The first question to ask regarding proposals to expand the role of the central bank in the monetary system is the payroll question: How is the payroll of a new small business that grows, for example, greenhouse crops that have an 8 week life cycle handled in this environment? For this example let’s assume the owner had enough capital to get the all the infrastructure of the business set up, but not enough to make a payroll of say $10,000 to keep the greenhouse in operation before any product can be sold.
Currently the opening of a small business account by a proprietor with a solid credit record will typically generate a solicitation to open an overdraft related to the account. Thus, it will in many cases be an easy matter for the small business to get the $10,000 loan to go into operation. Assuming the business is a success and produces regular revenues, it is also likely to be easy to get bank loans to fund slow expansion. (Note the business owner will most likely have to take personal liability for the loans.)
Thus, the first thing to ask about any of these policy proposals is: when a bank makes this sort of a loan how can it be funded?
In the most extreme proposals, the bank has to have raised funds in the form of equity or long-term debt before it can lend at all. This is such a dramatic change to our system that it’s hard to believe that the same level of credit that is available now to small business will be available in the new system.
Several proposals (including Ricks et al. – full disclosure: I have not read the paper) get around this problem by allowing banks to fund their lending by borrowing from the central bank. This immediately raises two questions:
(i) How is eligibility to borrow at the central bank determined? If it’s the same set of banks that are eligible to earn interest on reserves now, isn’t this just a transfer of the benefits of banking to a different locus. As long as the policy is not one of “central bank loans for all,” the proposal is clearly still one of two-tier access to the central bank.
(ii) What are the criteria for lending by the central bank? Notice that this necessarily involves much more “hands on” lending than we have in the current system, precisely because the central bank funds these loans itself. In the current system (or more precisely in the system pre-2008 when reserves were scarce), the central bank provides an appropriate (and adjustable) supply of reserves and allows the banks to lend to each other on the Federal Funds market. Thus, in this system the central bank outsources the actual lending decisions to the private sector, allowing market forces to play a role in lending decisions.
Overall, proposals in which the central bank will be lending directly to banks to fund their loans create a situation where monetary policy is being implemented by what used to be called “qualitative policy.” After all if the central bank simply offers unlimited, unsecured loans at a given interest rate to eligible borrowers, such a policy seems certain to be abused by somebody. So the central bank is either going to have to define eligible collateral, eligible (and demonstrable) uses of the funds, or some other explicit criteria for what type of loans are funded. This is a much more interventionist central bank policy than we are used to, and it is far from clear that central banks have the skills to do this well. (Indeed, Gabor & Ban (2015) argue that the ECB post-crisis set up a catastrophically bad collateral framework.)
Now if I understand the Ricks et al. proposal properly (which again I have not read), their solution to this criticism is to say, well, we don’t need to go immediately to full-bore central banking for all, we can simply offer central bank accounts as a public option and let the market decide.
This is what I think will happen in the hybrid system. Just as the growth of MMMFs in the 80s led to growth of financial commercial paper and repos to finance bank lending, so this public option will force the central bank to actively operate its lending window to finance bank loans. Now we have two competing systems, one is the old system of retail and wholesale banking funding, the other is the central bank lending policy.
The question then is: Do federal regulators have the skillset to get the rules right, so that destabilizing forces don’t build up in this system? I would analogize to the last time we set up a system of alternative funding for banks (the MMMF system) and expect regulators to set up something that is temporarily stable and capable of operating for a decade or two, before a fundamental regulatory flaw is exposed and it all comes apart in a terrifying crash. The last time we were lucky, as regulatory ingenuity and legal duct tape held the system together. In this new scenario, the central bank, instead of sitting somewhat above the fray will sit at the dead center of the crisis and may have a harder time garnering support to save the system.
And then, of course, all “let the market decide” arguments are a form of the “competition is good” fallacy. In my view, before claiming that “competition is good,” one must make a prior demonstration that the regulatory structure is such that competition will not lead to a race to the bottom. Given our current circumstances where, for example, the regulator created by the Dodd-Frank Act to deal with fraud and near-fraud is currently being hamstrung, there is abundant reason to believe that the regulatory structure of the financial system is inadequate. Thus, appeals to a public option as a form of healthy competition in the financial system as it is currently regulated are not convincing.