Sunday, July 27, 2014

Bair and Reserves for All

I think the Fed's new Overnight Reverse Repurchase Facility is great. Sheila Bair, in the Wall Street Journal, thinks it's awful.

I think it will enhance the stability of the financial system. She thinks it will lead to instability. Well, at least we agree on the important issue.

What is it? Banks can have accounts at the Fed, called "reserves," and these accounts pay interest. In essence, the new program allows other financial institutions, that aren't legally "banks," to also have interest-paying accounts at the Fed. The program involves repurchase agreements, which is a bit silly -- who needs collateral from the Fed? -- but really think of it just as interest-paying bank accounts at the Fed.

I like the Fed's big balance sheet and interest-paying reserves, and I like opening up interest-paying reserves to everyone. I regard this as the first step to putting run-prone short-term financing out of business, by giving depositors a safe alternative. The Federal Government drove run-prone private banknotes out of business in the 19th century. Interest-paying reserves and Treasury floaters can drive run-prone interest-paying money out of business in the 21st. (This is the theme of "Toward a run-free financial system")  Interest-paying money is not inflationary.

Bair does not like it. She is a voice worth hearing.
The mere existence of this facility could exacerbate liquidity runs during times of market stress. ... Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers. 
...Banks could confront a sudden outflow of deposits, particularly those which are uninsured. Even the U.S. Treasury—traditionally viewed as the safest harbor—could see its borrowing costs spike as investors decide that the Fed is even safer.
Ok, a crisis is defined exactly as a time in which investors want to take money out of private short-term debt and hold money -- now reserves. The Fed facility allows them to do that. But, without the Fed facility they can do it the old fashioned way -- put it in banks (preferably, for the investor, too big to fail banks), and the banks then use the money to buy reserves.

In fact, in the crisis, banks had a sudden inflow of deposits for exactly this reason, and contrary to Ms. Bair's prediction. The Fed's new program just takes the bankruptcy-prone intermediary out of that operation. And desirably so in my view.

And she forgets that in the end even reserves are backed by Treasuries. Reserves are Fed liabilities. The corresponding assets are ... Treasuries. (Well, and MBS, but let's not get too complicated here.) If money on net flows in to the Fed, either as reserves or through this new program, the Fed must go off and buy Treasuries. If the Fed does not, the quantity of reserves must decline dollar for dollar with expansion of this new program.

She mentions deposit insurance which is interesting. There is a limit to this business of putting money in to banks who put it in to reserves, giving perfectly safe interest-paying money, and that is deposit insurance. Overnight repo developed in may ways to provide a safer version of "deposits" in quantities larger than deposit insurance allows. And lending to the Fed directly allows for money to flow in to Treasuries without (unneeded in this case) deposit insurance limits too.

But so would holding a money market fund entirely invested in short term Treasuries. Large institutions can also just buy Treasuries directly. Which is exactly what they did in the crisis, driving up prices and down rates -- exactly the opposite of Ms. Bair's prediction.

A flight to quality is a flight to Treasury debt, directly, intermediated by the Fed, or intermediated by the Fed and then by banks.

Treasuries -> Fed -> Banks -> Deposits -> Investor

Treasuries -> Fed -> Investor

Treasuries -> Investor

It's just a question of how many intermediaries are in the way.

Now, Ms. Bair has a more interesting point. By providing an elastic supply of Treasury debt, including cash, intermediated or not, the Government facilitates the "flight to quality." She is advocating that the government stop doing it -- deliberately introduce financial frictions so that investors must hold the private short-term debt that they no longer want.

