Jane D’Arista is director of programs at the Financial Markets Center, where she conducts education seminars and authors Capital Flows Monitor, a quarterly analysis of international financial developments, a quarterly commentary on the Federal Reserve’s main compilation of domestic financial statistics. Previously, she served as an international economist at the Congressional Budget Office, and as a staff member of the House Banking Subcommittee on Telecommunications and Finance of the House Energy and Commerce Committee."

The Financial Market Center leaves one with the impression that it keeps far closer track of what goes on within the Fed than the Fed’s own high brass. Her latest study: "Rebuilding the Transmission System for Monetary Policy, November 2002," could hardly be more timely. It traces the crumbling of the Fed’s mighty apparatus of power, undermined by its own eagerness to serve the ideology in the saddle – to the point where, quite literally, no one is left minding the store.

"Open market operations – first used in the 1920s and formally acknowledged as a policy tool by the Banking Act of 1933 – have for many years remained the primary means for changing the price and supply of money and credit…But while the tools themselves remain in place, the institutional context in which they are employed has changed dramatically. These changes include a relative decline in the banking sector’s role in credit creation, reductions in the level of required reserves and the ascendancy of market forces – particularly unrestricted international capital flows – in determining the pace of credit expansion in a world of increased financial integration.

"This paper assesses the impacts of these far-reaching changes on the process of monetary implementation. It argues that the failure to modernize aging policy tools has deeply damaged the Fed’s ability to influence credit expansion…. Unrestricted credit expansion, in turn, fueled unsupportable debt levels for households, businesses and financial institutions. And unchecked credit growth helped inflate asset-market bubbles. Moreover, weakened policy tools now hamper the Fed’s ability to implement effective countercyclical policies in the event of a significant downturn.

"The paper also contends that this underlying problem can be remedied by introducing a new system of reserve management that assesses reserves against assets rather than deposits. This new approach would enhance monetary control by applying reserve requirements to all segments of the financial sector."

Canada’s case, where the statutory reserves against bank deposits were not just slashed and neutered by "switch accounts" and other such devices used in the US, but abolished altogether, is in this respect more drastic. ER readers may remember that with the abolition of denominator in the old multiplier banking statistic (the ratio of deposits held by the banks to the their cash holdings), we started publishing the "Indicator," the total assets of our deregulated banks to the legal tender they held for purely operational purposes. The alternative would be a zero denominator for the multiplier that would have given the ratio a meaningless infinity figure – i.e., the statistical system would have broken down in theory as it has largely done in practice.

"Over the past quarter-century, the US financial system has undergone a transformation, as household savings shifted from banks to pension funds and other institutional investment pools. Between 1981 and year end 2001, the assets of all depository institutions plummeted from nearly half of total financial-sector assets to 24%. Meanwhile, spurred in part by the funding requirements of the Employee Retirement Income Security Act (ERISA) of 1974, the assets of pension funds and mutual funds soared from 23% to 38% of financial sector assets. The shift in individual savings from banks to pension and mutual funds also produced a symmetrical increase in borrowing through capital markets, since securities constitute the primary assets held by institutional investors. As investors increased their demand for credit market instruments, corporations borrowed less from banks and issued substantially more bonds and commercial paper."

"Credit flows to individuals also moved into the capital markets as government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac and federally related mortgage pools securitized more mortgages and asset-backed securities. (ABS) issuers used securitization techniques to fund car loans and other consumer receivables. Between 1991 and 2001, the liabilities of GSEs and mortgage pools – used mostly to finance single-family housing – rose by $3.6 trillion to $5.1 trillion. During the same period, assets of ABS issuers jumped 530%, soaring to $2.1 trillion." ["Securitization" is the process of "slicing and dicing" huge blocks of individual loans and selling them to other institutions. The organizing bank takes an up-front profit but often leaves the debt unmonitored – no one is left "minding the store." On the surface it seems more efficient.]

"Asset management has become the dominant function in US financial markets and trading has become the principal activity. Bank lending remains important, particularly to small business borrowers that lack access to capital markets. But banks, too, manage mutual funds and offer asset-management services through their trust departments. And since passage of the 1999 Gramm-Leach-Bliley Act, larger banks have expanded their securities, asset-management and insurance operations through financial holdings companies. Since the 1970s [too] these institutions have been the dominant foreign-exchange market-makers. And more recently, they have developed a highly profitable niche – supported by their special relationship with the lender-of-the-last-resort – providing financial insurance as dealers in derivatives and sellers of committed lines of credit to back issues of commercial paper and other securities.

