Last week, the Fed decided to ask Congress for the right to pay interest on bank reserves. (Hat tip Barry Ritholtz, see also William Polley, Mark Thoma, Brad DeLong) This is a very big deal.

Don’t be misled into thinking that the Fed’s proposal is just some arcane, technocratic change. The Federal Reserve is asking taxpayers for a big pile of signed, blank checks. That’s far too much power to put in the hands of a quasipublic organization with little democratic accountability. This authority should not be granted without some strong strings attached.

First, some background. There is a trend among central banks to move from old-fashioned, fractional-reserve banking to a system whereby interest rates are managed via a “channel” or “corridor”, and under which fixed reserve requirements might be dispensed with entirely. The basic idea is simple. The Fed currently manages interest rates indirectly, by manipulating the supply and demand for cash in the banking system. But the Fed could adopt a more direct approach. It could choose two interest rates, a “floor rate” at which the Fed would stand ready to borrow funds, and a “ceiling rate” at which the Fed would stand ready to lend. As long as there is no stigma attached to transacting with the Fed, banks would never lend for less than the floor rate or borrow for more than the ceiling rate. The interbank interest rate would necessarily lie within a “corridor” defined by these two interest rates. The Fed would continue to adjust the money supply to keep interest rates somewhere inside the desired range. But the corridor would serve as a fail-safe. When banks have more cash than would be consistent with the policy interest rate, they would lend the excess money back to the Fed, causing it to disappear in a poof of green smoke. When banks have too little cash, they would borrow more into existence, until the quantity on hand becomes consistent with the Fed’s desired interest rate. The level of borrowing from or lending to the Fed would provide feedback, telling central bankers whether they need to add or remove cash from the banking system to achieve their targetted interest rate, usually at the center of corridor.

A corridor system would represent a meaty change to how central banking is done in the US, but the approach seems to work okay in other countries. Advantages for central banks include more robust control of short-term rates, and the ability to fine-tune monetary policy by altering the “spread” between the central bank borrowing and lending rates without changing the core interest rate. A disadvantage, from taxpayers’ perspective, is that the loss of zero-interest reserves amounts to a stealth tax cut for banks. On the back of my napkin, the cost to taxpayers would be between $190M to $530M per year if the level of reserves is unchanged. (I’m assuming “floor rates” between 1.75% and 4.75% against reserves of $11B). The Wall Street Journal reports estimates of $150M and $280M per year. If one assumes that corridor interest rates will roughly match the Treasury’s average cost of financing over time, and that the Fed invests reserves in Treasuries, then the total cost of the program in NPV terms would be the value of the current (interest-free) reserves. This amounts to a one time cost of about $11 billion. A more serious drawback is that a channel system paves the way for the getting rid of reserve requirements entirely, which seems a perverse thing to do in a credit crisis caused by too much leverage. But reserve requirements have already been eviscerated, and nothing prevents regulators from maintaining or strengthening reserve requirements in a channel system.

So far, so good, then. As long as the Fed is conducting ordinary monetary policy, switching to a channel system offers modest benefits at a modest cost to taxpayers. But the Fed’s monetary policy has not been ordinary at all lately. In fact, it’s been quite extraordinary. It is in the context of this extraordinary policy that the Fed has asked Congress to accelerate its authority to implement a channel system, and it is in the context of this extraordinary policy that we must consider the change.

The core of the Fed’s new exuberance is a willingness to enter into asset swaps with banks. The Fed lends safe Treasury securities to banks, and accepts as collateral assets that private markets consider dodgy or difficult to value. (This is the direct effect of the Fed’s TSLF program, and the net effect of TAF and other lending arrangements that the Fed sterilizes in order to hold its interest rate target.) In doing so, the Fed puts taxpayer funds at risk. If a bank that has borrowed from the Fed runs into trouble, the Fed would face an unappetizing choice: Orchestrate a bail-out, or permit a failure and accept collateral of questionable value instead of repayment. Either way, taxpayers are left holding the bag.

In December, the Fed had $775 worth of Treasury securities. That stock will soon have dwindled to $300B, give or take. The difference, about $475B, represents an investment by the central bank in risky assets of the US financial sector.

$475B is an extraordinary sum of money. It is as if the Fed borrowed more than $1500 from every man, woman, and child in the United States, and invested that money on our behalf in Wall Street banks that private financiers were afraid to touch. For bearing all this risk, if things work out well, taxpayers will earn about what they would have earned investing in safe government bonds. If things don’t work out well, the scale of the losses is hard to predict. The Fed will claim to have done “due diligence” on its loans, to have valued collateral conservatively, and will point to strength of bank guarantees and the enormous diversity of collateral assets to convince us that its actions are safe and prudent. But rating agencies made the same claims about AAA CDO tranches, and turned out to have been mistaken. Correlations often tend towards one when asset values fall sharply. Central bankers struggling to manage day-to-day crises in financial markets might cut corners when trying to value complex securities. They might find it convenient to err on the side of optimism, as the ratings agencies did, albeit for very different reasons. And even if the Fed is cautious and sober-minded, are we sure that central bankers can value these assets more accurately than private investors?

If the Fed were to blow through the rest of its current stock of Treasuries, it would have invested more than $2500 for every man, woman, and child in America. Public investment in the financial sector would have exceeded the direct costs to date of the Iraq War by a wide margin. Would that that be enough? If not, how much more? Just how large a risk should taxpayers endure on behalf of companies that arguably deserve to fail, to prevent “collateral damage”? Have we considered other approaches to containing damage, approaches that shift costs and risks towards those who benefited from bad practices, rather onto the shoulders of taxpayers and nominal-dollar wage earners? Does this sort of policy choice belong within the purview of an independent central bank?

