Some quick thoughts- Prudential and consumer regulations as a preferential tool for controlling bank money creation?

This quote from the Levy Institute’s recent paper entitled “Federal Reserve Bank Governance and Independence During Financial Crisis” really got me thinking:

 “Excessive private credit creation was the key policy challenge facing the Fed after WW2. The Truman Administration ran budget surpluses for several years, but strong bank lending neutralized their effects. The banks, in other words, created an amount of money just about as fast as the Federal Government, through its fiscal policy, contracted the money supply. "

MMT talks a lot about how the creation of bank money affects aggregate demand, and how permanent zero rates might be a good idea going forward. I think we should also begin discussing how growth in bank money might be controlled in this permanent zero environment. It seems to me that if raising interest rates to slow down lending is off the table, then we would need to have other tools available. Since I have been working in financial regulations for a while now, I have come to see firsthand the truth of MMT’s claim that regulations, not interest rates, truly affect lending. And anecdotally, I frequently hear compliance people complaining about how all the new Dodd-Frank rules are curtailing lending. So here are some of my preliminary thoughts on this issue: 

• The last few decades have demonstrated the failure of traditional monetary policy tools to control growth in the money supply

• We know that the Fed controls only price of required reserves, and cannot directly control quantities of bank money, since this growth is mostly demand based

• Central banks are moving away from reserve requirements and monetary aggregate targeting anyway. Cant’ push on a string during times of low loan demand

• Inflation can be caused by excessive and imprudent lending. It’s not always due to too much horizontal money creation by federal deficit spending (although its remarkable that the explosion of bad lending and large deficits of the Bush admin were *still* not enough to create inflation)

• Using interest rates to manage an economy has mostly failed, and created enormous side effects:
• Market volatility
• Creates unnecessary interest rate risk burdens for depository institutions (cost of short term funding goes up, while long term assets are fixed)
• Creates risk of deposit flight from traditional banking system into higher yielding shadow banking/money markets which are not as closely regulated or monitored

My premise is that:

• Consumer and prudential regulations can be a much more effective and precise way of reducing lending-based creation of bank money (M2), than the tradition tool of raising interest rates

• Question is how do you develop a regulatory regime that is flexible enough to be ratcheted up or down for macroeconomic needs?

• Housing finance is a major source of bank money growth and therefore aggregate demand, so it is a good place to focus, using these tools:
• Raising/lowering agency (Fannie, Freddie, FHA, VA) conforming loan limits (very influential in housing esp. now that they control so much of the market)
• Weighing of risk-based bank capital 
• Risk retention/QRM rules from the prudential regulators
• Qualified Mortgage standards from CFPB

• From the firm perspective, these changes would:
• Increase compliance risk/burdens (bad for banks)
• But decrease volatility/interest rate risk, if rates are permanently kept at zero (good for banks)

Therefore-- 

With the end goal being full employment, the primary focus of federal financial/fiscal policymakers should be to strike the right balance between US dollar creation via federal deficits, and bank money creation via net bank lending. Both of these money creation forces contribute to aggregate demand, and if they outstrip the ability of the nation to produce a commensurate level of real goods and services, can cause an undesirable rise in the price level. Policymakers should approach full employment with as much of a utilitarian mindset as possible-- the only “moral” issues that should be taken into consideration here are the deleterious social effects of involuntary unemployment. 

Thoughts?

Federal Reserve to begin test running new Term Deposit Facility (TDF)

Just this morning, the Federal Reserve Board of Governors announced that they will begin test running the new Term Deposit Facility, which was created in a final rule back in June of 2010 (link). This rule amended the Fed's Regulation D to allow for the auction of these new term deposits. I'm not entirely sure if this was the Fed's own initiative, or if it was a new authority granted the Financial Services Regulatory Relief Act of 2006, or some GFC related statute.

So now, in addition to paying interest on excess reserves through the new Excess Balance Accounts, the Fed  has another tool at its disposal to maintain a non-zero interest rate, without selling Treasury securities in open market operations. In other words, its now possible for the Fed to do QE-Infinity, buy up all the Treasury Securities on the market, and still maintain an overnight interest rate above zero. This new term deposit facility is basically just the Fed selling its own short term Certificates of Deposit (CDs), in order to provide an interest bearing alternatives to plain reserve balances. To be clear, these new term deposits do not satisfy an institution's required reserve balance or clearing balance and do not constitute excess balances. They are not available to clear payments and cant be used to reduce daylight or overnight overdrafts. 