"The size and importance of over-the-counter foreign exchange and derivatives markets and the dominant role of large US banks in these markets ensure that the Federal Reserve will intervene to support the banks’ derivative positions and financial guarantees. When the bond and derivative markets seized up and the dollar fell 17% against the yen during the last quarter of 1998, the Fed fulfilled its own [off-balance-sheet] guarantee of the guarantors’ role.

"Policymakers have long recognized the influence of these institutional changes on the conduct of monetary policy. In 1993, for example, Fed Chairman Alan Greenspan told the Kansas’s City Fed’s Jackson Hole Conference, ‘the fairly direct effect that open market operations once had on the credit flows provided for businesses and home construction is largely dissipated’ due to the diminished role of banks, the increase in savings channeled through institutional investors and the growth of securitization…. The Fed can still affect short-term interest rates, and thus have an impact on the cost of borrowing from banks, from other intermediaries, and directly, in the capital markets. [But] this effect may be more indirect, take longer, and require larger movements in rates for a given effect on output.’ [Indeed], during the 1990s, the Fed kept real interest rates higher in a non-inflationary environment but its policy failed to moderate the rapid raise in stock prices, credit or GDP in the final years of the decade. In 2001, the central bank reversed course and undertook an aggressive easing campaign. Yet more than a year later, this effort had still not produced the intended impact on output.

"At the same time…lawmakers and regulators were dismantling the quantity controls that once constituted a key feature of financial systems in the US and other countries. These [included] interest rates ceilings on deposits, international capital controls, liquidity and reserve requirements and direct limits on credit expansion. Historically, these ‘macro-prudential’ policy tools have contributed to financial stability by systematically restraining credit expansion and promoting the soundness of individual institutions. However, limiting the credit they can extend to customers also restricts the opportunities of financial firms for profit. During the 1970s and 1980s, offshore banking activity grew explosively as US depository institutions sought the higher returns available in external markets lacking reserve requirements and other restraints on lending. The rise of the unregulated Eurodollar market gave the Fed and other central banks a powerful incentive to relax or remove quantity controls to moderate the shift in deposits and loans from domestic to external markets.

"After experimenting with direct limits on bank lending in an effort to manage capital outflows in the 1960s, the US abolished capital controls in 1974. Six years later, the Monetary Control Act ended Regulation Q interest rate ceilings on depository institution accounts.

"Despite moving decisively in the direction of deregulation, the US has not eliminated reserve requirements – the primary quantity control used by the Federal Reserve and the tool most critical to implementing monetary policy. However, reserve requirements have been seriously weakened. In response to international competitive pressures on US banks during the late 1980s, the Fed supported a zeroing-out of reserve requirements on time deposits to make the cost of domestic CDs comparable to Eurodollar sources of funds. The central bank also lowered reserve requirements on demand deposits from 12% to 10%, as of 1992."

The foregoing paragraph is of special interest to Canadians. The American banking system may have had no direct interest in strengthening Canada’s large banks to compete with them at home and abroad. However, the end of the restraint on their credit creation helped qualify them as ideal fall-guys on whom the largest US banks could unload some of their more questionable securitized paper. Above all, there was a strong, ideological interest in imposing unrestricted capital movements throughout the world. Through the Bank for International Settlements and the IMF the Fed leaned heavily on the Bank of Canada and New Zealand, whose monetary and social security arrangement were a living refutation of the new gospel of financial deregulation. New Zealand had run into serious foreign exchange problems and was at the mercy of the IMF. Canada was not. Here it was essentially the servility of the Mulroney government that brought us the free trade arrangement with the US. Canadians today are thus at a disadvantage with respect to the US, when it comes to designing a monetary system that could best serve our interests. The D’Arista document should accordingly be obligatory reading not only for our federal, provincial and municipal authorities, but for those of our Non-Government-Organizations that resist even recognizing the way in which our banks’ statutory reserves were done away with in stealth. That, however, more than any other factor, led to the wholesale slashing of our social programs.

