Wednesday, November 20, 2013

The Payments System and Monetary Transmission

About forty minutes into the final session of a recent research conference at the IMF, Ken Rogoff made the following remarks:
We have regulation about the government having monopoly over currency, but we allow these very close substitutes, we think it's good, but maybe... it's not so good, maybe we want to have a future where we all have an ATM at the Fed instead of intermediated through a bank... and if you want a better deal, you want more interest on your money, then you can buy what is basically a bond fund that may be very liquid, but you are not guaranteed that you're going to get paid back in full. 
This is an idea that's long overdue. Allowing individuals to hold accounts at the Fed would result in a payments system that is insulated from banking crises. It would make deposit insurance completely unnecessary, thus removing a key subsidy that makes debt financing of asset positions so appealing to banks. There would be no need to impose higher capital requirements, since a fragile capital structure would result in a deposit drain. And there would be no need to require banks to offer cash mutual funds, since the accounts at the Fed would serve precisely this purpose.

But the greatest benefit of such a policy would lie elsewhere, in providing the Fed with a vastly superior monetary transmission mechanism. In a brief comment on Macroeconomic Resilience a few months ago, I proposed that an account be created at the Fed for every individual with a social security number, including minors. Any profits accruing to the Fed as a result of its open market operations could then be used to credit these accounts instead of being transferred to the Treasury. But these credits should not be immediately available for withdrawal: they should be released in increments if and when monetary easing is called for.

The main advantage of such an approach is that it directly eases debtor balance sheets when a recession hits. It can provide a buffer to those facing financial distress, allowing payments to be made on mortgages or auto loans in the face of an unexpected loss of income. And as children transition into adulthood, they will find themselves with accumulated deposits that could be used to finance educational expenditures or a down payment on a home.

In contrast, monetary policy as currently practiced targets creditor balance sheets. Asset prices rise as interest rates are driven down. The goal is to stimulate expenditure by lowering borrowing costs, but by definition this requires individuals to take on more debt. In an over-leveraged economy struggling through a balance sheet recession, such policies can only provide temporary relief. 

No matter how monetary policy is implemented, it has distributional effects. As a result, the impact on real income growth of a given nominal target is sensitive to the monetary transmission mechanism in place. One of the things I find most puzzling and frustrating about current debates concerning monetary policy is the focus on targets rather than mechanisms. To my mind, the choice of target---whether the inflation rate or nominal income growth or something entirely different---is of secondary importance compared to the mechanism used to attain it.

Rogoff was followed at the podium by Larry Summers, who voiced fears that we face a long period of secular stagnation. Paul Krugman has endorsed this view. I think that this fate can be avoided, but not by fiddling with inflation or nominal growth targets. The Fed is currently hobbled not by the choice of an inappropriate goal, but by the limited menu of transmission mechanisms at its disposal. If all you can do in the face of excessive indebtedness is to encourage more borrowing, swapping one target for another is not going to solve the problem. Thinking more imaginatively about mechanisms is absolutely essential, otherwise we may well be facing a lost decade of our own.

37 comments:

  1. Rajiv: Isn't this the central bank doing fiscal policy+monetary combo? We could get the same effect with money-financed transfer payments/tax cuts. It's helicopter money. When I hold $100 in US banknotes, it is exactly as if I have an ATM at the Fed, except I make payments by physically handing over my zero interest bearer-bonds, rather than by sending an electronic letter to the Fed, asking the Fed to transfer funds from my account to yours.

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  2. That's exactly what it is Nick, except that it doesn't run up against the debt ceiling, and it's credibly irreversible.

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  3. Plus, it has the advantage of (maybe) not needing to make its way through congress. With sane politics this might not matter, but in the current world we inhabit...

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  4. Rajiv: Aha! I missed the irreversibility bit. Yep. (Debt ceiling is a US thingy!)

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  5. a key point

    how precisely benefits
    at the point of injection of funds

    in QE its asset owners

    in schemes like yours
    the injection point
    can in bulk be
    the mass of
    simple members
    ---present past and future---
    of the job holder class

    macro policy
    in concrete implementations
    has a specific class distribution


    and a payment system in the long run
    is always better then a loan system

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  6. Tyler, that's really a key advantage of the proposal: doing this as a fiscal/monetary combo would require congress to pass a law each time Treasury checks are to be sent out. No matter how sane the politics there are massive transactions costs to this, with unpredictable outcomes and long delays. There's also a difference in the treatment of minors.