In that, she is advocating  a radical new approach to financial crises. Since about the mid 1800s in the UK and since the founding of the Federal Reserve in the US, our approach to financial crises has been to drown the system in money.  Bagehot's "lend freely" means exactly what Ms. Bair is decrying, allow investors to hold a vastly expanded amount of government liabilities -- money, reserves or treasuries -- and the government (mostly Fed, but Treasury too) in turn buys their assets or supplies the short term lending they no longer want to do.
Ironically, faced with a more acute liquidity crisis, the Fed would likely have to use the funds it is borrowing through reverse repos to provide a lifeline to the very markets that suffered. For investors seeking safety, the Fed would become the borrower of first resort. For borrowers affected by the resulting diversion of funding, the Fed would become the backstop lender. 
Yes! Exactly as Bagehot, Friedman, and Bernanke said to do!

If you force people to hold something they don't want, then prices, not quantities adjust. As in the crisis, government interest rates hit zero (prices shot up as far as they could) and private rates shoot up (prices collapsed).  A massive demand for money (government short term debt), if not accommodated, leads to deflation. Like in the Great Depression.

Let prices adjust you may say, and perhaps everyone from Milton Friedman to Ben Bernanke who says otherwise is wrong to flood the market with government debt and try to stabilize prices and interest rates. I'm not arguing yes or no here, but recognize the plan for its far-reaching audacity.
The reverse repurchase facility also seems to be at cross-purposes with Congress's efforts to contain the government safety net. After many years of consideration, Congress in 2008 reluctantly gave the Fed authority to pay banks interest on the money they keep on deposit with it. The reverse repurchase facility essentially gives large nonbank financial institutions the routine ability to place money in the functional equivalent of an overnight deposit with the Fed and receive interest. 
Exactly! But this is not a "safety net." In the 1800s Congress also allowed non-banks to hold Federal Reserve Notes, the same thing but that does not pay interest, rather than hold notes issued by banks. The world did not end. We're just doing the same thing with interest-paying money.
Finally, the reverse repurchase facility seems to be at cross-purposes with the Fed's own efforts to address systemic risks emanating from money-market funds, which were subject to disruptive runs after Lehman Brothers collapsed in September 2008. Market pressure should be causing this unstable sector of the financial system to shrink, particularly in today's near-zero interest-rate environment. But by giving money funds a de facto insurance program, the Fed has thrown them a lifeline.
Here Ms. Bair is making another fundamental mistake in my view. Money market funds that hold government debt are completely safe and run-proof. What failed in 2008 were "prime" money market funds that held short term debt issued by risky banks and other financial institutions. Those institutions could not suddenly switch to holding interest-paying reserves, because they'd have to sell all their worthless paper first. The Fed (and SEC) should be loudly encouraging money market funds that hold Treasuries. Because those institutions are exactly the same thing as the Fed's new program!


  1. The Federal Reserve System is carrying 4.4 T$ of assest on a capital account of 56 G$. That is a asset capital ratio of 78::1. If the Federal Reserve were a bank regulated by the Federal Reserve, the Federal Reserve would put it into receivership for being severely under-capitalized.

  2. The comparison of Bair with Bagehot is very helpful and illuminating. I think that the system is much more unstable than necessary because there are competing, slightly-differentiated providers of short-term dollar deposits, and small events can trigger a massive shift between them. Dollar deposits really should be handled as you advocate here and in other posts on floating rate treasuries. They should be backed by risk-free government debt, not by the lending activity of banks and prime MMFs.

    Bair worries about liquidity runs. I agree that deliberately introducing frictions is not a solution. I would rather *remove* frictions, by reforming the liabilities of private institutions so that they remain liquid in times of market stress - thereby preventing liquidity runs.

  3. John,

    "Banks can have accounts at the Fed, called reserves, and these accounts pay interest. In essence, the new program allows other financial institutions, that aren't legally banks, to also have interest-paying accounts at the Fed."

    How is this any different than Congress extending unemployment benefits to 5 years, 10 years, 30 years? You pay people to not work and you pay banks / individuals not to lend.

    "I like the Fed's big balance sheet and interest-paying reserves, and I like opening up interest-paying reserves to everyone. I regard this as the first step to putting run-prone short-term financing out of business, by giving depositors a safe alternative."

