Thank you for the invitation to testify on “Federal Reserve Oversight: Examining the Central Bank’s Role in Credit Allocation.” In my testimony I will argue that the Federal Reserve’s attempts to direct the allocation of credit are overreaching, wasteful, and fraught with serious governance problems. A central bank charged with the crucial task of conducting monetary policy should focus on monetary policy. Accordingly, the Fed should be removed from the formulation and implementation of credit policy.
Prior to 2007, the Federal Reserve System undertook five main roles: (1) clearing and settlement of checks, (2) issue of paper currency, (3) supervision and regulation of commercial banks, (4) “lender of last resort,” and (5) monetary policy. Since 2007, at its own initiative, the Fed has expanded its range of activities by undertaking unprecedented credit allocation policies that do not fit into any of these traditional categories.
A list of recent credit allocation policies and their beneficiaries
By “credit allocation policies” I mean efforts to redistribute financial funds toward uses that Federal Reserve policymakers prefer and (implicitly) away from other uses that market actors prefer. Based on a compilation by the Government Accountability Office (2011), with two additions, here is a list of twenty-two Fed credit allocation initiatives in recent years, the dates they commenced, and their beneficiaries:
- Term Auction Facility (Dec. 2007): depository institutions
- Dollar Swap Lines (Dec. 2007): foreign-domiciled commercial banks doing US dollar business
- Term Securities Lending Facility (Mar. 2008): primary dealers, a set of select Wall Street securities firms (numbering 20 at the time) from whom the New York Fed trading desk routinely buys bonds, and to whom it sells bonds, in the execution of monetary policy operations
- Primary Dealer Credit Facility (Mar. 2008): primary dealers
- Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (Sept. 2008): money market mutual funds (MMMFs)
- Commercial Paper Funding Facility (Oct. 2008): issuers and holders of commercial paper
- Money Market Investor Funding Facility (Oct. 2008, but never used): MMMFs
- Term Asset-Backed Securities Loan Facility (Nov. 2008): holders of mortgage-backed securities (MBS)
- Bridge Loan to JP Morgan Chase (Mar. 2008): JP Morgan Chase; Bear Stearns shareholders, bondholders, and counterparties
- Maiden Lane LLC (Mar. 2008): JP Morgan Chase; Bear Stearns shareholders, bondholders, and counterparties
- Revolving AIG Credit Facility (Sept. 2008): AIG and its counterparties
- Securities Borrowing Facility (Oct. 2008): holders of MBS
- Maiden Lane II LLC (Nov. 2008): AIG counterparties, esp. Goldman Sachs
- Maiden Lane III LLC (Nov.10, 2008): AIG counterparties, esp. Goldman Sachs
- Life Insurance Securitization (March 2009, but never used): AIG counterparties
- Credit extensions to affiliates of some primary dealers (Sept. 2008): four broker-dealer firms
- Citigroup non-recourse lending commitment (Nov. 2008): Citigroup
- Bank of America non-recourse lending commitment (Jan. 2009): Bank of America
- Agency Mortgage-Backed Securities Purchase Program (Nov. 2008): bondholders of Fannie Mae and Freddie Mac
- Operation Twist (Sept. 2011; enlarged June 2012), replacing short-term securities with long-term securities in the Fed’s portfolio to reduce long-term interest rates relative to short-term rates: holders and guarantors of long-term MBS, housing finance firms that originate long-term fixed-rate mortgages, and housing construction firms
- Quantitative Easing 1 (Jan. 2009), $1250 billion in MBS purchases, but with its effects on broader monetary aggregates (M2) offset by paying interest on reserves: holders and guarantors of MBS, housing finance firms, and housing construction firms
- Quantitative Easing 3 (Sept. 2012), ongoing MBS purchases of $40 billion per month, similarly offset by interest on reserves: holders and guarantors of MBS, housing finance firms, and housing construction firms
Inefficiency of directed credit allocation
Credit is fungible and can be re-lent in search of the highest risk-adjusted returns, so some of the lending programs listed above may have had little impact on the final allocation of credit. To the extent that they did alter the allocation of credit, the programs are more likely than not to have been wasteful, directing funds to less than most productive uses, even if Fed policymakers have had the best of intentions. While the beneficiaries of the programs are obvious, a full analysis must also consider the costs. The losers from preferential credit allocations are all those potential users of funds—often difficult to identify with any specificity—who suffer by having credit diverted away from them.
Financial markets generate prices and quantities of financial assets by aggregating the decentralized judgments of millions of market investors, who are staking their own funds, about the most promising avenues for investment. In credit allocation policy, Federal Reserve officials, risking taxpayer funds, substitute their own judgment about the proper prices of various securities and the proper shares of the supply of funds that should go to specific firms or segments of the financial market. The likelihood that any central committee can improve on a competitive market’s allocation of funds, even if the committee is limited to tinkering around the margins, is vanishingly small. In particular, a committee that allocates funds to prop up insolvent financial firms, making investments that prudent market participants shun, is following a recipe for throwing good money after bad.
The Dodd-Frank Act of 2010 restricts special Fed lending to “broad-based” programs, ruling out any program limited to a single firm. While a step in the right direction, having this rule in place before 2010 would have ruled out only about half of the credit allocation programs listed above.