is necessary that the Fed have special funds appropriated for it to lose whenever it engages in any risky lending. That's my position and I think it is an implication of, first of all, Congress's power over the purse, but also of the way the Federal Reserve Act and Section 13(3) are written, particularly Section 13(3) as revised by Dodd-Frank.

Selgin: The law, as revised, says that the Fed has to provide adequate protection against any prospect of taxpayer losses. Now, there are two ways the Federal Reserve can do this. One is by not taking any substantial risks. The other is by taking risks, but doing so only to the extent that the losses that arise as a result of risky lending fall short of particular backstops that have been provided by Congress to absorb them.

Selgin: This all goes back to put it very, very tersely. It goes back to the Federal Reserve's autonomy. Most government agencies are not allowed to employ funds even if they earned them themselves without having the specific authority of Congress to do so. Rather, any funds they generate or that are given to them belong, ipso facto, to the U.S. Government.

Selgin: Now, one way to look at what's happening with the Fed is the Federal Reserve Board is a government agency. It relies on funding from the Reserve Banks, which are private institutions. Those funds, the Congress exempts from the usual rule, that is the Board of Governors can rely on money from the Reserve Banks to cover its ordinary operating and administrative expenses and so on and so forth. However, anything else implicitly doesn't belong to the Fed, but belongs to Congress and should go to the Treasury.

Selgin: Now, this is all been somewhat complicated in the past by the fact that, superficially at least, until recently, the Fed's habit of sending remittances beyond its operating expenses, sending its earnings beyond operating expenses to the Treasury appear to be a voluntary arrangement.

Selgin: However, I believe that it was fundamentally an arrangement consistent with the basic structure of the Constitution and that has been more codified in recent years when Congress went ahead and actually stipulated that the Fed, first of all, could only hold a certain amount of surplus capital. They've raided the Capital Fund twice and now it's down to a rather meager amount of, I think, under 7 billion. Any earnings that don't go towards maintaining that very low level of surplus capital now expressly have to be sent to the Treasury. That is, that money doesn't belong to the Fed, follows that it doesn't belong to the Fed to lose on risky loans. From that it follows that if it does lose money on risky loans, that much has got to be separately appropriated to it by Congress. That's what the Treasury is doing with these backstops. I'm sorry that was a long answer.

Beckworth: Oh that's, that's good. But let me try to summarize it for our listeners here. You think it's important if an entity-

Selgin: I think it's necessary. I think it's necessary.

Beckworth: It's necessary, okay. If you think it's necessary, if an entity of government is going to potentially lose tax payer money, that that decision to do so was approved and voted by representatives of the taxpayers themselves, Congress and Treasury.

Selgin: Exactly.

Beckworth: And so, if the Fed were to lose the money on its own accord, independent of any approval from the body politic, from Congress, it would be taking power that isn't granted to it in the Constitution.

Selgin: That's right. It would be usurping a prerogative that belongs only to Congress. See, some people see the Fed is just being wimpy here and making excuses for grabbing funds from the Treasury, from the slush fund as Elizabeth Warren and some others have characterized it. I don't see it that way at all. I think rather what the Fed is doing and insisting on these backstops is it is avoiding using funds that haven't been duly appropriated by Congress. It's respecting Congress's power over the purse and therefore it is respecting taxpayers. That is the voting tax paying public, and so I think that's quite correct.

Selgin: That's not saying that I approve of all these backstops or the programs they're being used for and how they're administered. I'm merely saying that if that is going to engage in risky lending, backstops are an important, appropriate, legally appropriate, constitutionally appropriate counterpart of it's doing so.

Selgin: By the way, this is not something new. I think in a couple of places Peter suggested that this was, that's Peter Conti-Brown, suggested this kind of thing was unprecedented. That's not so. In fact, the only times that the Fed has taken risks with its lending, it has had backstops of one sort or another in the great financial crisis, for example. The TALF back then was backstopped by the Treasury $20 billion rather than $10 which is the backstop for it this time around.

Selgin: Other Fed 13(3) loans were backstopped either by the Treasury or by the FDIC, sometimes both and sometimes by private lenders, private financial institutions that puts skin in the game with the Fed always standing behind the others, once again, so that it's risk of actually using money is not appropriated to it for the purpose was trivial.

Selgin: Finally, and we'll talk more about this I know, but then in the previous Fed business lending program under authority 13(B) of the Federal Reserve Act, which no longer exists, the Fed engaged in risky lending in the Great Depression in the '30s, '40s and early '50s. It had a huge Treasury backstop. What I'm regarding as playing by the rules seems to be the way the Fed and the Treasury have looked at things, not just recently, but as long as the Fed has engaged in any sort of risky lending.

Beckworth: For someone who isn't following closely, including myself, I'll throw myself in that camp in terms of the backstop issue, this does seem, different, and maybe it's just the magnitudes involved, so we're talking about $454 billion. You mentioned in the Great Financial Crisis or the Great Recession, the Treasury did also backstop the TALF facility-

Selgin: And some others.

Beckworth: And some others, but not on the scale we see today. Do you think that scale matters or does a scale just a consequence of the severity of the recession we're in?

Selgin: Well, first of all, there's a sense in which the scale is not any greater now and that's if you look at things from a percentage point of view. Roughly speaking, it's not exactly right, but roughly speaking, we're talking about something like 10% Treasury backstop. That is the Fed is taking money from the Treasury as if it anticipated it might lose up to 10%. Now, then the actual number varies from program to program, but let us treat that as roughly an average. It's actually probably not exactly right, but there are some cases where it is exactly right.

Selgin: Well, if you go back to 2008 you've had similar backstopping. That is if you compared the total dollars of authorized risky lending to the total dollars of backstops by the Treasury and others, it's the same order of backstopping. In that sense, this is no different.

Selgin: Also, keep in mind, that while $454 billion have been appropriated for Treasury backstopping, thus far the Treasury has only used about half of that. Ultimately I suspect they've will use it all, but they've still got $200 and something billion that they have yet to allocate to any Fed programs. Presumably, they will get around to it the way things are going, but so far they haven't used all of the money that's available for that purpose.

Beckworth: Apparently-

Selgin: Last thing, David, if I may -

Beckworth: Go ahead.

Selgin: In the '30s, the backstopping was much greater than today percentage-wise, the actual Fed, Treasury backstopping of the Fed's 13(B) Main Street Lending was 50% of the loan capacity.

Beckworth: Oh, wow.

Selgin: So, much higher.

Beckworth: Maybe part of the reason this seems novel is just money illusion on our part. These big numbers, big nominal numbers, but as a percent what you're telling us this isn't anything radically new or different. That's great to know.

Selgin: As a percent the Fed risky lending authorizations or of risky lending potential, I don't think it's new at all.

Beckworth: Just to summarize your argument, again, it's that if the Fed is going to take on risky endeavors, risky investments and all these facilities that they it started up, it's effectively using taxpayer dollars to do that and it needs to be sanctioned by Congress who represents the tax payers.

Beckworth: Now from economic perspective though, it really doesn't make any difference. If the Fed had no Treasury backing and suffered some losses, the Treasury would still bear that loss. It'd be fear of remittances being sent to Treasury. But the difference is it's been approved or explicitly condoned by Congress.

Selgin: That's right. There are two reasons why this difference is not trivial. First, the losses for which appropriations have made respect the democratic process. This is something that can't be emphasized enough. This is not about the Fed's rights. This is not about the Treasury. This is not even about Congress, it's about voters and it's about whether the use of taxpayer funds has been approved of by the democratic appropriations process or not, so that's an important aspect of it.

This is not about the Fed's rights. This is not about the Treasury. This is not even about Congress, it's about voters and it's about whether the use of taxpayer funds has been approved of by the democratic appropriations process or not.

Selgin: But from the Fed's point of view, the other thing that's important is that the Fed enjoys this peculiar budgetary autonomy and it's very, very jealous of that autonomy. It understands that its special permission to use some funds without any appropriation, the funds that it makes, that the Fed banks make that go only to administrative and overhead expenses and thereby allow it to do ordinary monetary policy, those funds are a special exemption from the usual appropriations process and the Fed wants it that way because then it doesn't ever have to worry about getting budget from Congress to do its ordinary work.

Selgin: Now, the last thing the Fed wants to do is to cross a line where anyone can accuse it of not respecting that special deal. That's, again, a deal that exempts monies it uses to cover its basic expenses, ordinary operating expenses, from the appropriations process.

Selgin: From the Fed's point of view, it's a very dangerous thing for it to find itself using any money that it has not been expressly permitted to use because then by violating the terms of its budgetary autonomy, it puts itself at some risk. What exactly is the risk? What could happen? Who knows? But the Fed ain't going to chance it and I don't blame it. It's about Fed autonomy, Fed independence, such as it is, we all know it's limited, but it's about preserving that limited independence and it's about respecting the rights of the taxpaying public. Those are not trivial things.

Beckworth: Fair enough. It's in the taxpayer's interest and in the Fed's interest to do it this way.

Selgin: Yes.

Beckworth: Both parties gain from this arrangement. Now with that said, there's still, I think a line that's been crossed in that the Fed has become or is seen as more politicized in doing all these facilities during this time. For example, Chairwoman Maxine Waters has been complaining to the Federal Reserve about the firms that are getting funding through some of these facilities and she wants certain conditions. They have to have a minimum wage of $15 an hour, no dividends. We already are seeing some political pressure to do these facilities in certain ways based on one's political beliefs. So do you worry though that this has pushed the Fed farther away from its independence?

Selgin: Yes, because there are two different things here that put the Fed at some risk and one we've spoken of is it's dipping into its resources, its earnings beyond the point where it has got standing permission to use them as granted by its peculiar constitution. So that puts it at risk. But the other thing that puts it at risk as you suggest is the fact that Congress in appropriating funds for it to lose has also delegated to the Fed a tremendous responsibility in determining how these loans that it's making using those funds get distributed. And this is a problem with risky lending. Soon as you get away from lending based on fairly well defined financial parameters, say discount window lending or some repo operations that we've seen, you're now in an area where you're bound to make some loans that are not clearly financially sound.

Selgin: That's the whole point. But then of course something other than financial criteria are determining who gets the money and who doesn't. And all of those non-financial criteria broadly fall into the catch all of policy and politics. And that's not an area that the Fed is comfortable being involved in. Precisely because no matter what it does, and I'm not saying what it's doing meets my approval, but whatever it does, a lot of people are not going to like it. And that too can result in pressure from political authorities to try to place more controls on the Fed. And that finally can also leech into controlling it in ways that interfere with its monetary policy autonomy. So it's still exposed to risk. It would be worse if it didn't have these backstops but it's a situation where having the backstops doesn't exactly take the Fed off the hook politically speaking.

Beckworth: The glass is half full, not half empty. It puts it in a better position than it otherwise would be.

Selgin: It's in a different problem. The only thing that would keep the Fed out of trouble would be if it assumed any responsibility for the kind of risky lending it's been asked to take part in, and by the way, that's consistent with the Federal Reserve Act. There's nothing in the Act, as far as I can tell, that doesn't allow the Federal Reserve board to say, "No, we're not going to do this. No, we're not going to do that. We're not going to do these risky lending programs." The reason it's entangled in these programs is because it's very, very difficult in the middle of a tremendous crisis when Congress won't do it itself for the Fed to say, "No", it's been put on the spot. It's suffering from the fact that everybody sees it as an easy out for getting these funds where they'd like to see them go.

Beckworth: Yeah, that was the point I was going to make is in the fog of war, you got to do what you got to do. The fight's right in front of you, you can't have too much of an academic conversation about this. You got to get out and roll the sleeves up and get to work. But I think it is fair to say that Congress is leaning heavy on the Fed instead of doing a lot of lifting it on its own. And this leads me to a related point that was made by Kate Judge who was a part of that conversation between, well among you, Peter Conti-Brown, Dan Awrey, you guys were discussing this issue and she had a piece that she put out recently where she said, look, the Fed is not designed to do what Congress is asking it to do. I mean there's some things the Fed can do as the lender of last resort, but reaching main street, reaching small businesses, it just really isn't geared up for that.

Was the Fed Designed to Perform This Role?

Beckworth: The Fed is designed to provide loans and loans to bigger institutions who have great credit standing. It's much harder for a smaller business. Secondly, she also makes the point that some of these bigger businesses would do better undergoing bankruptcy and then getting some grants or some funds, but the Fed by law can only deal with solvent institutions. So the Fed is being asked to do a number of things that are very challenging for it and you put it nicely in a tweet that the Fed is conservative and cautious by design and therefore not able to do all that maybe the public wants it to do or Congress wants it to do and so Congress and the entities like the SBA also aren't seemingly well-designed or at least don't have the institutional capacity to respond quickly and nimbly to the challenge at hand as well. So that kind of leaves us in a bind here and the Fed is the one kind of stepping in to fill the void. I wonder though if there is a better way to do this.

Selgin: Yeah, I do too. I've been agonizing over that, David, because it's one thing to write about the Fed’s infirmities, its shortcomings as an institution to serve in providing what really in many respects are more like grants than ordinary loans. Certainly, they're very, very, very risky loans. It's absolutely correct what Kate says, the Fed is simply not meant to do that. It's not equipped for ordinary business lending. Business lending isn't like lending to financial institutions. Lending to financial institutions is relatively easy. It doesn't require a great deal of oversight, especially if you require loans to be secured. You have a fairly well defined sets of collateral that most of these institutions can be expected to possess and if they don't, they're probably in deep water and may not deserve to be helped. But business lending is a whole different kettle of fish.

Selgin: The losses at best are always much higher. It's always risky. Relationships and intimate knowledge of your borrowers is very important as is monitoring them and even getting involved in them, telling them what to do, so you told see your loan money go down the drain. This is something that that ordinary banks are fit to do. But even those banks aren't very good at making the kind of grants/loans that the current rescue package calls for. Whether we're talking about purchasing power protection loans administered through the SBDA or the main street loans that the Fed's going to be handling also with the help of banks. Even with those kinds of loans, I don't think the banks are very good at it. I'm writing an article now on this and the title kind of tells the theme. The title is "No Job for Banks" and that basically tells you where I'm headed with all this.

Selgin: I do not think support for small businesses or even some medium size ones, the kinds of support they need, I don't think the banks should be involved and I mean neither ordinary banks nor the Federal Reserve or their involvement should be very limited because what you really need is a bureaucracy that knows how to funnel what is essentially conditional grant money to a bunch of small businesses and do it quickly and do it for a fixed fee and that's what needs to be done. Banking has very little to do with it and banking skills to the extent that they have any bearing on how well it's done tend to undermine its being done well because those are all skills that are about how to get your money back. They're not skills about how to get the money out quickly. So the less we involve banks, the more we involve fintechs and other organizations and the more we think of these as grants rather than loans, albeit conditional ones, the more likely we can come up with a rational way of getting the money where it's needed.

What you really need is a bureaucracy that knows how to funnel what is essentially conditional grant money to a bunch of small businesses and do it quickly and do it for a fixed fee.

Beckworth: Yeah, there's all kinds of problems with the Paycheck Protection Program we've seen in the news from banks offering first come first serve or offering to their best customers or to people who are connected. But in general, I mean your point is Congress should be giving more grants out, fewer loans, but we really don't have an organization that's scaled up able to do that. I think one of the original arguments for using banks is they're already on the ground. They have the infrastructure in place, but your counter argument is, well maybe so, but they aren't in the business of providing grants.

Selgin: That's right. We can use banks to some extent. So I don't want to exaggerate too much. Banks are useful to the extent that some of the people we want to get money, some of the businesses, smaller businesses, have banking relationships and their bankers are actually well-equipped to help get money to them. So it's fine for them to be part of this. But there are many small businesses that don't have strong banking relationships. And even those, of course, most of all small businesses have bank accounts, but if they've never taken out credit from their bank, those banks are probably denying them these loans. So all of these businesses that haven't borrowed from banks in the past, banks are not so helpful to them. But there are zillions of fintech firms that can do this job very well and are already doing it.

Selgin: And what they can do is provide the means for getting this money to a lot of smaller businesses. And they could do it. There shouldn't be an ordinary origination fee for these loans. Even if it's graduated, it's stupid. There should be a set fee. That way you won't have a bias in favor of large banks. What are you paying them origination fees for when you don't really, the reason you do that is to make sure the loans are sound in the usual banking sense of the term. Well forget about that. These aren't loans, these are conditional grants. So all you need to know is whether a few conditions are being met, whether the conditions that have been specified are the right ones, there's something else we can talk about, but it's really just a little bit of diligence involved.

Selgin: But most of all we're trusting the recipients of the funds to tell the truth and presumably facing them with some consequence if it's discovered that they haven't. But for that you could pay a flat fee to the originators. So you give a fintech company that's really good at this a thousand bucks or maybe even less, 750, for every one of these things that it handles. And that doesn't come out of the borrowers loan, that just is paid for with government funds and that's it. And you get them to get as many of these loans processed or grants processed as possible. There's really not much need for its specific banking skills here. There's no need to pay banks for those skills and there's no need for the Federal Reserve to be too heavily involved either. The heavy reliance on banks of all kinds, including the Fed, I think is one of the big problems with what we're seeing and it starts with looking at these gifts or conditional grants as loans and then you call them loans. You think you've got to have all these banks involved and that's getting off on the wrong foot.

Beckworth: Yes. If you look at the CARES Act, what you find is that the number of dollars allocated to grants is about 400 billion. So 349 billion was given to the Small Business Administration for the Paycheck Protection Program, which ran out quickly and it looks like most of the organizations that got it were not small businesses. Another 50 billion went to airlines. You have about 400 billion and most of it did not go to these smaller businesses. So it's a bad look. And what you're suggesting is fintechs could do a better job and it may be more grant money, but do it through fintechs. Is that right?