According to the Fed, 

Term deposits may be awarded through a competitive single-price auction format with a non-competitive bidding option, a fixed-rate format at the interest rate specified in advance, or a floating-rate format. The interest rate paid on term deposits awarded through a floating-rate format will be the operation effective interest rate, which is determined by the average of the daily effective rates over the term of the instrument. 

However, just as with the interest-bearing Excess Balance accounts, Fannie, Freddie, and the Federal Home Loan Banks are not  eligible for this program. This means that they will continue to trade in the Federal Funds Market, which is why the effective Federal Funds Rate remains below the 25 basis points payed on excess reserve balances.As an aside, in the text of the final rule establishing the Excess Balance accounts, the Fed refers to un-remunerated reserve requirements as a "tax", just as Warren Mosler has.

I see this new facility as a modernization of monetary policy, which should make all the operations simpler to execute, and more importantly, easier for the general public to understand. Most people understand how CDs work, and these TDF are similar. For that reason, hopefully this test run will be successful, and will help us MMTers make our points, especially since Professor Scott Fullwiler has written extensively on these new advancements.

More information is available here. 

So can we please stop selling Treasury debt now? Its 2014 for Eccles' sake!

David Kotok on MF Global, Chutzpah & the New York Fed

...The MF Global affair is doubly muddied up by alleged fraud and misuse of client funds.  We cannot blame the NY Fed for an alleged fraud.  But we can ask if the sanction for a primary dealer that fails the “transparency” and the “accuracy” tests should be limited to getting kicked out of the club.  Maybe the $150 million minimum regulatory net capital requirement should be expanded, and maybe the shareholders and debt holders of a primary dealer should be told they are subordinated to claims that will include financial penalties for failure to comply with NY  Fed rules.  Maybe the NY Fed should take on an escrow safety-cushioning function in the same way a landlord holds a security deposit for a tenant.  Maybe this whole system of New York Fed actions and primary dealer status needs reexamination.  Maybe the system needs a chutzpah scan to remove the viruses. 

Was the MF Global risk taking apparent?  Many say no.  But there are some very smart and skilled folks who say otherwise.  One of them is Janet Tavakoli.  Janet nailed it.  For readers who are not familiar with Janet, see her website: www.tavakolistructuredfinance.com.

Here is an excerpt from a note that Janet wrote on November 3.  We are fortunate enough to see her superb and timely work.  We talked with Janet on Friday.  She walked us through the evidence that was missed by many.  Janet, you are awesome!

Janet wrote: “The fact that MF Global was exposed to default risk and liquidity risk because of these trades and that they were linked to European sovereign debt was disclosed in MF Global’s 10K for the year ending March 31, 2011, a required financial statement filed with the SEC.  The CFTC and other regulators had the information right under their noses, but it appears they didn’t understand that they were looking at a leveraged credit-derivative transaction that could lead to margin calls that MF Global would be unable to meet....”

 Read the whole post (long) at Zero Hedge, David Kotok on MF Global, Chutzpah & the New York Fed -- Parts 1 & 2, posted by Chris Whalen

Edward Harrison on government, regulation and free markets

I want to talk about why people blame government for the state of the economy more than Wall Street and what I think the remedies are. This will be a long post. So feel free to bookmark it to read it and the links when you have a moment.

On government, regulation, over-regulation and free markets by Edward Harrison at Credit Writedowns.

Enough already with the, "business is not spending because they're afraid of Obama's policies," nonsense.

The chart below shows the change in Gross Private Domestic Investment (equipment and software) covering Reagan, Bush I, Clinton, Bush II and Obama. Figures are in $ billions. As you see, capital spending under Obama surpassed all other presidents with the exception of Clinton (but Clinton had the internet boom and Y2K). The two worst periods were under both Bushes and Bush II had the lowest level of business investment despite a supposedly more “business friendly” environment. The claim that businesses are not spending under Obama is not borne out by the numbers.