"Simultaneously, the Fed played a key role in negotiating the Basle Accord, which set capital adequacy standards for all multinational banks in the G-10 countries. By establishing these standards at levels previously applied to US banks, the Basle agreement eliminated a key advantage enjoyed by non-US depository institutions. Moreover, the Basle standards represented the kind of prudential requirement acceptable to liberalization proponents, since they ensure that market forces – i.e., the providers (or withholders) of capital – determine the amount of loans banks can extend."

"Over time, the Basle capital standards tended to displace rather than complement the role of reserve requirements. And this displacement created problems for monetary control." COMER for almost a decade has emphasized this displacement of statutory reserves, plus the detail that in Canada and the US the capital monitored is not always really there – securities are recorded at their historic rather than their market value.

"And this displacement created problems of monetary control. Since markets inevitably supply more capital during a boom and less during a downturn, capital requirements tend to impose a pro-cyclical bias on bank lending…. Direct limits on lending remained a primary monetary tool for the uk and other European economies into the 1970s. European countries and Japan also extensively used regulations that required banks to match the maturity of assets and liabilities. Only by the end of the 1980s did all the EU nations undertake capital account liberalization to fulfill conditions of monetary union."

This in fact is no small detail in the inability of the EU to climb out of its deepening economic rut.

"As reserve requirements continued to weaken, reserve balances with the Fed fell from peak levels of $35-40 billion in 1986-1989 to $7 billion by 8/02. In large measure this steady decline mirrors the fact that the Fed has been applying its lowered reserve requirements to a proportionately dwindling universe of liabilities.

"During the past half-century, depository institutions’ share of financial sector liabilities declined in tandem with their share of assets. While financial sector liabilities expanded by more than 150% between 1991 and 1001, checkable deposits increased by a comparatively paltry 37% – with virtually all the growth occurring at savings institutions and credit unions (commercial banks’ checkable deposits grew by less than one percent over this period).

"Among other things, these trends reflect banks’ growing proclivity to sweep customers’ deposits from transaction accounts into time and money market accounts that are not subject to reserve requirements. [This is a daily process of moving such balances from checking accounts that require reserves to non-checking accounts that don’t. It takes place at the end of business hours each working day, and back again the next morning at opening hour.] From 01/1994 to 7/02, sweep accounts rose from $5 billion to $501 billion. Like the movement to capital requirements, these techniques increase the financial system’s procyclical bias, providing greater access to funds at lower cost in a boom and less access at higher cost in a downturn. They undermine the Fed’s capacity to implement anti-cyclical initiatives." And that had been a prominent goal when the system was founded in 1913 and reformed almost beyond recognition in the mid-1930s.

"As banks’ reserve balances shrink, the Fed has tried to compensate by altering some of its operating procedures. Since it began announcing its target federal funds rate in 1994, the Fed has increasingly relied on the announcement – as opposed to actual open market operations – to implement policy decisions. In operating ‘open mouth operations,’ the central bank essentially waits for market participants to adjust to the new rate level, based on their belief that the Fed can enforce the rate.

"Sweep accounts, repurchase agreements and securitization have expanded the role of non-reservable liabilities in credit creation and thus weakened the ability of reserve requirements to restrain bank credit growth. At the same time, non-bank financial firms have become much more prominent sources of domestic credit. [As a result] debt levels and debt burdens have grown explosively and crimped the central bank’s influence over output."

"At yearend 1971, outstanding US credit market debt totaled $1.8 trillion, equaling 155% of GDP. By 2001, outstanding domestic debt had climbed 16-fold to $29.5 trillion and reached 289% of GDP. The dangers inherent in those developments may be heightened by changes in their composition. During the 1980s, the debt of all US nonfinancial sectors surged from 139% of GDP to 191%. Over the next decade, these sectors’ aggregate borrowing remained at virtually the same level relative to GDP, but the burden of debt dramatically shifted from the federal government to household and non-financial corporations. During the past 30 years, household debt soared from 45% to 76% of GDP while nonfinancial corporate debt rose from 35% to 49%.

"As debt loads increased, their constraints became more apparent. At yearend 2001, outstanding household debt ($7.7 trillion) equaled 104% of disposable income, up from 87% in 1990. And debt as a share of nonfinancial corporations’ net worth stood at 59%, up from 40% in 1990.

