The Elusive Promise of Independent Central Banking

Marvin Goodfriend Carnegie Mellon University, Tepper School July 2012 Institute of Financial Studies Southwestern University of Finance and Economics Chengdu, Sichuan, PR China Overview

• Early central banks established (with right of note issue) to help finance governments • Operated under the gold standard • Took on independent monetary and credit policy powers gradually • Promise of central bank monetary and credit independence for macroeconomic and financial stabilization has been elusive • Story told in terms of the 19th century Bank of England and the Federal Reserve

2 Overview

OUTLINE OF LECTURE: 1) Evolution of independent monetary policy 2) Evolution of independent credit policy 3) Government , rule of law, and independent central banking 4) Securing the promise of independent central banking

3 Overview

• Lesson 1: Wide operational and financial Federal Reserve independence to implement policy “in the public interest” subjected Fed to incentives detrimental for macro and financial stability • Lesson 2: An independent CB needs the double discipline of a priority for price stability and bounds on expansive credit initiatives to secure its promise for stabilization policy

4 Bank of England Monetary Policy under the Classical Gold Standard

• Bank Charter Act of 1844 • Except for fixed fiduciary note issue, Bank required to hold 100% gold reserve against notes • No gold reserve required against bankers’ balances held at Bank of England • Interest forgone on securities limits B of E willingness to hold precautionary gold reserves • Limited independent monetary policy • Bankers’ balances increasingly important

5 Bank of England Monetary Policy under the Classical Gold Standard • Bank Rate (rate at which Bank of England would lend) normally kept above market rates • UK Treasury suspended minimum gold reserve requirement against notes in 1847, 1857, and 1866 so Bank could lend currency at Bank Rate during banking panics • Bank Rate would put a ceiling on short‐term market rates because Bank could accommodate demand for currency fully at Bank Rate

6 Bank of England Monetary Policy under the Classical Gold Standard • Bagehot’s Rule—Lend freely at a high rate on good collateral—worked because: • Profitable for Bank to reduce gold reserve against its notes if allowed • Bank would profit from lending at high Bank Rate • Bank shareholders earned profit and bore losses, so lent only on good collateral

7 Bank of England Monetary Policy under the Classical Gold Standard • “Lender of last resort” policy best thought of as independent monetary policy, not credit policy • Did not require Bank to take on credit risk for effectiveness • Worked by satisfying demand for currency against riskless securities • Monetary policy disciplined by Bank profit maximization, and by Treasury’s relaxation and re‐imposition of gold reserve requirements

8 Federal Reserve Monetary Policy under the Gold Standard • Fed helps finance World War I at low interest rates • From Oct 1919 to June 1920 Fed raises short term interest from 4% to 7% to defend minimum required gold reserve against its note and deposit liabilities • Recession from Jan 1920 to July 1921—unemployment rose from 4% to 12%, indust prod fell from 39 to 30, 40% deflation reversed wartime inflation • Fed traumatized by public, political reaction • Fed moved by 1923 to loosen link between interest rate policy and gold reserve requirement

9 Federal Reserve Monetary Policy under the Gold Standard • Fed builds up “free gold” above requirements • By stockpiling gold, the Fed divorces monetary policy from gold standard constraint • Lets gold stockpile run up and down to accommodate fluctuations in gold demand at fixed dollar price, sterilizes the monetary effects with securities operations • Fed eliminates sharp fluctuations in short interest rates and introduces high degree of persistence into short interest rates unknown previously • Sets stage for highly unstable price level

10 Federal Reserve Monetary Policy under the Gold Standard • Fed set up and run “in the public interest” • Given “operational independence” over its balance sheet and “financial independence” to fund itself from its interest income • Fed interest income after expenses transferred to fiscal authorities • Fed passes through interest lost by holding free gold instead of interest‐bearing securities as reduced revenue for fiscal authorities

11 Go‐Stop Monetary Policy

• By mid‐1960s, inflationary money creation eroded Fed’s free gold • Congress eliminated gold reserve requirements • US floated the dollar price of gold in 1973 • Fed subjected to incentives that produced increasingly inflationary go‐stop policy • Acting in public interest, Fed inclined to be responsive to shifting public concerns between inflation and unemployment

12 Go‐Stop Monetary Policy

• Fed justified periodic inflation‐fighting actions against an implicit objective for low unemployment • Pricing decisions embodied higher expected inflation when public prompted Fed to act against inflation • Aggressive interest rate actions were then needed to bring inflation down • Narrow window of public support for fighting inflation • Window closed when unemployment moved higher • Fed settled for higher trend inflation with each policy cycle