    If depositors want a "safe" alternative, there is the mattress or a home safe. You seem to want depositors to have a safe rate of return - all reward, no risk. The way you put run-prone short term financing out of business is by making long term financing less expensive than short term financing, not by eliminating the need for either.

    Sorry, this idea is just more of the same B. S. coming out of Washington - all bailouts, all of the time.

    1. I've always viewed interest on reserves as a backdoor bailout. Imagine telling the American people "We're going to charge every man, woman and child X dollars per year to bail out the banks". Instead, you just pay interest on reserves instead of sending the money to the Treasury. How many people understand what's being done to them?

      The ON RRP is already showing cracks, and I'll bet the cracks run even deeper in the shadow banking sector. It adds another layer of complexity and vulnerability to unintended consequences. It's almost biblical in nature and scope: the dot-com collapse begat policies that caused a housing bubble that burst, which begat a liquidity crisis, which begat QE, which begat a collateral shortage, which begat reverse repo. As Gollum might say, Please stop the stupid - it burns us!

      Money under the mattress underperforms a deposit account by a trifling amount, and is completely immune to failures and bail-ins. It's actually not too bad of a deal right now.

  4. Frank,

    The existence of interest paying reserves does not make much difference because there’s a totally safe way of getting interest anyway: government debt. But that’s not to say I approve of interest on reserves. The Fed only started paying interest on reserves in 2008. It should never have done so in my view. Come to that, I don’t even agree with governments incurring debt. Milton Friedman advocated a “zero debt” regime. And the real REAL REASON governments incurr debt was clearly set out by David Hume 200 years ago: it enables politicians to ingratiate themselves with voters.

    Re the rest of your comment, citizens shouldn’t have to store dollar bills under matresses: we’re living in an era where 99% of money transactions are done electronically, thus I agree with John: the state should provide an “electronic matress” for everyone. As to interest, as I said above, I agree with you: there’s no good reason to pay interest.

    1. The state would like nothing more than to be able to track every penny you have and where you spend it for several reasons, none of them healthy.

      I must disagree with Mr. Hume. Governments also incur debt to wage war. Historically thats probably the #1 reason for government borrowing and some bankers, like the Rothchilds, became very wealthy lending to both sides. The Viet Nam war was one of the reasons Nixon had to violate Bretton Woods. Actually it was the last straw; Triffin pointed out the flaw in the late 50s, and the London Gold Pool was the first admission that something was seriously amiss. DeGaulle pulled France out of the Gold Pool because of Viet Nam war spending and eventually we had the Nixon Shock, which was really just admitting the emperor had no clothes.

      Getting back on topic, I see the progression of increasingly unorthodox interventions (TARP, mark to make believe, QE, and now reverse repo) as being a similar progression of events as the rich and powerful desperstely cling to a doomed status quo. And like a drowning man they will not hesitate to take someone else down with them. In some cases, such as mark to make believe, they are borrowing from the Peso Crisis playbook except the deceit has been allowed to go on much longer.

      This is all just putting Band-Aids on a brain tumor.

    2. Ralph,

      "The existence of interest paying reserves does not make much difference because there’s a totally safe way of getting interest anyway: government debt."

      My question was, why should there be a totally safe way of getting interest - like a totally safe way to get a paycheck (unemployment insurance)?

    3. Frank,

      I agree with you! I don't see the justification for a totally safe way of getting interest. Milton Friedman and Warren Mosler thought/think the same. I.e. they argued that the state should only issue zero interest yielding liabilities. I.e. they argued that the US government should issue dollars in the quantity needed to bring full employment, but not not interest yielding debt.

    4. Ralph,

      And here is where I disagree with you. I believe that the U. S. government should be permitted to sell a liability with a rate of return. I just don't believe that this rate of return should be guaranteed.