Now I don’t actually mean to be too harsh. Putting aside the years of preventable foolishness that got us here, in the new day that began last summer, a crisis emerged that had to be managed and the Fed was the only organization capable of stepping up to the plate. I don’t love the decisions that were made, but decisions did have to be made, and there weren’t very good options. But now we have a moment to reflect. If the credit crisis flares hot and bright again, how much more citizen wealth should be put at risk before other policy options are considered? That’s not a rhetorical question: We need to choose a number, a figure in dollars. My answer would be something north of zero, but not more than the roughly $300B stock of Treasuries that remains on the Fed’s balance sheet. But this is a decision that Congress needs to make.

And what does all this have to do with the question that will soon be put before the Congress, whether the Fed should be permitted to pay interest on deposits? Everything, as it turns out. Suppose the Fed decides it wants to swap more than the $300B in Treasury securities it currently has available in order to support the financial system. Given its current tools and practices, the Fed would have to print money in order to buy more Treasuries to swap. But if it did that, the extra cash would drive interest rates below the Fed’s target level, quite likely provoking inflation. The Fed cannot simultaneously swap away more than its existing stock of Treasuries and satisfy its legal mandate to promote price stability, unless it resorts to something weird.

But suppose Congress gives the Fed the authority to pay interest on reserves. Suddenly the Fed can print cash to buy all the Treasuries it wants to swap for troubled assets. When banks find they have more cash than they need, they lend the money back to the Fed, collecting the “floor” interest rate and removing the currency from circulation. Since interest rates can be held to any level by adjusting the “corridor”, the Fed would retain the flexibility to respond to inflation. At the same time, it would be able print cash in any amount that it pleases — “to infinity and beyond!” — in order to fund asset swaps (or outright purchases) at taxpayers’ risk. This strikes me as a delegation of Congressional authority that would not only be undesirable, but arguably unconstitutional.

So, should we simply refuse the Fed’s request? Probably not. Brad DeLong makes an excellent point:

The Fed may also want to raise the general level of interest rates in order to fight inflation–which requires that it sell its Treasuries for safe bank reserves rather than temporarily swap them for risky MBSs.

The Fed is already rubbing pretty close to its “balance sheet constraint”. If, after exposure to gamma radiation from televised images of food riots, Ben Bernanke were suddenly transformed into The Incredible Volcker, he might lack the tools he’d need to jack rates up into the muscular high teens, unless he’s given this new authority. So what should we do? James Hamilton has an answer:

Congress has a quite proper role in determining the magnitude of the fiscal risk that the Fed opts to assume… [A] statutory limit on the non-Treasury assets that the Fed is allowed to hold might make sense. Perhaps the outcome of a public debate on this issue would be a decision that the Fed needs the power to lend to private borrowers even more than the $800 billion or so limit that it would run into from completely swapping out its entire portfolio… Or perhaps after deliberations, Congress would decide that the business of swapping Treasury debt for private sector loans is one that is better run by the Treasury rather than the Federal Reserve.

I agree. I think that Congress should grant the Fed’s request, but it should simultaneously impose constraints on the composition of the Fed’s balance sheet that cannot be violated without express legislative consent. This will be a complicated exercise, unfortunately. Besides government debt, central banks quite ordinarily hold precious metals and foreign exchange, and limitations on non-Treasury assets will have to take this into account. Plus, restrictions would have to be written carefully to apply to off-balance sheet arrangements such as TSLF, and contingent liabilities like the insidious reverse MBS swap proposal. Finally, Congress must consider restrictions on the Fed’s ability to enter into derivative positions, whether directly or indirectly via special purpose entities, including how the bank’s existing derivative book should be managed and whether the bank should or should not guarantee the liabilities of current Fed-affiliated SPEs.

Congress might also limit the quantity of reserves on which the Fed will be permitted to pay interest.

The Fed can retain full independence for the purpose of conducting ordinary monetary policy, exchanging government debt for cash and vice-versa. But if the central bank wants to put ever greater quantities of public money at risk, it will have to accept a lot more public supervision. If the prospect of intrusive oversight is too much for the Fed, then, as James Hamilton hints, perhaps the roles of central bank and macroeconomic superhero should be moved to separate boxes on the organizational chart. If we are not careful, the next bank requiring a taxpayer bailout may be the Federal Reserve system itself.

The graph below plots the US Federal Reserve’s stock of “uncommitted Treasury securities”, defined as Treasury securities held outright less securities lent to dealers. The graph starts in December 2007, just prior to the announcement of the TAF program.

As of April 30, the Fed’s uncommitted stock of Treasuries was $382B, just under half of its December 5 stock. The Fed recently announced a $50B expansion of the TAF program, and a widening of acceptable collateral for its TSLF program. Assuming the Fed sterilizes the extra TAF funding (very likely) and that the $200B pledged to TSLF is now fully exploited (likely), the Fed’s stock of uncommitted Treasuries will soon be $275.5B. Just over 64% of the Fed’s stock of Treasury’s will have been exhausted since the Fed began its unconventional lending programs in December.

Data are taken from H.41 Factors Affecting Reserve Balances. I’ve assumed that all securities lent to dealers are Treasuries.

See also FED: Running Out of T-Bills at Alea.

In my previous post, I suggested that “depth-weighted spreads” ought to serve as a measure of the uncertainty surrounding a asset’s future cash-flows. Felix Salmon quite correctly points out that quoted bid-ask spreads don’t in fact correlate very well at all with cash-flow uncertainty. Felix notes that the popular stocks often trade with one-penny bid/ask spreads, while you’d see much wider quotations on the more predictable bonds of the very same enterprises. So, what’s going on?

