Pursuant to Attorney General Loretta Lynch’s welcome change in DoJ policy, it occurred to me that an old draft post of mine might actually merit being posted, so here goes:
After listening to a presentation on the impressive growth in enforcement actions resulting in corporate criminal liability a few months ago, it occurred to me that people without legal training might not actually understand the reasoning behind the critique that individual prosecutions should almost always accompany corporate criminal liability. (The presenter at one point framed such critiques as claiming that prosecutors were colluding with management against the shareholders.)
The problem with corporate criminal liability is this: every crime has a mens rea or element of intent that must be proved as part of the prosecutor’s case. Negligence is one of the lower levels of mens rea, but many instances of negligence are not crimes. Often a “knowing” or “should have known” standard is applied in criminal law.
When a prosecutor chooses to seek corporate criminal liability, without bringing any cases of individual criminal liability, the problem is whether it makes logical sense to argue that the corporation had the mens rea for the crime, but no individual in the corporation had the mens rea (or the one with the mens rea managed not to take relevant action in promotion of the crime). Now one can dream up special circumstances where this position would actually be logical, but it seems to a lot of people that this situation should be rare.
Critics of corporate liability (I’m thinking of Judge Rakoff and Bill Black here, for example) would probably argue that pursuing corporate criminal liability, without pursuing individual liability is tantamount to stating that a crime was committed, but we don’t know by whom. (Note that the reverse where there is individual criminal liability without corporate criminal liability is likely to be much more common. Rogue employees and a genuine effort on the part of the corporation to avoid the criminal activity would both be good reasons – though not necessarily successful reasons – for not extending criminal liability from an individual to the corporation.)
Overall an important criticism of the growth of deferred prosecution agreements and non prosecution agreements is that finding this growth acceptable in the absence of individual prosecutions is essentially lowering the standards for what a prosecutor is supposed to do. “A crime was committed, but I don’t know by whom” should not be the normal stopping point for a prosecutor’s case.
The argument is, of course, not that there should never be corporate criminal liability without an accompanying case for individual liability, but simply that this outcome should be relatively rare. In general, we want our prosecutors to think of their jobs as going all the way to finding out “who done it,” and not stopping with “a crime was committed” and a fine was paid.
In short, the argument against treating a finding of corporate criminal liability as an end point is not about “collusion,” but instead goes to the heart of what it means to enforce the law.
Brad DeLong, who is a brilliant economic historian and whose work I greatly respect, has really mistaken his facts with respect to the history of the Bank of England. And in no small part because DeLong is so respected and so deserving of respect, this post is pure siwoti.
DeLong writes: “central banks are government-chartered corporations rather than government agencies precisely to give them additional freedom of action. Corporations can and do do things that are ultra vires. Governments then either sanction them, or decide not to. During British financial crises of the nineteenth century, the Bank of England repeatedly violated the terms of its 1844 charter restricting its powers to print bank notes. The Chancellor the Exchequer would then not take any steps in response to sanction it.”
DeLong gets the facts precisely backwards. In 19th century crises prior to any breach of the 1844 Act, the Act was suspended by the British government, which promised to indemnify the Bank for legal liability for any breach of the restrictions in the 1844 Act. The text of the 1847 letter was published in the Annual Register and was the model for subsequent letters. It read:
”Her Majesty’s Government have come to the conclusion that the time has arrived when they ought to attempt, by some extraordinary and temporary measure, to restore confidence to the mercantile and manufacturing community; for this purpose they recommend to the Directors of the Bank of England, in the present emergency, to enlarge the amount of their discounts and advances upon approved security, but that in order to retain this operation within reasonable limits, a high rate of interest should be charged. In present circumstances they would suggest, that the rate of interest should not be less than 8 per cent. If this course should lead to any infringement of the existing law, her Majesty’s Government will be prepared to propose to Parliament, on its meeting, a bill of indemnity. ”
In the kabuki show that took place during each of these events, the Bank typically denied that action on the part of the government was necessary. In 1847 it was the mercantile community that depended for existence on the support of the Bank, which sent a delegation to Downing Street to ask that the 1844 Act be suspended (Clapham, II, 208-09). Thus, the Bank most certainly did not act ultra vires. Instead, the terms of its charter were explicitly relaxed by the government each and every time the Bank breached the terms of the 1844 Act.
The relevant part of the 1857 Bill of Indemnity reads:
“the said Governor and Company, and all Persons who have been concerned in such Issues or in doing or advising any such Acts as aforesaid, are hereby indemnified and discharged in respect thereof, and all Indictments and Informations, Actions, Suits, Prosecutions, and Proceedings whatsoever commenced or to be commenced against the said Governor and Company or any Person or Persons in relation to the Acts or Matter aforesaid, or any of them, are hereby discharged and made void.” (See R.H. Inglis Palgrave, Bank Rate and the Money Market, 1903 p. 92)
In short, far from delegating to the central bank the authority to make the decision to take ultra vires actions, the Chancellor of the Exchequer and the Prime Minister were important participants in every single crisis — and they signed off on extraordinary actions by the Bank, before the Bank’s actions were taken.