Selgin: Do it with the help of fintechs, involve the banks to the extent that the banks can help with those small businesses with which they've already formed relationships so they can deal with them speedily, but other small businesses could go through fintechs, with which they probably also had some dealings, perhaps more dealings. And there are a bunch of fintechs out there again already doing this to a pretty substantial extent, but they're very good in dealing with the small firms and they can do it cheaply. So the thing is though that you mentioned the amount of money, this gets us to one of the other big fallacies that has to be overcome. And here I'd like to state that the modern monetary theorists have got things precisely correctly. Not enough other economists do. One of the great fallacies is that by involving the Fed, the Treasury is able to leverage its contribution ten to one.

Selgin: Or whatever that ratio of backstop to lending power is. This also partly comes from the fallacy of thinking of all this as a lending operation instead of a grant giving operation, but it also stems from the tendency to not look at the consolidated balance sheet of the government and the Fed combined. What we have here is a belief that somehow if you let the Fed leverage up the Treasury's contribution, that that is somehow saving money or making it go further. Taxpayers money, appropriated money, and this is just untrue. It would be better under present circumstances. Let's say you want to have a total of $2 trillion of support for small businesses. Let's say that's the amount of conditional grants you want to give out. It'd be better if the Treasury just financed that full amount using the Fed and the banks and the fintechs for administrative purposes only and not as sources of funds.

Selgin: It doesn't cost the tax payer more, it doesn't pose a greater tax burden or interest burden. In one case where the Fed chips in, the funds are still being borrowed, the liabilities consist of reserves that the Fed creates. The interest is the interest rate it pays on those reserves. That's only 10 basis points now, but that's an adjustable rate and if you're making long-term loans, and I think they should probably be making loans for more than the five years or so that some of these programs are allowing now, that rate will with any luck go up. Whereas if the Treasury had to just fund all of the 2 trillion or whatever by borrowing, by issuing that many more securities, let's say it uses 10 year securities at rates that are prevailing now in the long run, that could be cheaper rather than a more expensive than leveraging through the Fed.

Selgin: The only difference is that if the Treasury finance, it shows up on the national debt. Whereas if the Fed leverages a smaller amount of Treasury money, it doesn't, but this is talk about fiscal illusion. I think it's better if we see how much all this costs and we acknowledge the cost to the extent that we pretend that the Fed is somehow allowing us to get something for nothing, that there's a free lunch and all this leverage. We're just diluting ourselves about the costs of the programs. And that's a mistake. That's not helping us to be reasonable about anything.

Beckworth: So it's a facade to use the Fed and think it's cheaper for several reasons. One, there's this whole consolidated balance sheet view and two, as you point out, it might actually be cheaper if the Treasury straight up finance it by issuing bonds and locked in low rates as opposed to having reserves finance it and the interest rate on the reserves can quickly change. So we should cut to the chase, be explicit about it and have Treasury do more of the heavy lifting.

Selgin: Yeah. Or even have it, which is to say Congress, do all the heavy lifting and involve the Fed only as an administrator if that. And same thing with the banks. There's no need for any leverage here and not much is accomplished with it. Instead, you involve the Fed and things would rather not be involved with that could ultimately jeopardize its autonomy and lead to future abuse of its lending and balance sheet powers. And that's not in anyone's interest. So from both a fiscal and a monetary policy point of view, I think it's a very big mistake to be relying on leverage in this case. It's one big illusion and it's an illusion that causes trouble. It doesn't help anything.

Beckworth: Okay. Well, let's move on to the facilities. We've been talking kind of in general terms here, more philosophical: what's the point? What's the best way to do this? Let's look at some actual facilities with all those caveats behind us and all those concerns and ones that you've written about specifically and these relate to the small businesses. We've touched on this already, but you have a lot of concern, George, about small businesses, how they're getting funding or lack of funding.

Beckworth: And what the Fed has done is the Fed is trying to reach them, go that last mile through two Main Street facilities. And of course we have Congress, through the SBA, trying to reach them as well through the Paycheck Protection Program, and the Fed does have a Paycheck Protection Program. Liquidity facility is supposed to kind of help that program out.

Beckworth: But you've written about some of the challenges in reaching these small businesses. Again, we've touched on some of them already, but why don't we begin by highlighting the history of this because this is not the first time the Fed has attempted this, as you've note in your writing. So what happened in the past and what lessons does it have for us today?

History of Fed Lending Facilities

Selgin: Yeah, so often, many people assume that the Fed has never done anything like its current Main Street Lending Programs, but that's not true. The new programs fall under the 13(3) authority that the Fed has, and that's true for all of its emergency or special lending programs today.

Selgin: And that the authority dates back to 1932, but it was never used much to lend. It was originally given to the Fed so they could lend to non-banks sure enough, but the Fed hardly used it in the Depression. The Fed interpreted 13(3) back then in such a way as to essentially rule out most businesses from eligibility for loans through that facility by requiring them to secure loans with only the same sort of collateral that they required of banks at the discount window. Well, most firms didn't qualify, so they made 123 loans under 13(3) in the Depression so clearly as a way of propping up businesses. And by the way, most of those loans were pretty small. 13(3) authority didn't do anything in the Depression essentially.

Selgin: So in 1934, they gave the Fed a new authority, which was 13B, specifically for business lending and specifically allowing for broader collateral so it wouldn't be a big flop-a-roo as 13(3) had been so far.

Selgin: At the same time, Congress also extended the lending authority of the Reconstruction Finance Corporation. I'm mentioning this because it'll become relevant in discussing how the Fed's program went. But what's interesting is that both the Fed and the RFC were given, by the same law, more or less equivalent business lending powers and the terms of the business lending that was allowed under these new authorities were not unlike what the Main Street facilities are supposed to do today.

Selgin: Back then, I think the loans refer up to five years as opposed to four now, if I don't have it backwards, and they weren't really secured loans because the collateral that was ultimately accepted included things like receivables and office equipment, et cetera, et cetera. In other words, it was not the case that the Fed, if these loans went sour, the Fed wasn't going to realize it was not going to avoid losses by selling collateral behind them. So they were essentially unsecured. They were backstopped, as I mentioned before, but with a much heavier Treasury backstop than the 30s.

Selgin: Okay. Well, what happened is that the Fed had all this authority, but it didn't grant very many loans. First of all, it had all these committees set up, one in each Federal Reserve district to deal with the flood of applications that came in at first. There were quite a few applications at first, but they ended up rejecting, oh I would say something like 75% of the applications because they didn't consider them sound. And it didn't take long before the business community decided that they weren't going to get much help out of the Fed’s program, and applications dove down pretty quickly.

Selgin: By the end of the Great Depression, by 1939, the Fed had only lent something like... Well it never had more than $60 million of loans outstanding out of an authority to lend a 280 million. And even its cumulative loans were never half of its total lending authority.

Selgin: It still lost money though because it's so hard not to lose money. Its rate of return on 13(3) loans as of 1939 was -3%. It used something like 27 million of the 140 million Treasury backstop allotted to it. Not very much, but still plenty considering the low level of lending it was actually doing.

Selgin: All right. Well to make a long story short, the programs survived through the World War II and the Korean War, which gave a boost to demand for funds of all kinds, but then it petered out completely in the 50s. And by then, the Fed was sick and tired of it. McChesney Martin had taken over from Marriner Eccles as Fed Governor and he was determined to wind down the program and he actually encouraged Congress to take the powers away from the Fed and grant them to the Small Business Administration, which was created in the 50s as a substitute. And that's significant.

Selgin: The RFC did a little bit better. It was able, because of looser terms, it could lend for 10 years. Its business lending was on a higher magnitude than the Fed, so to that extent it was more successful. Even so, it was pretty disappointing. So they wound it down too. So all of the small business lending of the government ended up by the end of the 50s being channeled through, administered by the Small Business Administration. And until now, that was the end of the Fed's involvement.

Selgin: So you've got to ask yourself whether we're repeating history now. We've learned in the past that the Fed's crappy at giving small businesses money, particularly in a depression or crisis. We created a new system that was supposed to be better at it. We still have that arrangement now, the Small Business Administration. So why the heck have we dragged the Fed back in to making loans to Main Street?

So you've got to ask yourself whether we're repeating history now. We've learned in the past that the Fed's crappy at giving small businesses money, particularly in a depression or crisis.

Selgin: Now I know that the Small Business Administration loans are designed right now for firms of 500 or fewer employees, but we know perfectly well that in fact, that includes very large firms that happen to have a bunch of outlets, each of which has fewer than 500 employees. So it's not as if the SBA couldn't be handling the full range of firms that the Fed is now assigned to handle. The SBA has its problems. Don't get me wrong, they're big ones, but I think that if one has to pick one's poison between the two agencies, I would say the SBA is more suited for the present purpose than the Fed if only because the Fed needs to be able to concentrate on monetary policy and not get entangled in politics. The SBA has been entangled in politics for the whole of its existence, so this is nothing new for it.

Beckworth: So both political challenges may make it tough for the Fed to do the small and medium size loans through its Main Street new loan facility and extended loan facility as I mentioned earlier, and Maxine Waters is pushing the Fed to do it with certain conditions attached. So we have that political minefield to walk through as the Fed does, but also it may not be that effective in general. So, politics aside, what you're saying is the Fed may end up not giving that many loans because the difficulty of doing so.

Selgin: Yes, there are two ways the Fed can fail and we saw some evidence to each in the 30s. So let's start by remembering the Fed, as of right now, has 75 billion in Treasury backstop money to play with. It has the authority to lend small to medium businesses up to 600 billion so far.

Selgin: But what does that mean? It means it's got to kind of figure out how to put money out there, approve lending through banks mostly to small businesses. Where there's going to be a lot of risks, there's got to be a lot of losses. The fact that banks are only taking 5% of the losses means that you can't expect that much diligence from them, and particularly if you don't want to take forever to get that money out. And this is not a circumstance where taking forever is acceptable.

Selgin: So the Fed has a very difficult problem to solve. How to choose between getting money out very quickly, which means huge losses that could eat through its $75 billion backstop even before it has gotten to 600 billion, which would be a shame. Alternatively, it can scrutinize the borrowers more, make them suffer more that way and end up not using its lending. It will then lose less than 75 billion and it might still lend less than 600 billion.

Selgin: So there are all kinds of ways the Fed could fail to do as much as it might do because what we really care about, and here this gets back to the consolidated budget and all that. What do we care about more? Whether the Fed loses less than 75 billion or whether 600 billion in small business funds get allocated? The only reason we're worried about the former is because of the structure and the Fed's autonomy that it needs to protect and the Constitution that we need to protect.

I would say the SBA is more suited for the present purpose than the Fed if only because the Fed needs to be able to concentrate on monetary policy and not get entangled in politics.

Selgin: Whereas if this was all funded by the Treasury, the Fed would just be administering these funds, then it wouldn't be worried about 75 billion. It would be worried about getting 600 billion out and that would get what we care about because frankly, part of this whole operation is you're not going to get the money back, okay? That's the point. That's why thinking of loans instead of conditional grants is itself getting off, as I said, on the wrong foot.

Beckworth: So if there's one big takeaway from today's podcast, the government relief effort for COVID-19 crisis should be conditional grants. That should be the core focus, not loans, but we have in fact turned it around on its head and doing it the other way through the Fed.

Selgin: Yeah, it should be conditional grants and the monies should all be appropriated. We shouldn't be imagining that we get a free lunch by getting the Fed to leverage anything.

Beckworth: All right George, let's move on to another point I want to bring up with you. And that is just the flurry of activity the Federal Reserve has been engaged in.

Beckworth: So in addition to all that it's doing to ease monetary policies, we know it's cut interest rates to 0%. It's started unlimited QE. It also has a large number of facilities it's set up for different markets, different entities, and just a rundown of them are as follows.

Beckworth: So the Fed has set up dollar swap lines and expanded them to other countries. It also set up a standing repo facility for central banks. They can deposit treasuries and get dollar reserves in return. It has also set up a primary dealer credit facility, which it's not new, but it's re-established it. It's set up, again, the money market mutual fund liquidity facility. It has a commercial paper facility. It now has a corporate bond credit facility of two types, a primary market and a secondary market. It also has a Main Street loan facility, two types that we mentioned already. Has a Paycheck Protection Program liquidity facility, and it also has reestablished the Term Asset-Backed Securities Loan Facility or TALF. It's going to be setting up soon a municipal liquidity facility.

Beckworth: And all of these facilities create an alphabet soup of facilities the Fed has set up and it's just overwhelming if you try to wrap your mind around all of them, what they're doing. A number of organizations, for example, the Brookings has a nice summary of all these different facilities, but it's easy to get lost in all of them. And I'm just wondering, George, and I know your answer to this, but do you have any solution to simplifying this process? I mean, could you, instead of having 11 or 12 facilities, could you narrow it down to a couple that can do more and kind of bring everything under one or two roofs?

Can the Fed's Lending Facilities Be Improved?

Selgin: Well, I've been working on it a long time and I've made proposals in the past, none of which I think have been quite fully baked, but I think it is desirable not to have such an array of institutions.

Selgin: More importantly, though, it's desirable to have standing facilities so that you don't have to create batches of new institutions every time there's another crisis.

It's desirable to have standing facilities so that you don't have to create batches of new institutions every time there's another crisis.

Selgin: One of the things that I'm finding myself thinking is that, really, it's a shame that since 2008, really, the Fed, apart from switching to a floor system, which it did almost inadvertently by just staying in an arrangement that it found itself in in the crisis and eventually convincing itself that it liked that new arrangement, okay, so that was a big change.

Selgin: Otherwise, its basic facilities have not been revised at all, and I think that it deserves to be criticized for that, particularly since it's had all this talk about reviewing its strategies, et cetera, et cetera. The operating system of the Fed, the operating framework, has been pretty much static, and I think it's because of that that we saw in this crisis, it had to patch together all kinds of special facilities. Now, some of them clearly were special because they were dealing with problems unique to this crisis that the Fed couldn't have been expected to anticipate. Indeed, it could not have expected to be asked to make loans to ordinary businesses, for example, so I don't blame the Fed for not having any special arrangements for that. Nevertheless, it could have had more robust standing arrangements.

Selgin: And here, I think, of course the problem, it's easier to imagine how a streamlined set of standing arrangements could serve in any crisis, or many crises, if we take off the table the kind of risky lending that I've been saying the Fed shouldn't really be involved in at all. Okay?

Beckworth: Okay.

Selgin: I don't think we should have a standing facility such that some small business on Main Street can come to the Fed and ask for a loan, or do the same through another bank, simply because I think the circumstances where the government should be helping such a small business get a loan are ones in which it should be providing the funds directly itself, whether as a loan or as a grant, and without involving the Fed.

Selgin: Having said that, I think there's a lot more that we could do for the next crisis. It's too late now, and I think we can see lots of ways to have better standing facilities and fewer of them by looking at what other central banks do like the Bank of England or the ECB.

We can see lots of ways to have better standing facilities and fewer of them by looking at what other central banks do like the Bank of England or the ECB.

Selgin: One way to think about this is by thinking of an extreme possibility first. Suppose we had no 13(3) authority for the Fed, none. Now, if you left everything else the same, you'd have a pretty non-robust framework for dealing with crises, so nobody's suggesting we just delete or repeal 13(3) and do nothing else.

Selgin: But suppose we start by thinking about not having 13(3), and we think instead about broadening Section 14. That's open market operations, and those include both short term or repo operations and outright purchases of assets.

Selgin: Now, let's forget the outright purchases. Let's assume short-term treasuries only, which is what we have for all Section 14 activity now, but let's talk about broadening the repo component of Section 14 operations. There, we could do a lot. We could have as the Bank of England has. For example, we could have repo facilities, standing repo facilities, where they are authorized to repo a broader set of collateral, say all the kinds of relatively market collateral presently taken at the discount window.

Selgin: Suppose we stretched Section 14 so that the Fed could have standing repo facilities under that authority that accept broad collateral. An analogy there would be the Bank of England's indexed long-term repo facility, and it also has another complement to that that kicks in only during crises with a more extended collateral list still.

Selgin: The other thing we can think about is broadening counterparties. The Fed has already done this with its repo operations both for overnight repos and for others, so how about having a permanent standing facility that ... or two of them perhaps ... that accept a broad range of collateral and a broad set of counterparties?

Selgin: And, finally, how about setting up one of those facilities, at least. You need two kinds of facilities. You need one that could be setting the upper part of the interest rate corridor to call it that.

Selgin: As we've seen lately, you can have an upper part of an interest rate corridor, even with a floor system if you mess things up enough, and we need it now. So, David Andolfatto, of course, and Jane Eric, have talked a lot about a standing repo facility.

Selgin: I would take that standing repo facility and make it a broad collateral broad counterparty facility. The way you can do that is by having, first of all, you have to apply haircuts. The idea is that unless there's a lot of stress in the financial market, nobody's going to use this facility, and, particularly, nobody's going to use it to repo anything but treasuries except under extreme circumstances where it can kick in and some non-Treasury repos can kick in, but people are paying the appropriate haircuts.

Selgin: In England, with both of these term repo facilities that I was referring to, they use product mix auctions, so firms can actually put in bids for different kinds of collateral at the same time, but that becomes more relevant if you do full allotment, sort of fixed allotment options. You can do both, full and fixed, but the fixed allotment, broad collateral facilities could be useful for quantitative easing, which is the other part of monetary policy, but there you have some outright purchases.

