Thursday, June 15, 2017

The Treasury Portfolio

Charlie Plosser makes the case that the Federal Reserve should hold only Treasuries in its asset portfolio, at Hoover's "Defining Ideas"

Background: The Fed is essentially a giant money-market fund. Its liabilities are cash and bank reserves. Its assets are .. well, they used to be entirely short term Treasury securities, but now include mortgage-backed securities. In the crisis, the Fed bought a lot of other securities. Other central banks buy stocks, and it's pretty clear if there were a recession tomorrow, after interest rates hit zero the next day, the Fed would go on a buying binge. The Fed is a government agency, but it is "independent," enjoying a lot of freedom to do what it wants no matter what Congress or the Administration want it to do.

Plosser's proposal,
 1.        The Federal Reserve should be required to maintain a Treasuries-only policy as it pertains to the conduct of monetary policy. 
2.         The Federal Reserve should be prohibited from purchasing non-Treasury securities, private sector securities or lending against private collateral except through traditional discount window operations with depository institutions. 
3.         Emergency lending under Section 13(3) of the FRA should be eliminated and replaced with a new Fed-Treasury accord...

The Fed may buy other securities, but basically has to swap them back to the Treasury or sell them within 60 days. If the government is going to subsidize credit to various industries, voters, and constituencies, then the politically accountable Treasury should do it, not the independent Federal Reserve. Charlie allows here that the Fed may be able to move faster in a crisis.

Why only Treasuries? Why should the Fed not always have greater power to guide the economy more forcefully by buying whatever assets it thinks need propping up? Because, a democracy, independence must come with limitations on the central bank’s authorities and discretionary powers. Otherwise, central bankers can use their powers to venture into policy realms unrelated to monetary policy, especially fiscal policy, which more appropriately rests with elected officials. ...Engaging in such actions also undermines the central bank’s legitimacy and the case for independence
A central bank that hands out money to voters, or denies such money when it wants to prick bubbles, cannot stay independent for long. That central bank then becomes a piggy bank for legislators and presidents.
More troubling was the lending under Section 13(3) of the Federal Reserve Act (FRA), which included support of the creditors of Bear Stearns and AIG. The Fed also funded other lending programs designed to support the purchase of commercial paper and other types of asset-backed securities.... Regardless of the rationale, the Fed sold Treasury securities from its portfolio and used the proceeds to purchase risky private sector securities. These actions amounted to debt-financed fiscal policy but without the explicit authorization of Congress. Given the distributional effects of such interventions, it is not surprising they proved controversial.
...The discretion to engage in credit allocation represents an open invitation to politicians and interest groups to pressure the central bank to use its authority to manage its assets to further some other agenda. Maybe the Fed should invest in green energy companies, in domestic manufacturers who pledge not to ship jobs overseas, or infrastructure bonds issued by state or municipal authorities. This may seem far-fetched, but Congress asked the Fed to invest in the automobile companies in 2008. After all, it had already supported Bear Stearns and AIG, and weren’t the big four auto companies as important to the economy and employment as these financial firms? Fortunately, the Fed said no, but the discretionary authority to engage in credit allocation could prove to be a threat to Fed independence. 
My first reaction, a few years ago when I started talking to Charlie about these things was, this is a tempest in a tea pot. The Fed and Treasury have one consolidated budget constraint. If the Fed loses money, it comes out of the Treasury eventually. This is like arguing whether you should pay restaurant bills from the cash in your left pocket or the cash in your right pocket.

Both Charlie and quite a few conversations inside the beltway convince me this is wrong. The average legislator does not see things this way at all, the Fed balance sheet really does look like a piggy bank.

Charlie cuts the gordian knot cleverly, I think. The Fed does move faster in a crisis. But buying securities is not the same as holding securities.

Actually, I would think the Fed would want such a deal. Right now, as I understand the legalities, the Fed is not allowed to swap securities with the Treasury. This is one of the brilliant legal constraints our ancestors put in against inflationary finance. They didn't want the Treasury to force the Fed to buy securities at inflated prices. But for the Fed, the ability to buy what it wants but not have to hold the risks, or political fallout, forever should be very attractive.

If there is a contrary view, I think it must be that there really is nothing left to monetary policy. Now that reserves pay interest, all Charlie's Fed will do is to act as a giant Treasuries only money market fund, to undo the curiosity that the Treasury itself cannot figure out how to issue true floating-rate debt directly, and to figure out what rate to offer.

Take the view then, that the Fed's central role is to interfere with -- sorry, to "supervise," "regulate" and "stabilize" -- financial markets, perhaps in crises only, or perhaps because you view markets as inherently unstable and behavioral and the Fed somehow able to offer super-rational financial dirigisme. If the independent Fed is going to be running "macro prudential" policy and scrutinizing banks credit policies, telling banks who to lend to, then it might as well interfere directly in the same markets, and even start buying and selling stocks to offset "herd" mentality in markets or whatever. Charlie doesn't talk about it, but the Fed's regulatory arm is already allocating credit.

This is, I think, where we are and are heading. But I think Charlie's point applies. This Fed as Great Financial Director cannot, in a democracy, stay as independent as has evolved for a Fed whose power is limited to old-fashioned monetary policy implemented by buying Treasury securities and managing a vanishing stock of money. And while it's fun for economists to write papers about just how rational we are and if someone put one of us in charge we could spot those bubbles and herds, I think we all agree politicians, handed another set of excuses to start handing out credit here and there, are not going to do a great job of it.