      Issuing a quantity of dollars may bring about full employment at the expense of higher inflation. Selling government liabilities with a non-guaranteed rate of return that exceeds the real private cost of financing gets you to full employment without inflation.

    5. Ralph,

      I agree that the U. S. government should be precluded from selling securities that offer a guaranteed rate of return (bonds). I disagree that the U. S. government should try to control both inflation and employment with a single tool (monetary aggregate).

      My own preference is that monetary policy (setting of interest rate) is separated from fiscal policy entirely. The only way to achieve that level of co-indepence is to preclude government from issuing bonds.

      A government could still sell securities that offer a rate of return, but that rate of return should not be guaranteed.

    6. Frank,

      Re your “non-guaranteed rate of return bonds”, any government would have problems selling those, wouldn’t it? Would you like to lend me $10,000 with no guarantees from me as to what interest you’ll get?

      Next, when I said “US government should issue dollars in the quantity needed to bring full employment..” I meant “full employment” in the NAIRU sense: that’s the maximum feasible level of employment consistent with acceptable inflation (2% or whatever).

      Re your last sentence, I’m baffled as to how having government issue bonds that pay above the free market rate of interest improves the inflation / unemployment trade off.

    7. Ralph,

      "Re your non-guaranteed rate of return bonds, any government would have problems selling those, wouldn’t it?"

      Is the rate of return on private stocks / equity guaranteed? And yet people are buying them in droves. Government would have problems selling them if they were priced too expensively.

      "Re your last sentence, I’m baffled as to how having government issue bonds that pay above the free market rate of interest improves the inflation / unemployment trade off."

      Because they would not be government bonds, they would be government equity.

      The only distinction between bonds and equity is the additional legal protections that are afforded bond holders. In the case of government debt, bond holders get first dibs on tax revenue that a government collects.

      Suppose instead government sells a security where the rate of return can only be realized against a tax liability - hence nonguaranteed. This would be "interest paying" currency (similar to what the Fed is trying to do with interest on reserves), but that "interest" could not be used to directly fund expenditures - hence it would have no immediate effect on the demand for goods / services.

      "Re your last sentence, I’m baffled as to how having government issue bonds that pay above the free market rate of interest improves the inflation / unemployment trade off."

      Because with government equity that has a potential rate of return equal to or higher than the real interest rate, you overcome the zero bound on nominal interest rates. Meaning you can have deflation (high real interest rates even at the zero bound) without the corresponding credit defaults.

    8. Ralph,

      The statement "the free market rate of interest" in terms of government debt rests on a fallacy. First, a government is under no obligation to sell marketable securities. Indeed, all of the government debt held by Social Security is of the nonmarketable variety.

      Also, the government could just as easily set the rate of return on its securities and let the market set the duration.

      Treasury Department: We have 7% securities for sale, now accepting bids
      Bidder #1: I bid 15 years
      Bidder #2: I bid 26 years
      Bidder #3: I bid 50 years
      Treasury Department: Bidder #3's offer has been accepted

      In this instance, the rate of return is set by the government, the duration is set by the market.

  5. Bill Woolsey likes to point out that if the public were not allowed to hold FRNs, then there would have been no impediment to interest rates on safe assets going below 0%.

    So there is something to be said for a Fed that does less, rather than more.

  6. Jeffrey Rogers HummelJuly 28, 2014 at 3:04 PM

    "In the 1800s Congress also allowed non-banks to hold Federal Reserve Notes"? The Fed didn't begin operation until 1914. Did you mean 1900s, or where you referring to Greenbacks and other Treasury currency?

    1. I think John means "central bank" currency in this case - not federal reserve notes. Prior to the Fed being established in 1913, the U. S. had a central bank on two occasions:

    2. Jeffrey Rogers HummelJuly 28, 2014 at 4:31 PM

      Yes, but neither the First or Second Bank replaced private bank notes that were run-prone. Indeed, the Second Bank faced a run of its own in the Panic of 1819. Only as a result of the Civil War were state bank notes taxed out of existence and the notes of nationally chartered banks given a full government guarantee. The Fed was designed to phase out national bank notes, but that wasn't completed until the Great Depression.

