(This is the second of two instalments. The first part appeared in ER February issue.)

"More significantly, the Fed’s manoeuvring room was severely limited by its statutory inability to use the banking system’s large holdings of US government securities as collateral for discounts and backing for note issues. In 1932, emergency legislation authorized the use of Treasury securities for Federal Reserve Notes. This authorization, reaffirmed in the Banking Acts of 1933 and 1935 and made permanent in the 1940s, provided the framework for system operations still in use today.

"As financial-sector changes render this framework increasingly ineffective, the US central bankers now find capital inflows limiting their actions in somewhat the same way gold outflows handcuffed their predecessors 70 years ago. In addition, the Fed’s contemporary balance sheet – now composed almost exclusively of Treasuries on the asset side – offers the central bank far too little operational flexibility, much as the balance sheet of 1930 stymied policymakers of that era. US central bankers [then] are confronted with four basic choices. They can rationalize the erosion of their primary policy mechanism by changing objectives. They can attempt to muddle through. They can simply surrender to the powerfully procyclical market forces. Or they can acknowledge the need for new policy mechanisms as decisively as their predecessors did in the 1930s.

"As the Fed’s policy transmission system has worn down, the central bank’s policy objectives have narrowed. Many central bankers [declare] price stability the most important prerequisite for sustainable output and employment growth.

"Even though widely shared – and it offers a seemingly neat rationalization for weakened policy tools – this view has several major flaws. Focusing on a single goal would require a change in the Federal Reserve Act, which directs the central bank to pursue full employment and maximum output as well as stable prices.

"Equally important, the sustained pattern of divergence between credit and output growth over the last two decades points to a form of inflation that has not been curbed by the Fed’s interest rate policies. The persistence of credit inflation adds an important dimension to the longstanding debate over the relative influence of money and credit on macroeconomic outcomes.

"As long as depository institutions hold less than one-quarter of total financial assets, discount-window reform and other bank-focused initiatives can exert a limited influence at best on general credit conditions. Such initiatives may very well allow the Fed to defer a day of reckoning. But they will not cancel the event."

An Unpretty Outcome

"While most Fed officials acknowledge the importance of monetary policy in managing the economy, proponents of an unregulated economic system might argue that the difficulty of maintaining effective monetary tools makes the case for simply throwing in the towel and allowing market forces free rein. But the growing financial disruption over the past two decades suggests the outcome wouldn’t be pretty.

"If shorn of all restraining influences, the procyclical bias of market forces would ensure boom-bust cycles of increasing frequency. And since markets, unlike central banks, do not have the power to create liquidity in a crisis, these violent swings would further destabilize both economic and human development.

"Finally, the Fed could try to regain meaningful control over money and credit by modernizing – rather than fiddling with – its policy transmission system. Given the gravity of the situation, a thorough overhaul appears to be the most practical long-term remedy."

"No plausible scenario suggests banks regaining their once-hegemonic role in credit creation. As a result, [we] must establish new channels for exercising monetary control over all financial institutions. And nonbank financial firms cannot participate in the transmission-belt function unless they too meet reserve requirements.

New Transmission Belts

"1. One sensible approach would be to use the Gramm-Leach-Bliley Act’s definition of activities deemed financial in nature and apply reserve requirements to such activities. Requirements should be imposed only on those portions of a company engaged in financial activities (for example, on GMAC but not on those portions conducting nonfinancial operations (e.g., GM’s auto-making divisions).

"2. Despite their growing dominance, non-bank financial intermediaries are not designed for money creation [i.e., the loan to buy a new car when spent does not echo back as a deposit with General Motors as does a line of credit – minus statutory reserve – into the banking system]. Moreover, the liabilities of institutional investors such as pension funds and insurance companies are in longer-term contracts, rendering reserve requirements on those liabilities impracticable. In short, a liability-based system doesn’t permit central banks to create and extinguish reserves for nonbank financial firms.

"Efficiency and equity therefore require that reserves be held against assets. Though this notion may appear exotic, it actually embodies a range of real-world experiences, including the current model for US insurance regulation. For years, states have required insurers to hold reserves against their assets and in 1992, insurance commissioners instituted an asset valuation reserve (AVR) that assigns risk weightings to various asset types. Although these reserves were imposed for soundness purposes (as opposed to conducting monetary policy) and are held by firms themselves, they nonetheless illustrate the feasibility of systematically reserving institutional investors’ assets.

