Christina Parajon Skinner is a legal scholar at the University of Pennsylvania, and formerly was a legal counsel to the Bank of England. Christina joins David on Macro Musings to discuss her work on central bank activism. Specifically, David and Christina discuss comparisons between the Fed and the Bank of England, tensions between central bank independence and executive override, contemporary examples of central bank activism, and much more.
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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 [email protected].
David Beckworth: Christina, welcome to the show.
Christina Parajon Skinner: Thanks very much for having me. It's a pleasure to be here and speaking to the listeners.
Beckworth: It's great to have you on. Your article Central Bank Activism was quite a delightful read, and I think our listeners will enjoy the show today quite a bit. But tell us a little bit about yourself, Christina, how did you get into this world of financial regulation, central bank oversight? I mean, you were a legal counsel of the Bank of England, so you have a depth of experience in this area. How did you get there?
Skinner: Sure. Happy to talk a little bit about my career trajectory. I've always been very intellectually drawn to this space of economics, the intersection of economics and public policy, really, and I've studied a lot of different dimensions of financial regulation in central banking, pure macroeconomics, the economics of the European Union, public international law, more generally and also foreign policy. Then when I was in practice with the law firm, I worked with and at different financial institutions, which really helps me to understand the markets themselves. When I went to move into academia and I did my postdoc at Columbia, that was really just a few years after the Dodd-Frank Act was passed, and that's when I started to develop a robust research agenda around financial regulation and central banking. I was helped on by some great scholars there at Columbia as Kate Judge, I knew Bradford, Jeff Gordon.
Skinner: Then life took us to London for a couple of years before I began my post at Wharton. That is when I was able to join the Bank of England as a lawyer in the legal directorate. Hitting the pause button before I went into academia and getting some practice on the ground. I spent a good deal of my time there working on Brexit related matters. What a phenomenal time to be at the Bank of England in the midst of-
Beckworth: For sure.
Skinner: ... EU withdrawal, understanding the relationships between the bank, the Treasury, the parliament, and working to prepare the bank legally for that transition. I'm hoping going forward to continue to have this kind of career that flips between academia and public economic service.
Beckworth: Oh, that's exciting. I didn't realize you're a part of the Brexit experience. Sometimes timing is everything. You end up at the right place at the right time. Now, speaking to the Bank of England, you have a paper, I want to just go over it quickly because we're going to spend most of our time on the central bank activism paper, but you have another paper titled “Executive Override of Central Banks: A Comparison of The Legal Frameworks in the United States and the United Kingdom.” In it, you examine executive branch’s powers to override independent central banks using these two countries as a case study. But it's a nice segue from what you were just saying about your work there. Maybe for our listeners, and I know we have a number of listeners in the UK, so bear with us, but maybe talk us through the differences and maybe the bird's eye view of the findings of your paper.
Comparison: The Fed vs Bank of England
Skinner: Yeah. I'd love to talk to you about my paper that was coauthored with a former colleague of mine from the bank. Maybe before I get into the meat of that paper, I'll just give a brief overview of some of the similarities and differences of the Fed and the Bank of England. Both central banks wear a number of different hats and have different mandates, but the listeners are probably most interested maybe in hearing about the more macro facing aspects of monetary policy and financial stability policy. As a legal scholar, I'll focus for the listeners in particular on the different mandates that the Fed and the Bank of England have and the governance structures of the monetary policy and financial stability apparatus and committees there.
Skinner: In the Fed as many listeners no doubt will know, Congress formally gave the Fed their monetary policy mandate in 1977 and it includes price stability, maximum employment, and a little bit of interesting historical context there. The language around price stability had grown from language in prior statutes about the need to maintain purchasing power. It was pretty straightforward and clear that price stability is about maintaining the value of the dollar. This is going to become relevant later when I get into my activism paper. That term full employment, meanwhile, well, that had been imported from the Employment Act of 1946, which had then jumped to something called the Humphrey-Hawkins Act. That phrase had generally been understood as a proxy for economic growth.
Skinner: Now, Fed governance of monetary policy and monetary policy decision-making, what does that look like? Well, monetary policy is set by the Federal Open Market Committee, the FOMC and the Fed Board. They share duties. The board is responsible for setting the discount rate and reserve requirements and the FOMC for open market operations.
Skinner: Now let's look at the Bank of England and how they've structured things. Parliament gave the bank a statutory monetary policy mandate in 1977. Really this was a decision that appears to have been driven by the newly elected labor chancellor, Gordon Brown. And then it was formalized in the Bank of England Act in 1998. Those objectives as regards monetary policy are to maintain price stability, and subject to that, to support the economic policy of the government. I just want to pause a moment and note for the listeners, the distinction in the mandates.
Skinner: The Fed has what we call dual mandate, whereas you'll notice that the employment arm of their mandate, that's absent in the UK. The UK doesn't have that leg, that pedestal, if you will. It was thought by lawyers at the time of the Bank of England Act that it would be too tricky to have two principle aims in the way that the Federal Reserve Act is structured. Now, I will say that the issue of whether the Bank of England should have a dual mandate, that includes employment, it does come up from time to time. Also notable is that the Bank of England has what is referred to as a secondary objective, which is designed to make the bank more responsive to the government's economic policy. I'll get into this later, but query whether this is an open door to politicization of the bank now or at some point in the future. It's interesting that in March of 2021, HMT, the Treasury actually added what's sort of colloquial really referred to as a green remit for the Bank of England. Again, we'll talk about this later when we come on to climate change issues.
