In this first installment, I'll discuss issues related to Greenwood, Hansen, and Stein's Jackson Hole paper, and leave discussion of the future of currency for installment #2.
An important model for modern central banking was the Bank of England, founded in 1694, which subsequently developed a symbiotic relationship with the British crown. The crown needed to finance spending, particularly on wars, and the Bank was looking to make a profit. The crown granted the Bank an ever-expanding monopoly on the issue of circulating currency, culminating in Peel's Bank Act of 1844, under which the Bank became the sole supplier of circulating currency in the UK (save for some grandfathered Scottish private banks, which are still issuing currency in 2016). Given the Bank's monopoly on currency issue, it could lend to the crown at a low interest rate, and still make a profit. The Bank, through experimentation or accident, discovered crisis intervention. During financial panics the Bank could, through judicious use of information available to it, engage in lending to banks with liquidity problems (banks experience a lot of bank note redemptions). In so doing, the Bank would expand its note issue to fund lending to banks that it deemed illiquid but solvent and, on the flip side of that, give those holding bank notes a safe asset to run to. The Bank did this, driven by its motive to make profits on superior information.
It wasn't like some economist was promoting the idea that a monopoly on currency issue and financial crisis intervention were the natural province of a central bank, or that this central bank should be have some form of public governance. Those ideas came much later. Indeed, the Bank of England remained a private institution until 1946. However, the Federal Reserve System was founded as a public institution, albeit with semi-private governance, in terms of how the regional Federal Reserve Banks are run. The work that led up to the Federal Reserve Act of 1913 included, for example, the National Monetary Commission, created by Congress to study the U.S. financial system, and systems elsewhere in the world, and to come up with recommendations for reform. The Commission produced volumes of useful stuff, which you can find on Fraser. The basic ideas in the Federal Reserve Act are that the role of a central bank in the United States was to: (i) through its monopoly power, provide a safe currency; (ii) make the currency "elastic," i.e. make the supply of currency respond to aggregate economic activity, and to financial panics, by way of discount window lending.
Basically, the framers of the Federal Reserve Act had in mind an institution that would play the same role as the Bank of England, but the motivation was different. A currency monopoly for the central bank was seen as socially beneficial, as experiments with private currency issue in the U.S. had not turned out well. And crisis intervention was seen as a means for preventing the disruption to the aggregate economy that had occurred during the banking panics of the National Banking era (1863-1913).
Fast forward to 2016. In some ways things haven't changed. U.S. Federal Reserve notes are basically the same stuff (with some anti-counterfeiting features added) they were in 1914, and currency is still an important Fed liability. Here's the stock of currency relative to U.S. GDP: surveys by the Boston Fed show a declining use of currency, but currency is still important in consumer payments, accounting for 26.3% of payments in 2013, as opposed to 31.1% for debit cards. But, the quantity of Federal Reserve notes per U.S. resident is about $4,500 currently. I don't know about you, but I'm not holding my fair share of that. In this chart you can see that, by value, about 80% of currency outstanding is in $100 notes, and studies indicate that about half of the stock of U.S. currency is held outside U.S. borders. There are some legitimate questions about the role played by currency, and whether its use should be curtailed, but more about that in the next installment.
The key point is that, if we took large-denomination currency - which is likely serving no useful social function - out of the mix, only a small part of the existing Fed portfolio would be funded by what was once thought to be the primary central bank liability. As it is, even with all those $100 bills included, interest-bearing Fed liabilities are greater than the quantity of currency outstanding:
1. Reverse repurchase agreements, or ON-RRPs, used in "temporary open market operations." This is overnight lending to the Fed, with securities in the Fed's asset portfolio used as collateral. ON-RRPs are roughly reserves by another name - overnight interest-bearing liabilities of the Fed that can be held by a wider array of financial institutions than are permitted to have reserve accounts with the Fed. In particular, money market mutual funds cannot hold reserves, but they are key participants in the ON-RRP market. ON-RRPs play an important role in post-liftoff Fed implementation of monetary policy. The idea is that the ON-RRP rate, currently 0.25%, puts a floor under the fed funds rate, so that fed funds will trade between the interest rate on excess reserves (IOER), currently at 0.5%, and the ON-RRP rate.
2. Reverse repurchase agreeements held by foreign government-related institutions. This is somewhat mysterious, and explained here. Just as there is a foreign demand for Treasury securities, there is a foreign demand for very short-term liabilities of the Fed.
3. Currency. We know what this is about.
4. Reserve balances. As is well-known, this quantity has grown substantially, as this stuff financed the Fed's large-scale asset purchases post-financial crisis.
We're now in a world in which interest-bearing Fed liabilities have become very important. Is this a temporary change, or is it permanent? Should it be permanent? This gets us to Greenwood/Hansen/Stein (GHS). Basically, their answer to the last question is yes. GHS first argue that short-term safe assets are useful in financial markets and that, by looking at market interest rates, we can find evidence of "moneyness" for these assets. If assets are used in facilitating some kind of exchange, or they are in wide use as collateral, they bear a liquidity premium. That is, people are willing to hold these assets at lower rates of return than seem consistent with the actual payoffs on these assets. For example, Gomme, Ravikumar, and Rupert calculate real rates of return on capital in the U.S. since 2007 of from 5%-7% (after tax, for all capital). But here are some short term nominal rates of return:
What can we conclude? (i) Reserves are a less liquid asset than ON-RRP or short-term Treasury debt. Reserves can be traded among a smaller set of financial institutions than these other assets, and you have to pay banks more to take reserves than to take T-bills or ON-RRP. (ii) Short-term Treasury debt and ON-RRP seem to have roughly the same liquidity properties.