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  7. So what happens to the banks if a system like this is put in place? Surely the loss of deposits would have a large impact on the banking system.

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  8. Banks can continue to accept deposits but they will not be insured. If they want to promise redemption at par they will have to have a capital structure that has a lot more equity relative to debt. Admati and Hellwig have been arguing for significantly higher capital requirements to counteract the subsidization of bank debt financing; this will no longer be necessary under once deposit insurance is removed.

    Bank loans will be financed by bank equity, long term debt, commercial paper, and money market mutual funds. The only source of financing to be removed is insured deposits.

    The important point is that banks can be allowed to fail without putting the payments system at risk.

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  9. I thought about the idea of anyone being able to have a bank account with the Fed during the Republicans' first threat to make their own country default on its debt if their demands weren't met.

    It was hard to find a good safe place to flee to until the extortion threat was over. I thought, I wish I could just stick my money in a nice, safe, liquid account at the Fed, like a bank can. You can go through a bank, but you pay a middleman of dubious value, and your money has to be insured by the government, but only up to $250k.

    There could be great economies of scale and simplicity to the Fed providing much of banking.

    I'll note here also what I'm thinking more and more is a very powerful and important concept: The power and efficiency of directness.

    Examples:

    1) Having the government issue student loans directly rather than through hundreds of fragmented middlemen banks and finance companies. The savings was enormous, about $100 billion per decade. Huge economies of simplicity and scale.

    2) For medical research and advancement we spend trillions padding private medical company profits with long patents and a horribly fragmented and opaque medical system largely on the theory that if medical companies make an extra trillion in profits, maybe they'll spend an extra $50 billion on medical R&D. But you could get vastly more advancement in medicine if the government just directly spent $1 trillion more on medical research than if we give $1 trillion more in profits to private medical companies to get them to spend $50 billion more on R&D.

    3) And likewise, there are probably huge economies of scale and simplicity to the Fed directly providing much of banking and finance. Moreover, the more there's asymmetric information and it's serious, the more there is a benefit to having the product provided by an entity that doesn't have a profit incentive to exploit it, to trick people; the more it's efficient, therefore, to have the government provide it directly, especially if it's very expensive and difficult to regulate the private companies.

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  10. As far as what Nick was saying, cash is like an account at the Fed, but there are huge differences: No interest, and it gets expensive, hard, and risky to store and transact with large amounts. Funny to imagine people keeping hundreds of thousands, millions, or tens of millions of dollars in a safe deposit box at a bank.

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  11. Thanks much for the quick response Rajiv!

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  12. Richard, just to be clear, I am not proposing that the Fed get into the business of commercial banking, except with regard to deposits and payments. What I have in mind is that it serve as an internet-only depository institution for individuals, along the lines of ING Direct (now Capital One 360), with no branches and no capacity to make loans.

    The Fed has neither the means nor the expertise to be making or monitoring loans to individuals. Commercial banks would continue to do this, but would have to finance themselves with some combination of equity and money market borrowing, or by securitizing and selling loans in the capital market.

    Another possibility is that the asset side of commercial banking will be displaced by peer-to-peer lending, facilitated for instance by firms such as the Lending Club. These loans do not involve maturity transformation, so are not subject to runs or fire sales. The result will be a more robust financial system.

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  13. I'm not saying that the Fed should do lending to individuals, or business, or any particular finance role, necessarily. That's something I'd have to think about case by case.

    But given the severe market problems in much of finance, and the potential for large economies of scale and simplicity, I think it's worth thinking about. For example:

    – The idea of the Fed taking over the role of 100% safe demand deposits directly looks very efficient and good.

    – Consumer lending has devastating asymmetric information, expertise, and positional externalitiy problems. Predators in credit cards, private student loans, payday loans, mortgages, and so on have devastated so much of the poor and middle class. It's just astounding the things they do, payday loans with effective interest over 1,000%, a $26,000 home equity loan rolled over 10 times in four years for $29,000 in fees (The Fringe Economy, by Howard Karger, page 125), and on and on. At least this has to be highly, highly regulated, which can be very expensive and difficult.