I’ll tell the story in pictures. Don’t be fooled though. Despite the presence of graphs, there is nothing scientific about this exercise. I’m trying to illustrate stylized facts as I understand them, not provide new evidence in support. If you think I’m wrong, let me know.

At about noon today, I took a snapshot of the limit order book for Coca-Cola stock (as presented via my brokers’ trading tool). The “quoted spread” was one penny, bid price $58.10, ask price $58.11. At the same time, I found a Coca Cola corporate bond for which a spread was quoted. The quoted spread on the bond was much larger by any measure: You could sell a bond for $1043.34, or buy one for $1058.85, for a quoted bid-ask spread of $15.42. One penny for uncertain equity vs $15 bucks for a bond whose cash flows are virtually guaranteed!

Obviously, this is not an apples to apples comparison, just given the face values of the bonds. It’s not surprising that you have to pay a market-maker more to take on $1000 of inventory risk rather than $60. (Remember, market-makers are “in the moving, not the storage business”. Their nightmare is that they buy something whose price moves against them before they can sell. You gotta pay them more to take a big risk than a small risk.) But, in per-dollar terms, the spread on one bond is still much higher than that one share of stock. You’d have to pay roughly two basis points (0.02%) in spread on every dollar invested in order to buy and resell a share of stock. To take a round trip on a bond, you’d pay almost 147 basis points! 2 basis points vs 147! So, stocks spreads are much smaller than bond spreads any way you cut it, right?

Wrong. The graphs below shows “half spreads”, the difference you’d pay from the current midpoint price to buy or sell the security according published price quotes. Here’s our view of the world so far:

But let’s broaden our horizons, shall we? What if we want to invest, say, $15,000 in Coca-Cola? Is the spread still cheaper on stock?

Probably not. Note how even very large, popular stocks are not quoted very deeply, even though the apparent spreads are very small. And note the shape of the cost curve: The cost on a per-dollar transacted basis always increases, and at an increasing rate. (Spread is a convex function of volume.) It’s obvious that if you were to extrapolate on the buy-side, you’d end up paying more for the stock than the near constant, 73 basis point bond spread that would lock in $15K worth of the bond. The quoted spreads on the stock are very narrow. But the price action is a bitch, if you want to transact quickly and in quantity. (Note the asymmetry of the curve. The obvious conjecture is that market-makers are net short, and would prefer to hedge by purchasing than to go shorter by selling. But at some point not very distant from the midpoint, the spread would take off on the bid side as well.)

Here’s an entirely fabricated, but probably more informative picture:

Which security has tighter spreads, the stock or the bond? For small volumes, the stock wins. But as volume increases, the stock’s spread increases much faster than the bond’s, reflecting the bond’s greater certainty of valuation.

Now, again, this is all terribly stylized. Limit order books are notoriously incomplete, and give little hint as to either market supply and demand or market-maker willingness to transact. Actual transactions often occur inside of spreads. Quoted spreads do correlate with various “liquidity measures”, but they are terribly noisy because they ignore depth, and the informativeness of a spread increases with depth. Also, lots of trading happens inside quoted spreads. Volume-weighted “effective” or “realized” spreads, that compare actual transaction costs to spread midpoints would be more informative.

But still. A market-maker in Coca-Cola bonds this morning had written the entire world a free option to buy $74,000 or to sell $18,000 worth of a bond at will. Stock dealers, on the other hand, put less than $5K on the line in either direction. The bond dealer’s spread reflected a less precise but far more confident estimate of the bond’s value.

The shallow, tight spreads on uncertain stock valuations are what I think of as “paradoxical liquidity”. Why do market-makers guesstimate very precise values for (some) stocks, while signaling “no confidence” by putting little money behind their guesses? Why do bond dealers offer looser estimates, but back them with a willingness to trade at high volume? Perhaps bond market-makers face higher fixed costs, limiting how tight they can pull spreads and still be profitable. Perhaps it is because stocks trade in less fragmented, more competitive markets. Competition forces market-makers to converge upon a single midpoint price (however arbitrary), and drives spreads towards zero. But as spreads approach zero, so does profit. Some stocks have penny spreads and other stocks don’t. How come market-makers stick around to drive spreads down to nothing for some equities, but not for others? Is it because low spread stocks can be more precisely valued than other stocks? Absolutely not. As Felix mentioned, even glamour tech stocks, whose prices rise and fall like soap opera divas, sometimes have one penny spreads.

Instead, it is active randomness rather than staid certainty that drives some stock spreads to be much tighter than bonds or shares of less popular firms. Market-makers derive profit from “noise traders”, from people buying or selling at market prices for their own reasons, but who have no better insight into the future value of the stock than the market-makers themselves. When dealers trade with investors who are better informed than they are, they lose money on average. To make up for this, market-makers seek out the business of “fools” (as Tyler Cowen put it, reminding us of the seminal paper by Glosten and Milgrom and inspiring Felix to coin a memorable phrase). Stocks popular with noise-traders attract multiple dealers, who compete spreads down to minimal levels, and then share slivers of profitable foolishness. In the academic model, fools and informed traders are indistinguishable to market-makers, so market-makers must keep spreads wide enough to offset their losses to insiders. But that needn’t be the case. Those making markets in stocks popular with noise-traders could instead try to separate clienteles based on order size, flow, and type. During “lulls”, dealer competition forces prices to converge to arbitrary values at minimal spreads. Dealers collect pennies on small trades as “fools” trade back and forth at market. But as soon as they catch the slightest whiff of informed trading — large order sizes, inventory build-up, rumor, whatever — market-makers ramp up spreads and shift prices until they find a new price point that is somewhere inside of more informed traders lack-of-confidence interval. They then compete spreads back down to an arbitrary price point, and return to happily collecting pennies. The particular price at which a stock trades, despite microscopic spreads, contains little information about the “true value” of the security, other than that the price is “close enough” so as not to draw the attention of informed predators.