Indeed, to the degree that the Bank issued notes beyond the constraints of the 1844 Act, the government was paid the profits from the issue of those notes. Effectively this was the quid pro quo for the government’s indemnity of the Bank. (See e.g., George Udny, Letter to the Secretary of State for India dated January 1861 pp. 25-26).
Note: updated 8-3-15 3:25 pm PST.
I have taken my own advice and read (most of) Schumpeter’s Business Cycles with some care. He has completely blown my mind — and I am left bewildered by how it is possible that this body of work has been all but forgotten.
All the elements of what is now known as the Kindleberger-Minsky model of financial crises were present in Chapter IV of Schumpeter’s Business Cycles, and indeed Minsky cites his advisor as an important source for the financial instability hypothesis.
There is a crucial aspect of Schumpeter’s analysis that is, however, typically omitted from discussions of “Minsky moments.” Schumpeter separated out the “displacement” and “boom” phases of crises as fundamentally productive phenomena: displacement is naturally caused when a transformative innovation is funded by credit creation through the financial system and a boom is the inevitable result. Thus, Schumpeter is careful to construct his argument so that there is no doubt that we need the financial system to create credit. Credit creation ensures that growth due to innovation is accompanied by growth in the money supply, and thus that innovation does not result in deflation.
In short, for Schumpeter displacements and booms are an essential part of the process by which innovation drives economic growth.
Unfortunately the same financial system that creates credit to fund innovation, also creates credit to fund many other activities, including the finance of inventories, expansion of existing businesses, and consumption, all of which appear initially to be justified by the dynamics of the boom, but which in the end cause the economy to overheat. Kindleberger calls this phenomenon “overtrading.” The counterpart to an overheated economy is bad debt. As this economy works through the bad debt, “abnormal” liquidation takes place and “destroys many things which could and would have survived without it. In particular, it often liquidates and weeds out firms which do not command adequate financial support, however sound their business may be.” 155. When the economic circumstances are particularly adverse, debt deflation can set in and cause a depression. This is the stage that Kindleberger named “revulsion.”
Overall, Schumpeter didn’t just describe the dynamics of bubble, he also argued that there was a close connection between these dynamics and the capacity of an economy to take advantage of innovation and to grow. In the process, he concluded that almost every economic “catastrophe” can be attributed to dysfunction in the banking sector – and in particular to a failure on the part of bank lenders and business borrowers to exert appropriate control on the use of credit.
Schumpeter’s error presumably was to acknowledge that it was beyond the scope of economic theory to determine how to discipline the banking and business communities in their use of credit. 156. Thus, the intellectual debates of the middle of the 20th were dominated by economic theorists who could offer simpler answers (spend money, increase the money supply) to extraordinarily complex problems.
Brad DeLong needs to give Schumpeter’s 1939 work “Business Cycles” a read. DeLong writes that Schumpeter “genuinely seems to have no clue at all that the business cycle is a feature of a monetary economy,” that he did not understand Wicksell, and that he was a sound money ideologue. I have never studied the history of Schumpeter’s thought, so it is possible that there is an “early” Schumpeter of whom these accusations may be accurate, but by 1939 Schumpeter had not only grappled with Wicksell’s approach but written a very cogent critique of it, had worked out a monetary theory of the business cycle, and had aggressively criticized sound money advocates.
The problem is not that Schumpeter was not a monetary economist, but that he offered a fundamental critique of the way money is introduced into the Walrasian model upon which both modern Keynesianism and much of modern neo-monetarism are built. With Tobin and Friedman allied against his ideas, all that has been passed down into the modern canon of Schumpeterian macro is Minsky.
DeLong apparently has missed something very important about Schumpeter: His “entrepreneurs-disrupt-the-circular-flow-and-cause-structural-change-and-growth-theory of enterprise” is fundamentally a monetary theory. Schumpeter’s analysis is built on a whole theory of the monetary system that makes it possible for entrepreneurs to obtain the funds for their yet-to-be-realized projects without diverting too much in the form of real resources from the already established — and reasonably well functioning — economy. In Schumpeter’s theory at the core of a capitalist economy lies not just innovation, but more importantly the monetary finance of innovation.
