Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Thursday, December 2, 2010

Oh, the Outrage...

The U.S. Congress created the Fed in 1913. One of its duties is to prevent, or at least, to mitigate the adverse consequences of major financial disruptions, like the one that occurred in the Panic of 1907.

Financial panics, like the one we recently experienced, are characterized by (among other things) a sudden lack of "liquidity." What does this mean? It means that all sorts of debt instruments are treated like junk, whether they "deserve" to be treated as junk or not.  In a panic situation, the baby frequently gets thrown out with the bath water. Good assets (well-collateralized debt instruments) get penalized (severely discounted) along with bad assets.

A part of the Fed's mandate is to serve as lender-of-last-resort. What does this mean? It means that it stands ready to discount what it perceives to be good quality paper at a rate less than the market discounts such paper. This means lending cash at a lower-than-market interest rate on a short-term loan, if the debtor is in a position to put up high-grade collateral. This is what happens at the Fed's discount window. This is what happened with the Fed's other emergency lending facilities. The Fed was doing what Congress (representing the wishes of its citizens) has mandated.

What was the result? All the loans due have been paid back with interest. Yes, that's right. Contrary to the impression one gets from the media, the Fed did not "give" people or firms money. It lent them the money on a short term basis and in exchange for high-grade collateral (even if ascertaining the quality of collateral in emergency conditions can sometimes lead to mistakes).

The Fed has made a healthy profit on these activities. Last year, it remitted an extra $25 billion to the U.S. Treasury (the U.S. taxpayer). What sort of "bailout" makes money for the U.S. taxpayer?

So what is the source of all the outrage directed at the Fed? My own interpretation is that members of Congress like to use the Fed as its whipping boy. The Fed is a central bank and the Fed helped banks. And people hate banks. They hate banks because...well, because they won't lend people money. They also hate banks because they lend people too much money (leading to crisis). Go figure.


Addendum: 03 Dec 10

I said above that the Fed only accepts high-grade collateral when it makes a short-term cash loan. While this describes normal Fed practice, it evidently does not describe all the lending that took place in its emergency facilities during the crisis; see here: Crisis-Hit Banks Flooded Fed with Junk.

What I should have said is that when the Fed makes a short-term cash loan, it does so only when it has a high expectation that it will be paid back. The collateral for the loan is put up to protect the Fed in the event of default. And as the article mentions, when the collateral put up was lower-grade material, the Fed protected itself by applying a large "haircut" (discount) on the collateral. (Presumably, the haircut applied by the Fed was less than the haircut the market was willing to give, but so what--this is the point of being a lender-of-last resort!).

In any case, my basic point stands. The Federal Reserve Act of 1913, an Act of Congress, explicitly allows and expects the Fed to act the way it did during any financial crisis. Section 13(3) of the act reads as follows:

13.3. Discounts for Individuals, Partnerships, and Corporations

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

So maybe you don't like what the Fed did. That's fair enough. But this is no reason to blame the Fed. If you want something different, you should lobby Congress to change the Federal Reserve Act. Or lobby Congress to abolish the Fed. And then you'll have Congress managing monetary policy (unless you live in the fantasy world of Ron Paul, and actually believe that Congress would shackle itself to a gold standard). At the end of the day, I am sure that American voters will get what they deserve.

23 comments:

  1. You may find this quite interesting. There's also a paper: Selgin, Lastrapes and White.

    http://www.youtube.com/watch?v=yLynuQebyUM&hd=1

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  2. David, surely the outrage against the Federal Reserve from the Austrian perspective is that it is seen as a tool to enhance government power. The ability to monetize budget deficits allows the government to aggrandize itself and to redistribute wealth to favored special interest groups.

    Although of course dissatisfaction with the monetary regime was also prevalent during the 1890s at the height of the Gold Standard when there wasn't even a central bank.
    Monetary arrangements are so inherently political that there will never be an optimum and we are doomed to this dissatisfaction forever.

    pe

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  3. Prof J: I am in the middle of preparing a report for the next FOMC meeting. Will get back to you later on this.