The Bank of England has what is referred to as a secondary objective, which is designed to make the bank more responsive to the government's economic policy...but query whether this is an open door to politicization of the bank now or at some point in the future.
Skinner: Bank of England has a different governance for monetary policy as well. Policy decisions at the Bank of England are taken by a majority vote of the Monetary Policy Committee, the MPC. The MPC is made up of both internal and external members that are external to the Bank of England. Nine members, governor, three deputy governors for monetary policy, financial stability and markets and banking and the chief economist. Then you've got those four external members that are appointed directly by the chancellor. There's also an HMT representative that sits on the MPC, although that representative is a non voting member. Parliament, also different from our US system, empowers HMT, the Treasury department in UK to elaborate on the objectives in, again, this so-called remit letter, on at least an annual basis. HMT has a greater role in the UK in defining what price stability means.
Skinner: I'll just note that there's a greater role, sort of legally in their legal framework, for the Treasury in the Bank of England in its monetary policy institutional design. Again, both in terms of the secondary mandate and in terms of the governance for monetary policy decision making. All right. Let me quickly segue from monetary policy and tell the listeners a little bit about financial stability issues. Central banks have always had this assumed a role to play in maintaining a stable financial system as their role as lender of last resorts. But this role was really supercharged both in the US and the UK and formalized in many ways after the global financial crisis of 2008. Again, I'll just focus on mandates and governance and give you a little bit of a comparison.
Central banks have always had this assumed a role to play in maintaining a stable financial system as their role as lender of last resorts. But this role was really supercharged both in the US and the UK and formalized in many ways after the global financial crisis of 2008.
Skinner: In the US, the Dodd-Frank Act gave greater financial stability powers to a newly created body, The Financial Stability Oversight Council, the FSOC. Now, the FSOC is not a regulator itself. It's this inter-agency council that pulls from the various financial regulators we have in the US. Its main power is to designate non-bank SIFIs, Systemically Important Financial Institutions. You may remember the prior designations, AIG, Prudential, GE Capital, MetLife that had subsequently been rescinded. But the FSOC also has the power to make non-binding recommendations to its member agencies, including the Fed. Now, file that away because that's also an interesting development where we have a situation where we have very much placed a premium on Fed independence from the Treasury, and yet we have this newly created institution that's layered on that can actually give non-binding recommendations to the Fed. So that's an interesting sort of quirk, whether it was intentional or not. One can't really say.
Skinner: the Fed also though did get more of an implicit financial stability role in the Dodd-Frank Act by having Congress tell the Fed it needs to apply heightened prudential and supervisory requirements to systemically important financial institutions. Of course, it gets those non-bank SIFIs if the FSOC designates any within its regulatory perimeter.
Skinner: How does the UK do financial stability policy and governance? Well, the Banking Act 2009 gave the Bank of England a statutory financial stability objective for the first time. Specifically, that objective is to protect and enhance the stability of the financial system of the United Kingdom. The institutional arrangement is also very different. In the US as I've just described, you have financial stability responsibilities that are spread across the Fed, the FSOC and de facto, many of the other banking regulators and the SEC as well. The OCC and the FDIC they supervise for safety and soundness issues, which is meaningfully contributing to financial stability.
Skinner: The idea in the UK was different. The idea was to consolidate responsibility and authority for financial stability within the Bank of England. Essentially this meant that the UK went from having a unified model where the FSA, which is no longer in existence, played a major role to what we refer to as a twin peaks model. The Financial Conduct Authority, the FCA would henceforth be focused on conduct issues, and the bank would be solely focused on prudence, making sure that firms are safe and sound and the financial system is stable. The key here also is that the Bank of England parliament took the approach of creating another statutory committee within the Bank of England, Financial Policy Committee that would sit alongside the other two statutory committees, the Monetary Policy Committee and the Prudential Regulation Committee.
The UK went from having a unified model where the FSA, which is no longer in existence, played a major role to what we refer to as a twin peaks model. The Financial Conduct Authority, the FCA would henceforth be focused on conduct issues, and the bank would be solely focused on prudence, making sure that firms are safe and sound and the financial system is stable.
Skinner: The FPC is more or less the analog to the FSOC, but the FPC sits inside the Bank of England where the FSOC technically sits inside our Treasury. We flipped there in a way. In the UK, you have usually sort of more integration of the Treasury in the bank when it comes to things like monetary policy, but in the US we've chosen to put our financial stability, our macro prudential regulator within the Treasury. In terms of FPC governance, it has some similarities with the MPC, combination of senior bank officials and external members. Interestingly and importantly, I think the membership of the three committees overlaps significantly, and this recognizes that there are important interactions between monetary policy macro-prudential regulation and micro-prudential regulation, and I think very helpfully allows the bank to maintain this holistic view of the rest of the UK financial system while also bringing in these outside perspectives to ensure a culture of challenge and guard against group think.
Skinner: Now a couple of interesting features of the FPC that I'll mention to the listeners before we move on. It was very much intended that the FPC, the financial stability apparatus would be mindful of growth related concerns. There's a very famous quote, a famous among central bank watchers at least, that the idea was to avoid the financial stability of the graveyard. There was this concern that overzealous financial stability policy could have devastating effects on credit and growth. Two things were done to allay that concern. First, the Bank of England Act 1998 specifies that the committee cannot exercise its functions in a way that would, in its opinion, be likely to have a significant adverse effect on the capacity of the financial sector to contribute to the growth of the UK economy in the medium or long-term, that's a direct quote from the language of the statute.
