George Selgin on Reforming Open Market Operations and Normalizing Fed Policy

George Selgin, director of the Cato Institute’s Center for Monetary and Financial Alternatives, returns to *Macro Musings* to discuss his new proposal to reform how the Fed conducts open-market operations. He proposes abolishing the current primary dealer system and expanding the Fed’s number of counterparties. David and George also discuss the Fed’s plans for 2017 and whether it will seek to reduce its large balance sheet.

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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: George, welcome to the show.

George Selgin: Oh, thanks for having me again, David. It's a pleasure.

Beckworth: Yes, you have the distinction of being the first guest to return, so this is George's second episode. If you haven't heard the first one, I encourage you to go back and do so. But this one here, I think, it's very topical, very timely. We're going to talk about the Fed as it normalizes, because 2017 looks to be a year when the Fed's going to get several rate hikes. And there's increased talk about shrinking its balance sheet, which it has always intended to do all long. And as we'll get in to show later, there's some complications in doing that.

Beckworth: Now, before we get into that, and also your proposal for a new way of doing open market operations, I want you to talk briefly about this new book you have coming out. Tell us a little bit about it. When can we expect it?

Selgin: Yeah. So the book is called “Money: Free and Unfree.” And it consists of a collection of essays by myself, and a couple with Larry White, and one with Larry and Bill Lastrapes, previously published in various outlets, including the Cato journal, the focus of which is the history of money in the United States, particularly the history of currency culminating with the passage of the Federal Reserve Act. And then it also addresses the performance, the essays also address the performance of the Fed. So, it's really a US focused collection.

Selgin: It also includes a couple introductory essays that are designed to provide some general background on the whole question of government's role in money and a critical perspective on what it is that really drives governments to intervene in monetary systems, and what the consequences of those interventions typically are.

Beckworth: Okay. And when is that coming out?

Selgin: Oh, that'll be out in April. We're publishing it ourselves at Cato, and I'm really excited about it. It's a nice looking book.

Beckworth: Okay. Great.

Selgin: And I hope people will find the inside as nice as the-

Beckworth: We'll be sure to read it-

Selgin: ... as the cover.

Beckworth: ... here at the Mercatus Center.

Selgin: If they judge it by its cover, then that will be okay with me, but I hope they won't be disappointed by that.

Beckworth: Okay. And you have another book, I was thinking, that you were working on based on the number of posts you've written too, right? So that's coming out next year, or?

Selgin: Well, there are actually three books now.

Beckworth: Okay.

Selgin: So there's the one we just talked about, then there is the monetary policy primer I've been serializing, and it's almost done. We plan to also publish as a book, the working title of which is Monetary Policy, an irreverent primer that won't bore you. And then the third project, which is one that I have referred to many times that we have delayed since I got to Cato, is The Little Fed Book, the subtitle of which is Our Crummy Money And How It Got That Way.

Selgin: And that is meant to be, not a collection, of course, but a short history of money in the United States and of the Fed. And as the title or subtitle suggests, a very critical history.

Beckworth: You got your plate full there working on all these projects, as well as regular conferences and academic papers you write, so.

Selgin: Yes, and that's why I haven't done most of it yet, but we're-

Beckworth: Okay.

Selgin: ... getting there.

Beckworth: Honesty, a good character trait. Okay. Well, let's move to a proposal you have, as we talk about this, it'll be a nice segue into the normalization of policy, you have written a chapter for new book, and this chapter is on flexible open market operations. And the way you begin this chapter is that you say, currently, the way we think about monetary policy, the way it's currently done, it's done in a very unhelpful dichotomy for central banks. It's a relic of sorts, I think, you say.

Flexible Open Market Operations

Beckworth: And that dichotomy is, monetary policy does monetary policy, targets and goals of monetary policy, then it also acts separately as the lender of last resort. And because of these two diverse roles, there's different facilities geared toward them, and you say it's time to move beyond that. So tell us about your ideas for that.

Selgin: Sure. The essay, by the way, is in a Heritage volume-

Beckworth: Okay.

Selgin: ... that came out recently called “Prosperity Unleashed,” has a lot of essays with different proposals, alternatives to existing financial legislation. So, the idea for my essay was really largely motivated by the experience of the financial crisis and by all of the emergency lending facilities the Fed found itself compelled to resort to. It's also informed by comparison of the Federal Reserve's operating procedures with those of both ECB and the Bank of England.

Selgin: To make a longer story short, we know that in our conventional system we have two sets of facilities. For monetary control we had the open market arrangements where funding liquidity was provided to the private financial markets through a small number of scores, so of primary dealers, and it was from there that those funds were supposed to spread out to other parts of the system. Then for lender of last resort purposes, we had the various Federal Reserve discount facilities.

Selgin: And there the idea was that banks could present certain kinds of collateral to the discount window, and obtain emergency funding there, that is, funding that wasn't trickling their way through the regular open market system.

