The Fed admits it’s a failure

In a recent speech, Fed chair Jerome Powell talked about “balance sheet normalization” in terms that strike me as essentially admitting that the Fed is a failure as a central bank.

Here’s the quote:

The crisis revealed that banks, especially the largest and most complex, faced much more liquidity risk than had previously been thought. Because of both new liquidity regulations and improved management, banks now hold much higher levels of high-quality liquid assets than before the crisis. Many banks choose to hold reserves as an important part of their strong liquidity positions.

Source: Federal Reserve Board – Monetary Policy: Normalization and the Road Ahead

Powell seems to be suggesting that banks have chosen to treat reserves in the same way a gold-standard bank treated specie: as cash on hand to meet demands from depositors who want their money back.

I call this a failure because a big part of the reason behind the creation of the Federal Reserve was that this system—where every bank held some gold—was clearly inadequate. Commentators at the time likened it to a fire protection district which, instead of having a fire engine, required every household to have one bucket of water on hand.

By having a large common stockpile of gold at the Federal Reserve, a loss of confidence in any one bank could be easily handled. Faced with a bank run, a solvent but illiquid bank would bring some assets (loans, bonds, bills, etc.) to the discount window and receive enough gold to handle redemption requests.

Powell is saying that banks seem to have decided that they can’t count on the Fed to discount their illiquid assets—a basic function of a central bank. Instead they’re choosing to stockpile large quantities of reserves exactly the way nervous banks stockpiled gold reserves in the pre-Fed days.

I’m sure this is based on the experience of the financial crisis, where many banks held a bare minimum of reserves and safe assets, choosing instead to invest the maximum amount in complex derivative instruments, which were highly profitable until they suddenly became worthless (or at least of dubious value).

But that just means that this is a double failure by the Fed:

  1. As a lender of last resort it can’t be counted on to provide reserves to a solvent but illiquid bank.
  2. As a regulator it can’t be counted on to require that the banks hold enough high-quality assets with sufficiently transparent valuations to be usable at the discount window.

By paying interest on these reserves, the Fed is enabling this behavior—solving the old problem that “gold in the vault pays no return.” But banks should be in the business of facilitating commerce in the economy, not the business of using their depositor’s money to score some free cash from the Fed.

I completely understand the Fed not wanting to again put itself in the position of having to decide what discount rate is the right one to apply to 3rd tranche mortgage-backed subprime paper. But a strategy of “just hold more reserves” is a pretty poor solution to the problem, for exactly the same reason that “just hold more gold” was a poor solution in the pre-Fed days.

The Federal Reserve and the “gig” economy

The “gig” economy: all the sorts of work arrangements where you’re not a permanent employee and can’t expect that work one day implies that you’ll have work the next day—freelancing, contracting, temp work, casual labor, and most recently, software-mediated contract work like Uber driver.

These sorts of work have been growing as a fraction of all work. In fact, according to the Bureau of Labor Statistics, in the last ten years contingent workers have gone from being 10% of the workforce to being 16%. In fact,

all of the net growth in aggregate employment in the decade leading up to 2015 can be accounted for by contingent work arrangements, which means there has been no net employment growth in traditional work arrangements.

Source: FRB: Brainard, The “Gig” Economy: Implications of the Growth of Contingent Work

This matters to everyone with an interest in the U.S. economy, but it matters particularly to the Federal Reserve, which is charged by Congress to:

promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.

Source: The Federal Reserve’s Dual Mandate

So this raises the question: Does strong growth in the number of freelancers, on-call temps, and Uber drivers mean that we’re getting closer to maximum employment? Or, that we’re getting further away?

New expectation on the debt ceiling

During the debt ceiling crisis back in 2011, I suggested that it would be no big deal if the government just “prioritized” spending so as to match revenues for however long it took Congress to get its act together and raise the debt ceiling. I got some push back on this by people who said I was crazy if I thought that much spending would suffice, but I never thought it would suffice—I was just sure that the result would be so onerous that Congress would knuckle under in no time. I figured that was what the Treasury secretly had in mind.

I’ve changed my mind.

It would have gone like this: The laws are contradictory—Congress sets the tax rates, Congress sets the spending levels, Congress sets the debt ceiling. The poor Treasury, simply doing the best it could in a no-win situation, would hold up pretty much all payments except interest on the debt, judges pay, soldiers pay, and social security. Once payments to major corporations in districts where recalcitrant Congressmen lived got held up, the stalemate would have ended pretty quickly.

I no longer think that’s what’s going to happen. Basically, I’ve come around the view that the Treasury meant what it said when it claimed that its hand were tied: It is legally required to spend the money the Congress has appropriated, whether the money is raised or not.

And I think there’s a solution.

Really, it’s the same solution as the “platinum coin” solution or the “issue scrip” solution, but those solutions are just gimmicks to put a pseudo-legalistic shine on what basically amounts to paying our bills by printing money.

I don’t think there’s any need for the gimmick. I think what the Treasury means to do once the headroom for keeping under the debt ceiling runs out is: Nothing. They’ll just go on writing checks exactly as they’ve been doing.

They’ll stop issuing new debt of course, so there’ll be no new money in their account at the Federal Reserve to pay the checks.

At which point, I’m reasonably sure, the Federal Reserve will just pay the checks anyway—which the Fed can easily do by just crediting the depositing bank’s account. (In other words, printing the money.)

Basically, the Fed would let the Treasury run an unlimited overdraft.

This works on several levels.

First of all, it doesn’t require any reprogramming or rejiggering of the Treasury’s numerous systems for making all the many payments they make every day. (No entity makes more payments than the US Treasury.) That’s good, because any attempt to do so would be problematic at best, and probably catastrophic in the short term.

Second, the people who are being most recalcitrant about raising the debt ceiling are the ones who would be most outraged. (I can just see them frothing at the mouth. Oh noes! Inflation!!1!)

Third, under the current circumstances, it would probably be good for the economy. I’ve pretty much come around to Paul Krugman’s analysis that at the zero bound there is no inflation risk to printing money. Even better, if it did produce some inflation, that might get us up off the zero bound. (I for one would be very pleased to be able to earn a return on my capital.)

A generation ago the Fed would have hated this—bankers used to hate overdrafts in the deepest depths of their bowels. But overdrafts have been so profitable for banks these past 20 years or so, I expect we have a whole generation of bankers who have gotten over it.

As to whether it’s really legal or not, that’s something for the courts to decide. The debt ceiling applies to debt “subject to the limit.” The Fed and the Treasury will just say that, while an overdraft is debt, it’s not debt “subject to the limit.” The debt ceiling will be resolved long before any court case plays out.

The Treasury never admitted to having any contingency plans last time. Their take on it was that not raising the debt ceiling was unthinkable, therefore they would not think about it. But this is the only thing I can think of that could actually play out without chaos. If they weren’t planning on doing this (or something much like it), they’d have done something by now (such as having a dry run of their scheme for prioritizing payments).

Last time, I figured we’d get an 11th hour deal. This time, I think it’s pretty likely that the debt ceiling won’t get raised, and I think the Treasury will actually end up doing this—so I thought I’d share my thinking in case people find it useful.