Before there were money market funds — and their finance of banks and big corporations borrowing on commercial paper and other wholesale markets — monetary policy in the US used to be implemented by starving banks of funding and thereby constraining the credit they could provide to the economy (Burns 1979).
How is this possible, you ask, in a world where the money supply is endogenous? This was an environment where current accounts were required by law to pay 0% interest, bank time deposit interest rates were capped at 4-5% and all bank funding in the form of publicly issued debt was legally classified as deposits. When the Federal Funds rises to, say 6%, and other short term rates also rise, (i) the banks don’t particularly want to have to borrow reserves because they are a relatively expensive source of funding, and (ii) holdings of bank deposits become a hot potato, and banks have to adjust to a world where outflows of funds are faster and more variable, so at any given level of lending the risk of having to borrow reserves increases. Historically, banks chose to reduce their lending in this situation, making monetary policy very effective. This is well documented.
This world was completely transformed starting in the late 1960s, when so-called market-based finance first began to develop. Banks were now allowed to use Eurodollar and commercial paper markets for funding. Of course, only a select group of large banks had easy access to this “market-based” funding. These banks facilitated the development of money market funds that could invest in these market-based instruments, thereby freeing the banks from regulatory constraints associated with deposit-based funding. This created a two tiered monetary system in the US, the “money center banks” that were funding on “markets” through money market funds and through their relationships with corporations and their treasury departments, as well as earning income from providing services that made it possible for corporations to fund directly on these markets. In the meanwhile, the rest of the commercial banking system had little or no access to “market-based” funding and was thus still constrained by the regulations governing deposit based funding.
This two-tier system might not have lasted very long, had markets been allowed to function. However, in 1974 when the post-Bretton Woods monetary system had yet to prove itself, the Federal Reserve created “too big to fail” by bailing out a fraudulent bank, Franklin National, in order to stabilize the Eurodollar market — and to preserve the dollar’s position in the post-war monetary system (Sissoko 2019; Spero 1980). In fact, this was just a way of covering up the gross inadequacies of the US bank regulatory system, which continue to this day. (Allowing banks to choose their regulator is not an intelligent way of designing a regulatory system.)
In this era, the Fed’s traditional tools of monetary policy did not have much effect on the money center banks, which after the Franklin National bailout had access to funding at LIBOR, the interest rate on the Eurodollar market, and this funding was understood to carry an implicit US government guarantee. Thus, the reason people like Arthur Burns (1979) doubted that Paul Volcker could tighten monetary policy enough to control inflation was because the Fed had traction over only a portion of the banking system — and not the part of the banking system that provided funding for the biggest US corporations. What Paul Volcker proved was that monetary policy could control inflation even if it was only small- and medium-sized domestic enterprises and the general public that suffered from a significant credit contraction, while the biggest enterprises just faced an incremental increase in the cost of funds.* (Through the worst of Volcker’s interest rate hikes from December 1980 to August 1981, Libor was running 3 to 5% below the Federal Funds Rate.)
This two-tiered banking system continued to operate with the “too big to fail” money center banks receiving ever expanding forms of government support (the bailout of the banks on the backs of LDC countries, the Greenspan Fed’s regulatory lifting of the Glass-Steagall restrictions, the deregulation of derivatives and the hobbling of the CFTC, etc.) so that they grew to make up an ever increasing fraction of the banking system over the course of three decades. While monetary policy was operated as interest rate policy, monetary control was for the most part ceded to the money center banks which were allowed free reign to monetize assets by covering them with “off-balance-sheet” bank guarantees, thereby making them eligible assets for money market funds and so-called market based finance. (Money center banks were able to dominate this activity, because the credit rating agencies explicitly viewed them as having an expectation of government support.)