This is what Schumpeter has to say about Wicksell (pp. 128 ff.):
The necessity of reconciling a nonmonetary theory with obvious facts of the sphere of money and credit is, in particular, responsible for the idea that there are two kinds if interest rates, a “natural” or “real” one which would also exist in a barter economy and which represents the essence of the phenomenon, a permanent net return from physical means of production, and a monetary one, which fundamentally is but the former’s reflex in the monetary sphere. The two may, nevertheless, differ of course or be made to differ by monetary policy or by an expansion or contraction of bank credit, but this constitutes a disturbance from which a definite string of consequences, among them the business cycle itself, has been deduced. The roots of this idea reach very far into the past and are clearly discernible in the English monetary discussions of the fourth and fifth decades of the nineteenth century. Its role in the thought of our own time is due to the teaching of Knut Wicksell and to the work of a brilliant group of Swedish and Austrian economists. For us, however, there is no such thing as a real rate of interest, except in the same sense in which we speak of real wages : translating both the interest and the capital items of any loan transaction into real terms by means of the expected variation in an index of prices, we may derive an expected and, by performing the same operation ex post, an actual rate of interest in terms of “command over commodities.” But nominal and real rates in this sense are only different measurements of the same thing or, if we prefer to speak of different things even in this case, it is the monetary rate which represents the fundamental phenomenon, and the real rate which represents the derived phenomenon. Hence, the money market with all that happens in it acquires for us a much deeper significance than can be attributed to it from the standpoint just glanced at [i.e. Wicksell]. It becomes the heart, although it never becomes the brain, of the capitalist organism.41
Note 41: Moreover, profits in our sense display no tendency toward equalization. This and the essentially temporary character of profits in our sense should be sufficient to make it quite clear that both our distinction between profit and interest and the relation between them is not identical with an old distinction between normal business profits and contractual interest. However much the writer welcomes anything that will link his teaching to older doctrine, he must point out, first, that normal profits and interest are, according to this view, still the same thing— exactly as contractual and directly earned rent of natural agents is— which he thinks erroneous, and, second, that the analytic problem which he undertook to solve by his theory of interest was precisely to show how it is possible that a theoretically permanent income flows from essentially transient sources and that it should not disappear as a net return through a process of imputation.
One of the points that Schumpeter is making is that if you are going to bring up Walras’s Law then it is clear that you are talking about a barter and not a monetary economy, because the model in which Walras’s Law can be derived is fundamentally a barter economy. (See Jakab and Kumhof for a modern treatment of this issue.) Schumpeter doesn’t tack money onto a model of barter and call it “monetary economics.” Instead he studies the banking system to understand what it does, and then develops a model where the business cycle is driven by phenomena in the money market.
Schumpeter goes on to explain that he has a completely different notion of “capital” than that used by Wicksell. Roughly speaking Schumpeter views capital as financing rather than as a stock of productive goods. He writes (pp. 130 ff.):
Capital in this sense is not goods but balances, not a factor of production but a distinct agent which stands between the entrepreneur and the factors. It can be created by banks because balances can. Its increase and decrease are not the same as increase and decrease of commodities or any particular class of commodities. Its market is simply the money market, and there is no other capital market. No realistic meaning attaches to the statement that, in the latter, “capital” (= some kind or other of producers’ goods) is being ‘lent in the form of money.” But again as in the case of interest the introduction into our analysis of this concept of capital does not do away with the problems of what is traditionally referred to as real capital—on the contrary, they reappear though in a new garb—and results arrived at by means of a monetary theory of capital not always invalidate, but in many cases only reformulate, the proposition of “real” theories of capital. If our understanding of the processes of capitalist society hinges on realizing the fact that monetary capital is a distinct agent, it also hinges on realizing how it is related to the world of commodities.
In addition, Schumpeter explained very clearly that “catastrophes” in capitalist economies are usually due to defective regulation of the banking system. If I remember correctly, DeLong has acknowledged that one of his errors prior to the crisis was to underestimate dysfunction in the banking system. Perhaps if he were more familiar with Schumpeter, he would have been less likely to make that error. Schumpeter writes (p. 117):
Moreover, bankers may, at some times and in some countries, fail to be up to the mark corporatively : that is to say, tradition and standards may be absent to such a degree that practically anyone, however lacking in aptitude and training, can drift into the banking business, find customers, and deal with them according to his own ideas. In such countries or times, wildcat banking develops. This in itself is sufficient to turn the history of capitalist evolution into a history of catastrophes. One of the results of our historical sketch will, in fact, be that the failure of the banking community to function in the way required by the structure of the capitalist machine accounts for most of the events which the majority of observers would call “catastrophes.” [my emphasis]
Thus, Schumpeter’s error is not to fail to write monetary economics, but to have such a profound understanding of the relationship between money and finance that his work was not understood by the founders of modern macroeconomics.
Furthermore, when it comes to “sound money” Schumpeter writes of the 1830s experience with “reckless banking” in the U.S. (pp. 236 ff):
Whatever our opinion might be if we placed ourselves on other possible standpoints, however strongly we may feel it our duty to condemn both the misconduct involved and the public opinion that not only condoned but fostered it, the fact still remains that we have before us the clearest historical instance by which to illustrate the function of credit creation. It was the financing of innovation by credit creation— the only method available, as we have seen in the course of our theoretical argument, in the absence of sufficient results of previous evolution—which is at the bottom of that “reckless banking.” This undoubtedly sheds a different light upon it. Those banks filled their function sometimes dishonestly and even criminally, but they filled a function which can be distinguished from their dishonesty or criminality. Sound money men of all times, hence, threw and still throw away the baby with the bath by condemning the principles of that practice, however understandable their clamor for policing and controlling the practice itself may have been. The people felt this. So did some of the advocates of inflation, though they were unable to formulate their case correctly.