    Anon: I am aware of the Austrian perspective on this. It is a sophisticated argument that bears little, if any, relation to the outrage that is frequently directed at the Fed in the media (for example, the blurb I saw this morning on Fox News). I'm afraid that I have to agree with your concluding sentence.

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  4. Anon,

    Beware people claiming to be Austrians. Many people like to align themselves with Austrian economics because of certain policy conclusions - like the fact that Austrians tend to think the state intervention is inherently destabilizing. But the Austrian position on money is not homogeneous, thus there is not an "Austrian" position on all things. Austrian economics indicates that any monopoly is bad, and that includes monopoly on money production.

    I think Steve Horwitz has the most up-to-date statement of the Austrian position on this issue, but again - there isn't a uniform position on money creation and banking in the Austrian camp.

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  5. One complaint I've heard is that the Fed risked too much good money on bad assets, when no private sector bank was willing to play counterparty to these bets. As the lender of last resort, however, by definition it needs to be willing to take the pieces others aren't willing to.

    Like you said, people are unhappy whether the Fed does too much or too little, yet they have no objective concept of "too."

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  6. I appreciate your posts as always, like this post which helps clarify institutional details for non-Economist (wannabes) like myself. Thanks!

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  7. David,

    I think this is such an incredibly good post I just don't have the words.

    Whatever sequence of words would represent the english language's greatest expression of agreement, that's what I'm trying to say.

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  8. Good post David. I agree with most everything here.

    Where I feel that outrage at banks IS rational and appropriate (when I say banks I mean the system INCLUDING the fed) is in criticizing their secrecy and their duplicity. Duplicity in the fact that great lengths are gone to to avoid directly helping citizens of modest means (why thats socialism and nanny state) while no expense is spared in helping those who hold great wealth. The secrecy is in not disclosing what collateral was actually requested in return for the loans. They have outright refused to do so as requested by congress........ why? There is no way to say that the loans have been paid back without knowing the value of the collateral and who still holds it. If the bad collateral is still on the feds balance sheet then the banks havent "made" anything to pay back anything. Until the banks can put those bad assets back on their balance sheets and then have enough equity to cover those AND have a profit it is incorrect to suggest they have paid anything back, they've simply been relieved of their liability, big difference. So until they open their books and let someone examine their books they can say they've been paid back all they want but they havent shown that in fact they were.

    I am not an End the Fed kind of guy at all. I happen to think that the idea of lender or buyer of last resort is quite helpful to maintaining a stable economy. But make no mistake about it, it is socialism. It is using the power of the state to control outcomes in the markets and I whole heartedly support it. Those who decry it simply on grounds that its not "pure" capitalism should simply be ignored. Where it has gone wrong is that it has started to become a defacto private currency issuer which is counter to any view of democracy. The banking cartel has become engorged and is eating our system and demanding that everything be run through it. Not a healthy development in my view.

    The Fed doesnt need to be ended but it does need a little sunshine on its dark underbelly. I'm all for people understanding a lot more about how our money system operates. Instead of being scared what they will do with this new information we must be confident that most people will go "Oh so thats how its done okay" .

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  9. Greg:

    Well, we can't apply your charge of duplicity (the way you defined it) to the Fed. The Fed is not in the business of retail or commercial banking.

    You have a point, however, when it comes to nondisclosure practices, especially in terms of the discount window. I've written about this before; see here:

    http://andolfatto.blogspot.com/2010/04/information-disclosure-policy-for-fed.html

    When I talk to our (St. Louis Fed) lawyer about this, she suggests that the issue is not disclosure per se; but rather, disclosure with some lag. Congress wants to know in real time who is doing what at the discount window in a crisis. The Fed's argument is that such real time disclosure practices would dissuade discount window participation (owing to fears of stigma).