“Paradoxical liquidity” is why I suggested in the previous post that “depth-weighted spreads”, rather than simple bid-ask quotes, ought correlate with valuation uncertainty. As quantities in a limit order book go towards zero, Newtonian finance gives way to the quantum spookiness and game theory. In general, we should treat spreads with more money behind them as more informative than those with less, and compare the relative valuation uncertainty of different instruments using high dollar spreads, rather than best-bid-and-ask. But even scale is arbitrary, and noise trading isn’t just about little tech-stock speculators. Another word for noise trader is “liquidity trader”. People who sell at market prices because they want cash, or buy at market because they want a place to park cash for yield, but who don’t analyze the hold-to-maturity value of the assets they swap are, from market-makers’ perspective, no different than sweaty day traders. When, for whatever reason, liquidity traders go away, market-makers find they have no pennies to compete for, and spreads revert to bounds that reflecting valuation uncertainty of people actually willing to bear the risk of ownership. Paradoxical liquidity is fun while it lasts, and consoles naive traders by offering visibly tight spreads in exchange for hidden price volatility. But in the end it serves no one but the middleman. When it “dries up”, withdrawal can be a bitch.

Update: I’ve struck the last couple of sentences. It’s always fun to end stuff with a punch, but I’m not sure it’s right that paradoxical liquidity “serves no one but the middleman”. The shape of the spread curve is probably not something to get too moralistic about. There are positives and negatives associated with what I’ve called paradoxical liquidity. As always, trader beware.

Yves Smith packs a powerful insight into an unassuming sentence:

Liquidity is not a virtue in and of itself unless it produces a benefit to the real economy.

Liquidity is often said to be the great lubricant of financial markets. Let’s go with that metaphor for a moment. Yeah, baby, liquidity. It’s high performance motor oil that turns hard metal to smooth silk and keeps the engine of capitalism firing on all cylinders! Pop the hood and pour that stuff in. Rub it onto the gears and axles, so nothing ever squeals, pops, or (God forbid) grinds to a halt. Slather it all over the tires, so that no friction comes between our purring metal machine and the sweet American road.

Ummm, wait a minute… Putting lubricant on the tires might not be such a great idea after all. Friction is precisely what tires need to do their jobs. Throw a lot of oil on the tires and, well, something bad might happen.

Similarly, in financial markets, we want liquidity at some times and in some places. But there are times and places where we want, even need (gasp!) illiquidity!

Illiquidity. That word is so ugly. What might be another word for the same phenomenon? How about “commitment”? When a person invests in something that is not very liquid, they are committed. They are necessarily betting on its fundamental value. Liquid securities can be bought or sold as a trend or a trade or a play for a greater fool. But if the thing you are buying can only be sold with a big haircut, you’d better hope for a really gigantic fool if you have no confidence in its underlying value. (Clever managers did find ways around this problem, but let’s put principal/agent issues aside for the moment.) When financial markets are too liquid, everything looks like cash. Superfluous distinctions — like the economic meaning of the assets bought or sold — fall by the wayside. Sure, investors always prefer liquidity to illiquidity. An option to buy or sell quickly and cheaply is preferable to an option to buy or sell slowly and with large transaction costs. But just because investors like something doesn’t mean that it’s good. Investors like rainbows and ice cream and free money from taxpayers. But the rest of us prefer that investors make serious, informed decisions about what is and isn’t of value, and that they be paid for evaluating and actually bearing risk, rather than artfully shifting it (or whining when it cannot be shifted, because omigawd-there-is-no-liquidity!). Of course there is a balance here, commitment is one thing but a ball and chain is another, if assets become too hard to buy or sell, the costs of financing genuinely useful enterprises would increase until even good risks are not borne at all. It’s not that liquidity is a bad thing. It’s a good thing of which there can too much.

But how much? Another word that should be attached to any conversation about liquidity is “accuracy”. There is, in some sense, a “right” level of liquidity, defined by the uncertainty surrounding the present value of an assets future payoffs. We laud markets for “price discovery”, their ability to distill complex economic facts into simple prices that put a value to unknowable future events. But we need markets to communicate the uncertainty surrounding those valuations as well. The depth-weighted spreads of assets whose values are nearly certain should be much narrower than those of assets whose payoffs cannot be accurately predicted. When that is not the case, it represents a market failure. The recently wide spreads on complex structured credits are not the crisis — those spreads accurately reflect the uncertainty surrounding what the instruments are actually worth. Nobody knows, so spreads should be wide. The real crisis was two years ago, when “oceans of liquidity” meant that whatever the underlying value of a thing, you could sell it quickly for near what you bought it, so spreads grew artificially narrow. Confidence is good only when confidence is merited. We need not only accurate prices, but accurate confidence intervals, accurate spreads, accurate levels of liquidity rather than simply more, more, more.

This wasn’t the first time, and I can assure you it won’t be the last of my sudden disappearances. I’d like you all to think that I am occasionally called off on super-secret assignments by an unacknowledged branch of an unacknowledged government. Or perhaps I have a penchant for being abducted by aliens. (Callisto is fabulous in the springtime. I highly recommend.)

But no. Behind this curtain is a disheveled lump of a thing, a satisficer in the guilt-minimization problem that each new day presents. For correspondences lapsed and everything else unwritten or undone, the least I can do is apologize. And thank those who do somehow manage to write and rewrite the world every day. I drink words greedily even when I offer none at all. Never, ever let them tell you there’s no such thing as a free lunch.