In 2008, the contradictions at the core of this “market-based” monetary system were exposed. Money market funds are pass-through vehicles. Under no circumstances should they ever be treated as a reliable source of funding for any asset, because it is in their DNA that they are every bit as unstable as money demand itself. The 2007 ABCP crisis took place because this fact was not understood by regulators. On the other hand, the credit rating agencies do apparently understand this instability and as a result, when MMF funding exits the market, the banks have a contractual obligation to support the assets — and as long as the banks in question are “too big to fail” that obligation will fall to the government in extremis. This is the basic structure of “market-based” finance, at least as it applies to the funding of private sector assets on money markets.
Interest rates on money markets are inherently unstable. The most basic task of a central bank is to stabilize the funding of “good” short-term assets, while taking care not to support the value of “bad” short-term assets. The former is important because a lot of very valuable economic activity will be discouraged in an environment where short-term funding rates have a habit of spiking upwards. On the other hand, providing universal access to cheap short-term funding with no credit discrimination at all is a recipe for disaster, because the funds will be misused and bankruptcy and financial instability will result. The short-term funding system has to have some mechanism for distinguishing “good” assets from “bad” assets.
In the pre-2008 monetary policy regime, the problem of distinguishing “good” from “bad” assets was delegated to banks. The Fed ensured that banks could borrow at a stable rate. In theory, a bank that used that facility to lend “badly” was at risk of failure and being closed or sold off. In practice, of course, only small banks were subject to this discipline — and as we saw most “too big to fail” banks engaged in lending practices — including providing contingent guarantees that they were unprepared to meet without regulatory forbearance — that were at best unwise.
Now the Fed is looking for another means of implementing monetary policy. The key problem is, as it has always been, how to stabilize interest rates in a way that is consistent with financial stability goals. Or in other words, to provide stable funding for “good” short-term assets, while avoiding the funding of “bad” short-term assets.
The risk here is that the Fed still seems to be prone to assuming that “markets” will do its job for it. It was caught flat-footed in September, when it learned that “markets” will not stabilize rates by themselves (See BIS 2019 and Coppola 2019 on this).
Now the Fed appears ready to step in to stabilize rates in the repo market. The question is whether the Fed understands that there must be some mechanism for distinguishing “good” from “bad” assets, or whether once again it is expecting “markets” to solve this problem — despite the fact that (i) “too big to fail” is far from having been laid to rest; and (ii) so many businesses have been operating for decades in an environment where it is very cheap to extend and pretend that there has likely been too little feedback and the standard learning process for managing business debt may not be operating effectively. To make the latter point by analogy, just as regular small fires are essential to a healthy forest, so it is important to the economy that regular business failures take place to engender a healthy measure of caution in business decision-makers. As Frances Coppola puts it: “Why are we once again allowing the Fed to provide an implicit backstop for risky non-banks, thus enabling them to misprice risk and gorge on leveraged trades without fear of market penalty? Have we learned nothing from the past?”
In response to Frances, David Andolfatto asks whether a Standing Overnight Repo Facility that serves to cap interest rates in the repo market (as was proposed here and here) is an adequate solution. Unfortunately it seems that an overnight facility is likely to be inadequate to address interest rate volatility on the repo market, since the BIS discussion makes it clear that intraday repo demand was also very high.** Zoltan Poszar’s most recent Global Money Note (#26) explains that this demand for intraday liquidity is likely to due to the fact that Basel III requires the systemically important banks to prefund their intraday liquidity needs. Unsurprisingly this leads a hoarding of reserves in order to preclude the risk of being in violation of Basel III.
Furthermore, simply establishing Fed lending that ensures that money market rates don’t spike seems to be in line with the Fed’s historical tendency to rely on stop-gap measures that have not been thought out at all in terms of their effect on financial stability, but even so become permanent. The Fed needs to think long and hard about what mechanism is going to ensure that the liquidity that it provides is going to the right kind of short-term borrowing. Sixty years ago the answer to the problem was easy: the Fed provided liquidity to the banks and if the banks made bad loans, it was the bank shareholders that were going to eat the loss. Since the rise of market-based lending and bank creditors whom the Fed perceived as needing to be protected at all costs, in the US both the managers and the shareholders of money center banks have been coddled outrageously for decades, and after the experience of 2008 not many people have much faith that they even know how to distinguish good from bad assets any more.