Thus, Prof. DeLong is making very unfair accusations against Schumpeter when he claims that Schumpeter “denies that anything other than budget surpluses and ‘sound money’ can ever be appropriate economic policies.” Schumpeter indicates that the problem with people like DeLong is that they are unable to formulate their case correctly, because they don’t have a good understanding of the relationship between money and finance.
I think that Schumpeter would agree with my view that those who claim that monetary policy can solve the problem of “a shortage of safe assets” are confused. We have a shortage of safe assets, because we have a dysfunctional banking system that is currently incapable of creating safe assets. If this is correct, then holding interest rates at zero will not solve the problem and get the capitalist engine running again. That is like pouring gas into a broken engine and expecting it to run, when of course what is needed is that you make the effort to learn how to fix the engine.
Noah Smith, a finance professor, has written a piece arguing that the finance approach to “behavioral” economics/finance has been very successful, whereas it has been largely rejected by the macroeconomics profession. The piece is confusing, however: even though Smith explains that the term “behaviorial economics” refers to a much narrower field of study than the term “behavioral finance,” he does not explore fully the implications of these two different definitions.
Smith explains the different terms:
To most economists, behavioral economics means using findings from psychology to modify models of individual behavior. But behavioral finance has come to have a much more expansive meaning, basically encompassing anything that doesn’t conform to the Efficient Markets Hypothesis (which says that you can only earn market-beating returns by taking on extra risk).
What is left out of Smith’s piece is that many of the approaches that are categorized as “behavioral” in finance, are categorized as mainstream in macroeconomics. There’s no division between saltwater and freshwater macroeconomists on whether macro needs to study frictions using the whole of the microeconomic toolbox including contract theory, mechanism design, etc. The study of the many ways in which Arrow-Debreu (and more generally the efficient markets hypothesis) fails has been fundamental to the macroeconomic research agenda for at least three decades.
By contrast, when the finance profession categorizes mainstream economic theory as “behavioral,” this has the effect of defining as mainstream finance that which is consistent with the efficient markets hypothesis. As a result finance is probably the only economics-related field that has not yet integrated the mid-20th century critiques of the competitive model into its “mainstream” body of theory. For this reason, the fact that “behavioral finance” is alive and well is hardly surprising: if this were not the case, the field of finance theory would be decades behind the theory that is used throughout the economics profession.
The real question then is why the finance profession has not dropped the “behavioral” moniker from behavioral finance, and renamed non-behavioral finance “frictionless finance.”
Note: It is clear that Paul Romer finds that macroeconomists have a lot of work to do when it comes to incorporating decades-old critiques of the competitive model into the their work. As I understand his argument, he objects to the way the critiques have been incorporated in macro, because this constitutes a pluralistic “views about the shape of the earth differ” approach, rather than an effort to fully acknowledge and integrate the logical implications of these critiques into what constitutes mainstream theory. I suspect that Romer would agree, however, that macro theory is several steps ahead of efficient-markets-based finance theory — if only because mainstream macro at least includes theory that is not price-taking and frictionless.
Peter Conti-Brown and Philip Wallach are having a debate that cuts right to the heart of what appears to me to be the most important economic question of the current era: what is the proper role of the central bank?
Conti-Brown takes what I think is a fairly mainstream view of the central bank’s role as lender of last resort: In a crisis, the central bank should intervene to rescue a troubled bank as long as, given Fed support, the bank can over time be restored to solvency. He writes:
in a systemic crisis, the problem of determining whether a specific asset class is sufficiently valuable to justify its temporary exchange for cash isn’t just “murky,” it can be impossible to determine. This is true for two reasons: first, the reason the systemic crisis exists at all is because the line between illiquidity and insolvency has become a mirage. And second, whatever line is left is endogenously determined: what the central bank does in response to the crisis has immediate consequences on both liquidity and solvency. There is essentially no way, in the depth of a crisis, to draw the line meaningfully between solvency and illiquidity. After Lehman, the Fed recognized this and extended loans through 13(3) so quickly on so many different kinds of collateral that we saw an explosion in its 13(3) lending.
The clear implication here is that if there is doubt as to whether a firm is illiquid or insolvent, the Fed should err on the side of supporting the firm.
Wallach responds that if one follows this logic to its end, there appear to be no limits to the Fed’s powers:
If I’m understanding him correctly here, Peter means to put in the Fed’s mouth some version of an infamous 2004 pronouncement of a Bush administration aide: “when we act, we create our own reality.” Amidst the chaos of crisis, it is for the Fed to decide which firms are solvent and which kinds of assets are really valuable as collateral and, whatever they decide, the markets will follow, allowing the central bank to benefit its own balance sheet and the larger financial system through self-fulfilling optimistic prophecy. As they forge this new reality, making the security on loans satisfactory to themselves will be the least of their miracles.