Selgin: The point is, I think if we imagine repo facilities, if not outright purchase facilities that can acquire broad collateral under certain circumstances where the pricing structure, including haircuts, is such that it's only in those emergency circumstances that the broadness of the facilities becomes relevant, we could save on some of these alphabet soup arrangements that we've been having to rely on every time there's another crisis. And because we'd have standing facilities, they would handle things quickly, without delay, and that that would be all to the good.

Beckworth: Okay. Let me just summarize. So you would recommend, No. 1, allowing a broader array of assets to be used as collateral. Second, extend the number of counterparties, or the entities that can come to the Fed and engage in these operations. But it's not clear to me, how many facilities would you actually have, and what would be the differences between them?

Selgin: Well, you need a facility for outright purchases.

Beckworth: Okay.

Selgin: Let's call that the QE facility just for the sake of our argument.

Beckworth: Okay.

Selgin: And that facility is where you particularly don't want to have the Fed making outright purchases of dubious collateral, of non-treasuries, let's say, except under extraordinary circumstances.

Selgin: And, so, what you could do is just set the thing up with appropriate rules for when the broad collateral would kick in; very strict rules about crises, et cetera, and then you could have a specific schedule of broader collateral that could be purchased in a QE emergency.

Beckworth: Okay.

Selgin: If it were me, I would say that the facility can't be used until the target rate has already gone to zero.

Beckworth: Gotcha. So that would be the long-term facility.

Selgin: That's the long-term facility, yeah.

Beckworth: Okay. Go ahead.

Selgin: The short run facility or facilities are for repos. First of all, repos are like loans. So in principle, the repos could do anything the discount window does.

Selgin: Most of the facilities that central banks rely on for lending our repo facilities these days, rather than true loan facilities, partly because of stigma problems, but for other reasons.

Selgin: So the repo facility or facilities, let's say, try to have just two of them where they're broad, they accept a broad set of collateral for a broad set of counterparties that should include all banks with decent camels ratings and securities firms and, perhaps, money market funds.

Selgin: We can look at the past to see the kind of institutions we found it convenient to have the Fed to repos with in crises and just be set up so that no special action has to be taken to accommodate them, or the collateral that they tend to have available can apply certain haircuts so that it's not tempting for these counterparties to use the facility except in a crisis, and the facility is, therefore, never going to be competing with private market repo facilities. That's something you want to avoid.

Selgin: I think that the reason you would, perhaps, want to have two of these is because for certain purposes you might want to have fixed allotment auctions and for the others you might want to have full allotment.

Beckworth: Can you explain those differences?

Selgin: The full allotment is where you set the interest rate at which you want these transactions to go through, and then you acquire as much of the collateral as the counterparties are willing to offer for that rate given the haircuts.

Selgin: And the idea there is you're fixing the price and that's what you want to do. For example, if you're trying to set the upper bound for the interest rate corridor, you need to have a full allotment facility.

Selgin: For other purposes, you just want to provide a certain amount of credit. You've decided that you want to inject an additional amount of emergency credit in there, you make a decision about the total amount of purchases that you want to do.

Selgin: And that's what happens, for example, when you're in a proper corridor system and you have open market operations to stabilize the rate within the corridor, then they're guessing how big those have to be. Those are fixed allotment operations, but there are other purposes for which fixed allotment auctions may be desirable. And, again, I don't see why they can't have a standing facility that's designed to handle those with a great deal of flexibility.

Selgin: A standing facility doesn't have to be operating all the time. It just has to be ready to operate at any time. And any of these facilities that is mainly meant to operate during an emergency, you could have certain triggers required for it to be brought online and that is another way of checking against abuse. And you want to check against abuse because you ultimately want to limit any moral hazard that might arise from the existence of these standing facilities.

Beckworth: Okay. Well, we look forward to seeing your paper on this topic.

Selgin: Me, too.

Beckworth: Yeah. Well, maybe the Fed will read it before the next crisis and take it to heart.

Selgin: And anybody who's listening to this saying that this isn't right, that's not quite going to work, well, help me. I need help, but I think we should be thinking about better standing operating facilities for the Fed.

Beckworth: Okay. Well, with that, our time is up. Our guest today has been George Selgin. George, thank you so much for coming on the show.

Selgin: Anytime, David.

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David Beckworth
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Apr 27, 2020
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Government relief efforts for COVID-19 should focus on conditional grants backed by appropriated funds, and not on Fed’s lending programs.

George Selgin on Repo Market Stress, Fed Balance Sheet Volatility, and a Standing Repo Facility

George Selgin is the director of the Cato Institute’s Center for Monetary and Financial Alternatives and is a returning guest to the Macro Musings podcast. He joins the show today as part of a two week special on the Fed and repo markets, as he helps us take a look at recent repo market stress from the Fed’s perspective. Specifically, David and George discuss the basics of the Fed’s balance sheet, the problematic nature of the Treasury General Account and foreign repo pools, and how George would tweak standing repo facility proposals to more directly address balance sheet volatility

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

David Beckworth: Hey Macro Musings listeners. This is your host David Beckworth. Today's show is the first of a two week special on the Fed and repo markets. As you may recall, repo market interest rates spiked in mid-September, reached nearly 10 percent, while the interest rate on reserves was around two percent. This caught many by surprise, including the Federal Reserve, and revealed there was a severe funding pressure in the repo market, that is, there weren't enough bank reserves to fund repo activity. As a result, the Fed injected liquidity into the financial system through overnight repos, term repos, and outright purchases of assets.

Beckworth: There is some concern however that at the end of 2019 there will once again be repo market stress as lending by the big banks into the repo market will be dialed back as these big banks tidy up their balance sheet for regulatory reasons. No one knows for sure, but there are good reasons to be worried, and today's show, part one of the series, we will take a look at this problem from the Fed's perspective with the help of George Selgin. Next week we'll be joined by Josh Galper who is deep in the trenches of the repo market, and he will help us examine this problem from the perspective of the repo market. George, welcome back to a show.

George Selgin: Great to be here again, David.

Beckworth: Yes, you've written several interesting pieces on this situation, this development. We'll link to those in the show notes. You've also outlined some proposals to fix this problem for the near term, some practical fixes that kind of sits to the side for the time being, what type of operating system the Fed has, but given where we are, what are some pragmatic next steps and we'll get to those probably near the end of the program. What I want to do though is work our way through what happened in September and then talk about what might happen in December, this month, but later in the month, and there are some concerns about that.

Beckworth: The last time you were on the show we talked about real-time payments and I encourage our listeners to go back and listen to that. George had some great suggestions there too for some fixes for helping those who struggle with the payment system, those lower income folks. But today we want to get into the repo market stress and the Fed's relationship to that, and this is the road map we're going to take with George today. First we're going to review what happened, as I mentioned in September, what could happen, and his suggested solutions. And there are some really interesting ones, a little provocative, George, I will say, I'm sure you've got some feedback on those proposals as well.

Beckworth: But to help us understand, help me understand before we get into all of this, let's talk about the Fed's balance sheet. The basics of the Fed's balance sheet. So like any body, any institution, the Fed's balance sheet has an asset side and a liability side. And on the asset side, I think that's pretty straight forward. The Fed buys treasuries, they bought agency bonds and debt, can issue loans. Where it gets tricky and where the story I think is really buried is on the liability side.

Selgin: That's right. Yeah.

Fed Balance Sheet Basics

Beckworth: So talk us to the liability side of the Fed's balance sheet.

Selgin: Right. So, people are familiar with one of the most important Fed liabilities, that's the currency that's circulating in the economy, Federal Reserve notes. Next to that, they may be familiar with the fact that banks keep deposits at the Fed, which deposits count along with currency they have in their tills and vaults and ATMs, as part of their reserves. So those are the two more familiar Federal Reserve liabilities. There are others, however, and those turn out to be very important in the repo market troubles that the Fed has been experiencing.

Selgin: And chief among them as far as that issue is concerned, are two liabilities. First, the so-called treasury general account, which is an account the Treasury keeps at the New York Fed, which is a consolidation of accounts it has at all of the Federal Reserve banks that they put the money all together at the end of every day. And the other one is the foreign repo pool, and that is liabilities consisting of deposits by foreign central banks and other foreign official institutions that can place money at the Fed on deposit as it were, and earn interest on it because the Fed turns around and does repo operations with those funds. So those are the liabilities that people are less familiar with and that I think we're going to be talking about a lot.

Beckworth: Yeah, absolutely. And part of the story for September, or THE story for September, was that there weren't enough reserves given the demand for them during this time, given some of the developments in these accounts, these sub-liability accounts. And so what I want to think through before we get into the details of the story is, how do you get changes in reserves on the Fed's balance sheet? So there's several ways I can think, I want to walk through them with you and help me understand them.

Selgin: Sure.

Beckworth: So the first way there could be fewer reserves would be for the Fed to shrink its balance sheet outright. So the Fed sells off assets and it has to pull in reserves. So when it sells a treasury bill back to the public, it's taken out the reserves that would correspond to that. And that's what happened with quantitative tightening. Is that right?

Selgin: Yes, that's right. One way to think about this is to first imagine that the Fed's liabilities are all bank deposits at the Fed, and they're all therefore reserves that banks have. And then start asking what happens, is those other kinds of liabilities become important. So the first case would be people are taking currency out of their banks. That's going to obviously reduce bank reserves. The second… and this is holding the size of the Fed's balance sheet constant. Second is a growth in the TGA where the Treasury puts more money in the Fed. But that means that there are less reserves in the banking system because they're taking away the liabilities of the banks and transferring them accounts from the banks to the Fed. And the last one is these foreign repo pool, which again whenever an institution keeps a larger balance at the Fed that's not a bank. It means the banks have to have less.

Selgin: Finally though, you have the case where the Fed is shrinking its balance sheet as it did during its unwind operation. And then of course its liabilities are going down along with the assets going down. So the whole balance sheet is-

Beckworth: Shrinking.

Selgin: ... getting smaller and there the decline in reserves doesn't have to take the form of a redistribution from reserves to other Fed liabilities. It's just that there are fewer liabilities in total.

Beckworth: Okay. So with quantitative tightening, the last case you just described where the Fed's reducing the absolute size of its balance sheet, my understanding is about $600 billion in reserves was eliminated.

Selgin: That's correct.

Beckworth: Disappeared out of thin air, or disappeared into thin air. So we saw about a $600 billion reduction in reserves during QT, quantitative tightening, from 2017 and 2019. Then on top of that… so that's the first part of the story. But on top of that, there's these other developments which I didn't really pay attention to, I think many people didn't pay attention to, and this is the shuffling of the categories on the liability side you just described. So walk us through why is it that when the Treasury increases its account at the Fed, there's fear of reserves? What's the actual steps?

Selgin: Well, to give a typical example, let's say the Treasury is collecting taxes. So people are paying their taxes to the Treasury, they're writing checks to the IRS, and of course those checks are checks against their banks, commercial banks. And the IRS in turn places these funds in the Treasury general account. Well, and then the checks clear. When the checks clear, the count to TGA is credited, finally credited. And at the same time, some commercial bank accounts at the Fed are debited. So the reserves, which are those commercial bank deposits at the Fed go down, and the TGA balance, which is not part of bank reserves, of course, because the Treasury isn’t a bank, goes up, and there you have it. So the amount by which the TGA increases is the amount by which the stock of bank reserves in the form of deposits at the Fed declines.

Beckworth: Okay. And that means there's fewer reserves for these banks to lend into the repo market when this happens. This is one of the reasons that there were fewer reserves available.

Selgin: That's right.

Beckworth: Let me ask about the history of this, because you wrote quite extensively in these two pieces that we're going to link to about the TGA account. It hasn't always been used. In fact, you have a great chart in the article that shows before 2008, before the switch to the floor system the Fed currently has, it was hardly used at all. Now if you look at it, it's used extensively and it's very volatile, big, big swings. So, what's the history of this account and why do we see this change today?

The Treasury General Account

Selgin: Well, first of all, it's important to realize that putting cash in the Fed is only one of several options that for some time now have been available for the Treasury, for its cash management. The Treasury is always going to have some cash resources on hand or some liquid resources on hand like any of us would, so that it is always prepared to cover its expenditures it keeps a balance. Now it keeps these resources in several forms. It can hold its own bonds, is can actually issue so-called cash management bonds, which are bonds it issues for the purpose of managing its own cash. It can put money in the Fed of course, it can also put money in commercial banks through the so called treasury tax and loan program, which in one form or another has been around for a long, long time, actually since before the Great Depression.

Selgin: Finally, there's another investment it can make, which is a longer term, basically term deposits. And that's called the Treasury Optional Investment Program. So you have a bunch of alternatives and depending on the circumstance, the Treasury, like any of us, is going to look at these alternatives and say, "Which is the most economical way for us to keep liquid funds. And as you said, for most of the time before the 2008 crisis, the Treasury found it economical to use resources other than the TGA for most of its cash balances or liquidity. In fact, for a long time before 2008, the Treasury had a policy that it would try to keep a balance in the TGA of only about $5 billion. That's a lot for you and me, but it's very small.

Selgin: Today for example, there's something like, I don't know, I haven't looked lately, but let's say $350 billion in the TGA. There may be more, maybe a little less, but it's around there. So that's a big change. So, of course that meant that in those days the Treasury was mostly using these other programs for its funds because even though it was smaller, it wasn't that much smaller. So it had a fair amount of money in the TT&L accounts, the Treasury tax and loan accounts. It also used the Treasury Optional Investment Program. And through a combination of that and also keeping its own cash management bonds on hand, it was able to keep that TGA balance low and stable. Occasionally it would, certain times of year it would go up more as much as maybe to seven billion, but it was stable and low, and that meant that the Fed's balance sheet could be that much smaller because the Fed didn't have to compensate for the fact that part of its resources were going towards providing the Treasury with cash or with a cash balance.

Beckworth: So the Treasury can either hold its cash outside the Fed and the private marketplace at banks, different storage facilities in terms of term deposits or overnight accounts, or it can hold them in the Fed and the Treasury general account.

Selgin: Yes.

Beckworth: And the decision to do so depends on the cost it generates to the Treasury. And part of the story, not the only story, but part of the story post 2008 is that it's been more cost effective to park the cash at the Fed than to store it outside the Fed and the private sector. Is that right?

Selgin: Yes, absolutely. The big change, the most important change, though there are other elements to the story of course, was interest on reserves, and it's a little bit strange why that matters. So let me explain. The Treasury's account at the Fed doesn't pay any interest. So you might think that the fact that the Fed introduced interest on reserves would mean that commercial banks now can pay more interest in theory on deposits and maybe that would be a better place for the Treasury to put its money. But it doesn't work that way because the interest that the Fed pays on the reserves of commercial banks is interest it could be paying to the Treasury. So when the Treasury puts money in TT&L accounts at commercial banks, it may get a little interest on those accounts, it does get some interest, but it's also losing the interest that is being paid on the bank's reserves, which would not be paid if it kept its money, which would not lose if it kept its money at the Fed.

The big change, the most important change, though there are other elements to the story of course, was interest on reserves, and it's a little bit strange why that matters.

Selgin: So, depending on conditions, but generally speaking, it is a money losing proposition with interest on reserves for the Fed to keep money in the commercial banking system instead of…

Beckworth: The Treasury.

Selgin: Pardon me, David, yes, for the Treasury to keep money in the TT&L accounts rather than just leave it at the Fed. So that's the big change.

Beckworth: So Treasury gets a bigger check from the Fed if it parks its funds at the Fed?

Selgin: Yeah. That's right.

Beckworth: I understand that appeal. That makes a lot of sense.

Selgin: The Treasury might get some interest from those banks, but then it gets so much smaller, a check from the Fed as it were, that it actually is worse off.

Beckworth: And there were a few other reasons as well. I mean, that's the main one, but it wanted to have a bigger account balance for emergencies, a lot of things going on post process.

Selgin: Yes, the Treasury at one point, 2015, it had already shifted a lot of its funds into the Fed, but in that year it decided that it wanted to maintain a balance of at least $150 billion at the Fed, up from the five billion we were talking about before. That's a huge change and its rationale for that was that in the event of another major crisis, it wanted to be able to have sufficient resources on hand at the Fed to cover all of its expenses for… I think it was for a week, without having to go to private markets under the assumption that anything it had outside of the Fed might not be available during a big crisis. That's a rather extreme assumption and there are ways I think you could deal with that concern.

Beckworth: Now, was there some role the Fed itself played in this? Did the Fed kind of maybe beforehand discourage the Treasury and then after 2008 say, "Well, whatever, we've got ample reserves." Because part of the story here is prior to 2008, the Fed had to actually actively engage and try to manage the amount of reserves based on what it thought would be the demand for reserves. But after 2008, if there's ample reserves in the system, why worry about it? Why not just let the Treasury keep as much as it wants at the Fed because as you mentioned, there's a consequence. If the Treasury puts more funds into its account, there's less reserves at banks, but no big deal if there's ample reserves. So the Fed kind of let its guard down. Is that right?

Selgin: Well, it did, but it thought that it knew what it was doing. So in the old system, which was a scarce reserve system, and of course you and I have talked about this, and you've written a lot about it on the corridors versus floors, in that corridor-like system, the Fed relied on very minimum bank reserves and fine tuning of the quantity of bank reserves to keep interest rates on target. But of course to do that, it was desirable that the Treasury should not have a large and volatile TGA balance, because that would interfere with the quantity of reserves causing it to also be volatile, unless the Fed very actively intervened in the market. It would make the job of fine tuning the reserve supply much harder for the Fed. So there was certainly an understanding between the Treasury and the Fed that the Treasury should try to manage its TGA balance in the interest of making life simple for the Fed and allowing it to operate that system without too much difficulty.

