The Fed, Primary Dealers, and the Ineffectiveness of Monetary Policy

by Mike Kimel

The Fed, Primary Dealers, and the Ineffectiveness of Monetary Policy

The Federal Reserve’s primary tool for monetary policy is buying or selling securities, in particularly US notes, bills and bonds.

But… it doesn’t buy and sell bonds to you and me. Instead, it deals with primary dealers – the complete list is here. The list includes reputable and scandal-free companies such as Citigroup, Bank of America (actually, it’s subsidiary Merrill Lynch, Pierce, Fenner & Smith Incorporated), Goldman Sachs, and UBS. What does it take to get removed from the list? Well, the most recent change to the list occurred when MF Global was removed on October 31, 2011. By coincidence, that was the day that MF Global declared bankruptcy after making almost $900 million of other people’s money disappear. Bear Stearns came off October 1, 2008, four months after the company imploded and sold itself to JP Morgan. Lehman came off a week after it declared bankruptcy.

Other past luminaries include Countrywide, Drexel Burnham Lambert, Continental Illinois and Salomon Brothers, which makes for an interesting list if you tend to be the kind of person who remembers financial scandals of times past. I have no idea what criteria the Fed uses in picking its primary dealers – clearly controlling massive quantities of financial assets is a requirement, but financial viability and being off the public dole are not.

In fact, being a primary dealer is a way of being on the public dole. When the Fed confers the primary dealer designation, it confers a large, recurring financial gift on the designee. Remember, the Fed won’t engage in securities transactions with the public, just with primary dealers. So if the Fed is planning to sell bonds for $X, and you want to purchase bonds for $X + $Y, the Fed won’t just sell you those bonds. Instead, the Fed sells the bonds to Bank of America, and making the perhaps unreasonable assumption that Bank of America is able to execute without massively screwing something up, the bank then turns around and sells you the bonds, pocketing $Y.

This convoluted and inefficient way of doing business made sense in the 1960s when the scheme was cooked up. Now, its just another infusion of cash from you, me, and the Fed to many of the same institutions that took a good run at taking down the world economy, and which regularly require other infusions of cash to survive. These days we have computers – any halfway decent programmer could set up an auction system for the Fed that wouldn’t require regular transfers from the rest of us to Goldman Sachs and UBS. Heck, I can do it and I’m not a halfway decent programmer.

Of course, if you give it some thought, there is no particular reason the Fed’s way to conduct monetary policy has to involve buying and selling Treasuries. It could just as easily be funding social security benefits, placing money in the bank accounts of each American, flinging it from trebuchets or buying geraniums. Buying and selling securities is an inefficient way to adjust the money supply in this day and age, even if it made sense in 1913 when the Fed was established.

What do I mean when I say that buying and selling Treasuries is an inefficient way to conduct monetary policy? Well, its simple. As noted above, the Fed’s current process is a way to transfer funds from you and me to the primary dealers. By selecting how money is put into and taken out of the system, the Fed selects how monetary policy affects the economy.

The haves are less likely to spend an extra dollar of income than the have nots (in economic parlance, the wealthy have lower marginal propensity to consume than the poor), and when the haves do spend money, they generally don’t do it as quickly as the have nots (in economic-ese, the velocity of money is slower when wealthy people have it).

The reason it matters… during a recession, people and companies become more cautious and reduce their spending. That leads to less stuff being produced, less people working, etc., making the economic downturn worse. By pumping money into the economy, theoretically the Fed makes money cheaper, which in turn leads to more money being spent. That’s the theory, anyway.

But because the Fed’s way of increasing the money supply is designed to place more of it in the hands of the primary dealers, the process often doesn’t work very well even leaving out the fact that periodically, another member of this august group turns out to be corrupt, antisocial or incompetent. The money the Fed has been putting into the economy has not been getting spent. Since it isn’t getting spent, it isn’t doing any good for the economy. Rather, its been accumulated, in large part by the very same sectors of the economy that played so big a role in causing the crash. I believe that’s what Lloyd Blankfein was talking about when he said he was doing God’s work.

It is long past time to change the way the Fed operates.