So the real problem is that the Fed has a mechanism design problem that it needs to solve: How is it going to design the market through which monetary policy is implemented to ensure that it is no longer perverted by “too big to fail” and to ensure that any losses on bad assets fall in a way that fully aligns incentives in the market?
* I think it is possible to both approve entirely Martin Wolf’s assessment of Paul Volcker, the man: “Paul Volcker is the greatest man I have known. He is endowed to the highest degree with what the Romans called virtus (virtue): moral courage, integrity, sagacity, prudence and devotion to the service of country.” and yet at the same time to feel that the legacy he left us is very complex indeed. We need great public servants like Paul Volcker, but we need to recognize that they cannot save us when the underlying problem is systemic.
** In fact, the degree to which the Fed is currently providing intraday liquidity (anybody know where this data can be found?) is probably a good clue to whether the stressors in the repo market are mostly overnight or also intraday.
Synthetic Assets 
Quoting you:
…Before there were money market funds — and their finance of banks and big corporations borrowing on commercial paper and other wholesale markets — monetary policy in the US used to be implemented by starving banks of funding and thereby constraining the credit they could provide to the economy (Burns 1979).
How is this possible, you ask, in a world where the money supply is endogenous?
…This created a two tiered monetary system in the US, the “money center banks” that were funding on “markets” through money market funds and through their relationships with corporations and their treasury departments, as well as earning income from providing services that made it possible for corporations to fund directly on these markets. In the meanwhile, the rest of the commercial banking system had little or no access to “market-based” funding and was thus still constrained by the regulations governing deposit based funding.
My comment: I would argue with the Post Keynesian and MMT teams that government reserve supply was also endogenous, not just the overall money supply. I think this insight might help resolve some of the paradoxes you see—particularly if you are interested in even more deconstruction of the mainstream, textbook view. Now specifics related to this point:
(1) To some extent the Fed accommodated bank reserves needs through the reserve window, which you do not mention. Of course, funds there carried a premium, including the nonpecuniary costs of revealing financial weakness to those with information about who was borrowing.
(2) Also, smaller banks, including community banks, often sold jumbo CDs in this era. These were often bought by the large, money center banks who indeed had direct access to the cheapest short-term credit. In fact, smaller financial institutions were in debt as a group to these larger institutions, an echo of the traditional relationship between London and “country” banks in the U.K.
(3) Next, in those old days, there were regulations directly on lending supply, both with legal “bite” and with informal jawboning. Of course, those faded out with the rise of the neoliberal approach and monetarism.
(4) Deposit rate regulation is part of your story. Something similar happened in the U.S. with savings and loans, which suffered disintermediation in the 1970s as financial institutions’ costs of funds rose. These kinds of regulations often just helped create imbalances and problems in subsectors of the finance sector. They regulations were in part vestiges of an earlier system in which these subsectors had unique government mandates to provide certain kinds of loans (like cheap 30-year, fixed rate mortgages), which were thought to reflect social purposes.
(5) Also, of course, credit outstanding continued to respond to the price of credit. This is a demand-side phenomenon, but it also reflects the Fed’s policy decision to allow rates in repo markets to rise.
So, I would question the idea that the Fed suffered a loss of a former ability to implement monetary policy in a way that would reduce aggregate demand via through the supply side of credit markets. Moreover, some alternative means remained by which it could regain additional regulatory supply-side control. Finally, to some extent it exerted control through the demand side by controlling the price of credit.
For people who are new to some of these institutional facts, which are to some extent admittedly matters of interpretation, I would mention Hyman Minsky, Stabilizing and Unstable Economy (1986), Basil J. Moore, Horizontalists and Verticalists (1988), and L. Randall Wray, Endogenous Money in Capitalist Economies (1990).