Update: The previous post, almost a month old, attracted some extraordinary comments. I hope to have more to say on several of the themes discussed — seignorage and the credit crisis, fiat vs commodity money and full or fractional reserve banking, etc. etc. But don’t wait for me. Others have said it all already, much better than I will.

Yves Smith points us to a couple of pieces discussing the Fed’s “balance sheet constraint”, the notion that the central bank may run out of treasury securities to exchange, whether temporarily or permanently, for the questionable securities held by private banks. This asset swap has emerged as the Fed’s core response to the current crisis, and is the essence of what James Hamilton referred to as monetary policy on the asset side of the balance sheet. In an excellent summary, Greg Ip describes the various options the Fed would have if it were to run low on Treasuries.

Fundamentally, the Fed would have two options: It could increase the size of its balance sheet by issuing cash, which would require sacrificing its target Federal Funds rate target and letting that rate drop to zero. This option is referred to in the trade as “quantitative easing”, but that’s just a fancy term for printing money and tolerating any inflation that results. Alternatively, the Fed could expand its balance sheet by borrowing from someone else — from the US Treasury, from banks with excess cash, or from the public directly. This would permit the Fed to increase the scale of its asset swaps without sacrificing its ability to conduct ordinary monetary policy.

If you want to understand the details, do read Ip’s piece. The Fed’s “balance sheet constraint” is not a hard limit. The Fed can circumvent it. But that doesn’t mean that the size of the Fed’s balance sheet is not important. Consider this, from Ip (emphasis mine):

The easiest would be to ask Treasury to issue more debt than it needs to fund government operations. As investors pay for the bonds, their cash moves from bank reserve accounts at the Fed to Treasury accounts at the Fed. The Treasury would allow the money to remain there, rather than disbursing it or shifting it to commercial banks who, unlike the Fed, pay interest. Because the shift of cash out of reserve accounts leads to a shortage of reserves, it puts upward pressure on the federal funds rate. To offset that, the Fed would enter the open market and purchase Treasurys (or some other asset), replenishing banks’ reserve accounts. The net result is that the Fed’s assets and liabilities have both grown but reserves and the federal funds rate are unaffected. This wouldn’t cost Treasury anything so long as it doesn’t bump up against the statutory debt limit. The loss of interest on its cash deposits at the Fed would be roughly offset by the additional income the Fed pays Treasury each year from the interest on its bond holdings.

It’s only true that this operation doesn’t cost the Treasury anything if what the Fed buys with the excess cash pays as much as the Treasury’s cost of borrowing, and there is no loss of principal. But if the Fed uses the cash (directly or indirectly) to buy or lend against market-shunned securities, then the Treasury is only made whole if those securities perform, or the loans against them are repaid. If the market is irrationally shunning these securities, then the Treasury will eventually break even. But if the securities turn out to be worth less than what the Fed lends or pays, taxpayers might be forced to eat the loss.

Fundamentally, the Fed’s balance sheet constraint is and should be a political constraint. The size of the Fed’s balance sheet defines how much capital taxpayers and holders of currency are making available to the Fed to do whatever it is it’s doing. Whether Fed’s balance sheet should be expanded is an investment decision — should the public throw more money at the project that the Fed is undertaking? There’s a real downside — losses by the Fed will eventually be borne either by taxpayers or by owners of dollar denominated assets (which means especially workers with little bargaining power, whose wages are negotiated in nominal dollars and would not rise with inflation). But bearing those risks may be less damaging than the harm that would result from turmoil in the financial system if the Fed loses its capacity to act.

I don’t know whether expanding the Fed’s balance sheet is a good idea, if it comes to that. There are risks and benefits associated with the Fed’s proposed use of funds, and reasonable people can come to very different judgements. What I do know is that a decision to expand the Fed’s balance sheet ought not be treated as technocratic monetary policy. However funds are raised, their repayment would be guaranteed, so all downside risk would be borne by the public. Expanding the Fed’s balance sheet would represent a sizable investment of the public’s wealth, and the public ought have as much say over that decision as over any other investment of public money.

Update: Now here’s some creative thinking! These so called “reverse MBS swaps”, under which the Fed would refill their stock of Treasuries by swapping back iffy securities wrapped with a Fed guarantee, would have no direct balance-sheet impact whatsoever, and if repeated would provide the Fed with a potentially infinite supply of Treasury securities to swap! Of course, the proposal is simply a scheme to create off-balance-sheet liabilities in order to evade what might be on-balance-sheet limits. Wow.

I frequently marvel about how, in order to respond to the credit crisis, the Fed as well FHLB, Fannie, and Freddie, are doing precisely what got private actors into their messes in the first place. Off-balance-sheet liabilities are a logical next step.

(This was reported in Greg Ip’s piece, but somehow I didn’t grok the implications until reading Lou Crandall’s description , “[The reverse MBS swap] is sufficiently exotic that it might sidestep some of the traditional legal issues.” That kind of line is a spur to really think things through!)

I really thought that Michael Shedlock was overstating the case:

The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing…

Don’t expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem…

The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it’s easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

But then I read this piece, by Robert Shiller (hat tip Yves Smith), and all of a sudden I’m frightened. It’s one thing when Hank Paulson proposes turning the Fed into the macroeconomy’s philosopher king. Paulson will be gone in a blink of an eye. But Robert Shiller is an increasingly influential economist. He’s already got Mark Thoma signed up for the plan. These guys are smart, they matter, and they will continue to matter next January. So let’s think about this very, very carefully.