The tension remains. If the Fed is going to be deeply involved in directing the financial system, either it must be powerful, but then subject to the usual sort of political accountability as Treasury, and therefore subject to all the political craziness of the rest of government financial and credit allocation policy, or it must be severely limited in what financial levers it can push with great independence.


  1. Valter Buffo, Recce'd, MilanJune 15, 2017 at 11:32 AM

    Finally. Now we start getting closer to what I started discussing, here and elsewhere, a few years ago. Still, one very big point is missing here. NO, the Fed is not and cannot be a "giant mutual fund". Why? Its liabilities are not towards free economic agents (investors) freely searching for the best opportunity to allocate their financial supluses. Further: NO, we do not need and do not want the Fed to "direct" the financial system. Which, we should all hope, remains a "free market", with regulations, but NO not directed by anybody. If we will get also to that point, then we will be at ... home base. With one little problem left: what will we do, with all those securities that no free economic agent wants to buy?

  2. One question is how do you guarantee there will be enough treasuries to support the liability side of the balance sheet (maybe that rests on some bad assumptions)? It seems to me that this policy would force additional government spending during a crisis. Could you instead induce some type of automatic tax-refund upon the purchase of Fed treasuries to induce higher deficits without increasing government spending levels?

  3. Interesting post, and who am I to disagree with Charles Plosser, but I can't help it. Can we start by defining what "independence" means? Because, in essence, the FOMC committee members are, in fact, political appointees, and therefore accountable to the elected representatives, asked to meet goals given to them by Congress. In my mind, independence regards the tools used to achieve those goals and the fact that decision-making by the Fed requires some consensus by various people appointed by different administrations. Do we really want to have senators, some of whom have never taken a monetary economics class, vote on the structure of the Fed's balance sheet?

    1. Constantine,

      Independence means that the central bank can engage in permitted operations (interest rate setting, buying / selling bonds) without concern for the fiscal position of the federal government.

      "Because, in essence, the FOMC committee members are, in fact, political appointees, and therefore accountable to the elected representatives, asked to meet goals given to them by Congress."

      Yes central bankers are political appointees and yes they are ultimately accountable to the voting public, but their decisions are cannot be countered / undone by any of the three branches of government.

      For instance, a law passed by Congress can be judged unconstitutional by the Supreme Court or can be vetoed by the President. There is no Legislative / Executive / Judicial override system on monetary policy decisions.

      "In my mind, independence regards the tools used to achieve those goals and the fact that decision-making by the Fed requires some consensus by various people appointed by different administrations."

      Actually, it is much simpler than that - there is no veto power given to the directly elected politicians on monetary policy decisions.

      "Do we really want to have senators, some of whom have never taken a monetary economics class, vote on the structure of the Fed's balance sheet?"

      Do we really want the Fed doing fiscal policy?

      Independence is a two way street - it is just as important for the federal government to operate independently of the central bank as it is for the central bank to operate independently of the federal government.

  4. John,

    Perhaps Mr. Plosser can explain why the Federal Open Market Committee was created in the first place - given the temptations for the central bank to engage in credit allocation, and why it wasn't eliminated by the Gramm-Leach-Bliley Act?

    The Federal Reserve Board of Governors was created by the Federal Reserve Act of 1913.

    The Federal Open Market Committee was created 20 years later in the Banking Act of 1933 (aka Glass Steagall).

    If independence of the central bank is a crucial concern, shouldn't the first step be to eliminate the FOMC entirely while leaving Board of Governors intact?

    I have reviewed the House Bill on financial modernization here:

    And I don't see "eliminate the FOMC" anywhere in it's text.

  5. Independence is more consistent with a _prohibition_ on the purchase of U.S. debt. So that, in theory, inflation could remain stable even in a debt crisis.

    The crazy thing about these concerns inspired by the Fed's investment activities during the financial crisis is that if the Fed had really gone wild, then one of two things would have happened. Either the crisis would have been averted, or the Fed would have made an absolute fortune (which directly reduces the national debt).

  6. "Background: The Fed is essentially a giant money-market fund.........."

    You could observe that the Fed, in reality, has no funding source. It does not provide labor in trade for money, goods or services. It does not have the power to tax. The Fed does have the power to trade Federal Reserve Notes for other financial instruments.

    Of course, the Fed can create Federal Reserve Notes at will.

    It seems to me that this is a fundamental fact of economic life.

    This additional background (to me) puts a different spin on the question of what should the Fed own as securities. Should the Fed be able to buy ANY property by simply printing money? If the answer is "yes", we are giving the Fed unlimited authority to buy using unearned money.

    I think that becomes a problem.

  7. Yeah, right. Just like during the Great Depression, where estimates by the Department of Commerce put the net debt figure at the end of 1939 @ $183.2 billion compared with a figure of $190.9 billion at the end of 1929. I.e., for the period encompassing the Great Depression there was no over all debt expansion. Thus there was a paucity of eligible collateral, and a concentration of impaired collateral. I disagree that the Fed shouldn't be engaged in credit allocation.

    I.e., "pushing on a string" should have only applied prior to the nominal legal adherence to the fallacious "Real Bills Doctrine" which was terminated in 1932 - due to a paucity of eligible (hopelessly impaired), commercial and agricultural paper for the 12 District Reserve bank’s discounting purposes.


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