Selgin: My argument is that, first of all, what central banks should focus on today, and the only real responsibility they have, is creating the right amount of aggregate liquidity in the system. But of course we also want that liquidity to be distributed efficiently to different financial institutions, including ones that are suffering liquidity shortages, but are nevertheless solvent and deserving. So, we have a pretty good secondary market arrangement today for distributing liquidity, but it's obviously not good enough.

Selgin: What happened in the crisis, of course, is that the open market operations alone didn't provide sufficient liquidity, and this was partly because policy was too tight, particularly in 2008 and 2009, but it was also because the primary dealer system itself broke down. So, for all kinds of reasons, we didn't have a mechanism capable of getting liquidity to solvent institutions that needed it.

Selgin: As for the discount window though, the stigma problem of the discount window became notorious, and it may be less well known to people that in fact the discount windows of the various Federal Reserve banks had been moribund since the crisis. Nobody uses them. Banks don't use them. The same story is true in England. Nobody uses them. There's no discounting in England. So we have these systems that nominally are the lender last resort systems of major central banks, but that have not been used.

Selgin: Okay. So, what's the solution? Well, you can have all these ad hoc lending facilities such as those that the Fed created, or you can reconsider the whole open market system, because in principle, open market operations could suffice, should be able to suffice to get liquidity to banks that need it, even whether in normal times or in emergencies when there's a lot of stress in financial market.

Selgin: But our system of open market operations isn't equipped to do that on its own because it's been limited to a small number of primary dealers who are the only ones who have direct access to these open market operations, that is who participate in the actual auctions or repo operations, and also because, traditionally, it's been committed in dealing only with treasury security.

Selgin: In contrast, we have arrangements or examples of arrangements where those restrictions don't exist. The ECB has always dealt with hundreds of counterparties, including most of the banks of the euros system. And in England, you have an arrangement, and you have this as well in the ECB, in both countries, where open market operations are conducted with a fairly substantial number of securities.

Selgin: Okay. So here's my proposal. You get rid of the primary dealer system, you open up the auctions, the regular liquidity auctions of the Fed, to a wide set of counterparties consisting at least of all the banks that are officially eligible for discount window lending, and perhaps open it even more widely into money market funds and the other institutions, including primary dealers that are presently involved in the Fed's repo or ordinary open market operations.

Selgin: And, you get rid of or get away from treasuries only and allow the same collateral, at least the same marketable collateral securities that are, again, officially acceptable for securing discount window loans. You have open market operations where bids can be submitted using this wider set of securities.

Selgin: Now here's where another European example helps, the ECB has been using now for seven years something called a product mix auction which allows institutions that want to take part in the open market operations of the bank of England to submit bids for different kinds of securities where different haircuts are applied to the securities according to their riskiness. And this auction process allows the credit to be assigned where essentially you have to bid a little more for funds if you're using securities that are riskier and have a bigger haircut applied.

Beckworth: Okay.

Selgin: But it's a one competitive auction, and the funds are allotted therefore to the highest bidders in risk adjusted terms. In this way, there's direct access to The Fed's open market operations.

Selgin: For all the institutions that in the past would have to go to the discount window, using securities, using the same broader set of securities or collateral and a competitive bidding process, which means that the funds are being allocated efficiently and competitively, and not arbitrarily throw a bunch of ad hoc facilities where there's, for one thing, doubt about whether the risk is being appropriately priced, and the facilities are certainly not consistent, and who can take part in them, and who can get the funds, and how much they're paying, it's not an efficient setup.

Selgin: And so if you had this mechanism in place, it'd be very hard to conceive of a situation where conducting its ordinary open market operations and just making decisions about the extent of those needed to meet the aggregate liquidity needs of the economy, The Fed couldn't provide not only for ordinary liquidity needs, but also for liquidity needs during periods of financial market stress.

Selgin: And it wouldn't have to think about it. It wouldn't have to do anything. It would just hold the auctions, the market participants themselves would know when they really need liquidity and when they need to use this facility, how aggressively to bid for it. And so what you would see, I think, is an outcome where ordinarily it would still be the case that a relatively small number of counterparties participate in The Fed's auctions, and they participate using treasury securities because the price of funds is higher with other securities.

Selgin: But in times of stress you'll see a broadening of the counterparties who deal with The Fed, and more successful bids using less conventional securities. But it would be a very simple system. Shut down the discount window, no emergency lending, don't need any of that, and the market is really doing most of the credit allocation, and relatively efficiently compared to-

Beckworth: So this is...

Selgin: ... systems of the past.

Beckworth: ... in some ways a simplification of what's the Fed's doing. You open up open market operations to a larger number of counterparties or financial firms, you mentioned you get rid of the primary dealers, but they would still be there. Those firms would still be a part of the system.

Selgin: No reason why they shouldn't be able to-

Beckworth: Right.

Selgin: ... participate. That's right.

Beckworth: So you have a large-

Selgin: And all of this is done with compute... The origin of the primary dealer system is way back in time when-

Beckworth: I was going to ask that. Why do we have the primary dealer system?