"The experience of European countries during the Bretton Woods era provides additional examples of asset-based reserve systems – some designed to control overall credit expansion and others to shield key sectors from cyclical excesses and droughts. [such measures [were used] in Sweden for housing-related assets, 1972 for Netherlands credit ceilings 1967, and the Bank of England before 1971. France, 1967, targeted both deposits and assets. Italy [made use of them] to restrain inflation periodically, and Switzerland imposed credit limitations 1972-75]. Only by targeting financial firms’ assets can a reserve system hope to influence total credit extended to non-financial and financial borrowers and to ensure greater balance in the distribution of resources across the business cycle.

"By shifting reserve requirements in this fashion, the Fed would be able to extend monetary control to an assortment of assets that, as of year end 2001, was 36 times larger than the universe of reservable deposits ($35.8 trillion versus $998 billion).

"With the move to an asset-based system, reserve requirements would become far less onerous to depository institutions, represent a small burden (at most) to nonbank financial firms and remove a longstanding competitive inequality by leveling the field for the entire financial sector."

To the Canadian reader, this discussion of debt-based reserves in the present tense coming out of the United States, might seem like a message from outer space. When COMER revealed the phasing out in stealth of the statutory reserves from our Bank Act in 1991, we were told it had been an "unjust tax." In fact it had provided an alternative to the ruinously high interest-rates imposed by the Bank of Canada as "the one blunt tool to lick inflation." It also offered the government the use of considerable interest-free deposits as a quid pro quo for the transfer to the banks of most of the government’s historic franchise for the creation of money. Depending on the rate of interest at the time, this represented an entitlement to our bank system of from $5 to $8 billion annually.

Repurchase Agreements as Central Bank’s Primary Operating Tool

"Repurchase transactions are ideally structured to interact with all financial firms on the asset side of their balance sheets. For example, the Fed can use a repo to buy government securities (or agencies, corporate bonds, loans, mortgages, commercial paper, etc.) from any institution holding these assets – commercial and investment banks, mutual and pension funds, insurance and finance companies, or GSE (Government-Sponsored-Enterprises).

"Broadening the holdings on its balance sheet would bring the Fed closer to the practices of other central banks.1 More importantly, authorizing the Fed to conduct repos with any sound financial assets would strengthen the central bank’s ability to halt runs, moderate crises and curb excessive investment across the entire financial system, from over-the-counter derivative markets to the mutual fund industry.

"Extending the Fed’s range of eligible holdings would eliminate the central bank’s need to own a vast amount of Treasury securities – and its reliance on the federal government maintaining relatively high levels of indebtedness. The requirement that one government liability (government securities) be used to back another (outstanding currency) was redundant at the time of its adoption in 1932. While outstanding currency should of course remain a Federal Reserve liability, the central bank does not need to hold Treasury obligations to make good on that claim because it already wields a more powerful guarantee – the ability to create and extinguish Federal Reserve notes.

"In an asset-based system, the Fed could still acquire government securities as backing for repos. But most of its vast current holdings of Treasuries would be released for purchase by investors and financial institutions seeking the ultimate safe-haven asset.

"In a system of universally applied reserve requirements, financial institutions would book reserves on the liability side of their balance sheets rather than on the asset side. It would more accurately reflect the role of both reserves and the central bank in America’s current financial system. Defining reserves as liabilities to the Fed would make explicit that reserves represent the financial sector’s obligation to serve as a transmission belt for policy initiatives to affect economic activity. Recognizing reserves as liabilities to the Fed [i.e., as Fed assets] would moot the contentious issue of paying interest on reserves – removing a longstanding sore point for depository institutions and a potential expense for taxpayers... The Fed has maintained a set of bookkeeping arrangements that continue to treat its assets and liabilities like those of a mere bankers’ bank. Defining financial sector reserves as assets of the central bank would modernize these outdated arrangements by confirming that: (a) the Fed’s major function is to create and extinguish liquidity; and (b) it enjoys the unique ability to create the reserves that accomplish this function.

"Reserves would be recorded on the asset side of the Fed’s balance sheet, mirroring their entry as liabilities to the Fed on the balance sheets of banks, insurance companies, pension funds, mutual funds, GSEs and all other financial institutions.