    Anyway, thanks for your thoughts (and thanks to everyone else too).

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  10. David, I think you misinterpreted my position.

    The Fed IS, with their actions, aiding retail and commercial banks who are suffering loan losses. Some of these actions are standard procedure, stuff that has been done before, others are out of the ordinary and specifically picking winners.

    http://www.nakedcapitalism.com/2010/12/guest-post-fed-data-shows-b-of-a-and-wells-fargo-biggest-borrowers-under-feds-emergency-lending-program-foreign-banks-also-borrowed-huge-amounts.html

    They were DIRECTLY aiding foreign banks, multinational corps and hedge funds for Chrissakes!! Why werent they just stepping up and offering to by Joe Blows house so he could move somewhere else and find a job?

    Again liquidity operations, lender/buyer of last resort stuff is pretty standard and within the fed charter as I understand it but it looks like besides QE and QE2 they were resorting to other more creative ways to get money to folks who needed it.

    I happen to have very little problem with this in theory. I view money as a public utility in a perfect world. Everyone needs it and should have an access to a guaranteed minimum amount...... but we dont have that view by many here and in fact the appearance to many is that those with money WILL be endlessly helped out by the fed regardless of the consequences to the everyone else. And then we have the gall to call this procedure capitalism and not nanny statism for the well heeled.

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  11. Greg:

    Thanks for your reply. I'm sorry if I misunderstood what you were trying to say. It doesn't sound like we are disagreeing on anything fundamental. But let me respond to some of the points you make and go from there. (Your comments italicized below).

    The Fed IS, with their actions, aiding retail and commercial banks who are suffering loan losses.

    The goal is not to help banks (or other agencies) that are suffering loan losses. The goal is to help agencies who are facing liquidity problems. This is an important conceptual difference. Naturally, loan losses and liquidity problems may be correlated, but given that the Fed did not lose any money in these deals, it is clear that it engaged in no fiscal transfers.

    They were DIRECTLY aiding foreign banks, multinational corps and hedge funds for Chrissakes!! Why werent they just stepping up and offering to by Joe Blows house so he could move somewhere else and find a job?

    Yes, they "aided" these agencies and made a profit for the US taxpayer by doing so (for Chrissakes).

    I'm not sure what Joe Blow has to do with any of this. How is a $1 billion overnight loan to Joe Blow going to help him? Please explain.

    I happen to have very little problem with this in theory. I view money as a public utility in a perfect world. Everyone needs it and should have an access to a guaranteed minimum amount...

    I am not sure that you understand the business of banking (at least, not the way I understand it). The business of banking is not to give people money; it is to monetize their (illiquid) collateral. If their assets where liquid, they wouldn't need a bank loan to begin with.

    Giving everybody a minimum amount of money is a noble sentiment, but it is beyond the Fed's mandate. What you are describing is a fiscal operation; this is what Congress does all the time.

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  12. Why you rascal! You do work at the Fed. (I wondered, since your profile says you're in banking in St. Louis.

    And St. Louis, no less. Thanks for FRED. It's a magnificent piece of work. Pass it on.

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  13. Thanks for the response David

    Isnt it true that before it can be agreed that no money was lost (or money was made) we need to be able to see the transactions?

    If bank A has toxic assets it cant sell anymore (either because they truly are not worth what they were listed, due to fraud, or they are simply not trusted) and the fed comes along and says "we'll buy those from you", before we can agree that any money was made on that transaction we must first see that that which the fed bought has been resold AND the hole in the feds balance sheet must be refilled + some. The simple act of removing the toxin from the banks balance sheet improves their financial condition, which IS the point of the operation, and allows the bank to function more normally but unless their continued operations are making enough revenue to replace the original value of the removed toxin and repay the fed, how has any money been "made" for the taxpayer. I would appreciate an explanation of how this might happen.