Selgin: Because the different securities dealers had to hop on their horses and carriages and head to the New York Fed and get in a room where-

Beckworth: Okay.

Selgin: ... they did. This is...

Beckworth: Logistics and...

Selgin: Yes, it was in the days before you could do everything electronically.

Beckworth: So that's why the ECB is able to do what it does, because it was a more modern creation.

Selgin: Absolutely, yes.

Beckworth: ... institutional history.

Selgin: And it was compelled to have a broader set of counterparties by political considerations-

Beckworth: Okay.

Selgin: ... of course. They couldn't just have them all in a few countries.

Beckworth: Right.

Selgin: But when you consider the political problem that had to be resolved in deciding who could participate, you could well imagine how they ended up saying, lets just let all, and you don't have to let any old financial institution. It's just that they have good camel ratings, for example. You could have that to minimize. There is more risk in this system, there's no doubt about it, but a lender of resort is going to bear a little bit of risk.

Selgin: But essentially what we're talking about are either outright purchases of securities or more likely during emergencies and concerning the securities that would be less conventional. We're talking about repos. So it's essentially securitized lending of the quite analogous to discount window lending except plus arbitrary.

Beckworth: So one of the interesting things that happened in 2007-2008 period when there was a lot of financial stress is the Fed was making these loans to distressed institutions, but at the same time it was sterilizing it. For every dollar it would send out in terms of loans, it would pull a dollar in by selling treasury securities off its balance sheet. And that seemed inefficient or counterproductive in the sense that in the middle of the financial crisis liquidity demand is going up, and the Fed is keeping even. So in relative terms it's actually getting tighter, is that a consequence of the current flawed system in your view?

Selgin: Well, there were two things going on in 2008. First, the Fed's overall monetary policy stance was too tight. So the reason it's sterilizing is because it wants to keep the federal funds rate at 2% or whatever when in retrospect it's pretty clear it should have let it fall sooner. It couldn't keep it at 2% as it were, but by trying it made things worse. Part of the problem is, no system of last resort lending, or emergency lending, or general liquidity decision can work well if the authorities are making the wrong decisions about how much liquidity the system needs.

Beckworth: Okay.

Selgin: So my proposal doesn't fix that.

Beckworth: Okay.

Selgin: We have better ideas like another flexible monetary policy I've heard of called, I think it's called flexible inflation targeting, very clever. Anyway, I think that's the sort of thing, we need to get the policy generally. Right.

Selgin: But in any event, what happened in 2008 is you had the Fed picking and choosing got the liquidity instead of having an efficient market system for allocating it, and creating all these ad hoc programs against some were for certain markets, some were for certain institution, that for every set of different institutions and different counterparties you have a different arrangement with different terms and different collateral and so on.

Selgin: This is a lot of planning here, a lot of arbitrary allocation, whereas if I think of the open market arrangement itself had been the flexible one that I'm proposing, most of those arrangements... those arrangements would have been unnecessary. I won't say most of them, all of them, because remember, you don't have to have every potentially liquidity strapped institution be able to get to take part in the auctions. As long as the auctions cover enough counterparties, the secondary markets will work.

Selgin: But if you limit the number of counterparties enough, and then they're having problems, now you've got some sclerosis in your system. And so it's about getting liquidity allocated efficiently. By the way, of those various ad hoc arrangements, the TAF facility was, in many respects, a version, albeit a temporary one, of what I have in mind. Because remember with the TAF you were auctioning funds to banks, the same banks that could have taken part in the discount windows. But by auctioning funds you were avoiding the stigma problem, which is why the TAF became widely used and the discount window wasn't used at all.

Selgin: But unlike conventional open market operations, you had all the counterparties and securities that the discount window deals with. So the TAF was a experimental version, as it were, of what I'm proposing, more or less, what they didn't have was this clever multi-product auction that allowed you to make sure that you had competitive pricing, efficient pricing of credit for different kinds of collateral. With the TAF you had separate auctions for separate collateral category.

Beckworth: All right. Let's just walk through open market operations as they are now currently done. So the Federal Reserve, the FOMC in particular, they set monetary policy, that policy then is enacted by the New York Fed and their trading desk there. And they do both permanent open market operations where they permanently increase the monetary base primarily to meet the growing demand for currency, but they also do temporary open market operations by using repos, you mentioned, and that's to accommodate short run fluctuations and demand for bank reserves in the monetary base. So in this new framework-

Beckworth: Go ahead.

Selgin: I want to interrupt you David, because that's a good description of the pre 2008 framework where you had targeting of the effective federal funds rate, where the target was achieved through an appropriate combinations of different kinds of open market operation. It should be said that today a monetary control is being affected less by altering open market operations. Indeed, part of what we want to talk about is how the Fed's-

Beckworth: Right

Selgin: ... balance sheet has been constant more or less.

Beckworth: Right.

Selgin: Instead, it's a matter of manipulating these administrated interest rates for repos, for reverse repos, and for bank reserves. And that's what monetary control is today. So, the new today is a little less...

Beckworth: Sure.

Selgin: Is different from the old...