Selgin: When they switched to an abundant reserve system in 2008, it did become less desirable from the Treasury's point of view to keep money outside of the Fed as I explained, but it also became less important for it to do that from the Fed's point of view because under an abundant reserve system, the Fed doesn't worry about small changes in the reserve supply and doesn't rely on such changes to keep rates at their target level. Instead, it just sets the IOER rate, the interest on excess reserve rate, and that's how it controls other rates.

Selgin: So at that point, with that change, the Fed was happy to say to the Treasury, "Oh yeah, sure. Put all the money here you want. Do what you want, increase it, reduce it. It's no problem for us." For example, it might be, let's say a Treasury withdrawal of $140 billion from a TGA account that had that much and more in it originally under the old system. That would have been a huge shock to the quantity of bank reserves and the Fed would have had to come in there and make up for it by buying more securities. But circa 2015 let's say, that would have been a very small percentage of the outstanding amount of excess reserves. And so it wouldn't have mattered that much.

Beckworth: Yeah. And that's what the Fed thought and it was true for a long time up until recently when that complacency came back to bite the Fed in the rear. And we'll get to that because we'll see the TGA got so big relative to the demand for reserves it actually became an issue again. But before we get into that, we have a few more things we've got to work through, and I do want to highlight something else you bring out in your paper about the TGA account, and it was really interesting some of the history, and that the Fed and the Treasury had in similar issues they do today back in the '70s. So, the Treasury today is saving money by putting, as you mentioned, funds into the TGA, given interest and excess reserves, but in the '70s, it also resorted to that tactic because of double digit inflation and double digit interest rates. So tell that story because it's really interesting.

Selgin: Yes. So I think it was 1978 and basically the relationship between the interest rates being paid on the market. And I remember this was when interest rates that banks could pay, were still controlled by Regulation Q and related regulations and the rate that was being paid ... Sorry, those rates became sufficiently unattractive that the Treasury found it desirable to put money back in the TGA account and start using it heavily again, which it hadn't done for a long time. And in the end this had to do partly with the interest rates that the TT&L accounts were yielding.

Selgin: So, what ultimately happened was they worked out a new arrangement. They created a special kind of TT&L note account that bore more interest as a way to get the Treasury to once again use the TT&L program as it had done before. And the significance of this episode is that it was very similar to what happened recently in that the Fed found that because the Treasury was using the TGA account heavily again, and that account had become volatile, the Fed was having to intervene in the reserve market much more heavily to keep rates on target and was really having a hard time. So it had to work with the Treasury to come up with a way to fix that, which for a while it managed to do. So that's what it needs to be thinking of doing today. And for some odd reason, there's no talk that I'm aware of from the Fed or the Treasury about, "Hey, let's get together and-"

And the significance of this episode is that it was very similar to what happened recently in that the Fed found that because the Treasury was using the TGA account heavily again, and that account had become volatile, the Fed was having to intervene in the reserve market much more heavily to keep rates on target and was really having a hard time. So it had to work with the Treasury to come up with a way to fix that, which for a while it managed to do. So that's what it needs to be thinking of doing today.

Beckworth: Let's coordinate.

Selgin: "... figure out how to make these substitutes for TGA balances viable again."

Beckworth: Has there been a lot written on this episode from the '70s that's very similar to today?

Selgin: I don't know about a lot, but there's certainly a few sources out there on it. And I do link to one or two in my post.

Beckworth: Okay. So this would be a great area for research for some enterprising young scholar or current scholar, someone in the money markets group at the Fed to take a look at this period compared to the present. Okay. So the TGA, to summarize, is being more heavily used by the Treasury. At first, not a big deal given the ample amount of reserves, but we have seen it now is a big deal, like in the '70s, and it's causing problems for the Fed's management of its balance sheet. In fact, that's kind of a key theme. We're going to talk about the TGA and we're going to move on to the foreign repo. But in both cases, I mean, the striking point is the Fed has a sizeable portion of its balance sheet that is not under its control and is volatile.

So the TGA, to summarize, is being more heavily used by the Treasury. At first, not a big deal given the ample amount of reserves, but we have seen it now is a big deal, like in the '70s, and it's causing problems for the Fed's management of its balance sheet. In fact, that's kind of a key theme.

Beckworth: Now, currency has always been there. So currency has been beyond the Fed's control. It grows at a certain level. It's predictable.

Selgin: It's very predictable. Yes, very predictable.

And so part of the challenge we're trying to show here is that the Fed's having a hard time managing its balance sheet because there's these items that are beyond its control.

Beckworth: Very predictable. And it's relatively stable. Whereas these other two accounts have been explosive and volatile. And so you can just imagine your own balance sheet. I mean, imagine trying to plan your activities when there's a sizeable portion of your balance sheets, your liabilities are going to swing one direction to the other, be tough to make plans, be tough to implement what you want to do. And that's what the Fed's facing. And so part of the challenge we're trying to show here is that the Fed's having a hard time managing its balance sheet because there's these items that are beyond its control. So let's go to the second item and that's this foreign repo pool. So tell us what that is and what's happened to it recently.

The Foreign Repo Pool

Selgin: The foreign repo pool was created, I think it's close to 50 [ago] years now, but anyway, many several decades ago, and it's a facility, again, at the Fed designed for foreign official institutions. So that includes central banks, but also some of the international institutions that work with central banks. And it was designed to be a safe place for these foreign entities to place their funds, dollar funds. And it has its counterparts, it should be said, in like facilities provided by foreign central banks to the Fed for example. So, it's part of a reciprocal set of arrangements. However, of course, reciprocal in this case doesn't mean exactly symmetrical because the dollars, they're so much more important. So there's a lot more need for foreign central banks to have a place to park dollars than there is for the Fed to have a place to park most other kinds of… park its holdings of foreign exchange. So, that's the basic setup.

Selgin: Here once again though, the Fed's facility is a substitute or a supplement to private market alternatives, right? So the foreign central banks don't have to put dollars in the Fed. They can use private repo markets. They can, in principle, they could put funds in commercial banks, they can hold dollar securities, treasury securities-

Beckworth: Outside the Fed?

Selgin: All of these would be outside of the Fed.

Beckworth: Outside the Fed, yeah.

Selgin: All of these are alternatives for holding dollars or for depositing dollars or investing dollars that don't drain reserves from the US banking system. That don't mean an increase in the Fed's non-reserve liabilities. So here again, the question that foreign official entities [and] institutions face in this context is, "Okay. What is the best place for us to park dollars?" And that's going to depend on considerations of risk certainly, but also on what the return the foreign repo pool pays compared to other alternatives. And here I think the biggest problem is simply that the Fed, which sets the foreign repo pool rate, has made it too attractive. And it's the solution in this case, and I know we're going to get to solutions more detailed later, but it's relatively simple for the Fed to adjust that rate if it wants to and make it less attractive relative to alternatives so that the foreign repo pool doesn't get used to such a vast extent as has been the case lately.

And here I think the biggest problem is simply that the Fed, which sets the foreign repo pool rate, has made it too attractive. And it's the solution in this case to adjust that rate if it wants to and make it less attractive relative to alternatives so that the foreign repo pool doesn't get used to such a vast extent as has been the case lately.

Beckworth: And to be clear, its use, again, went up dramatically post 2008 compared to pre. So I'm sure part of the story here is also the Fed got a little relaxed again for the same reason they got relaxed about the TGA account, because ample reserves, not a big deal if these foreign central banks are depositing at the Fed, but it has created problems along the same dimension, same channels as the TGA and Zoltan Pozsar, a well-known analyst who looks at these issues, he's called it the black hole of the money market. So, why does he call it the black hole of the money markets?

The “Black Hole” of Money Markets and the “Accidental” Corridor System

Selgin: Well, the easiest way to think of that is you have a Federal Reserve that of course by expanding its balance sheet and buying securities adds to the supply of reserves. But to the extent that the foreign repo pool grows, and it has grown tremendously since 2008. It's like a black hole where those reserves instead of staying as bank reserves get-

Beckworth: Sucked in, okay. Yeah.

Selgin: ... sucked out of the banking system. But what that really means is that you have formerly, you have what were once Fed reserve liabilities being switched for non-reserve liabilities. So you can have this situation and Pozsar is very good about describing the circumstances in which the Fed's efforts to expand the supply of reserves by buying securities just end up pouring that many more reserves down the foreign repo pool drain. And it becomes a futile thing.

Selgin: So there are two different issues here, but they're related. One is that the absolute size of these non-reserve Fed liabilities, the foreign repo pool and the TGA, the bigger they are, the fewer bank reserves you have given the size of the Fed's balance sheet. Therefore, the bigger they are, the bigger the Fed's balance sheet has to be to create a given total reserve pool. But the other one is the volatility, and in this case the volatility is much worse for the Treasury general account. That thing really has bounced around dramatically. The foreign repo pool has ratcheted a lot, so you'd see a little bit of fluctuation all the time, but you also have seen several big steps.

So there are two different issues here, but they're related. One is that the absolute size of these non-reserve Fed liabilities, the foreign repo pool and the TGA, the bigger they are, the fewer bank reserves you have given the size of the Fed's balance sheet. Therefore, the bigger they are, the bigger the Fed's balance sheet has to be to create a given total reserve pool. But the other one is the volatility, and in this case the volatility is much worse for the Treasury general account.

Selgin: In any event, the volatility of these non-reserve liabilities, that particularly poses a problem as you get to a scarce reserve situation. So to tell the whole story, think about it this way. As these non-reserve liabilities grow, total reserves have been shrinking, other things equal. Add to that the Fed’s unwind, of course, they'll shrink even more.

Selgin: At some point they shrink to the point where reserves are no longer abundant. That is they're reaching a point where some banks are feeling shortages. Then the volatility means that you're going to have some interest rate action out there in the money market that's independent of the Fed's interest rate settings. Interest rates are going to take on a life of their own and the Fed is going to have to go in there with repos or whatever to try to stabilize those rates and keep them down as if we were back in a corridor system. But it's the worst kind of corridor system because it's an accidental corridor system.

Beckworth: No, no. That's the way I describe it in an article I wrote.

Selgin: Did you?

Beckworth: The Fed kind of stumbled or tripped back into a corridor system.

Selgin: It kind of, yes.

Beckworth: And now it's trying to get back out into a floor system.

Selgin: Yeah. It's not an argument, and I'm sure, I want to stress this point, both of us… it's not an argument against the corridor system. It's an argument against an accidental corridor system. And if you're going to have a corridor system, you can do it well or you can do it really badly. This is bad. This is very bad.

It's not an argument, and I'm sure, I want to stress this point, both of us… it's not an argument against the corridor system. It's an argument against an accidental corridor system. And if you're going to have a corridor system, you can do it well or you can do it really badly. This is bad. This is very bad.

Beckworth: Yeah. As I like to say, and I've mentioned this in the show many times, and people I talk to I've mentioned this, but Canada had a corridor system. Like the Fed it went to a floor system during the crisis, but then it successfully went back to a corridor system. So it is possible to have a smooth transition. Now they have some things that are different up there, so maybe it's not like a fair comparison, but there are ways, and we'll actually maybe get at the end, but we're really, again, working within the framework or the assumption that we have a floor system, how can we help the Fed manage its balance sheet in a practical, easier way?

Beckworth: Because again, the challenge of these last two categories, the TGA and then the foreign repo pool is, again, you've got a sizable portion, a meaningful portion of the Fed's balance sheet and a liability size that is exogenous, kind of beyond the control of the Fed, at least directly, and it creates real problems for the Fed in terms of managing reserves. And why does that matter? Because that then influences funding available to the repo market. And the repo market is hugely important to funding the financial system. It's how they fund activity on the longer end of the curve.

The challenge of these last two categories, the TGA and then the foreign repo pool is, again, you've got a sizable portion, a meaningful portion of the Fed's balance sheet and a liability size that is exogenous, kind of beyond the control of the Fed, at least directly, and it creates real problems for the Fed in terms of managing reserves. And why does that matter? Because that then influences funding available to the repo market. And the repo market is hugely important to funding the financial system. It's how they fund activity on the longer end of the curve.

Beckworth: Now, speaking of curves, one other question I have that's been brought up a lot, and that is that the inverted yield curve also made the foreign repo pool attractive relative to buying other treasuries, other long-term securities. So, having an inverted yield curve, this kind of tightened the screws of this problem, is that right?

Selgin: Yes. Well, it means that short-term funds are more attractive than long-term funds. And that means that as far as both the Treasury and the foreign official institutions are concerned, they're not thinking of longer term securities as a good place to vehicle for maintaining liquidity, and they're looking towards instead various kinds of deposits. And that's narrowing the field and it's narrowing the field in a way that makes it more likely that they're going to be holding funds, keeping funds at the fed.

Beckworth: And the Fed does have some influence over that.

Selgin: Yes, it did. Yes.

Beckworth: Okay. All right. We'll go beyond that. So here we are, we've discussed the Fed's balance sheet, the liability side. We've discussed these categories that are kind of beyond the Fed's control. I mean, really currency growth is beyond the Fed's control, but it's lived with that for a long time. It's just these other recent categories, the change, the volume, the volatility, and just to make this concrete, the Fed's shrinking of its balance sheet, quantitative tightening, reduced reserves by about $600 billion as we mentioned earlier, but the growth in the Treasury General Account and the foreign repo pool combined is a little over $600 billion too. So the magnitudes are very similar, just as big as the QT is, these other accounts have contributed as well. So this is a nontrivial development.

Selgin: Yes, that's right. It's nontrivial and your way of describing the sense in which it’s so is quite correct. The other way to think about it is that if you look at the amount of money parked in the TGA and foreign repo pool today combined, the Fed by reducing, taking steps with the Treasury's helps perhaps to reduce those accounts, those balances to small amounts, could create more reserves that way, than it's going to be creating in the next half a year or so by buying more securities again. And that means that if it wanted, in other words, if it wanted to create $600 billion in fresh reserves, it could do so without expanding its balance sheet or buying any more securities if you could just get those other liabilities back down again.

Beckworth: And just so we're clear on the numbers right now, the amount of reserves in the system are a little over one and a half trillion, and just to kind of do a back the envelope calculation, what if there had been no quantitative tightening? What if the TGA hadn't grown? What if it had maintained a kind of pre 2008 level? And what if there hadn't been any growth in the foreign repo pool? Then reserves would be up around 2.6 trillion. So, I mean that would have been presumably more than enough to maintain the ample reserve, the floor system that's in place. So again, the issue is these things have grown and the story now in September is closely tied to these and that there were big corporate tax receipts coming in, and the government was issuing a bunch of debt, which meant TGA was ballooning. The yield curve also contributed to the foreign repo pool growth.

Beckworth: So kind of the story there is reserves are shrinking both from quantitative tightening and from these other kind of exogenous developments beyond the Fed's control. So kind of the Fed was shifting its supply curve back, but it was trying to shift it back not too far, just far enough so it could reduce the balance sheet without becoming a corridor system. Again, that's accidental falling into it. But that coinciding with increased demand for reserves from regulatory reasons kind of pushed it in there.

Beckworth: Now looking forward to December, we know the Fed is earnestly trying to increase the amount of reserves in the system and it's quite hard to add up everything it's doing. But Jim Bianco, who does market research, he has an estimate out there that all combined, all these different measures, and again, to be clear, some of these are overnight, their loans will be liquidated, and in the future some of them are outright purchases. But combined, by the end of the year, there'll be about $300 billion plus injected. And the question is, will that be enough? And it's not clear we know the answer to that question, is it?

Selgin: No, it's not. And I know some very smart people who believe that a heightened reserve demand will, toward the end of the year, despite these additions by the Fed, will cause repo rates once again to climb up possibly above the Fed funds market upper limit, and that the effective Fed funds rate may also rise above its upper limit, which of course defines a failure of monetary control in our system.

And I know some very smart people who believe that a heightened reserve demand will, toward the end of the year, despite these additions by the Fed, will cause repo rates once again to climb up possibly above the Fed funds market upper limit, and that the effective Fed funds rate may also rise above its upper limit, which of course defines a failure of monetary control in our system.

Beckworth: Right. And in fact, one of the arguments for the floor system is we'll have much better interest rate control, and we've seen anything but that. And I sympathize with the Fed…

Selgin: It's been a long practice period too.

Beckworth: Yeah, I mean, again, compared to the Canadian corridor system, we're doing a pretty horrible job down here.

Selgin: Or our pre 2008 system, which had a much better record of the Fed despite the extra work involved, because in that system it was expected that the open market desk would be busy all the time. They had to predict, they had to do a lot of work. And one of the big arguments was we'd go to a floor system and everybody at the open market desk they'll have their feet up on the desk and they'll be telling jokes, and-

Beckworth: Be on Twitter.

Selgin: ... tossing paper airplanes. But in fact, they've been very busy, as we know, and still they have failed in a number of remarkable instances to get rates to behave the way they want them to. So that's not very good.

Beckworth: Yeah. So the issue then going forward, the end of this month, will be will there be enough reserves? And I guess the way I think about it is there's a potential outward shift in the demand curve for reserves, and it's going to arise because of these big banks having year end regulatory inspections. So they call them the global systematically important banks, the G-SIBs, and there's a capital surcharge that's applied to them. And my understanding is end of the year, they try to tidy up their balance sheets, make them smaller, leaner, so the charge they get will be less. But in doing so, these banks will lend less into the market. So effectively the demand for those reserves will have increased. So, even as the Fed is increasing supply of reserves, that demand curve might be shifting out going beyond where the Fed is.