"Meanwhile, repurchase agreements and discounts would move from the asset to the liability side of the Fed’s balance sheet to reflect the Fed’s liability for the private sector assets it acquires when it creates reserves. Foreign exchange assets (international reserves) also would become liabilities rather than assets since they too would be acquired through repurchase agreements. Outstanding currency would remain a liability, manifesting the Fed’s congressionally mandated authority to create money and manage its value.

"Since the Fed would no longer earn interest on holdings of government securities – and since it would back repurchase agreements and discounts with non-interest-bearing reserves – the central bank would no longer have income to pay interest on its repos. But because financial institutions receive invaluable interest-free liabilities when they ‘loan’ the central bank assets through repos, it seems eminently reasonable to compensate the central bank to receive earnings on the collateral backing these repos."2

Defence Amnesia of Financial Institutions

Time was when economists referred back to ancestral monarchies and their right of seigniorage – the coining of precious metals – to put the non-interest-bearing reserves into historical perspective. History, however, is hardly the strong suit of the profession: bankers and economists make a point of not remembering even what happened a decade ago. Asset-based central banking as proposed by D’Arista would help combat this tendency of the guild to amnesia. The creation of reserves by the central bank is a highly valuable service. Not only do the services of the central bank allow depository institutions to create credit many times their net worth, but they provide assurance of liquidity when a crisis threatens. It is helpful to bring that to the fore, rather than treat it as a sterile "tax." What is involved is by no means the sort of accountancy fraud that recently almost flattened the world’s stock markets, where debts became assets and assets debt for monumental fleecing of the unwary. Here double-entry bookkeeping is observed, and broadening the reserve base to include all financial organizations should keep the charge for this modest. "With all financial institutions participating in the federal funds market, volatility would decline as a result of those institutions making portfolio adjustments by purchasing and selling reserves rather than assets."

Up to now our central banks exerted themselves to create an ever more complicated universe through deregulation while narrowing their policy kit to a "single blunt tool" – interest rates. But interest does happen to be the revenue of a potentially parasitic economic group, and using it as the central bank’s one big stick entails a screeching conflict of interest. Broadening of the reserve system and shifting the accountancy from liabilities to assets will permit focusing on specific problem areas. Planned economy? No more than our fire departments are planned to cover emergencies only when and where they arise. They are not programmed to actually light fires.

Of course, even with the important D’Arista’s central banking reforms, system would be left with some serious distortions. Let me mention two of these.

The treatment of government investments as liabilities has gone on for decades. They have been handled as current expenses, and written off in a single year. But as of January 1996 the Bureau of Economic Analysis under the Secretary of Commerce began treating such assets as an investment to be depreciated over its useful life. But it didn’t call them "investment," but "savings" which is hardly apt, since they are not held in cash. Why? We can only surmise: The Clinton government was interested in just a statistic that bond-rating agencies would smile on; Clinton was determined to avoid arousing the lightly sleeping dogs of the right. Carried forward several years, the adjustment produced an improved balance sheet for the government of over one trillion dollars and helped achieve the lower interest rates that the government sought. Government investment – a term that reeked of the influence of Keynes – was not even mentioned.

In Canada in July 1999 a bill introducing accrual accountancy (a.k.a. capital budgeting) was passed on the insistence of the Auditor-General before he would issue an unconditional approval of the previous two years’ accounts. But nothing further was heard about it until mid-February 2003, when the government, beset with budgetary surpluses melting into deficits, crumbling infrastructures, commitments to restore slashings of grants to the provinces for health education and social services, pressure for increased military spending to meet the Iraq crisis, widening divisions in all parties, the disasters of privatization and of Deregulation and Globalization, with the Bank of Canada blowing the whistle about the danger of inflation when the world economy was clearly sinking into deflation. And then, out of the blue, the new Finance Minister, John Manley announced that capital budgeting would be introduced in the budget due in a matter of days.

The other similar reform that has been denied so much as a mention is the ever deepening stratum of taxation in the price level. This pays for the ever greater unpriced public services needed to keep our economy and our society functioning.

Were a flat price level retained as the main goal of the central bank, it would frustrate the proposed new transmission mechanisms for monetary policy that D’Arista proposes. These additional challenges lie beyond D’Arista’s mission. We can therefore hope that others will be inspired by her achievements to carry forward the analysis into these closely related fields.