Beckworth: Sure.

Selgin: ... these days

How a Flexible OMO Might Have Worked in 2008

Beckworth: Well, let's just go back in time, I guess, and we're in 2008, given that preexisting system, how would it have operated? Does it require a conscious decision by the FOMC, or is it just already built into place? So when there's a panic people run up to the New York fed and say, hey, here's my collateral, please buy it.

Selgin: Again, in those days, and still, open market operations were for ordinary monetary control purposes but were considered not designed to cater to emergency needs. So the FOMC would come up with, would announce it, choose it's Fed funds rate target, and then would instruct the folks at the New York Fed to figure out how many-

Beckworth: Right.

Selgin: ... securities, treasury securities, short term treasury securities, it needed to purchase either outright or temporarily in order to hit the desired federal funds target. And that was that. And they only dealt again with a score of a primary dealers, all of whom, I think, at that time were in New York.

Selgin: So, as for emergency lending, well, the idea there was if an institution found it couldn't get the liquidity it needed in the secondary market, which is to say couldn't get liquidity through the channels emanating from those open market operations in New York, if the liquidity didn't trickle its way but it had good collateral, then it would go to its district federal reserve bank in New York or elsewhere, depending on where it was located, and present the collateral for discount loan. That was the theory, and that's how the emergencies were to be dealt with. But again-

Beckworth: My question is, how would yours have operated back in 2008 if it were in place?

Selgin: In that case, the firms under the old system would have had to go to the discount window, could have used the same collateral to compete for funds being auctioned by the New York Fed in the open market, could take part in whatever repos or outright security purchases were being made to get a share of those funds.

Selgin: And again, if the Fed is making the right decisions about how much aggregate liquidity the system needs, right, if it's choice of the federal funds target or whatever its intermediate target is good, there's enough liquidity out there, it's just a question of making sure the firms that most need it and are most worthy of it get it.

Selgin: In this case, the competitive product mix auction and the fact that most financial firms have the ability to directly participate in the auctions using all kinds of decent collateral, means that any firm that could have gotten a discount window loan should be capable of securing credit through the auctions using the same collateral if it's-

Beckworth: So my regional bank in Tennessee would have been able to go and knock on the door of the Fed and engaged in open market operations.

Selgin: Well, it would have logged on to its computer-

Beckworth: Okay. Not literally knocked, but, yeah.

Selgin: ... and it would have submitted its...

Beckworth: Right.

Selgin: And if it needed the funds badly, it could bid more. It's a competitive-

Beckworth: Right,

Selgin: ... process. Other firms want liquidity too. So if-

Beckworth: Take a haircut if needed.

Selgin: ... you want it, if you have poor securities to offer, well, by God, you can still get liquidity within reason, but you're going to have to bid more, right? But this is just the way you want it to be. If we believe in the classical lender of last resort principles to which federal reserve authorities always give lip service but with which they never abide hardly, then this system should handle it.

Beckworth: Okay. So-

Selgin: It should meet those-

Beckworth: ... what happens...

Selgin: ... requisites.

Beckworth: ... in the next financial crisis and David Beckworth is in a big mess. And I want to take my car, let me sell my car to the Fed, or some of my financial assets to the Fed and take a haircut. Any thoughts on that?

Selgin: Under my proposal I'm afraid you'd be out of luck.

Beckworth: Okay.

Selgin: You would have to be one of these persons who would have to rely on your bank. So you still have a bank, right?

Beckworth: Right.

Selgin: If my system works, your bank has access now, no matter which bank it is, if it's a reasonably solvent bank with a good camel rating let's say, it can take part in the auctions. It should be able to get liquidity that it deserves it, that it's able to compete for, and you can go to it for help, right? Not everyone has to be able to take part in the auction. And by the same token, not every sort of collateral has to be involved. My proposal doesn't ask for the Fed to deal in any collateral it wouldn't be dealing with through its discount operations.

Selgin: Indeed, it would limit the collateral for open market operations to a subset of the stuff that potentially can be used at the discount windows, but isn't because nobody wants the stigma. So for example, loans can be discount window collateral, but as they are not marketable securities, they would not qualify. It should be only the marketable securities, the marketable instruments that you could bid with.

Beckworth: So even a very wealthy individual who owns treasuries would not be able to access the Fed, not directly.

Selgin: I don't think it's necessary.

Beckworth: Okay.

Selgin: You could make a case for broadening the number of counterparties further than what I propose, but at some point it makes no sense, because if the ordinary private financial institutions of the country have access to this facility, or most of them, those institutions will be kept sufficiently liquid and they can serve everybody else, which is what banks are supposed to do. Right? So the Fed's job is to see to it that the main components of the private financial system are up and running. It doesn't have to act as a bank or emergency supplier of liquidity to everybody.

Selgin: But what we want it to be able to do is to provide liquidity where it's needed to keep the private financial markets working. If it does that, those markets can tend to the vast majority of non-

Beckworth: Right.

Selgin: ... financial players in the-

Beckworth: I'm just-

Selgin: ... economy.

