Walter Bagehot Explains to the Fed What They Should Have Done on Thursday
The day before yesterday, the Fed made a somewhat unusual announcement of $500,000,000,000 of REPO offers a day for three days in a row. The idea was to let banks unload risky assets before they panicked nipping a financial crisis in the bud.
This move was controversial. Unfortunately many critics act as if the Fed was giving away $ 1,500,000,000,000 rather than buying assets with it. I hazard a guess that the Fed will profit from the operation (their efforts to save the financial system in 2009 generated the largest profits recorded in human history as an unintended side effect). However, it is also clear that the transaction amounts to a subsidy to banks. The Fed will pay a higher price than would have cleared the market. $ 1.5 Trillion will do that. Back in 2009 the Fed bought mortgage backed securities at the market rate when they were the only buyer in the market. This means that the open market operation was a massive subsidy (which also generated record profits).
The fact that the Fed pays much more than the market would without their intervention is pleasant for banks. Driving up the price of risky assets is part of the point of the operation. However it is also very irritating.
Fortunately someone figured out what they should have done. Walter Bagehot explained it clearly in 1873. The idea is that the central bank should lend freely accepting as collateral assets which would be accepted by private agents in normal times but not during the crisis. But Bagehot did not advise lending at the rate which prevailed before the crisis. Rather the maxim is lend freely at a penalty rate
First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who did not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.
Another way of putting it is that the Fed should buy risky assets at a price markedly lower than the pre.crisis price and contract to sell them back to banks at normal prices after the crisis is expected to be over. This is the REPO is the same as a collateralized loan irritating finance terminology issue (also there is no O in repurchase so why the hell is it called a REPO).
Another way of putting it is that we don’t want solvent firms to go bankrupt and be liquidated. In plain English this means if one can save a firm with a loan, then one should. The idea is that the firm should still exist when the crisis is over. In other words, the shares of the firm will still have positive value and won’t be worthless pieces of paper.
Bagehot’s point is that we also want that positive value to be low. Firms (which must be depositary institutions according to the Federal Reserve Act) should still exist even if they have to borrow from the lender of last resort. But to make sure it is the lender of very last resort, they shouldn’t be worth much.
Any value of a firm which needed the lender of last resort is basically a gift to owners who messed up and a moral hazard.
To combine this with the need for equity capital, it is possible to TARP, that is make the penalty rate loan junior to other debt as preferred shares not bonds.
Another point is that sometimes obtaining annual profits of only $97,700,000,000 is not satisfactory performance.
The main point is that if the Fed can make $97,700,000,000 while also granting a massive subsidy, then the previous arrangement was not efficient. The problem is that entities with deep but not infinitely deep pockets can’t always bear risk. The solution is for the government to be the residual claimant. That’s called socialism and the market says it works.
Are you saying that the contractual term compelling banks to buy back their traded in securities at the market price then, that this term does not exist?
So all subsidy and also a transfer of all the risk to the Fed; that is, to the public.
Remarkable. A glib word or one conveyed in astonishment.
We need civil and ‘market’ order, and this is based on trust, which itself is based on what?
I know the answer. We are not a kingship. We govern ourselves and we are a free society, as this term was understood at the time the Constitution was framed, or framed the institutional coordinate departments of public governance.
This all, of course, has nothing to do with this modern term we now throw about and name ‘capitalism’ — seems clear to me we need to govern all of these financial asset arenas much better.
We govern ourselves. We can not be the problem.
Unless we have been misled to see self government as ‘the problem.’
Anne Lowery at the Atlantic has a reasonable explanation article up on what the Fed is doing. The Fed Did Not Just ‘Spend’ $1.5 Trillion She claims “Despite criticism from the left, there’s a strong progressive case for the Fed’s actions.”
Anne has a different take on the “buy and the sell back” plan than what Robert is proposing if I read him correctly. She sees no problem in loaning the financial firms money with their assets as collateral at full value to which they pay a “small amount of interest (her words)”. They buy it back at the full value price. Robert (Bagehot’s suggestion) is suggesting the Fed should discount the value of the financial firm assets first, loan money against the discounted value, the firms pay full value of the asset upon redemption, and they pay a small amount of interest (my thought on the latter). It appears to be a liquidity issue.
I like Robert’s thoughts.
The complaints from Progressives are about student loans and Medicare for All which has some merit. In the former, we are burdening a couple of generations with debt for which many will carry into retirement and the debt will diminish productivity of the cohorts. If we had Med4All, we would have in place the ability to control costs which are creating higher pricing due to rent taking by firms. Again it limits productivity in other areas. I digress here.
The Fed is irrelevant. They don’t create money and never have.
Banks do create credit and if the asset markets they support stay in order, ok. But current signs are that these markets are perturbed, this unfettered credit creating and using network of parties and counter parties are in disorder, hence the need for someone to make all their positions forebearable by offering money in trade for an asset less desirable in these networks at this time (for whatever reasons).
The Fed creates money too, notwithstanding the intentionally misleading note by the commenter just above.
The Fed pumps out reserves/money via key strokes in order to make its side of the repo, of increasing sizable magnitude. This reflects credit creation and financial asset markets that are precarious, situations not created by the Fed. And it is good they are around to mitigate.
But we need to bring some open eyes here, the magnitudes are remarkable and both the credit creation and money creation tied to it, dwarf fiscal affairs in terms of interventions needed by the economy. This is not right. To be plain, bank bureaucrats and Fed bureaucrats have credit and money creation powers, but not the Congress, and isn’t that really a question.
We need to govern better here.
Nope, your wrong. The Fed creates no money. “Attempt to regulate”, yes, create, no.
“…(also there is no O in repurchase so why the hell is it called a REPO)…”
“…We govern ourselves. We can not be the problem.
Unless we have been misled to see self government as ‘the problem.’”
[We allow ourselves to be governed by political elites that are sponsored by economic elites in a publicly sanctioned “beauty contests.” That we somehow construe this to be self-government is just a giant brain-fart borne of false advertising. All systems of republicanism thus far have been elitist rather than representative democracy because these systems were all architected by elites very mindful of their own self-interests.]
“…It appears to be a liquidity issue. …”
[Totally, for whatever that is worth.]
“The Fed is irrelevant. They don’t create money and never have.”
[No, FDIC insures deposits and the Fed insures bank liquidity. Yes, double entry bookkeeping creates money with the assistance of credit worthy borrowers. The Fed helps take some of the worry out of worthy, but it could do more if Congress asked it to.]
“…The Fed pumps out reserves/money via key strokes in order to make its side of the repo, of increasing sizable magnitude…”
[Well, maybe. I don’t have time to unravel the intricacies of Fed repurchase and reverse repurchase operations stocks and flows. In any case, the monetary base is the total of all physical currency plus Federal Reserve Deposits (special deposits that only banks can have at the Fed). MB = Coins + US Notes + Federal Reserve Notes + Federal Reserve Deposits, but reserves are not included in m0, m1, m2, or m3 money supply.