The True Role of the Central Bank
saving big banks
At my recent meetup with readers in LA, one of them asked what three ideas I thought I was known for.
Obviously, the three languages of politics is one. An interesting take comes from Brian Chau.
I'm slowly becoming the guy whose main takeaway from KlingBlog's book is that the civilization vs. barbarism axis is extremely underrated
Another idea I am known for is “subsidize demand, restrict supply,” meaning my insight from Public Choice theory. The mainstream economic theory of government intervention is that you should either subsidize/provide what the market fails to provide in sufficient quantity or tax/restrict what the market does not price high enough to take into account social costs. But in practice, the political process tends to be controlled by incumbent producers/owners, who lobby for subsidized demand and restricted supply. So we get lots of subsidies to buy houses as if we wanted more people to own homes, while zoning restrictions ensure scarcity.
Another idea I might be known for is “price discrimination explains everything.” That is, fixed costs are high in many situations, especially with Internet-based businesses, where the marginal cost of serving an additional customer is close to zero. When marginal-cost pricing makes no sense, and your challenge is to recover fixed cost, then you want to come up with creative ways to charge more to people who are more willing to pay. Airline passenger pricing is just one example.
Yet another idea of mine is the topic of this essay: the true role of central banks. I took from Niall Ferguson the idea that central banks initially were tasked with funding the public debt. I want to argue that this is still the case.
In the 2008 financial crisis, what was the Fed’s main concern? I would say that the focus was on the health of the “primary dealers,” the handful of large institutions that are most responsible for maintaining a market in U.S. government debt. The Fed may have failed to forestall a recession, but except for Lehman, all of the primary dealers survived.
Recently, Moses Sternstein wrote,
Michael Pettis argues that China’s problem isn’t a surge in debt, it’s “the cumulative but unrecognized losses associated with the misallocation of investment over the past decade into property, [etc.]” but instead of recognizing the loss, “the entity responsible for the investment misallocation is able to avoid recognising the loss by carrying the investment on its balance sheets at cos . . . convert[ing] what should have been an expense into a fictitious asset.” That’s precisely what the BTFP does. Will the BTFP ever end? What happens when it does?
BTFP stands for Bank Term Funding Program. It allows banks to borrow from the Fed using as collateral underwater long-term Treasuries valued at par. Something similar was tried during the Savings and Loan Crisis, in which Freddie Mac (then a government agency under the Federal Home Loan Bank Board) was summoned to lend to S&L’s, using as collateral underwater mortgages (with interest rates below market rates) valued at par for lending purposes. This allowed FHLBB to “extend and pretend” rather than shutting down insolvent S&Ls. But that policy backfired, and taxpayers ended up footing the bill for a larger bailout.
If long-term interest rates come down, then the “extend and pretend” approach of BTFP will work. Banks will survive. But if long-term interest rates spike up, another form of bailout will be needed.
Anyway, my point is that central banks’ top priority is always going to be enabling the government to borrow money. The supposed priorities of dealing with inflation and unemployment will always be secondary in practice.
The Fed’s job is to make sure that the Treasury can market its debt. For that purpose, it has to be much more concerned with keeping banks healthy than with hitting a target for inflation, unemployment, nominal GDP, or any other supposed goal.
substacks referenced above:
@
What are Arnold Kling’s biggest contributions to the world of ideas?
1. Style - His style in short blog posts, book reviews and sharing links. That style is humble, concise, both thoughtful and thought provoking, and does much to encourage reading about important and advantageous ideas.
2. Virtue - His style is also one of leadership through virtue. That style and his best ideas - FITs, the Essay Grader, Three Languages, the NBU - all share in the theme of modeling and promoting virtue.
Where does his style and virtue come from? Maybe, much of it comes from the practices and doctrine of Judaism, The Old Testament, through his family and culture.
“The four main human virtues as defined by Plato are prudence, justice, courage, and self-control. These are the so-called cardinal virtues, from the Latin word cardo, or ‘hinge.’ These are the virtues upon which all other human virtues hinge. Each of the non-cardinal virtues is bound up in and depends on one of the cardinal virtues.
“In the Book of Wisdom, we read: ‘Wisdom teaches self-control and prudence, justice and courage, and nothing in life is more useful than these.’ That the Old Testament mentions the four cardinal virtues shows that the Jews valued the wisdom of the ancient Greeks.”
“Virtues are dynamic forces—witness the word's Latin root, virtus, meaning ‘strength’ or ‘power.’ Each, when practiced habitually, progressively enhances one's capacity to act.”
Excerpts from the book Virtuous Leadership: An Agenda for Personal Excellence by Alexandre Havard.
"The Fed’s job is to make sure that the Treasury can market its debt. For that purpose, it has to be much more concerned with keeping banks healthy than with hitting a target for inflation, unemployment, nominal GDP, or any other supposed goal."
As Treasury offerings have grown to exceed the savings available for investment in them at low interest, the Fed's portfolio has swollen to immense proportions. So I would add that the Fed's job now further extends to monetizing the deficit. In this scenario, the banks (primary dealers) function is to perpetuate the illusion that there is an functioning market for Treasuries at those interest rates.