Selgin: That's right. And it's important to remember that the demand for reserves of these large banks is, an increase in that demand, is equivalent to a reduction in the availability of reserves to be lent in the repo market by those banks, because those banks are holding most of the reserves. I don't have the recent percentage immediately on hand, but we know that they hold an outsized percentage of the total available stock of excess reserves. So if there's a reserve shortage anywhere in the system, and those banks are not in a lending mood, so to speak, or are not in a position to lend, then that's when you get these desperate bids by people trying to pay whatever to cover themselves because it's hard to find anybody who's got reserves who wants to part with them.

And it's important to remember that the demand for reserves of these large banks is, an increase in that demand, is equivalent to a reduction in the availability of reserves to be lent in the repo market by those banks, because those banks are holding most of the reserves.

Beckworth: Yeah. So these banks effectively will reduce the supply of funding available to the repo market. For them it'd be an increasing demand, but from the repo market perspective, reduction in the supply of reserves.

Selgin: That's right, and it can also affect the Fed funds market too, and that's why those rates could ...

Beckworth: Yeah. All the overnight markets.

Selgin: All the overnight rates.

Beckworth: But we see kind of a headlines coming from the repo market, because that is probably the most important overnight funding market.

Beckworth:  And Zoltan Pozsar makes this point that it's one thing to have maybe a temporary spike in the repo market, but if it continues to persist, then you're leading to actual credit problems, actual businesses going bust, funding drying up for longer term projects. So it becomes serious. I mean, this is a technical issue right now, but a technical issue can turn into a real credit issue if it's not fixed.

Selgin: Sure. Yeah. This is definitely serious. This is not just about wanting to make the Fed look better. This is about the wellbeing of many ordinary participants in those overnight markets.

Beckworth: Okay. So that's the problem. And the concern again is, we might accidentally fall back into a corridor system at the year end, rates will spike. All kinds of problems will emerge from that depending on how long it lasts. So the solution that's been presented by one of our previous guests, David Andolfatto and Jane Ihrig, who's at the Board of Governors, and it's received a lot of discussion and discussed elsewhere extensively as a standing repo facility, which would allow these big banks to let go of some of the cash reserves they're holding because they could take treasuries to the Fed and easily convert that into cash. So right now they could be holding treasuries instead of cash, but they think they may not be able to liquidate quickly. There might be losses if they try to do it quickly, but if the Fed were there, it would solve that problem.

Beckworth: But you bring up in your paper a way to improve the standing repo facility because what the standing repo facility fixes right now as proposed would only address these big banks. It doesn't address the problems we've discussed with the TGA or the foreign repo pool directly. And you have some additions to make it kind of an all-encompassing solution. So walk us through that.

How to Improve Proposals for a Standing Repo Facility

Selgin: Well first of all, David, the standing repo facility is conceived by Andolfatto and Ihrig, it is meant to be there as not as a substitute for these ad hoc repos that the Fed's been doing. But it's not a substitute for the Fed's security purchases, which are also going on now, which are meant to make permanent additions to the stock of reserves to get back to an abundant reserve situation. So the idea is you pursue those reserve creating steps by the Fed, and then you have the standing repo facility, which will help because it reduces the demand for reserves by allowing banks, big banks especially, to treat treasury securities as closer substitutes, as better perfect substitutes as it were, for actual excess reserves.

So the idea is you pursue those reserve creating steps by the Fed, and then you have the standing repo facility, which will help because it reduces the demand for reserves by allowing banks, big banks especially, to treat treasury securities as closer substitutes, as better perfect substitutes as it were, for actual excess reserves.

Selgin: Now, I should mention there that this only works if the supervisors and the regulators go along with it, right? They have to say, "Okay. You can treat treasuries as perfect substitutes for excess reserves," which Basel allows in its definition of high quality liquid assets, tier one, high quality liquid assets, but which I understand and several people understand is not necessarily satisfying the regulators, particularly with regard to the so-called living will liquidity requirements.

Selgin: So anyway, assuming that David and Jane's facility exists, it would both reduce the supply or the demand for reserves, and thereby make it possible for the Fed to increase the supply of reserves and be done with it and never have to do that anymore. That's the idea. And if it's working the way it's supposed to, it shouldn't actually be used very often. You know, there might be some rare instances where reserves are a little scarce at the margin and then it would kick in.

Beckworth: Okay. So it would stand available, it probably wouldn't be used much, but it would create this certainty so you wouldn't want to hold a bunch of precautionary reserves?

Selgin: Exactly, yeah.

Beckworth: So it's kind of a nice backstop that hopefully you don't have to ever use?

Selgin: Yeah.

Beckworth: And presumably it would overcome the stigma of the discount window. I mean, the discount window in some sense it's very similar what it would provide, but people don't want to use the discount window because of the stigma. So, this would be a work around to that solution as well. But again, it wouldn't solve this problem of the Fed's balance sheet being beyond its control and the TGA and the foreign repo. But you have a fix for that.

Selgin: Yeah. So, the thing is that what you want to do is to make the demand for reserves lower but also more stable, and make the supply of reserves more stable, and the standing repo facility helps. But to really, really do that and to achieve what has long been the Fed's supposed idea of a balance sheet as small as is consistent with carrying out its monetary operation successfully, steps should be taken in my opinion to rein in the TGA and to reign in the foreign repo pool. And so I propose a number of those.

Selgin: For the foreign repo pool, that's pretty simple because the Fed is completely in charge of that facility. It is a facility that it operates as a favor for foreign banks. It's not in the Federal Reserve Act. It's not obliged to operate it and it can certainly operate it any way it wants to, within reasonable limits. It should set that foreign repo pool rate lower than it does. I suggest in my paper that it take the SOFR rate, which it's probably now using as a guide to the foreign repo rate and set the foreign repo rate something like 10 basis points below and make it a little bit of a penalty rate relative to private market rates. SOFR rate, if anything, is a little bit above private market repo rates because it's an index that includes a broader set than the usual private market rates. So that's the one thing it could do.

I suggest in my paper that it take the SOFR rate, which it's probably now using as a guide to the foreign repo rate and set the foreign repo rate something like 10 basis points below and make it a little bit of a penalty rate relative to private market rates.

Selgin: It could also put caps on the foreign repo pool, it used to have caps. It could tell the foreign banks, "Look, you can only hold this much. Here's your maximum balance. Here's how much you can change it with any limited period of time. There's plenty of scope for the Fed to work on these agreements.

Beckworth: And it used to do that because it was a scarce reserve environment.

Selgin: That's right, yeah.

Beckworth: Okay.

Selgin: But the point is, and maybe this is a big takeaway from this, even if you have an abundant reserve environment, still there are reasons to not have more reserves than necessary to manage that system. You still want it to be efficient in that sense. And that has always been the Fed's principle. That's why it had the unwind in the first place. Otherwise, why didn't it just stay with the maximum amount of reserves it had way back then? So, if that's the principle, and I think it's a sound principle, well then these steps should be taken because they allow the Fed's balance sheet to be that much smaller within a floor system framework. And though they also serve as stepping stones for getting to an efficient corridor system, which is important, and maybe we'll get to that. But in any event, if the Fed is serious about keeping a small balance sheet as small as possible, consistent with its monetary operations being successful, this is a step towards doing it.

If the Fed is serious about keeping a small balance sheet as small as possible, consistent with its monetary operations being successful, this is a step towards doing it.

Selgin: And the other thing I recommend for the Treasury is, actually, what I recommended, one of the things I recommended is something it turns out the Treasury already is able to do. There was a program experimented with by the Treasury starting in 2006 called the Treasury Repo Program. It was a direct repo borrowing program so the Treasury could go into the repo market, and that was a good substitute for keeping balances at the Fed. It earned a higher return and it obviously earned the private repo rate return for the ... which is more than the TT&L accounts. And turns out that in fact, in an obscure law that had to do with adoptions in 2008, I didn't know about this when I wrote about it at first, that tentative program, that experimental program was in fact made permanent. But something like three weeks after that law was passed, the crisis hit, interest on reserves hit. And so-

Beckworth: People forgot about it, huh?

Selgin: ... they forgot about it because remember, for a long, long time, private repo rates were below the interest rate on reserve. So it was costly even with that to take advantage of that program for the Treasury. Now, that program should be-

Beckworth: It makes sense.

Selgin: Makes sense. Apart from, and this is the hitch, and it's also a bit of a hitch for the foreign official institutions, the hitch on all that I've said is you still have the contingency of a possible major financial crisis. And in those circumstances, these alternatives I've been proposing might not be fully attractive. So the Treasury might worry about using its direct repo purchases because there could be a shutdown and that's why it would still want to have, unless something else has done $150 billion in its TGA.

The hitch on all that I've said is you still have the contingency of a possible major financial crisis. And in those circumstances, these alternatives I've been proposing might not be fully attractive.

Beckworth: Okay. So the private sector may not be able to fund Treasury?

Selgin: Yeah, if the private sector completely breaks down of course, it's very hard to make up an alternative for the keeping money at the Fed that can compete. That's true also for the foreign repo pool. But, this is where I propose my very-

Beckworth: Radical.

Selgin: ... radical-

Beckworth: I like radical George, so go ahead.

Selgin: And some will say non-free market, non-libertarian or whatever solution, not that that kind of thing bothers me too much. And that is simply this, let the Treasury and the foreign official institutions that presently contribute to the foreign repo pool, let them be counterparties to the proposed standing repo facility. I understand that there are a lot of laws that have to be worked out and the details, let them be counterparties, impose penalties or haircuts on them. Haircuts are essentially penalties, so it's not too attractive for them to use these facilities, but the facilities are there and can reassure them so that they have no reason, so that the Treasury has no reason to have always $150 billion or more in its TGA account. In the worst possible scenario where it's been repo-ing, it can take advantage of the standing repo facility if everything dries up for the foreign official institutions.

Let the Treasury and the foreign official institutions that presently contribute to the foreign repo pool, let them be counterparties to the proposed standing repo facility. I understand that there are a lot of laws that have to be worked out and the details, let them be counterparties, impose penalties or haircuts on them.

Selgin: Now of course the complaint will be, "Why do we want to make last resort lending facilities of any sort available to foreign firms?" Is one complaint, or, "How can we possibly risk letting the Fed directly lend to the Treasury? We know how dangerous that is," et cetera, et cetera. And none of them are very compelling. Those arguments aren't very compelling because the penalty rates, these emergency facilities aren't going to be abused. And with respect to the Treasury, there's really no difference here between the Fed buying securities, which you'd have to do, or the Fed directly lending to the Treasury offering to do that.

Beckworth: So this would cut out the middleman in the middle of a crisis.

Selgin: In the middle of a crisis you cut out the middleman, but you're not changing the fiscal situation.

Beckworth: I think your point is in normal times, this facility wouldn't be used by banks, by the Treasury, by these foreign official entities.

Selgin: You could certainly structure it so that there's absolutely no way for them, you can make that part of the law even, "If there's not a crisis going on, forget it."

Beckworth: But in a crisis, the Treasury, banking system, foreign entities would come knock at the door, the standing repo facility, and have access to it. I mean, I think another argument against the critics of this would be if you want the dollar to maintain its status as a reserve currency of the world, then you have to open the door of the standing repo facility to the rest of the world. I mean, it's part of the price we pay for making the dollar so wide reaching and powerful.

Selgin: Perhaps that's right. But the point is there are right and wrong ways to manage a last resort-

Beckworth: Fair enough.

Selgin: ... lending facility in constitutions. We do need constitutional constraints. It's not clear that the right constraints are let's not have the Treasury under any circumstance ever be able to borrow directly from the Fed. And in fact, as I mentioned in my paper, until 1981 for many decades, the Treasury did have so called a direct draw authority, and it used it routinely. And it used it by the way to stabilize the TGA balance so it wouldn't be trouble for the Fed to manage monetary policy. It was exactly for that purpose, here it's a little bit different, but the same basic principle. And so it's been done before and it's a question of doing it again under a somewhat different operating system and with a different facility. But otherwise, there's nothing new here under the sun.

Beckworth: So the Treasury used to have access to the Fed through its security draw.

Selgin: Yes, or direct draw authority.

Beckworth: Direct draw authority. So it's not entirely new as you mentioned.

Selgin: Not unprecedented.

Beckworth: And again, going back to the point of this discussion, this is part one, part two will be next week. We're nearing the end of the show here. The whole point, or the big point here is that if these changes were implemented, the Fed could control its balance sheet a whole lot more effectively.

Let the Treasury and the foreign official institutions that presently contribute to the foreign repo pool, let them be counterparties to the proposed standing repo facility. I understand that there are a lot of laws that have to be worked out and the details, let them be counterparties, impose penalties or haircuts on them. And [it] could have a much smaller balance sheet.

Selgin: And it could have a much smaller balance-

Beckworth: And [it] could have a much smaller balance sheet. So yeah, for those who are concerned about the Fed's footprints, that actually would shrink it. But for right now, I guess the practical concern right now is the Fed is having a hard time controlling its balance sheet, a good portion of it, and that's the Treasury General Account and the foreign repo pool. And this would provide a way to kind of fix that problem. Very pragmatic, very practical, with other great benefits down the road of a smaller footprint as well. And I think that's a great, great point. So it may seem radical, but I think it's very pragmatic.

Possible Return to a Corridor System?

Beckworth: Yeah. So this is a great proposal, George. I'm glad you've written about it. I encourage our listeners to take a look at the pieces. It's a two part piece George has posted. So we've talked about how this will be useful. It's something that Fed officials should think about, because I know they're talking about the standing repo facility right now. So they should consider these other changes in concert with maybe consulting the Congress, but in addition to the pragmatic fixes for the here and now, this could also be a stepping stone down the road to a return to a corridor system. So this is more long thinking, future thinking. So walk us through that scenario.

Selgin: Well, it's actually pretty simple, David. Once you have all these reforms in place, if they're able to do that, then as I said, the Fed could operate a floor system with a much smaller balance sheet, but it also would be much easier for it to return to shrinking its balance sheet to the point where it's back in a scarce reserve situation because having tamed the TGA and having tamed the foreign repo pool, it could manage the needed open market operations to operate a corridor system again.

Selgin: If you read the statements of Fed officials about why they don't want to go back to a corridor system or don't think it's possible, they talk about the TGA, and the foreign repo pool, and these liabilities… would be so hard. So, solving that problem of how those liabilities behave, containing their extent and volatility would eliminate the main rationale given by the Fed for not going back to a corridor system… would make doing so much, much easier. But that's what I would ultimately like to see happen, of course.

So, solving that problem of how those liabilities behave, containing their extent and volatility would eliminate the main rationale given by the Fed for not going back to a corridor system… would make doing so much, much easier. But that's what I would ultimately like to see happen, of course.

Beckworth: And I share that view as well. Well, with that, our time is up. And again, I encourage our listeners to tune in next week when Josh Galper from Finadium, who's in the heart of the repo market, will talk to us on the same topic from the perspective of the repo market. But George, thank you for coming on and a happy holiday season to you.

Selgin: Thank you, David. You too. It's always a pleasure.

David Beckworth
Calendar Date: 
Dec 16, 2019
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Tweaks to current standing repo facility proposals would be an important step toward helping Fed gain more control over its balance sheet

George Selgin on the Past, Present, and Future of a Real-Time Payments System

George Selgin is the director of the Cato Institute’s Center for Monetary and Financial Alternatives and is a returning guest to the Macro Musings podcast. Today, George joins Macro Musings to talk about recent developments in the payment system. Specifically, George and David discuss the history of attempted payment system solutions, the challenges and costs facing the implementation of a real-time payment system, and why we should care about this issue today.   

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

David Beckworth: Our guest today is George Selgin. George is the Director of the Cato Institute's [Center for] Monetary and Financial Alternatives. And as a previous guest of the podcast, George joins us to discuss recent developments in the payments system [and] also what is happening with the Fed's review this year, and finally, the latest developments in the Fed's operating framework. George, welcome back to the show.

George Selgin: Always nice to be here, David.

Beckworth: Well, it's good to have you back on. You are the reigning champ on Macro Musings in terms of show appearances. I believe this is your fifth appearance.

Selgin: Hey, whoopee!

Beckworth: So, you are like the Mike Munger of econ talk, that's what you are for Macro Musings. So, he's, I think, like a regular, reoccurring, almost a co-host. So, you're like the number one appearance on this show. If you haven't heard any of George's previous shows, go back and check them out. But, today, I have brought George on to talk about the payment system. We will probably spend most of the time talking about the payment system, and then we'll get into the review, and finally, the operating framework as it relates to some of the developments in the money markets and in repo. But, there's been a lot going on with the payment system, George, and you've been a big part of that conversation recently, you were at a Senate hearing on facilitating faster payments.

Beckworth: Lots of real-time payment discussions, we've had Aaron Klein on the show, we've had a few others. But, I want to really dig into the weeds today and learn what's going on, and why does it matter? Because, for many people, including myself a few months ago, this is an esoteric technical subject that, it didn't get much attention. It's probably not on most people's radar, but it's very consequential. So, talk us through, why should we care about the payment system? And then, after that, maybe tell us what's been happening.

What’s Going On With the Current Payment System and How Can We Fix It?

Selgin: So, David, for a lot of people, the payment system seems just fine. So, you get paid, and you get your funds reasonably quickly for your needs and et cetera. But, there are many people who actually have reason to be very unhappy with the way the payment system works. Merchants sometimes have to wait a while, maybe for an extended period of several days for their funds to actually come through, and payments are recorded, but the actual final payment doesn't clear for a while, and it's only then that they have funds credited to their accounts that they can use. But the people who suffer the most from the slowness of payments in this country, and it is a problem, particularly in the United States, are poor people who live from paycheck to paycheck, and this is something that Aaron Klein has been particularly eloquent about.