Beckworth: ... pushing you to see how far this goes.

Selgin: No. I think it's a good question, but the point is people mustn't forget that although there are reasons we learn from the recent crisis if we didn't know already, that there can be occasions when just relying on a small number of counterparties as-

Beckworth: Right.

Selgin: ... conduits for liquidity that emanates through open market operations, that can prove problematic, but it doesn't follow that therefore, every Tom, Dick, and Harry has to be able to-

Beckworth: Sure.

Selgin: ... come to the Fed and trade a car for-

Beckworth: You're right.

Selgin: ... federal funds.

Beckworth: And I think, I mean, your point is well taken, that you want to unclog the financial system so that you can get around these primary dealership. They themselves are in financial despair.

Selgin: That's right. And there's no reason for a primary dealer system. There is no technical reason. There's no good economic argument. There've been studies that have been published by the IMF, and world bank, and other authorities that have recommended against reliance on such systems for countries that don't already have. It's an anachronism. It needs to go. And I think as well that Treasury's only as a hard and fast rule rather than a norm, I think that's, I don't know if I should call it an anachronism, but I think that the view that that's the only safe way for the Fed to operate doesn't have any solid foundation.

Selgin: By the way, the particular argument that the Fed needs to deal with treasuries only because otherwise it's engaging in fiscal activities strikes me as quite odd. There could be nothing more fiscal than a central bank that diverts credit solely to the treasury or other government agencies.

Selgin: It's true that we don't want central banks picking and choosing the proper particular markets as the Fed has been doing big time by buying all the MBS it has on its balance sheet now, but if we have a system where there's rules in place, not on like those that apply to discount window lending or the TAF, and it's so happens it under these pre-established reasonable rules occasionally some non treasury securities are sold, there's no picking and choosing, there's no fiscal policy in that sense, indeed the Fed's footprint on the economy is more neutral than it would be with the Treasury's only system.

Beckworth: All right. So we've talked about your proposal for opening up open market operations to what we call flexible open market operations, larger number of counterparties. I want to move and segue into a different proposal, it's also related to the Fed's balance sheet from a different perspective. And this is opening up the Fed's balance sheet to broader number of firms, maybe regular firms and households potentially. So now-

Should the Fed Open up its Balance Sheet?

Selgin: You're talking about the balance sheet, talking about open market operations, or?

Beckworth: No. I'm moving beyond open market-

Selgin: You're talking about federal reserve deposits.

Beckworth: Deposits. Yes. So in general we can think of all of these proposals that have come out as ways to avoid financial stress in the future to make things run more effectively. So what we have seen since the crisis, have been several developments toward this already. So we know banks, of course, already have access to the Fed's balance sheet. They think that we have these deposit accounts there. The Fed has opened them up to money market funds, to GSCs through the RRP, reverse repo facility.

Selgin: The GSCs had access before, but now they're-

Beckworth: Right.

Selgin: ... doing more.

Beckworth: They're doing more. But money market funds, also the Fed has opened up its balance sheet to some of the clearing houses under Dodd-Frank. And so you have, maybe those are incremental moves, but there are a move in that direction.

Beckworth: And there've been people who have articulated this, and I want to give one other example, JP Koning had a post up, he's a previous guest on our show, where he noted that the Bank of England, for many years, had accounts open to individuals, and it slowly phased those out. And just, I think, last year, it terminated its accounts for its employees. Up to, I believe, last year, its employees could still have a personal check in account with the Bank of England.

Beckworth: And one of the questions that comes up of course is, well, if you go down that path, you remove the role of financial mediation by private firms, and can a central bank do that adequately? And JP's comment was, if you look at the Bank of England in their example, they really only provided one thing, a very safe deposit. There were still other banks around that provided other services, other forms of financial intermediation that the Bank of England, in fact, the Bank of England shut down its services to its employees because it could provide online banking, all the services regular banks do.

Beckworth: So, what are your thoughts on these proposals for opening up the bank's balance sheet more broadly for deposits for regular folks?

Selgin: Well, I hate these proposals. I think they're awful. Look, the Bank of England, to just go to that example, started out as a private institution and remained so until the 20th century. And, for the most part, it was nationalized during the Napoleonic Wars, but nevermind, so of course it had regular deposits and a little remnant of that survived, and as you mentioned, till recently, but so what? That has to do with its private past, which dates to times when it wasn't considered an institution with any public responsibilities, just another bank who had special privileges and therefore bigger than the rest, but so what?

Selgin: So that precedent proves nothing. It proves nothing. And in fact, until recently, it was taken for granted by most economists, and certainly most monetary and banking expert, that central banks existed only for very special purposes, overall monetary control, which of course is essential in a fiat system, and also for providing emergency liquidity, which we've discussed. But their job was not to compete with private financial institutions which were understood to be much more capable of using savings efficiently, putting them to productive use, and also, this is very important, innovating in the financial system.