In contrast, Burns, whom you cite, was somewhat of monetarist, in the mainstream citadel of the NBER. So his account reflects the conventional wisdom to a great extent rather than a possible rethinking!
I enjoyed your talk at the Rethinking Economics Festival this morning, U.S. time. Thank you. I am glad to see your blog and had not been aware of it before.
I blog at Greg Hannsgen’s Economics Blog.
Commenting on myself, I need to correct my rendering of the title of L. Randall (Randy) Wray’s 1990 book. It is, of course, Money and Credit in Capitalist Economies: The Endogenous Money Approach.
Hi Greg, Thank you very much for your comment.
I’m a little confused, however. I do mention reserves and the fact that when the borrowing rate rose particularly high, e.g. 6%, the banks didn’t *want* to borrow reserves and therefore chose to reduce their supply of loans. This is entirely consistent with endogenous money. I was talking about the period before money market funds, i.e. before 1970 — and this I believe is also before jumbo CDs.
I agree entirely that this phenomenon was closely related to the regulation of lending and of interest paid on deposits. Although perhaps I did not state the latter clearly enough in my intro.
We will perhaps have to agree to differ on the effect of the growth of market based finance on the Fed’s ability to implement monetary policy. I think that it has fostered the growth of mega-banks that were barely affected by Fed monetary policy and pushed the burden of economic adjustment on smaller firms that don’t have access to international markets. To me this is the lesson of the Volcker disinflation.
Thank you very much for alerting me to the existence of your blog! Will read with interest.
Thank you so much for taking the time to respond to my comment. I remain somewhat unclear on where your post leaves me, as you remain unclear on my comment.
First question: quoting you, “I do mention reserves and the fact that when the borrowing rate rose particularly high, e.g. 6%, the banks didn’t *want* to borrow reserves and therefore chose to reduce their supply of loans. This is entirely consistent with endogenous money.”
How do you define endogenous money? I have to admit I am a partisan of endogenous money, and that this theory is part of where I find the basis for my likely disagreement with your post. In essence, I gather that if the banks are portrayed as choosing to reduce lending, then in your view the endogenous money view is sustained. I am then thinking that probably not all of this view is sustained, at least by my definition of endogenous money. Moreover, if they are simply reducing lending predictably in response to a government policy change, are we not somewhat on a money multiplier view, which is the standard, mainstream view in many of the most traditional neoclassical textbooks, etc? The multiplier then only fails to work after the changes you mention, which loosen Fed control. I would think I would mostly disagree, if indeed that is your view.
I will hold my next question for now. Thanks again.
A second comment on your original post: (I am continuing to pause on further comments or questions about your comment on my previous comment.) I am troubled and puzzled at the idea that monetary policy is no longer effective. You mention a credit-restraining effect that is no longer operative in Burns’s account. But what about other ways the Fed has “traction”? Gerald Epstein of UMass Amherst took on the claim that the Fed is no longer effective in a piece I mostly agree with in this volume* edited by him, Dymski, and Pollin. (I wrote this working paper** on the monetary transmission mechanism, which in revised form became part of the Elgar Handbook of Alternative Monetary Economics edited by Arestis and Sawyer*** outlining my heterodox view.) He finds many ways the Fed can restrain the economy. What of the effect on the value of the dollar, which was probably recessionary in both the U.S. and Mexico? Is it not commonsense financial advice that mortgage interest rates are factors in the decision as to whether a home at a given price is affordable? Most of the cost to the home buyer are going to be from mortgage interest. The Volcker era rate increases devastated construction and manufacturing-export industries. Finally, they eliminated the net worth of the U.S. savings and loans. On the other hand, I agree with the point that interest effects on _business_ investment are very weak to nonexistent based on the empirical literature and heterodox theory. Even if the only variables controlled by the Fed are interest rates (unless they use “credit controls” and jawboning to reduce lending), nonetheless, the effect on the economy can be huge. On the other hand, I argue that it has little chance of stopping an acceleration of inflation unless it can cause a recession as it more or less did in the early 1980s. What do you think?