  7. Canada had lots of independent banks issuing notes with no central bank, and their system was still more stable than ours with the Fed.

  8. John's criticisms would all be spot on if reverse repo worked the way she claims it does.

    But actually, reverse repo doesn't give non-banks the ability to park their money at will at the Fed. Reverse repo is issued in very limited quantities. There's nothing whatsoever in any Fed minutes or any governor's or any regional president's comments to date that would indicate any intention to ever make reverse repo available in unlimited volumes on demand.

    Sheila is warning about a danger that doesn't exist, and John is celebrating progress that hasn't happened. They're both assuming that reverse repo would be issued in huge volumes in a crisis, but there's no indication whatsoever of any such plan.

    The actual reason for reverse repo, which John dismisses as "silly", is to boost liquidity in shorter-dated Treasurys by lending out the Fed's supply of bonds that are approaching maturity. The collateral is the whole point.

    1. Tom: can you point to a speech or other document outlining this as the purpose of the reverse repo program? I read it as suspicion that banks will not pass on interest on reserves, and so a way to enforce tightening, when the time comes, in a less and less competitive big-banking system. If this liquidity bit is the primary motivation, I'd like to have some sources.

    2. Tend to agree here. The Fed's concern, the market's concern, about a mushrooming Fed balance sheet feels long forgotten. The value of this balance sheet seems to have dawned on all parties, and its much more than its ability to make Treasuries more liquid. With RRP, ON RRP and a essentially bottomless balance sheet, the can set the rate, the can set the speed they want to get there and they can rein it in just as fast. Its a rudder quite unlike anything they have had before. Begs the questions:
      1) What gives them the right to set the market? Is this a good thing.
      2) How is this power anything but irresistible to the Fed?

      Of less urgency but curious:
      3)What does the future hold for primary dealers?

  9. Fair point. The ultimate purpose of reverse repo is indeed to put a floor under short rates when it comes time to raise rates. They're obviously not yet serving that purpose, though. At present they're supplying Treasurys. My understanding is that banks are actually the main users. Either way they're not planning unlimited reverse repos, which should be clear from the minutes.

    1. Yes, for now they want to limit the quantity as they want to limit the quantity of reserves. When they try to control both a price (interest rate) and a quantity at the same time, we'll see what happens.

  10. I'm glad to see someone else also proposing that the Fed start allowing direct deposits. It's time we got the welfare babies out of the government trough. The Fed needs a retail window to take deposits and make loans. That would allow individuals of modest means to stash their money and small businesses to obtain credit, two functions that our financial sector can no longer handle.

    Let's hear more about: Treasuries -> Investor

  11. The Overnight Reverse Repurchase Facility is a bold move. It seems to me that TBTF became irrelevant, why use them anyway? This will effectively make the system totally government run, without some large banks pretending to be some private venture ... let's abolish commercial banks altogether!! Just like Cochrane, "I'm not arguing yes or no here, but recognize the plan for its far-reaching audacity".

  12. The problem, and why RRP can't be full allotment (though it was initially conceived as such) is because of the corridor - this is the point that Blair misses spectacularly and Cochrane nearly hits - you can't issue liabilities to a sector against which you can not discount liabilities. In a crisis, if the non-bank sector puts all its cash to the fed in the RRP program, you rely on the banking sector to buy the assets and then put them to the discount window to balance the balance sheets...that would entail massive frictions and that's why the program can't be full allotment.

    And yes, Cochrane is correct, the purpose of the facility is to impose a hard floor on all market rates, where the ROR has proven to be soft because of the GSEs and FDIC fee. The supply of collateral comes through the SOMA sec lending program. In normal times, RRP and ROR is just shifting the liability structure of the Fed, not "supplying" collateral to meet some unsatiated demand.


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