Skinner: Also, the FPC was, again, given one of these secondary objectives. Subject to achieving its primary financial stability objective, the FPC is required to exercise its functions with again, a view to supporting the economic policy of her Majesty's government, including its objectives on growth and employment. Again, there's a role for HMT. HMT has the power to specify what the government's economic policy has taken to be. Again, in practice, this is done by sending the FPC annual remit letter. I think this arrangement can cut both ways.
Beckworth: Okay, Christina, a lot there to unpack, but I think the essence of it is, as you've explained is that the Treasury in the UK has a lot more formal influence or power over the central bank compared to the United States. Is that a fair summary?
Skinner: I think it's fair to say that yes, parliament has given HMT a role, in for example, sending the annual remit letters to the FPC and the MPC and explaining what the government's economic policy is. With the secondary objectives, again, parliament wants to make the bank attuned to what the economic objectives of the government are. Yes, you are right in your summary.
Beckworth: Okay. I guess then, what is an independent central bank? What's the definition? Is it the Bank of England? I think of the Bank of England as a central bank that's independent, it's very proper and does the right, is disciplined. If you ask an American though, I think they would say, "Man, that's a lot of authority that's given to the Treasury. That's pinching on the independence of the central bank." How does the Bank of England see itself? Or how do you think others see the Bank of England? They see it as independent or not?
Central Bank Independence and Executive Override
Skinner: Yeah, absolutely. I mean, the Bank of England has a sterling reputation for independence as does the Fed. It's interesting, and this is what we studied in our paper, it's simply interesting to note that there were two different approaches to designing independence when you think about independence from the treasuries, both in the US and UK. The point that we made in the paper, and I'm happy to get more into depth on these override powers… The point that we made in our paper is that the fact that parliament created this very transparent, very clear legal framework for the Treasury to be involved and to specify economic priorities for the government, that in some ways reinforces the independence of the Bank of England relative to the Fed. The reason being is that, inherently treasuries and central banks are going to coordinate and they are going to cooperate, and in particular, they're going to do this in times of crisis. In a lot of ways, you might very well want this in a clearly established legal framework that the legislature can hold accountable, that the public can scrutinize and to which we can see where the lines are drawn. In peace time, I think in the Bank of England and the HMT, you have a very clear situation. The Bank of England has a secondary objective to have regard to the economic policies. And so HMT has a role in specifying, here's what those economic policies are. That's very clear. The public can understand it. Parliament can scrutinize that.
Parliament created this very transparent, very clear legal framework for the Treasury to be involved and to specify economic priorities for the government, that in some ways reinforces the independence of the Bank of England relative to the Fed.
Skinner: In crisis time, there are also other ways that the Treasury can override the independent decisions of the Bank of England, which I'm happy to tell the listeners about in a moment if they're interested. Again, I think that's very helpful for seeing where the lines are and holding the use of those override powers accountable.
Beckworth: Okay. There's a trade-off there. There's the independence where there's very limited oversight, but that ignores the inevitability that at some point there's going to be an interaction and you might as well officially design the rules of the game ahead of time before you get to that point. In the case of the US what happened last year, although there was a Cares Act that was passed, Treasury did ask a lot of the Fed to step in, and we'll get to this in your paper on central bank activism. I can see the argument going both ways. You clearly define the roles ahead of time and it gives, these are the special conditions in which Treasury steps in and overrides the central bank, as opposed to not defining them and then you have to make them up on the run.
Beckworth: Let me throw this out there. I thought about this probably last year for the first time. Typical American, you're not thinking about central banks overseas much, but last year the UK Treasury was considering a nominal GDP target for the Bank of England. I was very excited about this, but I was also very surprised to learn about it. There were going to... I guess, that letter that you mentioned, there were some people at the Treasury who were considering asking the Bank of England to change its focus from inflation target to a nominal GDP targeting. That never materialized, never came to fruition. But that would be an example of where the Treasury could push the central bank in a different direction. Is that fair?
Skinner: I think so. I mean, because the Treasury can specify in its remit letter how it understands price stability to cash out in practice…In theory, it could suggest a different way of inflation targeting just as it's suggested to the Bank of England to take sustainability in mind when it's doing things like conducting bond purchases as part of its quantitative easing program.
Beckworth: It's very interesting to see how these two central banks are similar and very different. Again, we'll put a link to this paper. The title of the paper is *Executive Override of Central Banks: A Comparison of the Legal Frameworks in the United States and the United Kingdom.*
Beckworth: Okay, I want to go on now to your main paper, the main reason we pulled you on the show today, and that's paper titled *Central Bank Activism*. It was a really refreshing read for me because the past year was very clear about this. Again, past year, of course, was a pandemic, some call it a wartime footing, special time where we asked the central bank to do a lot, but there's a worry that they're going to continue to be asked to do a lot. There's many developments that you cover in your paper regarding central bank activism. I think maybe just to get this conversation started, maybe you could define what central bank activism is. How do you see central bank activism?