Shiller points out that…

In recent years, central banks have not always managed macro confidence magnificently. The Fed failed to identify the twin bubbles of the last decade — in the stock market and in real estate — and we have to hope that the Fed and its global counterparts will do better in the future. Central banks are the only active practitioners of the art of stabilizing macro confidence, and they are all we have to rely on.

He’s right on both counts. For now, central banks are all we have to prevent a catastrophic unwinding of our unstable financial system. But they had everything to do with getting us here. It’s not just the Fed, with its famous “serial bubble-blowing”, its cheering on of any novelty as beneficial innovation, its absolute refusal to peer into the magical sausage factory that Wall Street had become. The problem with central banks is much bigger than that. If you haven’t been obsessing over every word Brad Setser has written for the past several years, you owe yourself an education. A growing “official sector” has largely defined the global macroeconomy in the first years of this millenium. In the USA, Japan, China, Europe, central banks have indeed been “active practitioners of the art of stabilizing macro confidence”. For most of those years, it seemed like they were succeeding. They were never succeeding. Call it what you want, call it “Bretton Woods II”, call it “financial imbalance” or a “global savings glut” or “exorbitant privilege”. Each central bank, while trying to stabilize its own bit of the world, found itself with little choice but to support and expand unsustainable financial flows on a scale so massive they have reshaped the composition of every major economy on the planet. As Herb Stein told us, what cannot go on forever won’t. “When the music stops, in terms of liquidity, things will be complicated.” Remember that? The music may have stopped already for Citibank, but it’s still playing for the USA. The record is just beginning to skip.

The Federal Reserve can keep every major US bank and investment house on life support for as long as it wants to. The “credit crunch” can be made to disappear in an instant, if we are willing to pay sufficient ransom to hostage-takers. But what the US economy produces is no longer well matched to what Americans consume, and we are structurally unprepared to generate tradables, goods or services, in quantity adequate to cover the difference. The Fed’s magic wand will be of no use if manufacturers in Asia and oil producers in the Gulf stop giving us stuff for free, using central-bank financial alchemy to hide their generosity.

Things may turn out okay. We’ve already begun to “adjust”, and knock on wood, we’ll manage a worldwide reequilibriation before things get too ugly. But it’ll be a close call. That financial alchemy by central banks is the ultimate source of skyrocketing inflation in China and the Gulf states, and an ominous sign that Stein’s Law is beginning to bite. We may yet escape, but we have been drawn very close to something very dangerous, to a genuine crisis of scarcity in the United States and a catastrophic failure of Say’s Law in China, to mass unemployment, social instability, and fingers and missiles pointed in both directions across the Pacific. This is serious stuff. And central banks are largely to blame.

Private, profit-seeking actors would not have generated the corrosive financial flows that have characterized this millennium. “Financial imbalance”, a euphemism for real resource misallocation, would have quickly been corrected, had Wall Street and the City of London not learned that the official sector could be their best customer. Less politically-independent monetary authorities could have leaned against unsustainable financing. A bit of capital-account protectionism might not have been bad policy for the United States during this period, but a central bank blind to obvious “facts on the ground”, accountable only to an economic orthodoxy, did not even consider such a thing.

As readers of this blog know, I’m not a laissez-faire, the-private-sector-is-always-right kind of guy. I like to think about the “information architecture of the financial system”. That leads me to dislike actors large enough to unilaterally move markets, especially when their motives might not be aligned with wise resource allocation. I dislike large private banks, and think they should be broken into itty-bitty pieces or turned into safe, regulated utilities. For the same reason, I dislike central banks. They have the power to act consequentially, but they do not have, and cannot have, the information or the wisdom to always be right. And when they are wrong, the consequences are devastating.

So, what to do? For now, we have no choice but to “use the army we have”. Our long-term plan, though, ought not be to canonize central banks, but to render them obsolete. It won’t be easy. The usual “sound money” trope, reviving the gold standard, is not a good idea. Much as it is suddenly out of fashion, we will need some “financial innovation” to build a new monetary architecture. Just because we’ve had a glut of snake-oil on the market recently doesn’t mean there’s no such thing as penicillin. We’ll have to do a better job of distinguishing novel idiocies from good ideas. But we will need the good ideas. We can and should liberate money from the bankers, central and otherwise.

It’s official. The LLC that the Fed and J.P. Morgan recently formed to manage $30B Bear Stearns assets has taken over a portfolio of derivative positions along with those assets. Those positions involve both rights to receive and obligations to pay whose value may depend upon both circumstance and counterparty quality. Of course, if liabilities associated with those positions ever exceed the value of the LLCs assets, the limited liablity company could declare bankruptcy, so in theory, the Fed’s maximum exposure is $29B. But, if, out of reputational concern or to promote systemic stability, the Fed would inject capital rather than let the LLC default, then the Fed has indeed become a counterparty of last resort. However, the derivative positions are all claimed to be hedges related to the LLC’s “cash assets”. So, I guess the word of the day is basis risk.

Timothy Geithner’s speech yesterday amounts to the clearest narrative and strongest defense we’ve seen from an insider regarding the Fed’s management of the Bear Stearns crisis. (Hat tip Felix Salmon, Calculated Risk.) We learn that the assets effectively acquired by the Fed from Bear Stearns are

investment grade securities (i.e. securities rated BBB- or higher by at least one of the three principal credit rating agencies and no lower than that by the others) and residential or commercial mortgage loans classified as ‘performing’. All of the assets are current as to principal and interest (as of March 14, 2008).