13 Go‐Stop Monetary Policy

• Public anticipated rising inflation, Fed became evermore expansionary with each policy cycle • Necessitating evermore contractionary recessions to fight inflation • Go‐stop policy produced rising inflation and unemployment, and more volatility of each • In 1979, Volcker Fed recognized better to reverse priorities—justify actions to stimulate employment against commitment to low inflation

14 Go‐Stop Monetary Policy

• Since Volcker disinflation of 1979‐1982, priority for low inflation enabled monetary policy to reduce both inflation and unemployment • Preemptive interest rate policy actions in 1983‐4 and in 1994 held the line on inflation, and reversed inflation scares in bond markets without increasing unemployment • Set stage for two of the longest expansions in US economic history • Fed adopts 2% inflation objective in 2012

15 Bank of England Credit Policy

• DISCOUNTS: Bills of exchange, i.e, bankers’ acceptances, purchased outright • ADVANCES: Bills of exchange, UK Treasury Consols, or other eligible securities purchased under agreement to resell at given price and date • Boom in global trade in 1850s and 1860s and the supremacy of British banks financing it, produced huge volume of foreign bills of exchange

16 Bank of England Credit Policy

• Abundance of bills of exchange provided risk‐ free collateral against which Bank could lend • Credit policy practiced by 19th century Bank of England more akin to monetary policy • Did not involve taking credit risk • No subsidy since undertaken at high Bank Rate • Satisfied public’s demand for currency • Open market purchases, not lending to banks

17 Federal Reserve Borrowed Reserve Targeting • Federal Reserve normally kept Discount Rate below market rates • Helped finance WW I by allowing banks to borrow at low Discount Rate against Treasuries • Discount Rate put a ceiling on riskless money market rates • Other rates floated above DR at spreads commensurate with liquidity and risk • Public understood DR anchored short rates

18 Federal Reserve Borrowed Reserve Targeting • Fed raised DR 4% to 7% to defend minimum gold reserve requirement in 1919‐1920 • Fed moved by 1923 to manage interest rates less visibly by targeting borrowed reserves • Placed administrative prohibitions against continuous borrowing by individual banks • Riskless money market rates floated above DR • Fed managed the interest rate spread by varying borrowing it forced banking system to do at its discount window 19 Federal Reserve Borrowed Reserve Targeting • Fed created illusion that money market rates were determined by market forces • To raise rates, Fed drains reserves by selling securities‐‐banking system forced into Fed discount window, market rates float higher until incentive to borrow at lower DR overcomes administrative prohibition against borrowing • Then, maintaining the higher market rate, Fed buys back securities, raises DR, and returns borrowed reserves to target • DR follows market rates higher

20 Federal Reserve Borrowed Reserve Targeting • Borrowed reserve targeting utilized in the 1920s, and later from the 1950s to the 1980s to obscure the Fed’s unpopular interest rate actions against inflation • Fed did not make interest rate policy actions immediately transparent until Feb 1994 • In 2003 Fed set DR for routine borrowing at penalty rate above the federal funds rate to eliminate the subsidy to borrowing, and also because no longer needed to hide rate actions

21 Federal Reserve Borrowed Reserve Targeting • Selling securities paying market interest to force banks to borrow reserves at lower DR was costly in lost Fed interest income • Financially independent Fed passed through interest cost in reduced revenue to the fiscal authorities • No explicit congressional authorization to “spend” interest income either to hide interest policy actions or to stockpile gold above legal requirements

22 Federal Reserve Emergency Credit Assistance • Federal Reserve Act of 1913 authorized Fed to extend credit only to member banks • Section 13(3) amendment in 1932 gave Fed authority to lend to “individuals, partnerships, and corporations” in “unusual and exigent circumstances” by vote of at least 5 members of Board of Governors • Reconstruction Finance Corp established 1932 by Congress to allocate credit widely to nonbanks

23 Federal Reserve Emergency Credit Assistance • Little lending under 13(3) due to RFC alternative during Great Depression, and highly restrictive collateral requirements • At urging of Fed Board of Governors, Section 13(3) amended by Congress in 1991 to grant virtually unlimited authority of the Federal Reserve Board to lend in “unusual and exigent circumstances” • Subsequently, regulatory permissiveness, technical innovation, securitization, structured finance of illiquid cash flows in money markets via shadow banking rivals depository intermediation in scale by mid‐2000s • Fed lending reach not accompanied by sup and reg