Selgin: Those who imagine that central banks could take over regular retail and other deposit business, and do it as well as private institutions, competing institutions, first of all, they seem to have forgotten what competition means, right? There's a reason why we rely on competition in almost all markets for goods and services and not monopoly, gee, what happened to that idea? Second, they're ignorant of most of banking history. They know all the warts. They didn't know none of the virtues of past private systems. They don't understand that many have worked very well.

Selgin: Third, they haven't read Adam Smith book two, volume two, about the advantages for productive investment of having a banking system where the bankers decide what loans to make, and for what purposes, and using what collateral. Smith points out the very important role banks have had in financing economic development.

Selgin: It's incredible to me to see how quickly since the crisis, and based on a lot of misunderstanding about the ultimate causes of the crisis, people have been jumping on the bandwagon of wanting to see the Fed or other central banks essentially nationalized credit, which the Fed has already been doing to considerable extent without getting involved in retail deposits.

Selgin: The other thing I would point out is that before the crisis, certainly, when central banks tried to increase their footprint in the economy, either by imposing high liquidity requirements or by otherwise inflating the demand for their liabilities, we had a name for it, a good name, I think a descriptive name. It was called financial repression.

Selgin: It was something that monetary economists took for granted, was done by a lousy little third world banana republics to grab more savings for the government, because the governments weren't fit to borrow on private markets and pay competitive rates to get the funding that was adequate to their rapacious desires. That's what it used to be called. Now it's called macro-prudential regulation, but it's the same thing.

Selgin: The liquidity coverage ratios, interest on excess reserves, banks holding trillions instead of billions of reserves. All of this stuff is a detriment to efficient financial intermediation and therefore to economic prosperity. It is a factor in the low productivity of the US and other-

Beckworth: Okay.

Selgin: ... economies today.

Beckworth: So this incremental march we see towards that already, that concerns you then?

Selgin: Yes.

Beckworth: The Fed opening up of its balance sheet to finance other financial firms?

Selgin: There's no doubt in my mind that if the federal reserve had its way, its monopoly powers would continue to grow even though they're already vast. Its footprint on the economy would grow, and it would be happy to have it grow in any possible way. The theory of bureaucracy helps us to understand why, as do other elements of public choice theory. The government, for its part, is happy to see any developments that enhance the demand for its securities.

Selgin: And so they think that all of these macro-prudential regulations are just peachy keen, because it means that banks have to hold more government securities, or they have to hold more reserve balances that are themselves backed by government securities, or agency debt, or some form of government debt. So the public choice motivations are very clear here. Instead of finding ways to endorse these developments and thereby undermine the effectiveness of private financial institutions in spurring productive growth, economists should be recognizing them for what they are, high tech financial repression.

Selgin: There are far better ways to have a deficient and safe banking system, but then by letting the government or its agencies take the thing over.

Should the Fed Shrink its Balance Sheet?

Beckworth: Okay. Well along those lines, you mentioned that the Fed's footprint has expanded tremendously. A part of that, I think we can look at, is its balance sheet has expanded tremendously since the crisis. So about the time of crisis erupted the Fed had about just under $900 billion in assets, now, just under $4.5 trillion. So almost a fourfold increase, roughly a fourfold increase, and it's acquired a large number treasuries as well as a mortgage related securities issued by Fannie and Freddie.

Beckworth: And as part of its exit plans, as part of its returns to normalization of monetary policy, it wants to shrink its balance sheet. Now, the Fed's stated path is to first raise interest rates to some levels, kind of mysterious, but some level, and then begin to shrink it. Let's first talk about that. There've been arguments against shrinking it, and I think you have responded to some of these already, but let's go through these.

Beckworth: So we know the Fed wants to shrink its balance sheet, and I think 2017 might be the year we begin at least to start a robust discussion on it, if not actually do it. But there's been some arguments for keeping it large, and then we'll move to why we should you shrink it, which I know that's where you stand, and I do too. But let's just work our way through some of these arguments for maintaining large balance sheets.

Beckworth: So the first one, promoted by number of well-known individuals, is that by keeping a large balance sheet, the Fed is going to be able to keep it open, going back to what we were just talking about, keep a number of safe assets, bank reserves open to financial firms in the event of a distress. And so therefore we might as we'll just keep it. Banks will be bailed out in any event, let's just let them have access to a large safe repository. So what are your thoughts on that?

Selgin: Well, I think it actually makes very little sense. Remember that we're economists, right? So what we care about is the real quantities. So what we're talking about is an arrangement where the real quantity of so-called safe assets in particular federal reserve balances is, as you said, far greater than it used to be. Now, if that's so, it's not because the Fed has supplied more real balances, not at all, it's because they have propped up the demand for real balances, because it's demand that's determining the real quantity and equilibrium. Right?

Beckworth: Right.

Selgin: Econ 101. So instead of saying, look at all the safe assets the Fed is supplying, what we should be saying is, look how the Fed and other agencies are artificially propping up the demand for safe assets, the regulatory demand for safe assets. That's what interest on reserves does. That's what overnight and other reverse repo operations of the Fed do. That's what the liquidity coverage ratio does. Okay. This is all creating demand, and that's what's keeping, in real terms, these-

Beckworth: Okay.