Teasing aside, I think that’s far from crazy, but one can get carried away. It can’t be the case that the Fed is capable of rescuing any institution through this kind of heroic thinking: if a firm is in a downward spiral, and the only collateral it has is rotten, then the Fed does not have the legal authority to funnel money into it.
I think that there are actually three question raised by this exchange: First, what are the Fed’s potential powers; that is, what is it feasible for the Fed to do? Second, what were the Fed’s powers in 2008; or alternatively, what was both legal and feasible for the Fed to do? And, third, what should the Fed have legal authority to do? Conti-Brown and Wallach are debating the second question, but I think it’s important to explore the first question regarding what the Fed can do, before moving on to the second and third questions regarding what the Fed is legally authorized to do.
A little history on the concept of the lender of last resort is useful in exploring the first question. A previous post makes the point that the term lender of “last resort” was initially coined, because the central made the self-fulfilling determination of whether or not a bank was solvent and worthy of support. The fact that the central bank has the alternative of saving a bank, but chooses not to is what defines the power of a lender of “last resort.” From the earlier post:
The term “lender of last resort” has its origins in Francis Baring’s Observations on the Establishment of the Bank of England and on the Paper Circulation of the Country published in 1797. He referred to the Bank of England as the “dernier resort” or court of last appeal. The analogy is clear: just as a convicted man has no recourse after the court of last appeal has made its decision, so a bank has no recourse if the central bank decides that it is not worthy of credit. In short, the very concept of a “lender of last resort” embodies the idea that it is the central bank’s job to determine which banks are sound and which banks are not — because liquidity is offered only to sound banks. And the central bank’s determination that a financial institution is insolvent has the same finality as a last court of appeal’s upholding of a lower court’s death sentence.
In short, for a partial reserve bank “solvency” is a state of affairs that exists only as long as the bank has access to central bank support. Solvency in the banking system does not exist separate and apart from the central bank – and this concept was fundamental to the 18th and 19th century understanding of banking in Britain [where the concept of lender of last resort was developed].
There is a long list of banks that were deliberately allowed by the Bank of England to fail in Britain, including the Ayr Bank in 1772, and Overend, Gurney, & Co. in 1866. The latter was, second to the Bank of England, the largest bank-like intermediary in England at the time, and its failure triggered a Lehman-like financial crisis — that was, however, followed by only a short, sharp recession of unexceptional depth. Bagehot made it very clear in Lombard Street that he did not believe that the Bank of England had mishandled Overend Gurney. He argued, on the contrary, that it was always a mistake to support a “bad bank.”
In short, just as it is in some cases the job of a court of last appeal to uphold the law in the form of a death sentence, so it is in some cases the job of a central bank to pronounce a death sentence on a bank in order to promote healthy incentives in financial markets. The fact that the bank would still be alive in the absence of the death sentence is as obvious and irrelevant in the case of the lender of last resort as it is in the case of the court of last appeal.
So let’s go back to the original question: What are the potential powers of the Fed? Can it in fact determine “which firms are solvent and which kinds of assets are really valuable as collateral” and expect markets to follow that determination? We have a partial answer to this question: from past experience we know that a central bank can choose not to support a bank in a crisis in which case it is almost certain the bank will fail, or that a central bank can choose to support a bank and with equal certainty carry it through a crisis of limited duration. We also know that sometimes a bank that was saved fails a few years or a decade after it was saved (e.g. City of Glasgow Bank). The British history also indicates that it is possible for a central bank to have a similar effect on assets (see here).
Thus, the fact that ex post the Fed did not lose money on any of the Maiden Lane conduits — or more generally on the bailout — is not evidence that the Fed exercised its lender of last resort role effectively. Instead this fact is simply testimony to powers of a central bank that have been recognized from the earliest days of central banking.
What we don’t know are the limits of a central bank’s ability to “create it own reality.” Can a central bank continue to support banks and assets for a prolonged period of time and still be successful in leading markets? At what point, if ever, does the central bank’s intervention stop being a brilliant act of successful alchemy, and end up looking like fraud?
What makes a lot of people in the financial industry nervous about the current state of central bank intervention (see for example here, here or here) is that they are not sure that the central banks will be able to exit their current policies without causing a crash in financial markets of the sort that none of us has ever seen before. Of course, we are sailing uncharted waters and literally nobody knows the answer. Let’s just hope that Janet Yellen and Mario Draghi are brilliant and creative helmsmen. (Should that be helmspeople?)
In summary, the term lender of “last resort” itself makes it clear that a fundamental aspect of a central bank’s duties is to refuse to support firms such as Lehman. Thus, in my view Conti-Brown, even though he gives a description of a lender of last resort that many modern scholars would agree with, envisions a lender of last resort that is very different from that of Bagehot and 19th century bankers. Whereas Conti-Brown appears to argue that, because the line between solvency and insolvency is so murky in a crisis, if a bank can be saved, it should be saved, Bagehot clearly understood that even though Overend Gurney could have been saved (ch X, ¶ 11), it was correct for the Bank of England to choose not to save it.