But the people who suffer the most from the slowness of payments in this country, and it is a problem, particularly in the United States, are poor people who live from paycheck to paycheck.

Selgin: And the fact that it can take several days for a paycheck to clear for them can be very costly. Costly because they have to resort to payday lenders, or check cashing services, if you like. Costly because they incur overdrafts in their accounts, because the money isn't there yet. And that is really the most serious, but not the only adverse consequence of the fact that we have a relatively slow payment system in this country. So, we don't all notice it, we don't all care. But, plenty of people do, and there really is no good reason for it. And especially when you consider that there are many, many countries that have payment systems that are very quick or practically all payments are completed and credited within minutes, if not instantly. So, we have some serious catching up to do.

Beckworth: So, we're behind other countries when it comes to real-time payments.

Selgin: Many countries, yes.

Beckworth: Okay. Which is surprising and you'd think we'd be at the cutting edge, but, like U.K. and Canada and Europe, they have much faster payment systems there.

Selgin: Indeed, yeah. I'd say that many of these countries are a decade ahead, conservatively. So, partly, it's the fact that our legacy payment system, in some respects, was pretty good, and so, there wasn't the urgent need that was felt, at least, widely enough to drive reforms. Some countries, in a sense, benefited from the fact that the payment systems were so slow that they knew they had to overhaul them, and they did. And now, they're ahead of us. But, we also have a challenge that other countries don't have in having so many banks and credit unions, not mention other payment services. And therefore, coordinating reforms that require that all of these firms be operating on common networks, is a lot more difficult in the United States than it is elsewhere.

Selgin: So, it's not an easy task that can be done to make our payment system as fast as the payment systems of other countries that have more concentrated banking systems, and are smaller, to begin with.

Beckworth: Yeah, we recently had your colleague, Diego, on the show, and he talked about one defining characteristic of the U.S. banking system is it's fractured. There's just so many different banks in many places, and you've written about the history of this yourself, but that's a big part of the story here, right?

Selgin: Yes, it is. So, we're talking about roughly five to 6,000 banks and almost equal number of credit unions. And then there are other kinds of depository institutions and other kinds of payment service providers. And many of them are very, very small. So, coordinating them, getting them all, just, you could establish a network that could handle fast time payments, you're only a third of the way down or something like that, because then you've got to get everybody to join. And as you'll see, when we get into this a little bit further, that can be a real problem, but it's important because networks can be much more effective, are much more effective, if everybody's in them.

Selgin: So, if I want to send a payment to somebody, if that person's bank is in the same network, that can make it a lot easier, and may not be possible at all for my network to send him a payment quickly, if his bank isn't in the same network.

Beckworth: Okay. So, that's the backdrop, the story to why we care about this and why it's an issue in the United States. We have an antiquated payment system, it takes time, it's costly for people in the lower half of the income spectrum, and for merchants as well, for businesses. So, there is a need for change. And there's been several developments, there's been two big stories, I think. One is the private sector's attempt to solve this with pressure from the Federal Reserve. And now, the Federal Reserve is attempting to address it itself. So, walk us through the history of attempted solutions. Selgin:  So, really, things got started back in 2014, and the Fed quite rightly took the initiative by convening a task force. A task force that had many participants from the private sector, particularly, and interest groups. And the Fed challenged or charged this task force with coming up with ways to improve payments. Particularly, the challenge was to come up with the so called solution to the problem of providing so called real-time gross settlement services for retail. Now, that's a real mouthful. So, the essence of real-time payment is that, the same message, the same, if you like, computer clicks that deliver the payment instructions, also deliver the funds, it's all done instantaneously, so there is no delay between a payment instruction being sent, and actual funds being transferred to the payee's bank, and thus, to the payee. It all happens instantaneously.

Selgin: Now, that's quite different from conventional payments, retail payments, which, depending on what form, the specific form they take, can take quite a long time, because, the payment order is one thing, but the actual transmission of funds from one bank to another is another. There is a process of clearing, which is, reconciling the different payment messages, and finally, a process of settlement, which is, when good funds, so called, think of them as bank reserves, get moved from the payer's bank to the payee's bank. And it's the clearing and settlement process, and particularly, the settlement itself, that's what can take a long time, and that's where those unfortunate delays come in.

Selgin: And so, with real-time payments, that is a solution. I'll try to emphasize that it is not the only solution, but it is certainly a solution. It is the fastest solution because it does away with the gap between a payment order being made and instruction being given, and actual funds getting where they need to get.

Beckworth: Okay. And so, the Federal Reserve encouraged the private sector to come up with a solution, and so, what was the private sector's solution?

Selgin: So, right, they convened this task force in 2014, and they got a number of proposals out of this task force, and they're all very interesting. But, only one of them really scored very high points. The Fed and others, they graded, they actually graded, they gave them like a report card on the different proposals. And one in particular, which was a proposal from The Clearing House, TCH, a private payments organization that's been around since 1853, based in New York, their proposal got very high marks all around, it was an A+. And this had to do with security, reliability, potential for becoming ubiquitous, which is to say, a universal, everybody could, in principle, join, equity. There were a number of criteria, got very high marks.

Selgin: Well, TCH, in fact, went ahead and set it up. They spent something like a billion dollars, and by 2017, they had the system up and running.

Beckworth:  What was the coverage like by that point?

Selgin: Well, of course, when it first was established, it may have had some preliminary subscribers, but, eventually, it had membership that covered about 50 percent of all bank deposits. That number's probably gone up some now, but it consisted mostly of the large banks, and which, of course, it doesn't take that many large banks before you're at 50 percent. They did not get that much membership from smaller banks, and they were struggling to do so. But, I suspect and they believe that over time, they would get more and more members, because this was a desirable service that smaller banks would want to be able to offer and not just leave to the large ones.

Beckworth: The bigger network grows, the more it is in your advantage to join the network. So, they're on this trajectory of this growing network of real-time payments, and then, a big shock on the road appeared before them, and what was that?

Selgin: Well, the shock was, let me step back a bit to make clear that, up to that point, to 2017, and for some time later, the clear, a fairly an unambiguous signal the Fed was sending was, "We're going to see if the private sector can do this. If it can, that'll be that."

Beckworth: So, the Fed was cheerleading this process.

Selgin: They were very much so, and they gave every indication that if the private sector solved the problem, they had not suggested that they might come in and offer this service themselves. And this is all, by the way, quite consistent with the spirit, if not the letter of the 1980 Monetary Control Act, and with the Fed’s own rules, which hold that it should not offer any new payment services, that, a service that the private sector is capable of providing. So, the idea is, if the private sector can do it, the Fed won't do it. The Fed will only do it if the private sector can't do it.

Selgin: So, TCH, with this understanding, had passed with flying colors, the competition to come up with a solution for real-time payments, set up its system, which is called RTP, for real-time payments, and had it running in 2017. And as I say, by that time, or, by sometime in 2018, had about 50 percent of the market, when the Fed, I think this was in August 2018, suddenly sent out a request for comment on the possibility that it would set up its own real-time gross settlement retail system, and also requested comment, and this is very significant, on whether it should provide 24/7/365 days a year settlement services, or some kind of settlement service. And that other part of that request for comment is very important, and I want to get to it.

Selgin: But, the first part, where it said, "Oh, we want to know whether we should enter in the real-time space," that was the bump in the road or the shock that TCH suddenly found itself confronted with, because now they're saying, "Good gracious, we've just spent a billion dollars, we're halfway, we've got half of the bank deposits signed up, and now, the Fed has really thrown a wrench in the works. Because, first of all, the possibility that they will set up a rival service, means that banks may wait and see about that service, because they won't want to join both. It's expensive for a bank to join any of these services. There are hardware costs, there are other costs that have to be expended by the bank, in order to link up, so to speak.

Selgin: And these two services, and this is very important, there's no indication, there was never any indication, and there still isn't from the Fed, that its rival service, which has since been given the name FedNow, will be interoperable with the RTP system. Which means, basically, that, if you want to send a payment, and your bank is on RTP, to someone whose bank is on the Fed system, when that gets set up, that may not be a fast payment because they're not connected, they're not interoperable. So, that meant that, of course, every bank that hadn't signed up for RTP, now has to worry about what's the right thing to sign up for. So, it had a chilling effect on membership to RTP, that the Fed might join, might compete with it.

And these two services, and this is very important, there's no indication, there was never any indication, and there still isn't from the Fed, that its rival service, which has since been given the name FedNow, will be interoperable with the RTP system. 

Selgin: And, of course, it faced RTP with the prospect of, The Clearing House, with the prospect of having to keep compete directly with the Fed, which is never something you really want to have to do. Because, and this is extremely important, we are economists, and many of your listeners will also be economists, so, of course, we like competition. But, competition with the Fed is not plain old competition, the Fed has lots of ways to cheat, to put it bluntly. First of all, they're regulator, as well as a competitor. So, they regulate firms they compete with, and that is a conflict of interest that is extremely problematic, extremely problematic.

Selgin: Second, although the Monetary Control Act requires the Fed to recover its costs for any service it provides, essentially, so that it can't cross-subsidize, it can't use its monopoly rents from issuing currency over which it has a clear monopoly. It can't use those, for example, to underprice other services. At least, it can't, according to the law. But, enforcing the Monetary Control Act is not easy. It's not always clear whether there are cross-subsidies involved and we rely on the Fed's own accounting procedures to determine whether it's recovering its costs, and those procedures haven't been subject to an outside audit since 1984. So, it's very loosey-goosey, to use a phrase that my good friend Bill Trumbo likes to use. And so, you have a lot of issues.

Selgin: You have a third issue with respect to the Monetary Control Act in this case, in that, the Fed is merely speculating that it's going to satisfy the MCA requirements, right? It doesn't know, but if it... I should say that I've jumped ahead a bit. Of course, ultimately, the Fed did decide to go ahead with FedNow. But it, in doing so, implicitly asserted that it would be able to meet the Monetary Control Act's provisions, even though it doesn't really know how much money it's going to make, it doesn't even know what it's going to charge. Because, unlike RTP, it hasn't resolved, made up its mind about a fee schedule, and that's another important issue. Anyway, this was all very disconcerting to the folks at The Clearing House, understandably.

Selgin: And they joined with some others in responding to the comment, request for comment, naturally, quite critically. And I also wrote critically on this, saying that I did not think it was going to be helpful for the Fed to compete in this space, and I did not think it was going to be necessary. So, there were a few people who wrote against the FedNow, what became the FedNow plan. On the other hand, they were also thousands of letters, mostly rather perfunctory, from community bankers, mainly who'd been urged to chime in in favor of FedNow, which they did. So, ultimately, what the Fed did, was to say, "Look, the overwhelming number of comments have been favorable for FedNow, therefore, we're going to do it."

Selgin:  And that was a correct statement, if you just went by the sheer volume of comments that were favorable, even if they weren't very substantive, and many were not. But, there were many comments, fewer, of course, but there were many very substantive comments that criticized the proposal and said the Fed shouldn't go ahead with it. So, anyway, they went ahead, and now, you have two potential rival systems, one of which is already in existence, and the other which will be coming, according to the Fed, in four or five years, which is a very long time. We can talk about that too.

Beckworth: Right. So, let me summarize what you've said. I want to use the analogy here of a sports game. Let's say is football, all right? So, the Fed got this team together, called the private sector, and they're saying, "Hey, go play that other team out there. The other team it's the lack of a real-time payment system. We want you to play and beat them, and we're going to cheer from the sidelines. We're going to cheer loud, hard, we're going to encourage you." So, the private sector gets out there, The Clearing House takes the lead. It's playing and it's making progress, it's getting out to near the end zone. And all of a sudden, they hear this loud whistle, and they look in the stands, and suddenly, the cheerleaders say “Get off the field, we're going to play."

Beckworth: And they're like, "Well, we've almost won." And they're like, "No, we want to play, and moreover, we're going to rewrite the rules. If you don't like it, we're going to rewrite the rules, we're going to get in, and we're going to take over." Which seems kind of strange. And I have to ask this question, were some of those cheerleaders in the past, now supporting the Fed? I mean, specific people, like Dan Tarullo, I imagine he must have been one of the people who supported the TCH's plan, did he change his tune? I mean, how did this conversion take place, I guess? Going from cheerleader to proponent of the Fed’s own system, there's got to be a story there.

Selgin: I'm sure there is, David. By the way, I really like your analogy, because the Fed has, indeed, announced it's coming on the field itself, and it's going to be the umpire, or the referee. And I also like it because it stresses the fact that, although people have said, "Oh, we can't let The Clearing House run a monopoly," the payment space is very crowded with different providers, some of which do provide instant payments, but for small networks. And TCH is competing with all these other established payment services, including the legacy services that are not real-time. So, it's not as if there's no competition, and I'll talk about how the Fed could have confronted TCH with much greater competitive pressure, without doing what it did, when we get around to talking about 24/7 settlement services.

Selgin: Anyway, I really like the analogy, I think it's correct. And I completely forgot what you were asking about.

Beckworth: What I was going to ask, so, the interesting part of this-

Selgin: Oh, whether the change, how did the... Yeah.

Beckworth: How did you go from being a cheerleader, to just saying, "I want to take the field"? I mean, that's a pretty big move, right?

Selgin: It is, indeed. And as I said, it caught a lot of people by surprise. I wish I could tell you what the inside politics of all this consisted of. The only prominent Fed official I know who does not, who has argued that the Fed's entering directly into this space is not a good idea, is Randy Quarles. I don't know about Tarullo.

Beckworth: Well, he's no longer at the Board of Governors, but I'm just wondering like how his views of evolved…

Selgin: I don't know what his views are.

Beckworth: Or Lael Brainard, I mean, I know she was pretty strong advocate, I wonder where she stood back in 2014 in all of this.

Selgin: Yes. I don't know, I don't know. I do know that the major source of this decision for the Fed to create its own system, a lot of that is coming from the Federal Reserve Bank of Kansas. Which, the economists at that bank have made a specialty of real-time payments. And clearly, for quite some time, I think really predating the task force of 2014, have been, as it were, looking forward to the Fed moving in and establishing its own real-time payment system. So, I suspect that a lot of the pressure came from the Kansas City Fed.

Beckworth: All right, let me play my analogy out a little bit more then. So, you have these cheerleaders, the Fed in the stand of the game for starts, and there's a bunch of fans out there, all the different Fed officials, but there's a small group of those Fed officials sitting quietly with their arms folded, that's the Kansas City Federal Reserve Bank. Everyone else is cheering, "Rah, rah, rah, RTP," and they're just grumpy, they're upset, and they slowly work the crowd over and say, "Hey, it's time for us to take the field." Maybe that's part of the story then, huh?

Selgin: I suppose. Like all analogies, this one's starting to get a little bit frayed at the edges.

Beckworth: Okay, fair enough.

Selgin: But I do think that you had a sort of technocratic impetus, where, you have people who have been thinking about these things for a while, and they really like get their hands dirty, running a system, they think they can do it. And you also, let's face it, have the usual bureaucratic motives. For a long time, the different Federal Reserve Banks, their main function, we think of them as most people think of the Federal Reserve Banks, other than, apart, I'm not talking about the board, I'm talking about the 12 banks, think of them as places where you have some expert economists, and then you have a president who takes part in the FOMC, perhaps, and helps make decisions about monetary policy. Or, you also have bank supervisors, et cetera.

But I do think that you had a sort of technocratic impetus, where, you have people who have been thinking about these things for a while, and they really like get their hands dirty, running a system, they think they can do it. And you also, let's face it, have the usual bureaucratic motives. 

Beckworth: Well, let me give them a hearing here.

Selgin: Sure.

Beckworth: I'll take their side, a little pushback on that point. So, Thomas Hoenig now, who's a colleague of mine here at the Mercatus, and I had him on the show, and he mentioned that he had to actually lay off a bunch of people because of this whole technology change, in terms, we don't carry cash, checks, around much anymore. And so, there were people who were let go from the Fed, but you're saying, the incentive is always there to find a new reason for existence, to be relevant.

Selgin: Yes. If they could have found something quick enough, they wouldn't have had to lay off those people, and Tom wouldn't have had that unpleasant experience. And so, they're trying to be forward-looking, and, of course, I didn't mean to imply that they don't actually want to see their budgets grow, which is also part of the standard bureaucratic model. So, there are a lot of bureaucratic factors that I think play in here. I don't think ultimately it matters what the Fed's motives are, what matters is whether their intruding the spaces is necessary and whether it's the best thing they can do to promote faster payments. And that, I'm sure, the answer to the second question is no. And that's what I want to talk about, if you don't mind.

I don't think ultimately it matters what the Fed's motives are, what matters is whether their intruding the spaces is necessary and whether it's the best thing they can do to promote faster payments. And that, I'm sure, the answer to the second question is no.

Beckworth: Yes, please do.

Selgin: I want to talk about the other part of the Fed's request for comment back in 2018, and what resulted from that.

Beckworth: So, just to summarize, the first part was a real-time payment system.

Selgin: Yes.

Beckworth: And now, let's jump into the second one. Tell us about that.

Selgin: Yeah. So, the second thing the Fed asked about, was whether it should set up, or offer 24/7 settlement services, and to assist the liquidity management in private payments networks. Or, in the established legacy networks. Now, let me give you an example of how this reform could help RTP, for example. But, first, let me step back and say, at present, and for some time, the Fed has two wholesale settlement services it offers. They're the, Fedwire is one, and the other one is the National Settlement Service. Now, I don't want to go into any real deep details about those, but these are services that essentially see to the final settlement I was talking about earlier.