Selgin: ... values very high, and it's the real magnitudes that matter, the relative magnitudes, not the nominal magnitude. Those indeed might be high just because the Fed's balance sheet is huge, but the real magnitudes are high because of these elements that determine the demand for these assets. Now, does creating an artificial demand for these assets therefore actually enhance the availability of liquid resources? And the answer is no. The private market now is starving for safe securities for collateral. Right? So this is a lot of, can I say crap on your program?

Beckworth: Yes.

Selgin: Okay. It's a lot of crap. It's financial repression pretending to be an arrangement that makes markets more liquid. No, you don't make markets more liquid by creating artificial demand for liquid securities that therefore makes less of them available where they might be needed. By the way, it's the same argument more or less, as applied in the 19th century where governments would impose strict reserve ratios or legal tender reserve ratios on their banks and the result was that the reserves weren't there when they were really needed, or the banks were reluctant to make use of them.

Selgin: So it is easy to force institutions to hold more liquid reserves of certain types, it is easy to prop up the demand for those securities, but it doesn't actually make the financial system more liquid. What it does do is to channel scarce resources to the government, which is the source of the security, that's called financial repression. And so, I find these arguments terrible.

Beckworth: Okay.

Selgin: And let me say one thing about the Fed's argument that we want to raise interest rates and then shrink the balance sheet when they're high enough, it doesn't make any sense. By the way, I don't believe that they really are intent on shrinking the balance sheet. They've been waffling on it, they're always-

Beckworth: But James Bullard has been talking about it.

Selgin: But he's one of the few people in the Fed who want to do it, but then there plenty of others who are waffling, and want to put it off, and I think will eventually say, gee, this nice big balance sheet is wonderful, why don't we keep it?

Selgin: If you want to raise interest rates, one way to do that is to sell security, right? You sell a security and the rates go up. So, just saying we wanted to make rates go up instead of selling securities, it doesn't make that much sense. Now what they are doing when they raise policy rates interest on excess reserves in the overnight repo rates, is they are maintaining, if not augmenting, the demand for liquid Fed balances, right? They're adding to that demand, and that, of course, is, in real terms, doing the opposite of what you need to do to reduce the balance sheet.

Selgin: So it's a way of sustaining a big balance sheet in real terms. The demand side is crucial. It isn't just about the nominal size of the Fed's balance sheet, even though, I'm sorry to say, some prominent economists, including some federal reserve officials, have argued that banks have to have all these excess reserves because the Fed bought so many assets and its balance sheet expanded.

Selgin: The failure to heed the distinction between excess reserves, which are always a choice, be it when informed by the rates of return on the different assets, and plain old reserves, which necessarily have to be geared to the size of the Fed's balance sheet allowing for currency withdrawal, the failure of prominent economists to heed that distinction has to rate among recent monetary fallacies near the very top. And that's saying a lot, because there are a whole bunch of those fallacies.

Beckworth: Well, let's move on to another argument, and let's do this one in the time we have left. One other argument and we'll move to your plan for reducing the Fed's balance sheet, but the other argument is a public finance argument, and that is that basically the Fed itself can earn a positive return by funding through some reserves basically and then going in and investing in long-term treasury. So basically operate like a big bank itself.

Selgin: You mean a big hedge fund.

Beckworth: Oh, a big hedge fund.

Selgin: Because if a bank did what the Fed's doing, and assuming all duration risk, it would be in bad trouble, indeed with mark to market accounting, which is applied to ordinary banks but not to the Fed. It would be insolvent. The Fed wouldn't have any capital in mark to market. Well, it's capital is very slim as you know, but in fact this is a tremendous amount of duration risk. No private bank could do what the Fed's doing, a hedge fund might, but no private bank.

Selgin: Certainly if it tried we would want the regulators to do something about it, and quick, so you can't compare it to bank. Indeed, it's a very irresponsible policy financially. It's not something that the Fed should be commended for. But as interest rates rise, the losses on the Fed on a mark to market basis can become very, very large, far larger than its capital for whatever that may be worth, because we know the Fed doesn't mark to market, and we know that it's not like an ordinary firm that fails if it's capital is wiped out.

Selgin: Nevertheless, if you were looking at the Fed as if it were a private financial institution, you could only condemn this so-called profitable, physically advantageous arrangement.

Beckworth: This industry risk would hit the Fed as the economy recovers, and it would be born by tax payers ultimately.

Selgin: Only if it's realized, right? So if the Fed sells the securities after interest rates have risen from the historical levels, then it has to realize that there's a realized loss rather than just a paper loss. And that comes out of the Fed's earnings of course, and out of remittances to the treasury.

Selgin: Now, the question is, does it matter if the losses are not realized but instead the Fed holds onto the securities until they mature? And here it needs to be emphasized that we should think about these things like economists and not like tax accounts, a loss for an economist, the paper losses, our losses, their losses. They're paper losses. And so, judged by ordinary economic standards, the Fed's risks are real, and its losses are real whether it realizes them or not when interest rates rise and it has a lot of longterm assets on its books.