24 Federal Reserve Emergency Credit Assistance • Money markets could expect support from independent Fed credit policy • In moment of crisis Fed in no win situation— deny credit and risk financial collapse or lend and feed expectations of expansive future lending • Fed exhibited tendency in credit turmoil of 2007‐8 to expand its lending reach in scale, maturity, and eligible collateral at low interest

25 Federal Reserve Emergency Credit Assistance • Bagehot’s rule worked for 19th century Bank of England because last resort lending functioned as monetary policy to provide currency • Bagehot could be sure that B of E would lend at a high Bank Rate, not take credit risk, and not distort credit flows because the Bank was a private profit maximizing entity • The problem was to encourage the Bank to lend freely at Bank Rate in a banking crisis (upon suspension of gold reserve requirements)

26 Federal Reserve Emergency Credit Assistance • The problem today is the opposite—it is to limit the Federal Reserve’s lending reach • Fed is inclined to lend in a crisis because its own funds are not at stake, and because it has implicit backing of taxpayer funds to absorb losses • Fiscal authorities are content to let Fed take independent lead because its inclination to lend usually matches their own, notwithstanding potential future cost to taxpayers • Fiscal authorities have option of ex post criticism • Set‐up facilitates lending laxity and moral hazard

27 Government, Rule of Law, and Independent Central Banking • Primary responsibilities of government: external and internal security, enforce contracts, resolve disputes with agreed political mechanism for taxation and spending • Fiscal, regulatory, judicial procedures must be regarded as legitimate—conforming to recognized principles or accepted rules and standards—openly agreed, readily understandable, thoroughly fairly enforced • Complexity, opacity give advantage to insiders, undermine legitimacy, confidence in govt

28 Government, Rule of Law, and Independent Central Banking

• Independent central banking has veered between two public purposes • “Fiscal finance” valued for occasional emergency financing of government • “Monetary stability” valued for low inflation and financial stability to promote sustainable employment, economic growth

29 Government, Rule of Law, and Independent Central Banking • Since the credit turmoil of 2007‐8 CBs have employed expansive credit policy for fiscal finance purposes beyond boundaries ordinarily regarded as legitimate • Whether justified by the need to act in a timely manner or in lieu of paralyzed fiscal authorities, expansive credit initiatives call into question legitimacy of the central bank and the government

30 Securing the Promise of Independent Central Banking • MONETARY POLICY: • Congress should accept the Fed’s 2% inflation objective and hold the Fed accountable for achieving it on average over time • Congress should insist that the Fed manage its monetary liabilities with a “Treasuries only” asset acquisition policy (except for occasional lending to banks) to avoid credit risk • The Fed would recycle interest income on Treasuries (net of operating expenses and interest on reserves) directly back to the fiscal authorities • Independent monetary policy would steer the central bank clear of political entanglements

31 Securing the Promise of Independent Central Banking • CREDIT POLICY: • Fed credit policy is debt‐financed fiscal policy—the lending of public funds to private borrowers financed by selling Treasury securities from its portfolio (or by issuing interest‐bearing bank reserves) against future taxes • Emergency credit policy works by interposing government creditworthiness between private borrowers and lenders to facilitate credit flows • The Fed returns interest on its credit assets to the Treasury, but all non‐Treasury loans and securities carry credit risk and expose the central bank and ultimately taxpayers to losses and controversial disputes regarding credit allocation 32 Securing the Promise of Independent Central Banking • The 2010 Dodd‐Frank Act recognized the problem and requires Fed lending extended beyond depositories to be approved by the Treasury Secretary and to be part of a broad program not directed to any particular borrower • The Dodd‐Frank requirements are insufficient • The Administration alone is no more authorized to commit taxpayer funds than the independent central bank, and it too is likely to favor expansive credit policy in a crisis rather than risk collapse

33 Securing the Promise of Independent Central Banking • To deal effectively with expansive Fed credit policy, Congress in its oversight capacity should: 1) Authorize expansive Fed lending before the fact 2) Only as “bridge loan” with a “take out” 3) Process should alert taxpayers to potential future cost 4) Taxpayer reluctance to bear the costs could credibly bend down expectations of expansive Fed lending 5) Markets would better self‐insure against liquidity risk 6) Strengthened congressional oversight would preserve the legitimacy of the independent Fed and secure its promise for stabilization policy

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