Selgin: That is, they see to it that, after payment instructions are sent from one bank to another, that the funds get transferred from the sending bank to the receiving bank, and so, the receiving bank can give credit to whoever the payee is. And so, that's done either using Fedwire or using the National Settlement Service or both. Now, here's the thing, both of those services have limited operating hours. They're not open 24 hours a day, and that already restricts the number of payments. It restricts the potential for payments to be settled within the same day. There's just something called the ACH system, Automated Clearing House, and depending on when payments are sent through it, there are two payment windows during the day, and if they're sent in time for those windows, they're settled on the same day.

Beckworth: Why is that? Why don't they have a 24 hour system?

Selgin: That's a good question. But, if payments don't come on time for that second window, they don't get cleared until the next day. And that is a lot of payments are processed through there. And again, the problem here is, Fedwire's hours are limited. It's extended its hours somewhat over time, but I think it closes at nine o'clock now. 9:00 P.M. Eastern Time, if I'm not mistaken. And, Fedwire and the National Settlement Service are closed on weekends and holidays. It's because of these limited Fedwire and National Settlement Service hours, that payments can sometimes take days to settle. It's because of those.

Beckworth: Which is hard if you're a poor person.

Selgin: Your average poor person doesn't mind, isn't harmed that much, I should say, right? They're not harmed that much by payment that takes hours to settle, but it's still settled the same day. They're not even harmed that much if it gets settled the next day, but they’re harmed some. But they really suffer if it's a weekend or with holidays. But that's all because these established existing Fed settlement services don't run 24 hours a day, seven days a week, 365 days a year. Other countries have services, a central bank operated settlement services, that do run all hours.

They're not harmed that much by payment that takes hours to settle, but it's still settled the same day. They're not even harmed that much if it gets settled the next day, but they’re harmed some. But they really suffer if it's a weekend or with holidays. But that's all because these established existing Fed settlement services don't run 24 hours a day, seven days a week, 365 days a year. Other countries have services, a central bank operated settlement services, that do run all hours.

Selgin: Okay. So, the other component of the Fed's 2018 request for comment, was, should we provide this kind of extended wholesale settlement service, either by increasing the operating hours of these existing services, or by providing what they called a new liquidity management tool? And the response to that component to the comment letter was unanimously in favor. Yes, the Fed should do this. And that's not surprising, because, actually, various people in the payments industries have been pushing the Fed to do just that for years, and the Fed has known. It has talked about doing these extended hours for years, but it keeps dragging its feet.

Selgin: Even a third payment window was supposed to have done it some time ago, and it dragged its feet, didn't do what it needed to do, and now, it's delayed for almost two more years. That's just to get a third-

Beckworth:  Why? Why this delay?

Selgin: Well, it's a great question, David. Because, think about it, the Fed has managed, in a very brief period of time, to convince itself that it has the know-how and ability to go forward with their new, completely new technologically sophisticated real-time payment service. It was able to say, "Yes, we can do that." Because that was the result of that part of the comment letter to determine that there was enough support, they can do it. But, apparently, they need more time how to increase the hours. And this is the thing, it's absolutely shocking, if you go to the Fed's 2019 announcement, I think it was January 2019, where they said, "Okay, here's what we've decided to do in response to this feedback." The first part of that announcement is, "We're going to go ahead with our real-time FedNow system."

Selgin: The second part, which is kind of buried in there, but I urge your listeners to go ahead and look this up and read it. You can provide a link.

Beckworth: I'm going to put a link to it on the show, yeah.

Selgin: Well, look for the paragraph where it says what it decided to do about 24/7, and this is absolutely scandalous. They say, "Well, as for that, we're going to keep thinking about it. We need to explore that possibility further." And this is a possibility, remember, that's, they were urged to pursue for years. And then, at one point, way back, they said, "Oh, yeah, we're going to eventually get around to this." And this one, this no brainer of a decision, they say, "We have to explore further." And just to add insult to injury, they say, "We may get around to requesting comment on the possibility."

Beckworth: Comment on a comment.

Selgin: Yes, comment on a comment. This is a response to a comment request that asked for comment on extending the hours of Fedwire and National Settlement Service, and now, they're saying, "Well, in response to the universal comment in favor of doing that, we've decided that we may seek comment about this possibility." It's absurd. Now, this is where things get really nasty. So, remember that, the main, not the only, but the main impetus here, and most important reason for wanting to make change is the poor people who are suffering from, not just from delays of a few hours in settlement, but delays of a day, or two days, or three days, or four days, and depending on holidays.

Selgin: This simple, relatively simple reform would be able to solve that problem, eliminate those delays, on just using existing or legacy payments services, and arrangements, and networks, and could probably do it. I can't imagine why it would need to take more than two years. But, the Fed has decided not to take that step, where the cost-benefit ratio, you would think, the benefit to cost ratio would be pretty darn high. But it did find it easy to decide to undertake a much more ambitious reform, the necessity of which is hardly clear because it would replicate the services of an already established real-time payment network, and which will, according to the Fed's estimate, not be up and running for another five years. And you can bet that adding two years to that is a conservative proper adjustment.

This simple, relatively simple reform would be able to solve that problem, eliminate those delays, on just using existing or legacy payments services, and arrangements, and networks, and could probably do it. I can't imagine why it would need to take more than two years. But, the Fed has decided not to take that step.

Selgin: And in the meantime, what are all these poor people to do? They're going to have to put up with exactly the costs, and delays, and hardships that they've been putting up with for all these years, for another five, six years. It's disgusting. Finally... Sorry, I'm on a rant.

And in the meantime, what are all these poor people to do? They're going to have to put up with exactly the costs, and delays, and hardships that they've been putting up with for all these years, for another five, six years. It's disgusting. 

Beckworth: Please do, this is great.

Selgin: I hope your listeners will forgive me, but this really is terrible. The other point that's very crucial here is, if the Fed had in fact decided to take the steps to make its existing settlement services operate 24/7/365, that alone, of course, would have confronted RTP, The Clearing House system with an important source of competition. Because, it would have meant that ordinary payments would be much faster, there would be no really serious delays. And they wouldn't be as fast as real-time payment, that's true, but the difference would have been small enough that, for RTP's ability to overprice its service, which is what you worry about a monopoly doing, right? Its ability would have been very limited.

Selgin: Because, if the fee goes up just a cent or more in the RTP arrangement, and we need to talk about fees more.

Beckworth: Yeah, absolutely.

Selgin: But, their ability to extract rents would be limited because of the greater contestability of the payments markets, where contestability isn't just a matter of having more than one provider of the exact same service, but of having multiple providers of close substitutes or near substitutes, that's enough, that would have done a lot. So, the Fed could have, as it were, by making the opposite decisions it made in response to the comments that it requested, by deciding, "We're not going to do RTP, but we are going to do the 24/7 thing with our settlement services." It would have provided relief for the poor much sooner, and it would have provided an important source of competition to RTP, and therefore, it would have had the best of everything.

Beckworth: Yeah, the best of both worlds.

Selgin: And it did just the opposite. And I believe it did so because of completely unjustified bureaucratic motives, also encouraged by misguided perceptions in the part of the public that it did nothing to allay about the potential for abuse from RTP. And I do want to talk about that.

Beckworth: Yeah, this is very interesting. I wasn't aware of the second part of the story. I knew the RTP story somewhat, but the second part of the story is interesting. So, that, the second part of the story, so, the legacy or the ordinary payment systems that we have, could have been dramatically improved. I mean, and you said, they talked already about having a third window, but just simple fixes on existing frameworks could have been tweaked, could have been fixed. And because they hadn't been fixed, there was this push to do real-time payment system. So, the real-time payment system is a symptom of a deeper problem that could have been fixed easily, and so, they're going to take a whole different approach, a whole different tack, which is kind of mind blowing, really.

Beckworth: I mean, why take such a difficult course when there was a much shorter direct path to accomplishing the goal of helping getting faster payments?

Selgin: Well, I don't know the answer to that. I do want to say that I don't want to imply that having a retail payment system, and even one that could cover most of the country was an unnecessary goal or unworthy goal, I think it's a fine goal, it's a fine objective, but it isn't the whole story about how to improve payments in this country, and it doesn't make sense to have left the legacy payments arrangements in their decrepit backward state, when they too could be improved. And so, I'm all for real-time payments, but I think that the Fed already had accomplished much of what it needed or perhaps all that it needed to accomplish with those, by getting the private sector to step up to the plate and establish a system, which has been in place since 2017.

Selgin: What the Fed should have been doing, first and foremost, is healing itself, right? Doctor heal thyself. Fix up your existing payments, you have a monopoly on settlement services. The Fed is the only institution that can push reserves from one bank to another directly. And I can explain how RTP handles that in a moment, and I probably should. But, RTP, ultimately, is also dependent on the Fed for funding. The Fed has this monopoly on settlement services, which it runs inefficiently, or, at least, inadequately, from the point of view of all the payments providers and who, unanimously, see that it should be open for more hours. They could have provided three windows a day for ACH payments, 24 hour service, and weekend service, holiday service, and provided a vast improvement for it would have made a huge difference. There'd still be scope for real-time payments.

Selgin: Because, some people really do need, it really matters a lot to some people, mostly to merchants, the difference between it taking a couple hours and it taking seconds, that can matter to a lot of people. And real-time payments can also be very useful for inventory management and information purposes, because the message is used to also include other information about the transaction. So, real-time payments is great, I don't want to put it down at all. But, if the Fed were responsible public servant, it would have improved its settlement systems, first of all, and then, it would have seen if it could also encourage the development of real-time payments, and it would only have intervened to do that if it was absolutely sure that private sector couldn't.

If the Fed were responsible public servant, it would have improved its settlement systems, first of all, and then, it would have seen if it could also encourage the development of real-time payments, and it would only have intervened to do that if it was absolutely sure that private sector couldn't.

Beckworth: Well, let me restate what I said earlier then, real-time payments is great, and there's good reasons to pursue it, but the reasons that have been listed, or argued for it have been the poor story, those in need. And what you're saying is that it could have been fixed a whole lot easier, and there's this more direct way of doing that. And I think there should be a cautionary tale for all those out there, who've argued, "Let the government do it, because they're the ones that they're going to care about the poor, they're the ones they're going to solve the problem." This should be a very cautionary tale that sometimes they don't get it right. And we could have had the best of both worlds, we could have had a system that does help the poor, as well as a real-time payment system been developed by The Clearing House.

Selgin: Yes, absolutely.

Beckworth: So, let's move on to some of the challenges with the real-time payment system in terms of costs, because, our time is running out here, and it looks like, listeners, we’ll have to have George back on to talk about the Fed's review.

Selgin: Yay, I've been preserved by status.

The Cost and Implementation Challenges Facing a Real-time Payment System

Beckworth: Yeah, bring you on for your next show. But, let's talk about some of the challenges in implementing the real-time payment system. So, I know you've touched on this cost issue, but one of the requirements of that 1980 law is that, whatever the Fed gets into, it has to recover its costs, when it does something. So, if it does a real-time payment system, it's going to have to cover its cost. It can't just have a freebie, where it hands out their service to the public.

Selgin: That's right, unless it cheats.

Beckworth: Unless it cheats. And what's interesting is, one of the implications that comes out of this, and this is where I've been really puzzled, and maybe you can explain why this is the case. But, if the Fed has to cover its costs, there's a good chance it will have to start offering volume discounts, so that, someone who does a whole lot of use of this payment system gets a cheaper price, which is typical, you see that in any walk of life. And so, who will that be? The big banks. The big banks will get cheaper prices than the small banks, most likely, if this cost rule applies, and so, small banks themselves, may be harmed by the Fed stepping into the real-time payment space.

Selgin: That's exactly right, David. I think the small banks, the community bankers have been sold a bill of goods. And here's how the story actually developed, when the RTP launched, they did so with a contractual commitment to their customers, to charge a flat fee. That is, no volume discounts. And that's a legally binding contractual commitment that they have. When the Fed announced that it was prepared to compete with them, or maybe after it decided that would compete, then RTP said, "Well, we may not be able to continue to offer this flat rate fee commitment, if the Fed enters."

Selgin: Now, they were very good reasons for the RTP to do that, because, RTP knew, The Clearing House knew, from experience, that the Fed was likely to offer volume discounts, and then it would have to follow suit, because it would lose the business of the large banks, and including, ironically enough, including many of the owners of The Clearing House. But, they, the bankers, are going to take the cheapest solution. And, in fact, that's exactly what happened in the Automated Clearing House space. Today, the Automated Clearing House network is jointly run by, ACH payments are jointly provided by the Fed and The Clearing House. Originally, The Clearing House charged a flat fee, then the Fed turned to volume discounting, to compete, not with The Clearing House, but with Visa, which was a big player and was offering volume discounts.

Selgin: Then, as ACH, sorry, as The Clearing House became a more important player or wanted to preserve its market share, it, too, resorted to volume discounts. So, The Clearing House has good reason to know that, if you're competing with the Fed, you might be competing with a firm that offers volume discounts, and you'll have to match. That's the only reason why they announced that their commitment to flat fees was contingent on whether the Fed ended up competing with them or not. Well, the Fed, it was a clumsy announcement, because it played into the Federal Reserve's hands, and the Federal Reserve and its supporters, they started saying, "See, you can't trust TCH. Look at them, they're planning now, to renege on their commitment to flat fees, they're going to screw all the community bankers. This is why you need us to intervene."

Selgin: But, the reality is, that TCH would have had no reason to renege on those commitments, and has no reason now, unless it's to be able to compete effectively with a Fed that's itself charging volume discounts. So, volume discounts are probably going to be the outcome of all of this, whether the community bankers like it or not, but it won't be TCH's fault. And this relates to another point, the TCH, at least, has made a now, qualified commitment to flat fees, right? They're going to be there until the Fed makes it impossible. And I think they'll stick to that, which is to say they'll stick to it till the Fed actually gets its system up and running.

Selgin: What about the Fed? The Fed has been urged to say what its pricing policy is, will it commit to a flat fee, if ACH does? I mean, if TCH does. And the Fed absolutely refuses to do that. When, at the hearing, you mentioned, they were pressed, Esther George was pressed to say, "Well, what is your pricing strategy?"

Beckworth: Now, who's Esther George? For our listeners.

Selgin: She's the president of the Federal Reserve Bank of Kansas.

Beckworth: Okay.

Selgin: She was pressed to ask, "Well, what are your pricing plans? RTP has its pricing schedule and its commitment that's qualified, what about yours?" And her answer, shockingly, was, "Well, we haven't figured out what rates we're going to charge." Now, you tell me, how did the Fed determine that this was a good thing for it to get into, and that it could do it and meet the obligations of the Monetary Control Act, if it still doesn't know what fees it's going to charge? Wouldn't it need to have thought about that, in order to determine whether this was a worthwhile project, and whether it could recoup its costs? I think so.

Now, you tell me, how did the Fed determine that this was a good thing for it to get into, and that it could do it and meet the obligations of the Monetary Control Act, if it still doesn't know what fees it's going to charge? Wouldn't it need to have thought about that, in order to determine whether this was a worthwhile project, and whether it could recoup its costs? I think so.

Selgin: So, what essentially George was admitting, though, perhaps unwittingly is, the Fed has no idea whether it can do this in a way that allows it to meet the Monetary Control Act, and it has no idea whether it's going to charge volume discounts or not, and it's unprepared and unable to commit to not doing so. There will be volume discounts, there's no question about it. But, again, it won't be RTP's fault.

Beckworth: Let me ask this, the Fed now has made a decision to pursue it, has the authority to pursue it, I guess, may it still opt out of it? I mean, it says, "Look, we have made a decision we can do it." Could it say, "We've looked at this, we've decided maybe it's not in our interest, we'll let The Clearing House have the RTP, and maybe we'll just focus on the existing legacy payment system"?

Selgin: The only way that could happen, David, is if there's such an outcry against what the Fed is up to, which will require people to give a lot more thought to the whole question of The Clearing House's role and whether it's okay to have a private organization operating an important payment service. If enough people were to study this matter, you could potentially get sufficient outcry. There are already some representatives, mainly Republicans, who are concerned about the Fed's decision. That, such an outcry could cause things to change. But I think it's very unlikely because of the misperceptions out there.

Selgin: At the hearing, again, you had Sherrod Brown just essentially identifying TCH with big banks, and saying, "Look at all the bad things big banks have done, we don't want these big banks to ruin the payment system." And, of course, he's correct insofar as TCH is owned by 20 big banks, but not all those banks were bad. And TCH is not responsible for what Citibank did, or what some of the other big banks did. Furthermore, the ownership and governance of RTP is separate from that of The Clearing House itself. It has its own little association, et cetera, and it has representatives from community banks on its advisory board, I think three of them. And finally, what people don't know about RTP is that, it's always operated its payment service is like a public utility.

Selgin: It doesn't seek profits, it pays no dividends, it gets no dividends from any of its payment services. And that's because it was formed, in the first place, back in 1853, as a club for banks to provide services that would themselves be beneficial to its members. It doesn't need to make profits from the services. The fact that the banks can use the service is enough of an incentive. Finally, there was a lot of silly talk about how this could be dangerous. You can't trust them to have enough safeguards, et cetera. But, The Clearing House's record, again, going back to 1853, is better than the Fed's. On safety, it's never had any failures on any of the several payment services it supplies, its outstanding. And, of course, if anyone had found anything bad about TCH in its history, they'd have brought it up. Nobody has, they can't, they just make claims out of thin air, as it were.

Beckworth: So, the RTP, or the real-time payment system that it set up, it's owned, there’s shares that are owned by the big banks, but it's run separately.

Selgin: Yes.