    – Too big to fail, taking down the economy again and again, taking trillions in risk with the government picking up the tab if it goes wrong – The Fed taking over some of these functions cannot fail, and it can do the clearing house function with 100% safety. Moreover where monopoly power and asymmetric information are great, the Fed or the government also offering it can put a ceiling on what can be charged.

    The Fed may not have the expertise to do much of this now, but it could get it if it decided to. The federal government had no expertise in health insurance before Medicare in 1965, but it decided to set up the organization and get it, and it now does health insurance vastly cheaper and better than the terribly problematic free market carriers. And consumers don’t live with the terrible asymmetric information risk of something not being covered by a private health insurer due to the legalese fine print they never knew about.

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  14. Regarding TBTF, I think that insulation of the payments system will remove one major rationale for bailouts, so the proposal does have some impact there. Predatory lending is certainly a serious problem, but I really don't think that the Fed can or should enter that space. The solution has to lie elsewhere. Thank you for your comments, though, as always.

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  15. Awesome Rajiv.

    I've been developing this very idea you propose on your blog post for a few years. Check out my article at cmamonetary.org if your interested.

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  16. How is this different from getting the Glass Steagall act back in place which worked so well for 60 odd years ?

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  17. Totally different from Glass-Steagall. Fed provides some features of narrow banking and protects the payments system instead of commercial banks being provided with subsidized insurance in exchange for limiting their activities.

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  18. If the Fed takes in the deposit, then how would the deposit be transmitted to the economy?

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  19. Also it would appear that the Fed exists only for the purpose of serving the bank albeit in the guise of doing it for the economy or main street as showing it for what it is - working for TBTF banks so that they can privatise profits and socialise losses (otherwise called theft). If this system is implemented then how would it be possible for banks to profit. So even if it works it is a non-starter!

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  20. I think this view of the Fed is too cynical. It's Treasury that has had the more serious problems with the revolving door at the top (witness Rubin, Paulson, Geithner). The fiercest pushback against Brooksley Born's attempts to regulate derivatives came from treasury, as did the most pro-bailout positions in the crisis. Sheila Bair's book (which I reviewed in an earlier post) gives a pretty good account of this.

    Bernanke and Yellen are grounded in academia and not beholden to the banking sector. For all its flaws, the Fed is one of the better functioning institutions in American life. The deeper problem lies in the means available to the Fed rather than the motives. I have no way of knowing this but I suspect that my proposal would find some support there. Congress, however, is another matter.

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  21. Rajiv, This seems like a really interesting idea. Providing individuals a safe place to put money directly is the ultimate realization of Glass-Steagal.
    But, I wonder if this should be combined with a broader payments system. Governments have long been responsible for "creating" money first as coin, then as bills. Today the government still prints paper bills. But, so much of the economy is mediated by small electronic payments not by paper bills. In the current system, private companies take a rake from each of these transactions. Should we extend this Fed deposit account to a government run consumer payments system that removes the private tax on transactions?

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  22. Fred, I think I would prefer greater competition and lower barriers to entry in the transaction processing business. The Fed should just focus on monetary policy and providing a secure deposit account from which transfers to accounts at commercial banks can be made easily online.

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  23. What if people want to move their funds from a commercial bank to the fed would that be possible under your proposal?

    Much of the payments system is already operated by governement or central bank clearing houses. Clearing and payments and deposits are highly systemic so why not also create a systemic refuge operated by the CB that works alongside the current private system?

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  24. Yes, online transfers between Fed and CB accounts would be possible. What I have in mind is the Fed operating as an internet-only bank along the lines of ING Direct (now Capital One 360) with minimal services beyond deposits, withdrawals and transfers. Salaries could be paid by direct deposit into the Fed account.

    Not sure what you mean by systemic refuge though.

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  25. By systemic refuge I mean a place to leave deposits in a safe manner in case of systemic issues like we had recently.

    Do you agree the fed could just create money and transfer into citizens accounts instead of just passing out its profits from OMO's? The rate of money expansion would be in reference to inflation or ngdp.

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  26. I agree that the Fed could do this, but I don't believe that it should. For one thing, credits to accounts cannot be reversible (otherwise they would not in fact be safe, and we could have a run on Fed accounts). So there would be no mechanism for monetary contraction other than open market operations. So I see such operations as a continuing component of monetary policy, used in more ordinary recessions with high interest elasticity of demand and room to lower rates. The optimal mix of the two policies is an interesting and open theoretical question.