By the way, I have found one of your earlier posts interesting and helpful in understanding your “Rethinking” position. I have downloaded your 2016 paper “Re-imagining Money and Banking: A New Monetarist Approach.” I am surprised to find a monetarist in this movement, though I saw earlier you attended the UCLA Ph.D. program. I am not shocked, given your views of the monetary transmission process. I wonder what leads you to the Rethinking Economics movement at this point in your career. Are you open to learning some truly dissident views?
*https://www.questia.com/library/1341056/transforming-the-u-s-financial-system-equity-and
**http://www.levyinstitute.org/publications/the-transmission-mechanism-of-monetary-policy
***https://www.e-elgar.com/shop/usd/a-handbook-of-alternative-monetary-economics-9781848441194.html
Thank you, Greg, for your comments.
Indeed, I was trained at UCLA and am familiar with formal macroeconomic modeling techniques. The paper you refer was one in a series that attempts to bring endogenous money into the formal modeling of macro-economics — which I think is entirely possible. The fact that I have been utterly unsuccessful in convincing the “New Monetarists” should I think give me some qualifications as a dissident economist.
My approach to endogenous money is a variant of Graziani’s circuit theory with a strong dose of Schumpeter, and thus is focused on bank finance of commercial activity — which is in my theory of money that channel through which endogenous money affect economic performance and growth. Trying to implement monetary policy through the housing market rather than through commercial activity appears to me to be a mistake that has implications for the growth rate of the economy. This is the sense in which I think the Fed can be said to have inadequate traction on the economy — in the world of TBTF and an economy dominated by multinational corporations the Fed’s policy measures don’t bind where they need to in order to influence economic activity in a way that is constructive rather than destructive of growth potential.
Regarding the situation in the 1960s which opened this post, it is important to pay attention to deep institutional factors when discussing endogenous money. As a result, where one finds endogenous money is completely different in the different eras of financial regulation. Is it via on-balance-sheet or off-balance-sheet bank liabilities? What are the alternatives for the flow of deposits once they are created, and what costs are associated with these alternatives? These questions are all very important and can vary dramatically from one decade to another.
Thank you again for your comments.
I meant only to refer to the UCLA as a neoclassical pedigree and one that is unlikely to indicate a heterodox approach. Hence, I had a personal bio for you that helped to make sense of someone who even had an approach that was neomonetarist. I was simply finding it remarkable that any form of monetarist was involved in an effort to rethink things. It is interesting that you have in fact been too different to be accepted by the new monetarists. It must be an interesting story.
Your own theoretical approach sounds interesting, but I my comment was only addressed to your post.
Heterodox approaches also often use formal mathematical modelling–though the neoclassical school has been the most mathematizing of all since about the 1950s. For example, are you familiar with the formal approaches of, say, Piero Sraffa, who developed a classical (neo-Ridardian) model of value and distribution? Are you familiar with the dynamic macro models of Michal Kalecki and his followers? Of course, most neoclassical economists are not familiar with these other approaches, and they are not taught in top 20 departments such as UCLA.
My comment primarily addressed Fed policy and hence the endogeneity of the monetary base. Given monetary-base endogeneity, the banks have few ways of restricting credit from the supply side other than by credit constraints–direct limits on the amount of lending. Hence, to influence the economy, the Fed relies on control of policy interest rates, not monetary aggregates. This in my view remains more or less true through the institutional changes you mention. For example, in the 1950s, the banks had plenty of extra Treasury bonds. So, a bank could simply sell a bond when it wanted to lend.
It does not appear you have responded to my points about the exchange-rate, mortgage-rate, and auto-finance rate channels. All of these work even when the Fed controls only the price of money and not the quantity.