However, these “cash assets” are bundled with “related hedges”. What are these hedges? It’s not stated explicitly, but the “Summary of Terms and Conditions” regarding the formation of the LLC, published with the speech, includes the following language:

[Bear Stearns] will sell to [the new LLC]… the assets identified by JPMC, the NY Fed and the Asset Manager as described on Schedule A hereto (the “Scheduled Collateral Pool”), together with the hedges identified by JPMC, the NY Fed and the Asset Manager [BlackRock] as described on Schedule B hereto (the “Related Hedges”) and including the Pre-Closing Date Proceeds Amount. For the avoidance of doubt, the Related Hedges include the amount that the Borrower [the new LLC] would have to pay to, or the amount that the Borrower would receive from, the applicable counterparty if the Borrower had entered into an identical transaction on March 14, 2008 based on the Bear Stearns marks as of such date (the “Transfer Value”), as well as all accumulated mark to market gains or losses thereafter and any cash proceeds as a result of Related Hedges’ being unwound.

…

[The new LLC] will assume as an economic matter the obligations under the Related Hedges and receive the benefits thereof by entering into a total return swap with the [Bear Stearns], such total return swap having an initial fair value as of the Closing Date equal to the fair value of the Related Hedges as of the Closing Date. The Controlling Party (as defined below) [the NY Fed] shall have the right to make all determinations related to the underlying hedges (e.g., whether and when to terminate) that are subject to the total return swap. At the request of the NY Fed, the Seller will use its commercially reasonable efforts to replace the total return swap with direct hedges with underlying counterparties through novation.

In English, Bear Stearns is selling various securities to an LLC controlled and largely financed by the Fed, but it is also transferring (“as an economic matter”) a portfolio of derivatives that are characterized as hedges of those assets. (In practice, these derivatives may be bilateral contracts not easily transferable to the Fed’s LLC, so the LLC and Bear are establishing a new contract, a total return swap, under which the LLC reimburses Bear for whatever is owed, and Bear forwards to the LLC whatever is earned, on positions that can’t be replaced with direct contracts.)

Specific information about the securities and the portfolio of derivatives has not been revealed. The schedules on which they are listed are not public. They could be credit default swaps on which the Bear Stearns had acted solely as protection buyer, which would be pretty benign. (These are like insurance contracts — the very worst that could happen is the LLC pays a regular premium, but when some of its bonds catch fire and disappear the insurer fails to pay up.) But lots of instruments could arguably qualify as a “related hedge”, some of which would be much riskier.

I would like to know general types and notional values of the LLC’s contracts, as well as the current exposures, gross and net. I know. I’d like a pony, too. Still I can’t see why the Fed should withhold this information other than potentially “bad optics”. Is this really a set of well tailored hedges to the cash assets described? How much counterparty risk has the Fed taken on?

There are some other interesting tidbits in Geithner’s speech. Geithner claims that, when the Bear crisis broke on Thursday, March 13, the Fed agreed to “extend an overnight non-recourse loan through the discount window to JPMorgan Chase, so that JPMorgan Chase could then ‘on-lend’ that money to Bear Stearns.” That differs from contemporaneous statements, which announced “a secured loan facility for an initial period of up to 28 days allowing Bear Stearns to access liquidity as needed.” The difference is important, as one of the big puzzles of the Bear collapse was why the firm, which had survived its public brush with bankruptcy by end-of-day March 14, suddenly had to be sold by Sunday evening. Most of us thought the crisis had been stabilized and the firm had 28 days to resolve it. (Bear insiders too: “We thought they gave us 28 days. Then they gave us 24 hours.”)

Another curiosity is this:

Does this give you any comfort? I guess it depends what you think the Fed wanted to do here, and what you think it ought to have done. Did the Fed cherry-pick relatively good assets and hedges, to protect taxpayers? Or did it knowingly take the riskiest assets that it could within its broad-outline criteria, intentionally making itself a risk absorber of last resort to forestall future crises? It may be a while before we know, if ever.

Ambrose Evans-Pritchard published a column this morning suggesting that the U.S may adopt the so called “Nordic model” of nationalizing insolvent banks. The piece has drawn a lot of blogospheric comment. [ Scurvon, Naked Capitalism, Financial Armageddon, Curious Capitalist, Across the Curve ].

You would think that moral hazard fetishists like me would applaud. The “Nordic model” is a very tough approach. When regulators deem a bank insolvent, they nationalize it outright, wipe out the equity holders, and unceremoniously can the incumbent management. That is harsh, as it should be. Managers who steward significant enterprises to ruin should not be rewarded, and stockholders, who earn high returns as compensation for risk, should be held accountable when they err by placing their money in the hands of gamblers.

But what you are hearing from me is the sound of one hand clapping. (Finally, an answer to that riddle!) An automatic policy that wipes out equity but makes all creditors whole creates a perverse incentive. It suggests that anyone investing in a bank should structure their investment as debt to capture the implicit guarantee. But highly leveraged balance sheets are a source of the brittleness that leads to banking crises in the first place! Our policy preference should be for equity rather than debt financing, as less leveraged firms respond much more flexibly to adverse shocks. Regulation can address this to a certain degree, but unless bank finances are kept very, very simple, probably not so much. Clever minds can come up with all kinds of contingent liability arrangements that would evade regulated balance-sheet ratios while serving as debt financing, even if “special purpose entities” are banned.

Since debt can substitute for equity, killing common stockholders while making whole even junior creditors amounts to a loophole by which lazy investors can shirk their duty of market discipline. It’s not easy to learn which firms are genuinely worthy of ones trust, but that work is precisely what investors get paid for when they earn better-than-risk-free returns. Bondholders, counterparties in derivatives transactions, and other creditors are supposed to assess the credit risk of the firms with whom they entrust money, just as stockholders evaluate business risks. Letting bank creditors enjoy high-returns effectively risk-free creates an obvious arbitrage: short Treasuries and lend as much as you can to any firm that is too big to fail!