This very traditional view of the central bank, as the entity that determines which banks are managed in such a way that they have the right to continue operating, indicates that the Fed’s error in 2008 was not the decision to let Lehman fail, but the failure to prepare the market for that decision beforehand. The Bank of England announced its policy of not supporting bill-brokers such as Overend, Gurney & Co. in 1858, fully eight years before it allowed Overend to fail. This failure was followed by a full century of financial stability. The Federal Reserve, by contrast, never clearly stated what the limits of its lender of last resort policy would be in the decades preceding the 2007-08 crisis. Indeed, the Fed was busy through those decades expanding the expectations that financial institutions had of support from the Fed. Thus, the post-Lehman crisis was decades in the making, and was further aggravated by the inadequate warning signs provided to markets subsequent to the Bear Stearns bailout.
The definition of the proper role of the central bank is probably the most important economic question of our times. We are learning through real-time experimentation what are the consequences of extensive central bank support of the financial system — and whether financial stability is better promoted by a 19th century lender of last resort that very deliberately allows mismanaged banks to fail or by a 21st century lender of last resort that provides much more extensive support to the financial system.
Bengt Holmstrom has a paper explaining the “diametrically opposite” foundations of money markets and capital markets.* This dichotomy is also a foundation of traditional banking theory, and of the traditional functional separation that was maintained in the U.S. and Britain between money and capital markets.
Holmstrom explains that “the purpose of money markets is to provide liquidity,” whereas price discovery is an important function of capital markets. In a paper I extend this view a step further: money markets don’t just provide liquidity but a special form of price stable liquidity that is founded on trade in safe short-term assets; by contrast capital markets provide market liquidity which promotes price discovery, not price stability.
A century ago in Britain privately issued money market assets were, like capital market assets, actively traded on secondary markets. The two types of assets traded, however, on completely different markets with completely different structures that reflected the fact that money market assets needed to be “safe.”
To understand why the markets had different structures consider this question: how does one ensure that the safety of the money market is not undermined by asymmetric information or more specifically by the possibility that when the owners of money market assets have information that the assets are likely to default they do not use the market to offload the assets, adversely affecting the safety of the market itself, and therefore its efficacy as a source of price stable liquidity? The answer is to structure the market as a discount market.
In a discount market, every seller offers a guarantee that the asset sold will pay in full. (You do this yourself when you endorse a check, signing its value over to a bank — while at the same time indemnifying the bank against the possibility that the check is returned unpaid.) This structure was one of the foundations upon which the safety of the London money market was built. The structure ensures that the owner of a dubious asset has no incentive to attempt to sell it, and in fact is very unlikely to sell it in order to hide from the public the fact that it is exposed to such assets.
From their earliest days it was well-understood that discount markets were designed to align the incentives of banks originating money market assets and to promote the safety of the assets on the money market. (See van der Wee in Cambridge Economic History of Europe 1977.) Any bank that originates or owns a money market asset can never eliminate its exposure to that asset until it is paid in full. For this reason a discount market is specifically designed to address problems of liquidity only. That is, a bank that is illiquid can get relief by selling its money market assets, but if it has originated so many bad assets that it is insolvent, the money market will do nothing to help.
Contrast the structure of a discount market with that of an open market. On an open market, the seller is able to eliminate its exposure to the risks of the asset. This has the effect of attracting sellers (and buyers) with asymmetric information and as a result both increasing the riskiness of the market and creating the incentives that make the prices of the risky assets that trade on open market informative. Thus, it is because price discovery is important to capital markets, that they are structured as open markets. Capital markets can only offer market liquidity — or liquidity with price discovery — rather than the price stable liquidity of the money market. On the other hand, an entity with asymmetric information about the assets that it holds can use the open market structure of capital markets to improve its solvency as well as its liquidity position.
Historically it appears that in order for a money market to have active secondary markets, it must be structured as a discount market. (Does anyone have counterexamples?) That is, it appears that when the only option for secondary trading of money market instruments is an open market, then secondary markets in such instruments will be moribund. This implies not only that the absence of incentives to exploit asymmetric information plays an important role in the liquidity available on money markets (cf. Holmstrom) — but also that price stable liquidity is an important benefit of the discount market structure.
Both discount markets and open markets can be adversely affected by extraordinary liquidity events. But only one of the two markets is premised on safe assets and price stable liquidity. Thus, the lender of last resort role of the central bank developed in Britain to support the money (discount) market only. (In fact, I would argue that the recognized need for a provider of liquidity support to the discount market explains why the Bank of England was structured as it was when it was founded, but that goes beyond the scope of this post. See Bowen, Bank of England during the Long 18th c.) One consequence of the fact that the central bank supported only assets that traded on a discount market is that it was able to support the liquidity of the banks, without also supporting their solvency.
Given the common claim that one hears today that it is unreasonable to ask a central bank to distinguish illiquidity from insolvency in a crisis, perhaps it is time to revisit the discount market as a useful market structure, since acting through such a market makes it easier for a central bank to provide liquidity support without providing solvency support.