"Meanwhile, the financial sector itself experienced extraordinary increases in borrowing that reflected the dramatic shifts in its products, practices, and structure. From 1990 through to year-end 2001, financial institutions’ debt rose by $6.8 trillion to $9.4 trillion. Overall, the financial sector’s share of total annual borrowing jumped from about 20% in 1980 to about 50% at the end of the 1990s. In other words, at the height of the 1990 expansion and during the following downturn, financial firms routinely borrowed more than their domestic customers.

"It seems clear that this unrestrained credit boom played a crucial part in financing the US stock market bubble of the late 1990s. Growing volumes of margin debt and home equity credit enabled households to bid up equity prices to unprecedented levels. In addition, executives and other employees borrowed heavily (often from their companies) to exercise stock options – a practice that also put upward pressure on share prices. At the same time, debt-financed stock buybacks by corporations substantially reduced the supply – and thereby propped up the price – of their shares.

"In addition, the unprecedented scale of financial-sector leverage carries troubling implications. Widespread borrowing among financial institutions exacerbates the possibility of problems in a few of those firms spreading to many others through their web of debt and derivative obligations.

"For the economy merely to move forward, household and business borrowers must set aside large portions of their income just to service debt. And the financial sector must continue to raise the mountain of funding needed solely to refinance its own and its customers’ existing borrowing.

"During the past decade, the foreign sector became a large net supplier of credit to US borrowers. As net US obligations to foreigners swelled during the course of the decade, the gap between US ownership of foreign assets and foreign ownership of US assets rose from -$165 billion, or -3% of GDP in 1990 to -$2.3 trillion, or -23% of GDP at yearend 2001.

"Foreign lenders offered particularly strong support for the corporate bond market, becoming its dominant buyers during the second half of the 1990s. By yearend 2001 they owned 24% of outstanding corporate bonds, up from 13% in 1990.

"Foreign investors also own $1 trillion (about one third) of outstanding Treasury securities and, as the supply of new Treasury debt dwindled in the late 1990s, they ramped up their purchases of [government] agency securities.

"Foreign purchases of US credit market instruments played a prominent, albeit indirect, role in pumping up the equity bubble of the late 1990s. More than any other class of investors, foreign buyers purchased corporate bond issues supporting the stock buybacks that helped prop up unsustainable equity prices. To a substantial degree, these huge inflows of foreign funds reflected monetary policy decisions by the Fed – though not always in ways the central bank had intended. In February 1994, for example, the central bank began a series of interest rate hikes to preempt inflation and prevent the economy from overheating. Rising rates [however] helped attract inflows from foreign investors, encouraged US investors to shift back into domestic assets, fueled domestic credit growth and interrupted what had been a consistent outflow of funds to Mexico (thereby precipitating the December 1994 peso crisis).

"Over the rest of the decade, the Fed maintained interest-rate differentials between US and other G7 countries that favored dollar investments. As the US current account deficit widened and inflows of foreign savings soared, domestic credit expansion blossomed into a full-fledged boom. While the strong dollar restrained inflation (aided by recurring financial crises), it did so at the expense of manufacturing and other export sectors while shifting a larger share of credit flows to households and to corporations financing equity buybacks. And at the peak of the 1990s expansion, the strong dollar-soaring inflows-expanding credit-strong consumption daisy-chain exerted an increasingly powerful pull on asset prices.

"However, should US demand falter and import growth decline, new foreign investment in US financial assets will diminish as the investors’ export income recedes. And a reduction in inflows will strain the ability of households and businesses to refinance extremely high levels of debt, thereby disrupting economic activity. In addition, a shock to the US economy or a substantial loss of confidence could precipitate a dollar crisis. Should that occur, the Fed might feel forced to push up interest rates to halt capital outflows – a lingering prospect that underscores the degree to which monetary policy has become captive to high levels of foreign investment."

Though it has been likened to a high-power computer capable of keeping track of an ever increasing number of balls in the air, it could end up more like a case of lobectomy, unmindful even of its own history.

The second instalment of this review of the D’Arista paper will deal with her suggestions for the restructuring of our monetary system.

— from Economic Reform, February 2003