    Second, credits to the accounts ab nihilo would result in accounting losses on the Fed balance sheet. This is feasible and sustainable of course, but for reasons discussed by Ashwin in his post (on which I was commenting when I first made this proposal) this is just not going to happen.

    Finally, the Fed still needs to serve as a liquidity backstop and lender of last resort to the banking system in order to deal with and fend off liquidity crises. The profits from this need to be distributed - they now go to Treasury, but would be more effective if credited to individual accounts.

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  27. The fed doesnt need to contract the money supply it can simply reduce the rate of expansion or just stabilise the nominal supply of base if inflation is above target. If inflation is excessive in times when the fed is not expanding the supply then the source of inflation is not monetary and contracting the money supply should have no real effect on gdp.

    The fed can credit accounts without needing to recognize these entries as liabilities. The fed notes should be recognized on the balance sheet as equity. This is more correct as the people are owners of the fed as it is or at least should be a public entity.

    The fed can still serve as a liquidity backstop or LLR. Just because it adopts a method of directly interacting with the public doesn't mean it needs to abandon this role.

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  28. Regardless of the source of above-target inflation (and there are usually multiple sources) the Fed has an obligation to lower it. Under current institutional arrangements it also has the means to do so. If monetary expansion could never be reversed, it would lose a powerful lever for inflation control.

    It is true that the Fed can change its accounting practices to record credits as equity, but this is a cosmetic change, it doesn't mean the congress or the public at large will interpret the balance sheet in a different way.

    There were two excellent comments on tis post on Economist's View, which raised similar points to those you are raising. First Dan Kervick:

    "Also, there is no fundamental reason why the central bank or other institutional monetary authority needs to maintain positive financial "equity" to perform its appropriate role in the economy, so Sethi's idea that the crediting of accounts needs to be funded by the profits from open market operations is a bit of a red herring. As the ultimate source of the nation's medium of exchange and the world's main reserve currency, the whole notion of a central bank financial "balance sheet" is merely a convenient fiction that helps the Fed communicate about its operations to a monetarily constrained business world that speaks the language of balance sheets, but it doesn't represent a deep economic reality. As before, monetary policy control mechanisms and judgment need to be in place to preserve desired levels of price and currency stability. But there is no reason to think that in a growing economy, the sweet spot entails the central bank being in a condition of positive financial "equity"."

    And then, Amileoj

    "The crediting of savers' accounts is effectively a helicopter drop (which QE decidedly is not), similar in effect to a tax cut. The business about using "profits" from the Fed's open market operations is of course just a mystification of the underlying operations, designed to keep the monetarist inflation paranoiacs at bay."

    I agree with a lot of what is said here about economic feasibility, but I think that keeping "inflation paranoiacs at bay" is actually an important component of a viable policy. Again see Ashwin on this.

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  29. “Regardless of the source of above-target inflation (and there are usually multiple sources) the Fed has an obligation to lower it. Under current institutional arrangements it also has the means to do so. If monetary expansion could never be reversed, it would lose a powerful lever for inflation control. “

    There is no benefit in lowering inflation if it also has to lower ngdp at the same time, the real effect is nothing. Its just a cosmetic nominal change. If inflation is excessive while the fed has stabilised the base (assuming stable C/D ratio) then it places the onus on the government to address it. The central bank can only address non monetary inflation in a cosmetic manner. For example if a storm wipes out food production causing inflation a contraction of money wont address it. The government needs to address it as it had more effective tools for this.

    The central bank will only mask an economic problem manifesting itself as inflation. MP is not an effective tool for addressing non monetary sourced inflation.

    “It is true that the Fed can change its accounting practices to record credits as equity, but this is a cosmetic change, it doesn't mean the congress or the public at large will interpret the balance sheet in a different way. “

    It is a cosmetic change in a sense. But it is also better because the fed doesn’t need to acquire assets to offset currency liabities. The ultimate backing of the central bank should be the economy not balance sheet assets of the CB. Im not against the CB holding reserves or assets btw. Its also more accurate to record currency as equity because the CB should be a public entity. For a private entity its more accurate to record the currency it issues as as liab.