Beckworth: All right, well let's move into a period where the Fed does begin to shrink its balance sheet. You're skeptical will occur anytime soon.

Selgin: That's right.

Beckworth: Although I think this year we might see more discussion on it, but nonetheless, let's say we get there, you have noted in some of your recent work that it's going to be trickier than we first imagined, why is that?

Selgin: As I mentioned before... Well, let me step back a bit. As the economy recovers, the money multiplier, which has been more of the lending multiplier of ordinary commercial banks, should start to get higher, other things equal. And that's why we speak of the need to raise interest rates as recovery proceeds somehow.

Selgin: As I said, there are actually two ways to do this. You can raise the administered rates on reserves and for the repos, reverse repos, which amounts to propping up, again, the demand for federal reserve balances, and therefore making sure the multiplier stays down. That's what that is. Or you can sell assets, or at least allow the balance sheet to shrink as they mature, and by not reinvesting principle and interest. You can do that to raise interest rates, which is reducing the supply of balances and high powered money, and having the same ultimate results.

Selgin: Now, why is the shrinkage approach a problem? Well, it's not really. Here's the thing. You don't want to shrink the Fed's balance sheet precipitously. You want to have these changes, the sales, not disrupt markets too much. This is something Bernanke has emphasized, what he hasn't noted is that actually planning sales is a way to smooth their consequences, whereas if you have passive reduction as things mature, that's when you can get a big lumpy amounts that mature at the same time.

Selgin: So Bernanke is disingenious when he equates passive balance sheet reduction with orderly reduction, those a two different things. Orderly reduction we want, but that doesn't mean you have to have passive where you should have passive reduction.

Beckworth: Let me just mention also briefly, the amount of currency in circulation has grown too, so you wouldn't have to completely reduce it to where it was 2008.

Selgin: That's right.

Beckworth: So you just reduce it to where normal money demand would have been.

Selgin: That's right. But the problem is that, as we know, for monetary control purposes, open market operations, it takes a little bit of art to get the amount of such operations right to achieve the desired level of targeting. So it's hard to have a commitment to a smooth schedule of sales and have the monetary control the way you would like it. So then the question is, well, would we therefore have to still rely on these other interest on reserves in our RP? And I would rather we didn't because I would like to see those things phased out.

Selgin: I don't mind interest on required reserves, but I think interest on excess reserves has been a disaster from the get go. But there is another tool there, the term deposit facility that the fed can use. If it finds a multiplier reviving too much given its schedule of open market sales, then it can use these term deposits, which essentially means getting the banks to hold more reserves through a different device in the short run to make sure money growth isn't excessive.

Selgin: But I don't just want to see the balance sheet reduced. I want to see the Fed return to more conventional monetary control arrangements that it had before the crisis. And that's going to mean eventually getting rid of this RRP, so the overnight repos, and the term repos that they are also doing. It's going to mean getting rid of the reverse repos. It's going to mean getting rid of interest on excess reserves. And it also, I'm afraid, requires that we deal with the liquidity coverage ratio, which is propping up the demand for reserve or for treasuries.

Selgin: Here's the thing, just on that, the liquidity coverage ratio alone would generate extraordinary demand for US government securities because they're high quality liquid assets, but with the overnight, sorry, with interest on excess reserves, at rates that exceed the yields and some of those treasury securities, that liquidity coverage ratio becomes an extraordinary source of demand for reserves, it ordinarily wouldn't be.

Selgin: So I'd like to phase out interest on excess reserves, but I also don't like the liquidity coverage ratio because it's another financially repressive device disguised, again, as sophisticated macro-prudential regulation.

Beckworth: One of the challenges you noted in your writing is that if you do unwind the balance sheet and the liquidity ratio is still there, it will create some tension for banks because as long as banks can earn more holding reserves over treasuries, and that's the way it currently is, they can earn a higher return, higher interest rate on reserves, and given that they have to hold some safe asset, some high liquid asset, banks will want to hold reserves over treasuries, but if the Fed is unwinding its balance sheet it'll actually be reducing the amount of reserves.

Selgin: But, remember, this is all premised on the assumption that interest rates are rising generally, and of course the security sales themselves are going to raise rates. So if the interest rate on excess reserves is not raised itself, it will ultimately become lower-

Beckworth: Okay.

Selgin: ... than yields on treasuries and ideally on yields on short term treasuries. Now, if that doesn't happen, of course the solution is to lower the interest rate on excess reserves. Again, you can do that and still have your monetary policy target, that is get the money as tight or as loose as you want it by appropriate adjustments in the size of the balance sheet, perhaps augmented by term deposits.

Beckworth: Okay.

Selgin: So, I'm not saying any of this is easy, I do think it's worth.

Beckworth: Okay. Well, our guest today has been George Selgin. George, thank you for coming on the show.

Selgin: You're welcome, David. Anytime.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.