*His focus is actually money markets and stock markets, but in my view he draws a distinction between debt and equity that is far less clear in practice than in theory. In a modern financial system unsecured long-term bonds are not meaningful claims on the assets of a firm, because as the firm approaches bankruptcy it is likely to take on more and more secured debt leaving a remnant of assets that is literally unknowable at the time that one buys an unsecured long-term bond.
Peter Conti-Brown argues that the Fed could have bailed out Lehman Bros. but chose not to and is using the law as “ex post rationalization” for political action. Philip Wallach argues that the fact that the Fed wasn’t satisfied with Lehman’s collateral means that it could not bail out Lehman.
The underlying question is this: What does the criterion in section 13(3) of the Federal Reserve Act, “secured to the satisfaction of the Federal Reserve Bank” mean? In my view the text itself makes clear that the interpretation of the meaning of the term “secured” has been delegated by Congress to the Federal Reserve Bank in question, subject in theory (although arguably not in practice) to a “reasonableness” standard.
For this reason, I am having difficulty following Conti-Brown’s argument. He writes in a follow up post:
The point is that “satisfaction,” in the midst of a financial crisis, is an entirely discretionary concept. . . . Instead, my argument—and critique—is that Bernanke, Paulson, Geithner, and others made a decision. They exercised the discretion they were entitled to make. They made these decisions knowing that there would have been enormous political fallout if they had bailed out another Wall Street “bank.” And they made it knowing that the legal authority to go in another direction was broad, robust, and entirely left to the discretion of two bodies of decision-makers within the Federal Reserve System. The Fed wasn’t legally obliged to do anything. But nor was it legally prevented from doing something.
I think there is confusion here. The Fed was granted discretion to interpret the meaning of the term “secured” within reasonable bounds. It was not, however, granted discretion to do whatever it thought was necessary in a financial crisis.
Thus, I don’t think it makes sense to call the Fed’s claim that the law prevented it from lending to Lehman an “ex post rationalization.” Conti-Brown appears to be arguing that he knows that the Fed first decided not to bail out Lehman and then later determined that it did not have adequate collateral to “secure” a loan. But it seems much more likely to me that these two determinations were so closely intertwined that they were more or less determined at the same time: that is, it is at least equally likely that the Fed was unwilling to bail out Lehman, because in its discretion it found Lehman’s collateral to be inadequate. Given that the Fed is by law the entity that interprets the meaning of the term “secured” in section 13(3) of the FRA, such a finding by the Fed is close to a final determination on the issue. Thus, far from being an “ex post rationalization,” the Fed’s explanation that a bailout of Lehman was not permitted seems to me simply a description of its decision-making process.
In my view, the fact that the Fed could potentially have exercised its discretion differently is irrelevant. What makes this complicated is, of course, the fact that the Fed turned around found that collateral that was deemed inadequate on September 15 had become adequate a few days later. In short, Conti-Brown appears to be arguing that, if the Fed had authority to bail out AIG et al., then it must have had authority to bail out Lehman.
In my view, this gets the reality of the situation precisely backwards. I think that since the Fed didn’t have the authority to bail out Lehman, it probably didn’t have the authority to bail out AIG. Indeed, the AIG trial has made it clear that regulators believed that an AIG bailout was necessary and that they pushed legal interpretations of Fed authority to their absolute limits. In fact, I suspect you could even get some of the attorneys involved to admit the latter — though they would almost certainly also assure us that no lines were actually crossed. (For an example of this, see the Sept. 21 email from Fed General Counsel Scott Alvarez indicating that a term sheet produced five days after the AIG loan-for-stock bailout was announced had to be changed because the Fed couldn’t own AIG stock.) Whenever you are that close to a boundary, however, it seems very likely that there are lawyers and regulators close to the action and possibly even at a decision making level who believe that lines were in fact crossed — but that they were crossed in order to do what was necessary and in that sense in good faith. On the other hand, I would not expect any such privately held views to come to light until the passage of time has rendered them statements of only historical interest. (And even then only the non-lawyers are likely to speak out.)
In short, it seems to me that a position equally valid to that taken by Conti-Brown is that the Fed didn’t have the authority to bail out Lehman and didn’t have the authority to bail out AIG et al. But the more important point is that the law as drafted deliberately renders this whole discussion moot. The Fed was granted the authority by Congress to make two decisions within a week of each other that would appear to be contradictory. This, in fact, is the essence of what “to the satisfaction of the Fed” means.
Nick Rowe has a post up from a week ago on macroeconomic policy. He points out that as long as we have a central bank, that central bank will be affecting the macroeconomy, so it doesn’t really matter whether we need a central bank to stabilize the economy. The only relevant question is what the central bank should do. In Nick’s view the old question was whether the central bank should follow rules or act on a discretionary basis, but now there’s a fairly strong consensus in favor of rules and the debate centers on whether central bank monetary policy can be effective in contemporary circumstances (i.e. at the zero lower bound).