    "Also, there is no fundamental reason why the central bank or other institutional monetary authority needs to maintain positive financial "equity" to perform its appropriate role in the economy, so Sethi's idea that the crediting of accounts needs to be funded by the profits from open market operations is a bit of a red herring. As the ultimate source of the nation's medium of exchange and the world's main reserve currency, the whole notion of a central bank financial "balance sheet" is merely a convenient fiction that helps the Fed communicate about its operations to a monetarily constrained business world that speaks the language of balance sheets, but it doesn't represent a deep economic reality. As before, monetary policy control mechanisms and judgment need to be in place to preserve desired levels of price and currency stability. But there is no reason to think that in a growing economy, the sweet spot entails the central bank being in a condition of positive financial "equity"."

    Exactly and recording currency issued as equity makes it easier to not go into negative equity and removes the unnecary condition of the CB needing to fund itself in order to credit accounts. You are arguing my case.

    "The crediting of savers' accounts is effectively a helicopter drop (which QE decidedly is not), similar in effect to a tax cut. The business about using "profits" from the Fed's open market operations is of course just a mystification of the underlying operations, designed to keep the monetarist inflation paranoiacs at bay."

    Yes.

    “I agree with a lot of what is said here about economic feasibility, but I think that keeping "inflation paranoiacs at bay" is actually an important component of a viable policy. Again see Ashwin on this.”

    That’s why the fed should credit public accounts while referencing inflation.

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  30. Rajiv, sorry but this is an off topic comment.

    I notice that you commented over at WCI about Stephen Williamson's latest mix up. I also notice you let it go at failure to consider disequilibrium dynamics.

    Fair enough I guess but did you notice how SW's post read?

    For most of it the statements are all qualified, "in my model..." and so he appears to be simply giving an example of something that may be relevant to policy, or just to our understanding.

    Then, in the last two paragraphs we get unqualified statements about the Fed leading us into a trap. Straight scaremongering.

    This is a cheap form of bait and switch and is not academically honest. I think you need to be much harder on him.

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  31. Adam, we all suffer from this tendency to take our models too seriously... while living in a glass house I don't want to throw too many stones. But pointing out flaws in the model itself is fair game. The blog post was quite confusing, so I still can't quite figure out which (if any) of the critiques are valid.

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  32. The greatest point of beauty in this idea is it would show that even "money" isn't about money. It is about real Freedom. Credit is Faith. It is Love. It is many good things manifest in the material part of our World.

    While Franklin cautioned against "too little money" we are fearful of "too much money". The proof that giving money to TBTF banks doesn't do anything, including lead to "Hyper-Inflation", even when it becomes known how much given the TBTF banks.

    Of course, nothing good happened either.

    But, if every person who was already, or could be made to be, more productive through free, abundant money WAS GIVEN THE MONEY the great myth about easy money would be gone forever, the living standard doubling in 24 months and again in 72 months and so on...and on...

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  33. Seems different. I am not proposing that banks be precluded from making loans by crediting deposit accounts, only that the Fed option be available to all, including minors, and that these accounts be credited with funds that would otherwise be transferred to Treasury. These credits could be frozen or held in escrow until such time as monetary expansion is called for. Banks could continue to issue liabilities convertible into currency, including deposit and money market accounts, but with no implicit or explicit guarantees. The FDIC could be dissolved.

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  34. It does basically offer a form of narrow banking though I guess. Seems logical that this option would exist - sort of like Bill Mitchell (I believe) on the Postal Banks of Australia. If the option existed, I imagine quite a few people would avail themselves of it.

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  35. The latest episode of NPR Planet Money, titled "A World Without Banks", is about this topic. It features Martin Wolf, peer-to-peer lending, Paul Krugman saying he isn't sure where he stands, a proposals for a "crisis-free core".

    http://www.npr.org/blogs/money/2014/05/30/317030992/episode-543-a-world-without-banks

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  36. Thanks Charlie, I enjoyed this. I was contacted by NPR's Quoctrung Bui shortly after this post went up and mentioned the Lending Club to him. Not sure if that conversation eventually led to this piece but it's a natural connection.

    Unfortunately the segment doesn't address the possibility of using individual Fed accounts for monetary policy, which I think is at least worth a debate.

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