Central Bank Activism
Skinner: Absolutely. I think the distinction that you draw between wartime and peacetime is a key one that I want to bring out a lot in our following conversation. Broadly speaking, the definition that I'd offer of central bank activism is relatively straightforward. It's central banking action in response to a new economic problem for which the central bank lacks statutory mandate to address. Now, of course, that very general, as I say, straightforward definition, begs a few questions. For one, how am I thinking about the scope of the Fed's mandates? It's true that many of the Fed's mandates confer a good deal of discretion, but discretion doesn't mean open-ended. There are limits, and I think it's very possible to draw lines. One can look at the text of the mandate, which is often the Federal Reserve Act and examine that text in light of historical convention and construction, which itself has usually been a reflection of the mandate's purpose. And there are structural red flags of activism that I point out. Usually, activism is going to involve the central bank taking on some fiscal activity or it's going to appear to be responding to political pressure to stretch the colorable interpretation of a mandate.
Beckworth: Would another way to define that, maybe much simpler, be mission creep... I mean, that's a term that's often thrown out in terms of central bank activism. That doesn't define anything because mission creep is very subjective, but that's a term we often associate as well to central bank activism. Is that fair?
Skinner: I think with activism, you can look at it in one of two ways. You can look at it as mission creep, central banks trying to aggrandize their power, but you can also look at it in a different way, which is the way that I'm looking at it, which is that central banks are under an incredible amount of pressure externally from the political branches, from popular forces and also perhaps potentially from internal constituents as well. So the institution itself may feel under a good deal of pressure to expand, to flex their statutory mandates to meet the economic problems of the day. The paper largely focuses on the Fed, but there may very well be different dynamics at play in different central banks around the world. But I think mission creep may be oversimplifying in some cases, where you see the executive or even Congress pushing the Fed to do more.
I think with activism, you can look at it in one of two ways. You can look at it as mission creep, central banks trying to aggrandize their power, but you can also look at it in a different way, which is the way that I'm looking at it, which is that central banks are under an incredible amount of pressure externally from the political branches, from popular forces and also perhaps potentially from internal constituents as well.
Beckworth: Yeah. I mean, I had Kate Judge, which you mentioned earlier in the show on last year and we talked about this. They're just asking the Fed to do everything. It's the only game in town. It may not be the Fed itself desiring to take on these extra responsibilities, but it's being pushed and asked to do it because Congress isn't stepping up to the plate and doing things that it normally would. Maybe we should list some examples. You go through a number of recent examples in your paper. Let's start with the first one. You list the lender of last resort role. Talk us through that. How has central bank activism permeated into that area?
“Lender of Last Resort” as Central Bank Activism
Skinner: Yeah. Great. Yeah. I mean, I do go through a number of examples in the paper. You're right. Including, I've got the first group of examples involves Fed lending or the use of its balance sheet in a crisis context. Now, I want to put an asterisk around these examples, which I'll explain later because I do firmly think that we need to carve out crisis exceptions. We need a safety valve and escape hatch for crisis situations.
Skinner: And I'll come back to this. So for now I'll just sort of describe what I mean here. And the point is that the Fed's lender of last resort power, if you will, has expanded into markets. That is making new use of the balance sheet to calm down markets in economic storms, and I'm certainly not the first person to have observed this. You've got the power in Section 13 (3) of the Federal Reserve Act to lend to non-banks, individuals, partnerships, corporations, "unusual and exigent circumstances" with collateral that secure it to the satisfaction of the Federal Reserve. That's the statutory language. Now, it was used pretty rarely up until 2008, but both in the '08 crisis and last year of 2020 during the COVID situation, that power was used to create a number of different liquidity facilities to stabilize the financial markets and not just banks.
Skinner: For example, some key examples, the Fed was worried about corporate funding. You've got the commercial paper facility and the money market fund liquidity facility. What was going on there? Well, commercial paper short-term debt, companies use it to pay for short-term needs, payroll, working capital, operating expenses. You've got money market funds that are heavily invested in commercial paper. When investors need cash fast, they're panicking, they want to pull out money from that money market funds, those funds, they need to sell off their commercial paper to redeem those shares. At the same time, no, they're not looking to buy more commercial paper, which means that these companies that aren't able to get financing in the markets in the way that they normally work. The Fed one of these markets to be unclogged so that companies could keep up with these short and medium term expenses and so that businesses and households would be able to redeem their shares from the money market funds to meet expenses.
Skinner: That's just sort of one collection of ways in which the Fed expanded into markets with 13 (3) powers. Now in 2020, the Fed also more directly supported the corporate bond markets. Again, the idea was to provide liquidity to outstanding corporate bonds. There was both the primary corporate credit facility and the secondary market corporate credit facility. I will say that all of these bond purchases were done in a very sector-neutral way, but it was a new role for the Fed again, sort of expanding its 13 (3) power. Continuing with our theme of talking about how treasuries and central banks interact, Treasury was also involved in these 2020 facilities.
Skinner: You had to have the [Fed-Treasury] coordination really for two reasons. First, you had amendments that were put in place in the Dodd-Frank Act in 2010, that require the Treasury to approve the use of any new 13 (3) facilities, and also because the US Treasury was covering up to 30 billion of losses from exchange stabilization fund. Technically, so these are just the liquidity facilities. I think technically, I say these 13 (3) facilities are activist because they are expanding that 13 (3) power. But for the most part, when we get into the normative assessment of this, I think it's on the fairway of crisis management, we've been seeing coordination, not fiscal control. And most of these programs are already now in runoff mode. Maybe it's activist, but I'm not too worried from a rule of law or politicization standpoint.
