– March 23, 2017

The Government Accountability Office in 2011 enumerated twenty new Fed credit allocation initiatives since 2007. Most had narrow groups of privileged beneficiaries: special dollar swap lines favored foreign banks doing US dollar business, special “lending facilities” favored the twenty-some “primary dealers” who buy and sell bonds to the New York Fed trading desk, special lending programs favored money market mutual funds and issuers of commercial paper, and two programs favored holders of mortgage-backed securities (MBS). The New York Fed created a novel (and legally dubious) special-purpose subsidiary, Maiden Lane LLC, to buy $30 billion in dodgy assets from the balance sheet of the failed investment bank Bear Stearns, and thereby to enrich Bear’s purchaser JPMorgan Chase, as well as Bear’s shareholders, bondholders, and counterparties. Similar favors (via creation of Maiden Lane II and III) went to AIG and its counterparties, which especially meant Goldman Sachs. The Fed made special non-recourse lending commitments to two well-connected and faltering banks, Citigroup and Bank of America. The Fed’s Agency Mortgage-Backed Securities Purchase Program favored holders of Fannie Mae and Freddie Mac IOUs. These special lending programs have mostly been discontinued, while Maiden Lane’s asset holdings have fallen to $1.7 billion.

But three large initiatives keep going. Under “Operation Twist” the Fed sold short-term bonds from its portfolio and replaced them with long-term bonds. The intervention aimed to reallocate credit toward long-term bonds, raising their prices and reducing their yields. The intended beneficiaries were financial institutions holding long-term mortgages and MBS (which are bundles of long-term mortgages), and new mortgage borrowers (by lowering 30-year interest rates). Under “Quantitative Easing 1” the Fed bought $1.25 trillion of MBS. Under QE 3 the Fed bought hundreds of billions more of MBS at the rate of $40 billion per month. The Fed’s balance sheet today remains twisted toward long-term securities, and in particular the Fed continues to hold $1.7 trillion in MBS. All three programs allocated credit away from other lenders and borrowers toward the banks and other financial firms that here holding MBS when the price-support operation began.

Government programs that divert credit away from the most productive uses, as evaluated by the marketplace, are inherently wasteful, even if policy-makers have the best of intentions.  It is easy to see the beneficiaries, and easy to see why the beneficiaries would lobby for such programs. Less obvious, but not less real, are the losers, namely all those potential users of funds who suffer by having credit diverted away from them.  Resources are also wasted in the rent-seeking game of lobbying for preferential allocations, for example, by banks expanding merely to become so big or so connected that the authorities will consider them “too big to fail.” The implicit bailout guarantees come at taxpayer expense.

Financial markets generate prices and allocate resources based on the decentralized judgments of millions of market investors, who are staking their own funds, about the most promising avenues for investment.  When Federal Reserve officials alter the allocation of credit, risking not their own but taxpayer funds, they substitute their own judgments for the wisdom of the market. Having no unique knowledge lacked by market participants, Fed officials cannot improve on a competitive market’s allocation of funds even if that is their sincere aim.  To prop up insolvent financial firms is to makes investments that prudent market participants shun. Bailouts and below-market-rate loans throw good money after bad, and create moral hazard (reduce the incentive of financial firms to invest prudently).

The Fed should not try to divert loanable funds to any particular firm or any subset of financial markets, but (so long as it exits) should only judge the scarcity of money in the economy as a whole.  Assuming we have a central bank, its least disruptive policy option is to provide more money to the economy as a whole when money is too scarce (to support the current level of nominal spending), and less money when too abundant. It can do this without playing favorites by not lending to particular banks or buying favored private securities, but by expanding and contracting the quantity of money through purchases and sales of Treasury securities only.

The Fed’s decisions about how many securities to purchase represent monetary policy, because (other things equal) they alter the amount of money held by the public. But the Fed’s decision to purchase and hold mortgage-backed rather than Treasury securities, holding constant the dollar volume of purchases, does not qualify as monetary policy because it does not alter the amount of money. 

The QE programs could have had expanded the quantity of money held by the public, but the Fed deliberately combined QE with interest on reserves – paying banks not to lend out the excess dollar reserves that the Fed was creating – in order to negate that potential impact.  The path in M2 has been steady since 2007 even while QE programs made the quantity of the Fed’s own monetary liabilities (the “monetary base”) skyrocket.

If the combination of the Fed’s continued large MBS holdings with interest on reserves is not a monetary policy, what is it? It is a fiscal policy. The Fed in effect borrows funds from the commercial banks, paying interest on reserves at a favorable rate (initially 0.25 percent, now 0.75) slightly above the prevailing rate on short-term Treasury bills, and spends the borrowings in pursuit of a policy goal, higher MBS prices.

A fiscal policy of wasteful subsidies, under our Constitution, traditionally originates with the Congress, not with a federal agency that has no Congressional mandate to subsidize. It is past time to normalize the Fed’s asset portfolio and restrict it to Treasury securities. Conceivably the Fed could buy a basket of private stocks and bonds, as the Swiss National Bank does, but there are severe practical problems with designing and implementing an unbiased basket that avoids distorting the allocation of credit.

Lawrence H. White


Lawrence H. White is a Professor of Economics at George Mason University, a Senior Fellow at the Cato Institute, and a member of the Mercatus Center’s Financial Markets Working Group. He was a Visiting Scholar at the Federal Reserve Bank of Atlanta from 1998 to 2001 and again in 2003. An expert on monetary theory and banking history, he has published in leading academic journals, including the American Economic Review and the Journal of Money, Credit, and Banking. White earned his M.A. and Ph.D. in economics from UCLA and his A.B. in economics from Harvard University.

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