    Let me give an analogy to make my thinking clear. If you, me and a third party represent a closed economy and I am the bank holding your mortgage as my asset and the third party has bought your mortgage which is now "underperforming", my balance sheet has now made me insolvent because the underperforming mortgage is not worth what the asset side of my balance sheet says it is. In this situation a "new" entity comes along and says "I'll buy that asset" . He is outside our economy and represents "new" money. This purchase is called a loan (with the asset as collateral) by the new entity but until this new entity actually receives the repayment of the loan AND the asset is returned to the banks balance sheet at original value, there can be no credible way of saying the new entity made money. They can say they forgave the value of the collateral and let the bank continue operating as if they never had that bad asset but this is not the same as repaying....right?

    Now, I suggest that its less important how many bad assets the fed is willing to hold on their balance sheets and more important that the assets held are not determined by who you are. There must be a degree of non political favoritism to the decision to buy an asset, or extend a loan using an asset as collateral. As soon as the appearance is that only certain parties get this treatment, the credibility of the Central Bank is lost IMO.

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  14. More thoughts on this post.

    The whole concept of the CB "making money for the treasury" is a false one to begin with. Not for the reasons I described above but because this assumes the goal of any govt operation is to make money, when clearly its not. The goal is to keep private markets working and humming along and not let little things like mispricing gum things up.

    This is a hard money concept being applied to a soft money system. The govt CB/Treasury is never revenue constrained and doesnt need to "make money" like a private entity does. So in that respect its a nonsensical notion. What CB should say to its critics is not "we made money for the taxpayer", but "we kept the system operating smoothly without rewarding failure". Now of course either claim should be up for examination in a healthy system but its important that we stop talking about govt entities making money or running surpluses. If they are making money they are making it OFF OF the taxpayers. I suggest we absolutely do not want any more of our money transferred out of the private sector than is necessary to retain stable prices and full employment.

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  15. Greg:

    Isnt it true that before it can be agreed that no money was lost (or money was made) we need to be able to see the transactions?

    Yes. But we are now able to see most of the transactions and their settlement. You are writing as if the Fed largely purchased toxic debt in its emergency lending facitilities, rather than using toxic assets as collateral for short-term loans, and that these toxic assets are still sitting on the Fed's balance sheet, and that we won't know whether the Fed made money off of these until it disposes of them. My understanding is that material such as this (e.g. Bear Sterns) constitutes a tiny fraction of the Fed's balance sheet. (I presume you are not talking about MBS purchases, which are high-grade debt, making the Fed lot's of money).

    As soon as the appearance is that only certain parties get this treatment, the credibility of the Central Bank is lost IMO.

    Yes, appearances matter. The Fed understands this. This is why the Fed was eager to unwind the emergency facilities quickly. It is also why the Fed wants to unwind its MBS holdings as quickly as possible. It is not so much the credibility of the Fed that is threatened. What is threatened is its political independence.

    If they are making money they are making it OFF OF the taxpayers.

    I do not think that this is correct.

    First, if the Fed made a loss on its operations, this loss would have to be financed, one way or the other, by taxpayers. So the fact that the Fed did not make a loss means that it did not burden the taxpayer.

    Second, if the Fed made money, from whom did it make it? Well, it made interest income off the emergency loans it made to private agencies (both domestic and foreign). The shareholders of these firms voluntarily paid the Fed for services rendered. I am not sure why you want to call this income flow a "tax." It was a fee for a service.

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  16. Well the fed, being an arm of the govt, can only make a profit (run a surplus?) IF the non govt pays the profit. From where else can it come?

    This is why I think the whole language of fed making a profit is nonsensical. The fed is an arm of the govt meaning it is outside the private sector, anyhting it does to enhance the private sectors position is a vertical transaction. For example, if the fed were to offer to buy all the underwater mortgages and pay full price, this would add nominal value to the balance sheet of whoever held that mortgage. It would also be offset by the same nominal liability on the feds side but the private sector would be in surplus and the govt side would be in deficit... right?
    So if this transaction is called a loan and then payed back, with interest (the profit that is spoken of) the payment of this interest is from the private sector, it must be. Is the fed paying itself a profit?