You had to have the [Fed-Treasury] coordination really for two reasons. First, you had amendments that were put in place in the Dodd-Frank Act in 2010, that require the Treasury to approve the use of any new 13 (3) facilities, and also because the US Treasury was covering up to 30 billion of losses from exchange stabilization fund.
Skinner: Then while we're still talking about the balance sheet and the lending programs, you have the invention of QE, which is justified under a different provision, Section 14 of the Federal Reserve Act. These large scale asset purchases that were generally justified along a few dimensions, calming markets in the eye of a storm, and from their, steaming aggregate demand so that the central bank can hit its inflation targets.
Skinner: Now, the way that QE is currently being run in the US by the Fed, I would not call that activist. It's been very sector neutral, right? They've just been buying risk-free government backed products. But I do caution about the potential for activism. The 13 (3) liquidity facilities that I just mentioned, they have some important statutory constraints. Again, they're limited to "unusual or exigent circumstances." They've got these statutory expiration dates. Now, the authority for QE doesn't have that constraint. There's some danger, and I'm not saying it's happened yet, but there's some danger to watch out for that QE could run indefinitely and even more problematically than that, that the Fed could be pressured into some kind of QE activism, right? One example of that would be pressure to engage in debt financing, reminiscent of the era around the World Wars.
The way that QE is currently being run in the US by the Fed, I would not call that activist. It's been very sector neutral, right? They've just been buying risk-free government backed products. But I do caution about the potential for activism.
Skinner: Another example could be using the balance sheet to start to try and achieve social goals on the agenda of the executive branch, which I'll come onto in a little bit. Two other examples I go through in the paper that fall under this lending expansion category are lending to small businesses and lending to foreign governments. The lending to small businesses, that was certainly new in the main street facility. Yes, Congress did tell the Fed to do this in the Cares Act, but in doing so, Congress really seemed to have changed its mind about some provisions in the Federal Reserve Act without actually amending the Federal Reserve Act. For one, Congress had long ago ditched in industrial lending role for the Fed in the 1950s when it removed section 13 (b) from the Federal Reserve Act.
Skinner: Now, also, as Lev Menand has pointed out, Congress did not formally alter the 13 (3) requirement that liquidity has to be provided for the financial system. What we want to watch out for here is a Congress that looks keen to use the Fed as a piggy bank for dispensing cash to the real economy. It seems more like Congress told the Fed to do the work that was perhaps more properly for the Small Business Administration or the Treasury. It's muddied the waters a little bit about whether this is a permanent or temporary suspension of the requirements of section 13 (3).
Skinner: Now, the last example I have in this category, which I'll go through quickly are Forex swaps foreign exchange swaps. Essentially what the Fed does here is it swaps dollars for a foreign currency. It's a loan to a foreign central bank that's secured by that foreign governments currency. Unofficially, it's seen as a lifeline to a foreign central bank because that foreign central bank once it gets those dollars, it can dispense them throughout its financial system. In effect though, the swaps are doing hard and good work to support the dollar markets abroad. And so it is in the interest of US businesses and consumers. Again, here, I would just underscore as with other examples in this crisis era lending space, it's the potential that worries me given the current political economy environment. Is the Fed going to be able to escape claims that it should be acting like a backup IMF, dispensing aid wherever dollars around the world could be needed? Is it going to be taken to task for not dispensing credit to the developing world, irrespective of the credit worthiness of the borrowing economy?
What we want to watch out for here is a Congress that looks keen to use the Fed as a piggy bank for dispensing cash to the real economy.
Beckworth: Yeah, those are all great points. I think I am very sympathetic to your observation that most of those facilities, most of those actions are something that were warranted in the middle of the crisis, Even the more controversial ones like the bond facility, which was brand new, a lot of people freaked out about it. I was talking to Robert McCauley, he was on the podcast recently. He mentioned how when the Fed just announced that, it affected not just the US bond market, but global markets that are doing dollar funding. There's many countries that issue bonds in dollar terms. As you mentioned, it was important to keep those markets functioning and to keep the global dollar system functioning. The bond facility as well as the dollar swap lines helped keep the dollar system going.
Beckworth: I do think it's important to view these things in the context of what happened last year. It's easy to see them turning into something more than what they have been, and I've had George Selgin on the show and he has a book on this. I think it's called the Menace of Fiscal QE, but tapping into the Fed's balance sheet to support some endeavor whether it's green bonds or whatever it may be, there is that potential... and this is a hobby horse of mine, so I'll just get this out while I can. I think this is in part a function or a result of the fact that the Fed changed its operating system from a corridor one to a floor operating system. That's not the only reason. I think there's political pressures around the world.
Beckworth: It's not just the operating system, let me be very clear, but it certainly doesn't help that the size of the Fed's balance sheet is now independent of the stance of monetary policy. The Fed can set its target interest rate and new value at once and it doesn't affect or doesn't have... or the balance sheet doesn't have a bearing on it. The Fed can expand its balance sheet, buy all these other bonds and still be able to implement monetary policy. That degree of freedom that's been given to it by using a floor system, I think makes it more susceptible to these political tinkering that could happen by Congress. I think it's useful to look at these facilities as you have as being productive over the past year, but to be careful moving forward and the potential dangers they create. But let's move into the areas I think are the most contentious and the ones being pushed hardest and that's inequality and climate change. How does that play into your discussion of central bank activism?