There is one and only one class of creditors to whom we have, as a matter of public policy, agreed to make whole under all circumstances. Those are small depositors, and they should bear no risk or inconvenience whatsoever should a bank run aground. All other creditors knowingly assume credit risk when lending to banks, and should be forced to bear some downside when a bank goes south. Admittedly, reducing this theory to practice is walking a knife’s edge. The goal of nationalizations and bail-outs is to keep the financial system functioning smoothly. Too harsh a policy towards creditors might provoke self-defeating runs at the first whiff of trouble.

Can this circle can be squared? Probably. Creditors who try to accelerate replayment in advance of a firm’s insolvency can have the funds clawed back under the doctrine of preferential payments. Regulators can make clear that recently withdrawn funds will be pursued aggressively, in order to treat all creditors equitably. It makes less sense to stage a run on the bank if you know that the bank will come right back and stage a run on you. Creditors will hate all this. They will fume. Creditors are supposed to hate insolvencies. That’s the point. They should have thought about the risks ahead of time, and better supervised the firms they were lending to.

That said, creditors obviously oughtn’t be wiped out entirely like shareholders. The point here is to remind the market that on the liability side of a balance sheet lies a continuum of risk, not a bright line between junk and safety. The financial world does require a superhero, but not the Fed-on-steroids of the Paulson proposal. We want the bond vigilantes back. It’s probably sufficient to wipe out the equityholders (both common and preferred, there’s no basis to discriminate if the bank is genuinely insolvent) and let creditors suffer some delay and uncertainty prior to repayment, perhaps with a small haircut inversely proportional to seniority of claims if public funds need to be deployed.

Writing this stuff makes me feel mean, nasty, cruel, low. Isn’t it enough to take a pound of flesh from stockholders? Must we go after the creditors too? But remember, the creditors are mostly getting bailed out here, by you and me, the taxpayers. A bit of inconvenience and frayed nerves in the service of an important policy goal is not so much to ask in exchange. And there are few public policy goals more important in the financial world than getting more equity and less debt on corporate balance sheets, and encouraging all classes of investors to exercise a lot more adult supervision over the firms that they fund.

Update: See Dean Baker, who offers a similar view, more plainly and clearly expressed.

I know it’s mostly bull, the hippie management bromide that “in Chinese, the word for crisis is danger plus opportunity!” I don’t care. We’re gonna go with it here. I see the current financial crisis as dangerous, but also a tremendous opportunity to fix a lot of things that have been broken for a very long time.

The “sophisticated” banking systems and capital markets that we’re always flogging to developing countries are like nuclear reactors of the Chernobyl design. Sure, they are very powerful, very sexy. When they work they can light up whole cities, and that’s gotta be attractive if you’re sitting in the dark. But they have deep weaknesses, structural flaws, inconsistencies that are resolved only with generous applications of duct tape. Everything seems to work most of the time, but they are an accident waiting to happen. When an accident does happen, there is a story, perhaps a true story, about the particular screw-ups that were proximate cause. But focusing on those misses the point. We ought to get the engineering right before trying to operate the plant.

Financial systems are much more massive enterprises than nuclear power plants, and much more important. We need to redesign our financial system not only to be more robust, but to be more effective. Lost in the flamboyant pain of the current crisis is a quieter tragedy. We have misallocated natural and human resources on a vast scale over the past few years, and it won’t have been the first time. The real economic meaning of financial losses in the housing sector is that hands and minds were squandered bulding houses when they should have done much better things. Timber was felled and oil wells pumped dry, and what we made turned out to be of less value than what we destroyed. We could have predicted and avoided that. A reasonable financial system would have predicted and avoided that.

Treasury Secretary Henry Paulson has mooted a variety of reforms in response to the present financial crisis. Reading through, those proposals amount to a rationalization of the hodge-podge institutions that regulate financial markets. That’s not unwelcome, but it’s not what’s needed. It’s like responding to the Chernobyl meltdown by issuing three-ringed binders filled with better procedures about how to manage the plant. Regulation can compensate for minor flaws. But it can’t overcome a design that is structurally unsound. Our financial architecture is structurally unsound, so our task is not to rationalize the regulatory regime, but the financial system itself.

That will require changes far more challenging to incumbent firms than what Mr. Paulson proposes. Institutions that are too big to fail and/or capable of moving market prices unilaterally don’t sit well with the theory of financial markets. Financial firms can be regulated utilities that handle essential plumbing but bear little risk, or they can be aggressive risk-seekers looking to play every angle and milk every opportunity. They cannot be both. The gentlemen at Mr. Paulson’s alma mater may not like the implications of that, but the principle is correct regardless, and we ought insist that it not be fudged. The “Nationally Recognized Statistical Rating Organizations”, and the constellation of professional norms and judicial safe-harbors that link their opinions to the behavior of institutional money are an abomination, a legal discouragement of the independence of judgment upon which accurate prices and market stability are based. Their special status simply has to go the way of the dodo. This has to go a lot farther than merging the SEC and the CFTC. Rather than placing our faith in the Fed as an ever-watchful superhero, saving us all when financial catastrophe strikes from outer space, we can and should better manage our affairs here on Earth to avoid those catastrophes in the first place.

These have been great times to be a cynic. But, at long last, appropriate cynicism is finally getting priced into the market. There’s not much intellectual alpha left there. When this all washes out, we do want an informationally efficient, market-based financial system. It’s time to start talking specifics about what we need to do to get there. Before very long, all options may be on the table. Let’s have some good ones ready to go.