Nick argues that monetary policy can be effective — the central bank just needs to keep buying something in order to put more money into circulation. He rejects the view buying private sector assets ends up being fiscal policy and argues that it can be kept neutral (as opposed to the picking of winners and losers that characterizes fiscal policy) by, for example, having the central bank buy the index of all marketable securities.
My model of a central bank is based on the role of the Bank of England in the early 20th century and thus it is very different from Nick’s (and from that of most macroeconomists). I don’t understand how it could ever be possible for monetary policy — or for a one-dimensional policy tool that adjusts either “M” or “i” — to stabilize the economy. To stabilize the economy the central bank needs to monitor and discipline the flow of credit through the banking system. It needs a window on how credit is flowing to the different sectors of the economy. And when the banks are allowing so much credit to flow to a certain sector that prices are becoming (or are likely to become) misaligned in that sector, the central bank needs to force the banks to restrict the flow to that sector.
In short, I think the focus on one-dimensional monetary policy is the reason we had the mother of all financial crises — and let’s be clear, from the British perspective this crisis was indisputably worse than any crisis experienced over the past two centuries with the possible exception of the outbreak of World War I.
Macroeconomists need to start thinking outside their general equilibrium models where there are no relative price distortions, and understand that the banking system has the capacity not just to inflate prices, but also to distort prices. And that when these prices get so out of line that readjustment is forced, the result is often disruptive. Thus, the important tasks of the central bank include keeping an eye on the flow of bank credit and taking quick action when this flow is clearly out of kilter.
Let me give a specific example. From mid-2004 to mid-2006 the Federal Reserve was raising interest rates. At the same time the origination of adjustable rate mortgages which have interest rates that are very sensitive to the short-term rate did not fall, but actually rose and remained elevated throughout the period of rising rates. (Compare Figure 14 with Figure 17 here.) When significant increases in interest rates have no effect on the quantity of credit, alarm bells need to start going off at the Fed. This is a clear indicator of Ponzi finance.
And we all know what was happening to housing prices as the same time that mortgage credit markets were clearly out of whack. The Federal Reserve should have observed the clear indicators of dysfunction in mortgage markets, and it should have taken action to adjust the flow of credit. If the Fed recognized this duty, the housing bubble would have been much less severe.
Unfortunately the Fed was very much focused on one-dimensional policy. If the Fed wants to stabilize the economy, it will have monitor the flow of credit through the economy and be ready to take action to address any markets where the data makes it clear that something is going very wrong.
The “real bills” approach to banking is profoundly misunderstood, as I explain in this paper. What I’ve just recently realized is that Minsky’s financial instability hypothesis is probably derived from real bills. In particular, Minsky cites Schumpeter, who was I believe familiar with contemporary banking theory.
A real bill is a short-term loan that arises out of a commercial transaction. These bills circulated as money in the commercial cities of Europe in the 17th and 18th centuries because banks stood ready to buy the bills. In accounting terms a real bill monetizes an asset that is earned, but not yet realized. What very few modern writers understand is that if a bank, instead of demanding payment on a real bill, rolls it over, the resulting line of credit is not a real bill. There are many names for this kind of loan including fictitious bill, accommodation bill, and finance bill. Finance bill is the term that stuck and lasted into the 20th century.
Limiting credit to real bills is very constricting, so in Britain finance bills were made negotiable (so they too could circulate easily as money) in the 1830s. Through a series of subsequent crises Britain learned about the dangers of zombie banks and loose credit more generally. By the third quarter of the 19th century, however, the Bank of England had learned how to manage the brave new world of finance bills, and Britain experienced a century of banking stability.
What was the key to banking stability in Britain? The principle that money market instruments should not be used to (i) finance the purchase and carry of capital market assets (or land) or (ii) be rolled over to such a degree that they were effectively playing the same role as an equity stake in a firm. This is the real “real bills” approach to banking.
What I’ve just realized is that the same principle underlies Minsky’s financial instability hypothesis (probably through Schumpeter). In fact, when the early Fed was worried about credit markets, it discusses the problem of an excessive growth of speculative bills. (See the Fed’s 10th annual report.) And the Fed uses the term “speculative” in exactly the same sense that Minsky does.
Recall that Minsky defines three types of finance:
Hedge finance takes place when the borrower is able to pay both interest and principal out of cash flows. This is not destabilizing.
Speculative finance takes place when the borrower only has expectations of paying interest on the loan and thus the loan has to be rolled over repeatedly. Just like the Fed in 1923, Minsky argued that the growth of speculative finance was a sign of destabilization building up in the economy.
Ponzi finance takes place when the borrower’s cash flow leaves the borrower unable even to pay interest, so the borrower must either sell assets or rely on increases in asset value together with new loans to stay current on the debt. Minsky argued that this is what is going on right before a crash.
Overall, the real bills approach to managing the banking system should be understood as a policy of controlling the growth of speculative and Ponzi finance in the economy. The evidence indicates that the Bank of England was actually very good at doing this for many, many years.