Can the Fed Combat Climate Change?
Skinner: Sure, absolutely. I think climate change is really the signature issue when it comes to contemporary essential bank activism. It's not unique to the Fed by any means. There've been some significant initiatives along the world's leading central banks to use the policy tools at their disposal to make the financial system greener. You have Christine Lagarde at the ECB referring to climate change as mission critical to the ECB. She's said that she's committed to using all the tools she has to try and address climate change. The ECB for some time, at least was considering a green bond buying program. These programs are referred to as green QE.
Skinner: Mark Carney, while he was governor of the Bank of England, he was instrumental in sort of expanding the definition of financial stability risk and in turn the Bank of England's stress testing framework, and there have been calls from various quarters around the world to heighten capital requirements, perhaps focused in terms of a Basel regime changed to try and deter banks from lending to so-called brown companies. Now, for a time, the Fed was more measured in its approach. But it has recently started to dip its toes in the water. You can sort of see in the media that the Fed has been under tremendous amount of pressure to take on climate change.
Skinner: In December of last year, it joined the Network for Greening the Financial System, which is this consortium of central banks that are, as the name suggests, committed to using central banking policy tools to green the financial system. In November of last year, the Fed said for the first time in its financial stability report that it's thinking about if and how it should characterize climate changes as a financial stability risk. The picture on whether the Fed can address climate change is very mixed.
Skinner: In a separate paper, I take a deep dive analysis into the various different statutory powers the Fed has to show again that the Fed has relatively limited legal authority to address climate change, and to do anything would be activism. Let's start with monetary policy. The Fed has very strong legal footing in a reactionary posture, the use of its lender of last resort powers. It has considerable authority to react to any kind of macroeconomic shock that could be caused by a climate change event. The use of these powers is completely agnostic as to the actual cause of a shock, but there's very limited, if any, legal authority to go on the offensive to try and green the financial system with the Fed's balance sheet. Things like green QE along the lines of what had been on the table for the ECB is not really an option for the Fed. There are limits in the Federal Reserve Act.
[The Fed] has considerable authority to react to any kind of macroeconomic shock that could be caused by a climate change event. The use of these powers is completely agnostic as to the actual cause of a shock, but there's very limited, if any, legal authority to go on the offensive to try and green the financial system with the Fed's balance sheet.
Skinner: Section 14, I mentioned before, that's the authority the Fed has to buy assets in the open market and the reserve banks can buy a few things, but they're not expressly permitted to buy private bonds, green, brown purple or otherwise. Second, there's a specific and narrow monetary policy mandate in section 2(a) of the Federal Reserve Act. This is the so-called dual mandate. It refers to maximum employment and price stability. It's a stretch to tie price stability right now to climate change. Monetary policy is not anticipatory. It responds to observed changes in price levels and employment. And I think it's helpful actually here to compare the legal framework you have in the US around monetary policy to what you have in the European Union, for example.
Skinner: If you look at the treaty for the functioning of the European Union, the ECB actually has as part of its mandate of requirement that it take a view of the environmental goals of the union in fashioning its monetary policy. This may conjure recent memories of me talking about the secondary mandates in the Bank of England. So this is a very sort of continental and UK thing to give the central banks these secondary objectives to have regard to economic priorities. We don't have that in the US. The Congress could've given the Fed the power to make policy or to have regard to the administration's priorities, but it hasn't. If the Fed were to go out on the offensive to try and use its balance sheet to green the financial system, well, it does look and feel a lot like environmental law policymaking without congressional instructions and authority to do so.
Skinner: Regulation is a similar sort of story. The Fed has authority under Section 165 of the Dodd-Frank Act to increase capital requirements in the name of financial stability. But when you look at the US case specifically, it's a bit challenging to make the case that climate change is a financial stability risk right now based on the information we have about banks exposures right now. I looked at the bank's balance sheets for the past couple of quarters, and banks exposure to carbon exposed industries, like automotive oil and gas, is very small and it's declining every quarter. The wholesale loan exposures are similar in the range of four and a half percent to a smallest, 2%. Then when you look at the tier one equity capital that these banks have, it's three, four times the size of its wholesale loan exposures to these carbon facing industries.
Skinner: There's not an obvious case that banks are so heavily exposed to climate products to justify a conclusion right now that climate change is a financial stability risk. Supervision, I think that the Fed, again, does have sound legal footing in regard to micro prudential supervision. There's language about safety and soundness in the Bank Holding Company Act that's pretty capacious. It does make a lot of sense for the Fed to be dialoguing with banks about how they're evolving their understanding of credit risks to account for climate risks. But then when you shift to more of the financial stability, macroprudential types of issues, our stress testing framework is very much statutorily tied to capital planning. Yes, the Fed can do some things, like devise a climate scenario in the stress test, but to do things like the Bank of England has done and devise an entirely new stress that's focused on banks resilience to climate change, well, if you recall, there's much more leeway for the Financial Policy Committee, the FPC to do this because in the Bank of England Act, section 9(c), it gives the FPC an explicit, clear financial stability mandate with that secondary objective to support the UK government's economic policy.
There's not an obvious case that banks are so heavily exposed to climate products to justify a conclusion right now that climate change is a financial stability risk.