Beckworth: And let me ask this question, so, let's say, one of the big banks did have problems. The big bank's balance sheet is not overlapping with RTP. So, you could have a bank have problems, and RTP still would run just fine, is that right?

Selgin: Absolutely, yeah. RTP is fully funded. So, the way it operates is very simple. For listeners who are aware of the history, the Suffolk System in the 1820s in Boston, it's just remarkably similar. There's a joint account at the Fed, and this funded by all the banks that have joined the RTP system, that are members. And they have to put money in that account. And all the clearing and settlement is done on the books of this one account, just transferring funds, or credits, debit here, credit there, and it's fully funded. Now, that means they have to preload the account or the payments won't go through.

Selgin: So, that's where Fedwire and the National Settlement Service, that's where they put a wrench in the works, because, the account has to be pre-funded enough by the participants, to last through the weekend and last through the holiday. Of course, they wouldn't have to, they'd be more liquid and wouldn't have to pre-fund as much otherwise. So, that adds a little bit to the cost. But, anyway, it's fully pre-funded, there's no risk of failure in the settlements, because they are essentially backed, the payments are all backed by 100 percent reserves, and the reserves move… real-time gross settlement, you can't have a failure. It's not like where you're waiting for the funds and something could happen before the end of the day or something. So, there's no risk here, there's essentially no risk.

Selgin:  And as for security and all that, I dare say, the folks at The Clearing House know more than the Fed does, about how to get those things right.

Beckworth: Okay. Well, with that, our time is up. And, again, listeners, we will have George back on for, I believe, his seventh show next time, when he comes on and then we'll talk about the items I mentioned earlier, we didn't even get to the review and the Fed's operating system. But, George, thank you so much for coming on and enlightening us on this debate over the payment system.

Selgin: Oh, thank you very much, David. It's a pleasure to be here again, and I really appreciate the opportunity.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you, find the podcast. Thanks for listening.

David Beckworth
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Nov 11, 2019
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The US is trailing the world on real-time payments, and it’s important we get caught up to speed

Round Two: What Role Should the Federal Reserve Play in Developing a Faster Payments System?

Friday, April 26, 2019
Brian Knight

This is round two of a multi-part debate series on The Bridge. The debate consisted of two rounds of email exchanges between three participants. An introduction was published Wednesday, April 24, and round one was published Thursday, April 25. The series has been lightly-edited to preserve the original spirit of the email conversation that took place.

Jim Angel

We are in broad agreement: the US economy badly needs faster payments and the Federal Reserve should play a large role in facilitating faster payments. The devil is in the details of what role the Fed should play.

Aaron seems to believe that the Fed can wave a magic regulatory wand under the Expedited Funds Availability Act and make faster payments happen. Were it so simple!

It is not clear at all that the Fed actually has regulatory power to just mandate faster payments. I believe Aaron is referring to 12 US Code § 4002(d)(1) which reads

“Notwithstanding any other provision of law, the Board, jointly with the Director of the Bureau of Consumer Financial Protection, shall, by regulation, reduce the time periods established under subsections (b), (c), and (e) to as short a time as possible and equal to the period of time achievable under the improved check clearing system for a receiving depository institution to reasonably expect to learn of the nonpayment of most items for each category of checks.

Alas, the referenced subsections refer only to check clearing, not wires or other non-check forms of payment. Alternatively, the Fed could use its broad rulemaking authority under Dodd-Frank §805 over payment system risk management and rightly declare that slow payments impose risk on the financial system. However, some may view this as a regulatory overreach.

Even if the Fed did have the authority to just mandate faster payments, a mere rule from the Fed would not be enough. The Fed itself is one of the biggest impediments to faster payments. The Fed is where the different payment providers can settle their payments. Even the bank-operated check clearing and ACH networks depend on the Fed for part of their activities. The Fed’s systems that allow banks to settle payments with each other operate on 20th Century East Coast bankers’ hours, Monday through Friday.

In order for our banking system to speed up and offer true 24/7 service to everyone, the Fed has to operate 24/7.

In order for our banking system to speed up and offer true 24/7 service to everyone, the Fed has to operate 24/7.

George agrees that the Fed should offer 24/7 settlement services and a 24/7 liquidity management tool, but disagrees on whether the Fed should offer a 24/7 RTGS facility. I think that here we have different visions of what the Fed has actually proposed. I see the Fed’s proposal as a modern 24/7 version of Fedwire that would allow competing payment providers to interact with each other on a real-time basis. What is the problem with letting Fedwire operate 24/7? If competing payment providers cannot settle 24/7, they have to work out a system of deferred net settlement in which risk piles up until settlement occurs. Such accumulation of risk is totally unnecessary.

As far as legality goes, only the Fed can offer a service that settles in Fed money at the Fed with no counterparty risk. Thus, the Fed’s proposal easily meets the legality requirement that other providers cannot provide the service.

Rather than slow down faster payments, letting the Fed provide needed infrastructure to competing payment will allow numerous entities to innovate and provide 21st-century service.

Aaron Klein

The Federal Reserve has the legislative authority, what it has lacked is the will. Under the section of the Expedited Funds Availability Act that James cites, the Fed could mandate checks to clear within an hour, as well as cash deposits in ATMs (that is covered by subsection e). In addition, the Fed has broad authority under Section 15 of the Check 21 Act, which states: “The Board may prescribe such regulations as the Board determines to be necessary to implement, prevent circumvention or evasion of, or facilitate compliance with the provisions of this Act.” It is harder to get broader language than that, which is not surprising given that the legislation is based on a proposal from the Fed.

One of the three enumerated purposes of the Check 21 Act is “To improve the overall efficiency of the Nation's payments system.” Combining that broad authority and the purpose of the legislation, Congress has made it clear the Fed has authority. There are probably other regulatory hooks the Fed has at its disposal as EFAA provided and the Check 21 Act affirmed, Congress “provided the Board of Governors of the Federal Reserve System with full authority to regulate all aspects of the payment system.” The Fed has the authority.

We could have a real-time payment system for consumers without the Fed itself operating every aspect of it. That said, there are some critical areas where the Fed needs to up its game, such as making Fedwire 24/7x365, a proposal that I think all three of us agree on. In fact, the slow nature of Fedwire also reduces the ability of securities firms to settle, a separate but also important issue.

James and I are in agreement that the Fed itself is one of the biggest impediments to faster payments. George makes the critical observation that as the Fed continues to play Hamlet, debating whether to create their own system or not, has practical effects on other banks decisions to join alternative payment systems. Economists should be very familiar with uncertainty delaying adoption. The Fed has had the choice to adopt real-time payment technology for over a decade (the UK moved in 2008), formed multiple faster payment groups, and issued multiple studies over many years. The private sector moved forward, the Fed did not. The Fed’s waiting has taken billions out of the pockets of middle and working class families. The Fed’s delay has increased and continues to increase income inequality.

The simplest, most efficient, and fairest thing the Fed can do is use their own authority and change the system now.

Americans who can least afford it are stuck paying billions a year in fees and high-cost loans to access their own money. The simplest, most efficient, and fairest thing the Fed can do is use their own authority and change the system now. As George points out, waiting for the Fed to build its own system will take years, maybe a decade or more. Unless the Fed is willing to use its own funds to pay the tens of billions that it will cost working families to handle that delay, then the Fed needs to fix the problem the best way it can: through adopting regulations requiring real-time payments.

George Selgin

Like Jim, I’m encouraged by the many points on which all three of us agree. I hope by my response today to narrow our remaining points of disagreement still further.

Jim observes, in reply to Aaron, that the Fed may lack the power to simply mandate faster payments. He concludes therefore that it can’t “wave a magic regulatory wand” to get us there. But while both statements are strictly true, the Fed could speed things up considerably by encouraging more financial firms to take part in TCH’s private RTP set up, instead of doing just the opposite, as it does by holding out the possibility of establishing a competing fast payment network—that is, by “playing Hamlet,” as Aaron eloquently puts it. It could, as we all agree, offer 24/7 settlement or liquidity management services.

It could allow RTB member account balances to count towards banks’ LCR requirements, while also allowing interest on those balances. It could encourage further widening of the RTP Business Committee to assure adequate representation of smaller banks. Finally, to encourage participation by certain non-bank payments service providers, it could allow, and could encourage TCH to allow, some of those suppliers to participate in the RTP network.

Jim points to certain advantages of the Fed’s proposed RTGS system, consisting mainly of the fact that it eliminates counterparty and other credit risks inherent in deferred net settlement arrangements. But while RTGS on the Fed’s books, rather than on those of a private clearing entity, may have certain advantages, it is not essential to achieving faster payments.

Therefore, although Jim is correct that the Fed is uniquely capable of supplying final RTGS services, it doesn’t follow that, so far as achieving faster payments is concerned, there is a compelling need for it to do so. Finally, RTGS, as an alternative to a 24/7 Fedwire (deferred settlement) system, is not free of disadvantages of its own, which consist of higher bank liquidity requirements and a correspondingly heightened risk of payment delays and gridlock. Indeed, according to some experts, drawing upon experiences with existing central-bank RTGS systems, such systems don’t really reduce banks’ credit exposure at all. Instead, they merely redistribute credit risk among various payment-system participants.

To have the Fed continue to toy with the possibility of establishing its own RTGS system today is to guarantee an avoidable delay of several years in achieving faster retail payments.

In short, while a good debate can be had concerning the merits of deferred net vs. RTGS central bank settlement arrangements, that debate is largely orthogonal to the one concerning the most expeditious way to achieve faster retail payments in the US today. The two discussions overlap in but one crucial respect, to wit: that to have the Fed continue to toy with the possibility of establishing its own RTGS system today is to guarantee an avoidable delay of several years in achieving faster retail payments.

Brian Knight

Thank you, everyone, for an incredibly informative debate. This was a great discussion of a challenging topic and the scope of issues that were brought up go to show how challenging a question this is. I want to thank our participants for graciously giving us the benefit of their time and expertise and I hope our readers have found this as educational as I have.

Photo credit: Alex Wroblewski/Getty Images

Round One: What Role Should the Federal Reserve Play in Developing a Faster Payments System?

Thursday, April 25, 2019

This is round one of a multi-part debate series on The Bridge. The debate consisted of two rounds of email exchanges between three participants. An introduction was published Wednesday, April 24, and round two was published Friday, April 26. The series has been lightly-edited to preserve the original spirit of the email conversation that took place.

Jim Angel

Thanks for asking me to begin.

  • The US payment system is slow and archaic. This imposes a tax on economic activity that affects all Americans. Other countries have instant payment systems. Why don’t we?
  • The Fed operates on 20th century East Coast banker’s hours. The fact that they are closed for the majority of the 8,760 hours is a year is a huge impediment to the launch of faster payment systems that can interconnect with each other.

The Fed has proposed two actions to facilitate faster payments in the US. From their press release, they call for

"1) the development of a service for real-time interbank settlement of faster payments 24 hours a day, seven days a week, 365 days a year (24x7x365)"

"2) the creation of a liquidity management tool that would enable transfers between Federal Reserve accounts on a 24x7x365 basis to support services for real-time interbank settlement of faster payments, regardless of whether those services are provided by the private sector or the Federal Reserve Banks."

To oversimplify, the Fed is mainly proposing to operate its existing services around the clock. This is long overdue. The first proposal is for the Fed to run a service similar to the venerable Fedwire around the clock. The second proposal would make it easier for competitive payment networks to interact with each other around the clock instead of waiting for the next business day.

To oversimplify, the Fed is mainly proposing to operate its existing services around the clock.

The Fed’s goal is to support the interconnection of private sector payment systems, not to replace those systems. Note the key word in their statement: interbank. When I served on the Federal Reserve’s Faster Payments Task Force (FPTF) it was abundantly clear that the Fed did not want to establish and run its own new faster payment system the way the European Central Bank (ECB) has.

What will happen if the Fed does NOT modernize and operate 24/7?

Numerous bank, fintech, and crypto players have launched payment solutions: PayPal, Venmo, Zelle, Square Cash, RTS, Apple Pay, and Google Pay are just a few of them. Behind the scenes, many of these systems still rely upon the slow 20th century rails of our existing payment system. Payments look instant inside these networks, but it may take days to get a payment out of the network. Most importantly, they don’t interconnect with each other. A user on one network cannot easily send a payment to a user on another network. The Fed’s proposal is to allow these different networks to meet at the Fed to transfer funds to each other around the clock. This is important for facilitating a 24/7 payment system as the different networks need to exchange funds immediately to avoid risk piling up overnight. This is also important for maintaining our global competitiveness as our financial system needs to be open when our trading partners are awake.

If the Fed does not act, we will be left with a slow, fragmented payment system that leaves out many Americans. Even worse, it is likely that network economics will kick in and leave us with one or two dominant networks that will monetize their market power to tax all Americans on every transaction while freezing out innovative new payment systems.

Our economy operates 24/7 and so should the Fed.

Aaron Klein

America’s slow payment system is a major hidden contributor to income inequality. When low-income consumers approach the zero lower bound of their bank account, myriad high costs for short-term liquidity appear that wealthier people never face. Just three of these fees, bank overdraft, check cashing, and payday loans, total over $35 billion a year. Demand for these arise, in part, from the long lag time between when consumers deposit funds and when those funds are available.

The rest of the world is far ahead of America. The UK adopted real-time payments 12 years ago. Poland, South Africa, and Mexico are already there, and soon the European Central Bank will have real-time payments. A Slovakian payment deposited in Ireland will clear before a payment from Minnesota is available in Florida. This is not a problem of technology; it is a problem of leadership.

The Federal Reserve once was a leader in payment modernization. In 2001, the Fed proposed and Congress adopted the Check-21 Act. Since then, the Fed has failed to use its legal authority to adequately keep pace with technology and benefit consumers. Under the law, the Fed has the legal authority to mandate and/or operate a real-time payment system. Instead, the Fed has done neither. That inaction continues to cost working class America’s billions a year.

Modernizing, our payment system will empower Americans to better manage their hard-earned cash and have more of it.

What should we do now? The answer is simple. The Federal Reserve should use its existing legal authority (Section 603 of the Expedited Funds Availability Act) and simply mandate real-time payments in six months. Safeguards to protect against fraud ($5,000 funds limit, existing customers only, etc.) can be reasonably carved out. Financial institutions can choose to participate in existing real-time payment systems, develop their own, or provide the funds to consumers before they actually clear (several already do). The Fed is conflicted in its dual role in operating a payment system while regulating payments for everyone. Modernizing, our payment system will empower Americans to better manage their hard-earned cash and have more of it.

George Selgin

Not so fast.

Let me first make clear my considerable agreement with James and Aaron. I agree that the slow speed of many US payments is harmful, to the poor especially, and that it should be possible for all payments to be processed in hours, if not instantly, rather than in days. I also agree that the Fed, as a monopoly supplier of final settlement services for the nation’s banks, has an obligation to reform those facilities as needed to expedite payments. Finally, I agree that it should do so in part by offering 365-day, round-the-clock interbank settlement services, either by extending the operating hours of Fedwire or by creating a special “liquidity management tool” (LMT) for the purpose.

I disagree, on the other hand, with James’ view that, to achieve faster payments, the Fed must also establish a new all-hours Real Time Gross Settlement (RTGS) facility, for several reasons:

It isn’t necessary. It’s important here to distinguish faster clearing of a payment, which makes funds available more rapidly to the payee, from faster final settlement of dues among involved financial institutions. Reducing the social costs of slow payments is a matter of arranging for faster clearing of those payments. It doesn’t necessarily require faster settlement among banks.

It’s important here to distinguish faster clearing of a payment, which makes funds available more rapidly to the payee, from faster final settlement of dues among involved financial institutions.

The proposed Fed RTGS system is uniquely capable of achieving both instantaneous clearing and instantaneous interbank settlement. But faster—and even instantaneous—clearance itself can be achieved without it. What’s more, a rapid-clearance arrangement already exists. With the Fed’s encouragement, The Clearing House (TCH)—a company owned by a consortium of large banks—launched its Real-Time Payments (RTP) system in 2014. The system maintains a pooled account at the Fed, in which all banks are able to maintain funds. Payments made within the RTP network are settled instantly on the RTP account ledger.

Although only a portion of US banks have joined thus far, in principle all might take part, thereby satisfying the Fed’s “ubiquity” requirement. And although many smaller banks have yet to join, RTP’s fee structure, which allows no volume discounts and is below the Fed’s present same-day ACH fee, actually favors them. Finally, non-bank payment service providers might take part using special purpose banking charters from the Comptroller of the Currency, though that’s likely to take some nudging of TCH by the Fed.

It may not be legal. In so far as the proposed RTGS system provides no essential public benefit “that other providers alone cannot be expected to provide with reasonable effectiveness, scope, and equity,” its establishment would be contrary to the criteria set forth by the 1980 Monetary Control Act.

It will delay, rather than expedite, the establishment of a ubiquitous faster payments network. Because the RTP system already exists, banks might easily comply with Aaron’s six-months mandate simply by joining it. In contrast, it will take the Fed several years to establish a new RTGS system. Yet the very prospect of an alternative Fed-administered fast-payments mechanism has discouraged many banks from joining the RTP network, for none wish to invest in a network that Fed actions may render obsolete.

It will stifle future innovation. While any established payment network enjoys a first-mover advantage, the fast-payments market remains both contestable and dynamic, with many players offering competing—if generally less than ubiquitous—networks. The Fed’s unique privileges, including its status as a regulator of private-market payment service providers, equip it with unique monopoly powers that may ultimately stifle competition and innovation. The history of the Fed’s involvement in check clearing offers an object lesson in this regard.

Photo credit: Jessica McGowan/Getty Images