So, once the case has been made that short-term safe assets bear liquidity premia, reflecting their usefulness in financial markets, who is going to supply these assets? There are three options: (i) the private sector; (ii) the Treasury; (iii) the Fed. GHS argue that the private sector does not do a very good job of this. Why? First, there are some "externalities" involved, according to GHS. This is somewhat vague, but GHS seem to have in mind that private sector production of short-maturity assets involves intermediating across maturities, which is risky. And maturity transformation makes these private financial intermediaries sensitive to market stresses, according to them. Second, regulatory changes, for example the Supplementary Leverage Ratio requirement, gums up the private sector's ability to produce safe short-maturity assets. GHS also argue that the Treasury does not issue enough short term debt, because it is worried about the risk of auction failure if it has to roll over a lot of short-term debt.
The heart of the argument is that the Fed has advantages over both the private sector and the Treasury in issuing short-term debt. But what kind of short-term debt should the Fed issue? Currently, the choice is between reserves and ON-RRP, though in principle we can think about the possibility the Fed could issue Fed bills - short term circulating debt that looks exactly like Treasury bills. The Swiss National Bank can issue such securities, for example. But, if wer're constrained to considering only reserves and ON-RRP, it seems clear that ON-RRP is much more successful in serving the liquidity needs of financial markets than are reserves. After all, you have to give the institutions that are permitted to hold reserves a 25 basis point inducement to get them to do so.
So, it seems that, in general, ON-RRP is a better instrument for the purpose than reserves. As GHS point out, if the Fed were to expand its ON-RRP program and shrink reserves, this would amount to savings for taxpayers, given the level of short-term market interest rates. This is becasue the Fed could have the same effect on market interest rates, but be paying lower interest on its liabilties, thus handing over larger transfers to the Treasury. What expands the ON-RRP program? One approach would be to set the ON-RRP rate equal to IOER.
But, how large should the Fed's ON-RRP balances be, and what's the optimal size for the Fed's balance sheet? Prior to the financial crisis, the size of the Fed's balance sheet was essentially determined by the demand for currency (in real terms), given the level of market interest rates, as the quantity of reserves was very small, and almost all of the Fed's asset portfolio was financed with currency. If we take the GHS proposal at face value, there should be a similar natural limit for ON-RRP. If the Fed sets an ON-RRP rate, and conducts a fixed-rate full-allotment auction, with IOER equal to the ON-RRP rate, what could happen? (i) the Fed reaches the upper bound on securities that it can use as collateral in ON-RRPs - it gets more bids than it can satisfy. (ii) the Fed does not reach the upper bound on available collateral, and there are some reserve balances outstanding. In case (i) it seems the ON-RRP program is too small, and in case (ii) it's the right size, but the Fed's balance sheet is too large. The bottom line, if we accept GHS's hypothesis that a Fed supply of short-term interest-bearing liquidity is a good thing, is that the market can determine how much of this stuff it needs. I should make it clear that this is my conclusion, not theirs. But I think this is the logical implication of their analysis.
1. How does this relate to quantitative easing (QE)? GHS seem to think this is a different issue - that QE is aimed at some short-run problem, and the role for ON-RRP is long-run. I don't think so. What GHS is putting forward is indeed a theory of how QE works. They are assuming that the Fed has a special role in maturity transformation, and when the Fed does this it matters. And this matters all the time, not just in unusual circumstances, so the implication is that QE should be an ongoing thing. But it seems there is a role for long-maturity debt in financial markets too - presumably the Fed shouldn't be sucking up all the long-maturity assets in existence, and GHS don't seem to be thinking about that.
2. I've got doubts about whether there are limitations on the private sector's ability to intermediate across maturities. Turning long Treasury debt into overnight debt is risky, but there are ways to manage such risk. It's not clear that the Fed and Treasury are any better at bearing such risks than are private financial institutions.
3. If the problem with private sector liquidity transformation is what can happen in crises, why shouldn't the Fed's intervention be confined to crisis times? For example, expand the ON-RRP program in a crisis, and contract it when the crisis is over.
4. A concern of GHS is a possible flight to safety during a panic. The argument is that, during times of financial stress, financial market participants could abandon private sector liquidity for ON-RRPs, and that could be bad. The "cure" for this is caps on the ON-RRP program. I've always found this idea puzzling. In the ON-RRP auction, the Fed can either set the quantity, or the price, but they can't set both. If there's a binding cap on the ON-RRP program, the price is too low, i.e. the ON-RRP rate is set too high. Presumably, in a crisis the correct policy is to lower the ON-RRP rate.
5. GHS's explanation for why the Treasury did not, or could not, issue more short-term debt did not make sense to me. This seemed more like a call for the Treasury to do a better job of auctioning their securities. Further, if a Treasury auction "fails" on a given day, I'm not sure why that's the end of the world. For example, the Treasury has a reserve account with the Fed, and the balance looks like this:
In general I found this paper very useful. It's the first coherent story I've seen about a legitimate role for a central bank in what we would typically call "debt management." But much more research and thought needs to go into these questions.