Skinner: The upshot in the climate space is there are a few things the Fed can do. It can react to climate related shocks. It can engage in micro prudential supervision. It can undertake important research. But to again, go on the offensive and try and use the reputation, the power, the balance sheet of the Fed to make the financial system greener, that would be activism.
Beckworth: Okay. And in your paper, you go on and talk about some other examples, historical examples of central bank activism. And for the sake of time, we're going to have to go by them. I'll encourage the readers to go check them out, but I want to move on to your conclusions or your policy implications. What do we do with central bank activism? I want to begin it by talking about one of the points you raise. This is the question of the legitimacy. Even if the Fed was given this role by Congress to go after the climate issue, even if it were legal, there's still a legitimacy question. Do we see the central bank as the best place for it to happen? Do they have the tools? Speak to this question of legitimacy, which is different than just the rule of law issue. I think that's an important point that you bring up in your paper.
Is an Activist Central Bank Legitimate?
Skinner: Yeah. I mean, you're absolutely right. There are two kinds of legitimacy. There's the rule of law legal legitimacy, and then there's a sort of broader concept of democratic legitimacy. What society is willing to accept as appropriate. I think the two though are connected when it comes to central bank activism. We are a society bound by the rule of law, our agencies and our central bank are creatures of statute. They only have the power that our elected representatives in Congress gave them. If the American people want the Fed to do something that it doesn't have the power to presently do, then the Congress would need to revise its mandates. But then this bleeds into the point about democratic legitimacy and why it might not be acceptable or prudent or wise press the Congress to give the Fed more things to do.
Skinner: The broad point here is that simply because there is an important economic issue on the horizon doesn't mean that it's a job for the central bank. There are a number of these kinds of issues. Just to name a few examples, technology disruption, trade, immigration, our economic relations with China. These aren't all the job of the Fed to take on. Not only does the Fed not have the clear legal authority to address them, but as you say, even if it did, do we want it to. History has not looked kindly on central economic planning, and separate from that, do Americans really want a central bank Leviathan that's comprised of, as Paul Tucker would say, unelected power?
The broad point here is that simply because there is an important economic issue on the horizon doesn't mean that it's a job for the central bank. There are a number of these kinds of issues. Just to name a few examples, technology disruption, trade, immigration, our economic relations with China.
Beckworth: Yeah. And I think it's important for people to remember that we are a very polarized country, right? Maybe for the next four years, maybe for the next eight years, you get a party in power who takes advantage of the central bank, the Fed and pushes a green agenda. But what happens if you get the other party in power and they go the other direction. They see all the power that's been used by the Fed and they say, "Hey, we don't like that direction. We're going to go completely in a different direction and use its power to our ends." That's what concerns me, is we have a nation that's strongly divided and depending on who is in power, you could have decisions swinging in one direction or the other. It makes me a little nervous, I guess, as we go down in this area, and I think this speaks to some of your other points as it relates to this, what happens to the authority of the Fed, the independence of the Fed as you get this increased politicization of it?
Skinner: Exactly. I mean, to respond to your... I think there are two really important points that you just mentioned that I want to bring out. The first is what I refer to as this slippery slope problem, which is a version of this pendulum swing, what is the priority of one administration will change to the next. To the extent we put the Fed in the middle of trying to allocate credit to politically favored or disfavored sectors, that can potentially become really problematic. It's not hard to imagine how this slippery slope could get out of control. One sector might be disfavor today, what's next?
Skinner: Even within, an arena take climate for example, since that's alive issue, even if the government puts the Fed in the business of buying green bonds, from there even the Fed has to make very politicized decisions about what's in and out of the green perimeter? It's not only this question of which sector could be next? Also, this question of this uncertainty of within the sectors, how is the Fed going to go about choosing that? My guess is the Fed really doesn't want this job either because it values its independence, its neutrality, its historical reputation in this regard.
Skinner: The other point that you bring out is this gridlock question. What happens when the Fed is the only game in town? I do have this question asked of me when I'm discussing this paper. What we're seeing is political stalemate or gridlock and factions, and the government may wish to leverage the Fed's efficacy to replace an inert political process. Is that okay? I mean, in my view, that ends justifies the means outside of maybe an emergency situation, like a financial crisis, an emergency situation that the Fed has been built to address. This is the system that our framers built. When our nation is divided about how or what to do, slows down until consensus is built. And sometimes it's messy, but it works better than any other systems. In the extreme, I think putting the Fed in this position is anti-democratic just because other actors in government won't mobilize.
This is the system that our framers built. When our nation is divided about how or what to do, slows down until consensus is built. And sometimes it's messy, but it works better than any other systems. In the extreme, I think putting the Fed in this position is anti-democratic just because other actors in government won't mobilize.
Beckworth: Yeah. You mention an interesting point about if the Fed were to start buying green bonds, even that decision, even if it were approved by Congress, would become highly politicized. I just think as an example of this, to illustrate the potential danger, go back to the last year when the Fed began its bond purchases. It was highly controversial because the Fed didn't do a whole lot, but it definitely affected the bond market in a very positive way. Well, who's in the corporate bond market? Big corporations, right? Little businesses weren't helped by the corporate bond facilities and people were getting upset, "You need to go after the small businesses." So then they opened up a small business facility.