    I really dont mean to belabor what you might consider a minor point but calling it a fee for a service or a tax is just semantics (I didnt call it a tax but it is functionally the same). The core idea is that money is transferred OUT OF the private sector for this "profit" that is spoken of and the private sector is supposed to be grateful that the govt made a profit?

    Its like the govt running budget surpluses. Who cares? Their surplus comes from us. Dont take it in the first place just let us keep it and stop beating your chest over creating a surplus.

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  17. Greg: I feel like at some point I should let you have the last word on the matter!

    Let me just say that to my way of thinking, a fee for service seems distinct from a tax, in the sense that the former constitutes a voluntary payment (revealing that the contributor is grateful for the service rendered) whereas the latter is a coercive act (revealing that the contributor is not grateful for the "service" rendered).

    If the Fed had screwed up its emergency lending operations, it would have subsidized some and taxed others. So we can agree on this.

    But the Fed did not screw up its emergency lending operations. It faciliated liquidity provision and payments when it was needed. For example, it allowed Harley-Davidson to meet its payroll when HOG was having difficulty in the commercial paper market. The Fed had a feeling that HOG would not default. And it did not. It paid back the loans with interest. A happy HOG. Happy workers. Shareholders who happily paid interest to the Fed. Fed happily remitting this income to the Treasury. Call it what you want, but I'm not sure why you want to call this a tax.

    I'll let you have the last word. Promise! :)

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  18. Sorry, but there's plenty of errors here.

    "The Fed has made a healthy profit on these activities. Last year, it remitted an extra $25 billion to the U.S. Treasury (the U.S. taxpayer)."

    A hedge fund that moves into riskier waters should also return larger profits to its investors. You must risk-adjust your returns. I don't think on a risk adjusted basis the Fed has returned any more than before... after all, many of its loans were and continue to be incredibly dangerous.

    "All the loans due have been paid back with interest."

    No. TALF, Maiden Lane 1, 2, and 3, are still outstanding.

    "This means lending cash at a lower-than-market interest rate on a short-term loan, if the debtor is in a position to put up high-grade collateral. "

    Historically, along the tradition of Walter Bagehot, discount lending was at a penalty rate upon good collateral. Unfortunately that important distinction seems to have been lost by modern economists.

    "It lent them the money on a short term basis and in exchange for high-grade collateral"

    Hello Maiden Lane. You should do more research on the Bear Stearns stuff and the length of the loan. Three years + is not a short term loan.

    "And as the article mentions, when the collateral put up was lower-grade material, the Fed protected itself by applying a large "haircut" (discount) on the collateral."

    Again, check Maiden Lane. There was no haircut on the stuff.

    Anyways, I like a man who stands up for his employer. Loyalty and all ;)

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  19. JP Koning:

    [1] I made no error in asserting that the Fed made a healthy profit from its emergency lending (just as Bagehot would have expected, I imagine).

    [2] You are correct. When I wrote that line, I was aware of this and expected someone to comment. I decided not to get into specifics, because they really don't matter for the basic point I was trying to make. As a practical matter, the outstanding value of these holdings is tiny relative to the size of the Fed's balance sheet.

    [3] The modern economists I speak to at the Fed are well aware of Bagehot's prescription.

    Thanks for pointing this out. Yes, I know it appears that I am standing up for my employer, but I do not view it that way. If people were instead universally and mindlessly praising the Fed, you would see take the other side. In the present case, I don't think that most of the critics know what they're talking about.

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  20. How can you work at a central bank? Central banks belong in eastern europe, not in a free society. It is disgusting and destructive, and would absolutely be better without it. It is so duplicitous, one will admit that price fixing and central planning does not work, but than work at an institution that does just that?

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