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 [email protected].

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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