Beckworth: There's this sense of, "Well, if you're going to help one sector, why don't you help another sector?" I can see the same thing happening in the process of buying green bonds. Well, which firm truly is a green bond firm? How do you know? Is this firm truly following the norms? I just can see this process getting incredibly messy. I think you're right. I think the Fed probably wants to avoid it altogether. But maybe the Fed is being pushed down that direction.
Beckworth: Well, let's move on to guard rails that you suggest that may help the US system avoid further central bank activism and allow the central bank to preserve its independence and provide price stability and full employment without being too overly distracted with these other mandates.
Guardrails for Central Bank Independence
Skinner: Yeah. I think the first sort of precursor point I would make about guardrails is, as I've continued to think about this project, I've realized that it is very important to be nuanced about these various examples. To me, I think some of them were problematic. End of the spectrum examples are where you get into credit allocation functions, which is, what you were just alluding to before, making these credit determinations, and that's precisely why that's a job for the fiscal authorities because you want the democratically accountable institutions to be making those value judgments. But there's the other end of the spectrum, which I've alluded to a few times, which I think is financial crisis management mode. Then the question becomes, if we're going to have an escape hatch for crisis, how do we design it as a matter of regulatory and institutional design.
Skinner: I didn't get in depth in this podcast about the HMT's powers to override the Bank of England in times of crisis. But there are statutory powers that the HMT has to override on a time limited, highly transparent basis. That's one example of designing an escape hatch that allows for greater central bank fiscal coordination. Maybe we should adopt it though. Then again, maybe not. Things went very smoothly with the system that we had in 2008 and 2020. The point that I really made in the override power on this score is, who knows what the future holds? Leaving things down to the personalities in power might be a bit dicey for future crises. Otherwise, in a peacetime kind of situation, I wholeheartedly agree that we need guardrails to increase public understanding, public scrutiny of when the central bank is stepping into new territory so that we can make informed discussion decisions about whether this is properly a job for the central bank.
Things went very smoothly with the system that we had in 2008 and 2020. The point that I really made in the override power on this score is, who knows what the future holds? Leaving things down to the personalities in power might be a bit dicey for future crises.
Skinner: I've proposed a framework in some of my other writing that the Fed could sort of use. to demonstrate a burden of proof, if you will, that, yes, this is the job for the Fed and here is how it's going to work that's consistent with our statutory mandates. I sort of sketched out four prongs of this framework. The first question would be, how exactly is the Fed interpreting its statutory mandate in the Federal Reserve Act or the Bank Holding Company Act or the Dodd-Frank Act that encompasses any new given risk, right? Whether that's climate change or inequality or cyber risk. One can see how this could apply to a range of issues that could come on the horizon.
Skinner: The second question to be asking is, how is this policy going to be operationalized? Are we going to be developing new policy tools, modifying existing policy tools or just wheeling the same tools out of the toolbox that we already have?
Skinner: The third question, which is becoming increasingly important is, what are the expected interactions between monetary policy and macro prudential policy? There's this growing conversation about the interaction between monetary and financial stability policy. And we're just starting to learn and understand how these policies can sometimes be reinforcing, but they can also sometimes be counterproductive. It's important for the public to be involved in that debate to the extent that it can be.
There's this growing conversation about the interaction between monetary and financial stability policy. And we're just starting to learn and understand how these policies can sometimes be reinforcing, but they can also sometimes be counterproductive. It's important for the public to be involved in that debate.
Skinner: Then finally, what exactly are the internal or external guardrails to, whether they be statutory or conventional, to prevent mission creep, to prevent things like the bad case scenario I described before where, crisis mode QE then creeps into this peace time QE that's being sort of pressured by the executive to do all sorts of things that we might not have agreed to upfront. I think that could go a long way and at least bringing to the fore, the fact that we do need to have this robust discussion about the role of the central bank if we're in a moment in time where we're seriously thinking about changing the job description of the Fed.
Beckworth: Those are all great suggestions. I have a question in the moments we have left here. What is your outlook for this conversation? Do you think we're going to have it at the level that you want, are some changes needed? I mean, maybe if we started having higher inflation and people began to worry about the Fed again. Where do you see it going and what would be the catalyst needed to go in the direction you'd like it to go?
Skinner: Yes. Great and tricky question. I'm optimistic. I think there is a tremendous amount of societal respect for the Fed's independence. I have a tremendous amount of respect for Treasury Secretary Janet Yellen. She knows better than most about the boundaries between the Fed and the Treasury. I think there are various pressures that are pushing and pulling on the Fed, and I think it's getting a little bit messy, but I do think that we're having the conversations that we need to have to flesh out where are the lines? When I went into a deep dive with you in climate change, I think it's a matter of having this discussion. Okay, there are actually seven different ways that we could think about the Fed being involved in climate change. And here are the two ways that they can focus productively and within their mandates. And here are the other ways that really aren't the job for the US central bank.
Skinner: I think having this continued dialogue about comparisons between the US and legal frameworks abroad is really healthy because it's easy enough just to say, "Well, look at what ECB is doing. Look at what the Bank of England is doing. The Fed should be doing this too." But in reality, they are very different legal frameworks, institutional designs, and all of that context, I think is really helpful in separating different roles for each central bank in each respective society.
Beckworth: Okay. Well with that, our time is up. Our guest today has been Christina Parajon Skinner. Thank you so much, Christina, for coming on the show.
Skinner: Thanks for having me. It was a lot of fun.
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