The Fed, Primary Dealers, and the Ineffectiveness of Monetary Policy
by Mike Kimel
The Fed, Primary Dealers, and the Ineffectiveness of Monetary Policy
The Federal Reserve’s primary tool for monetary policy is buying or selling securities, in particularly US notes, bills and bonds.
But… it doesn’t buy and sell bonds to you and me. Instead, it deals with primary dealers – the complete list is here. The list includes reputable and scandal-free companies such as Citigroup, Bank of America (actually, it’s subsidiary Merrill Lynch, Pierce, Fenner & Smith Incorporated), Goldman Sachs, and UBS. What does it take to get removed from the list? Well, the most recent change to the list occurred when MF Global was removed on October 31, 2011. By coincidence, that was the day that MF Global declared bankruptcy after making almost $900 million of other people’s money disappear. Bear Stearns came off October 1, 2008, four months after the company imploded and sold itself to JP Morgan. Lehman came off a week after it declared bankruptcy.
Other past luminaries include Countrywide, Drexel Burnham Lambert, Continental Illinois and Salomon Brothers, which makes for an interesting list if you tend to be the kind of person who remembers financial scandals of times past. I have no idea what criteria the Fed uses in picking its primary dealers – clearly controlling massive quantities of financial assets is a requirement, but financial viability and being off the public dole are not.
In fact, being a primary dealer is a way of being on the public dole. When the Fed confers the primary dealer designation, it confers a large, recurring financial gift on the designee. Remember, the Fed won’t engage in securities transactions with the public, just with primary dealers. So if the Fed is planning to sell bonds for $X, and you want to purchase bonds for $X + $Y, the Fed won’t just sell you those bonds. Instead, the Fed sells the bonds to Bank of America, and making the perhaps unreasonable assumption that Bank of America is able to execute without massively screwing something up, the bank then turns around and sells you the bonds, pocketing $Y.
This convoluted and inefficient way of doing business made sense in the 1960s when the scheme was cooked up. Now, its just another infusion of cash from you, me, and the Fed to many of the same institutions that took a good run at taking down the world economy, and which regularly require other infusions of cash to survive. These days we have computers – any halfway decent programmer could set up an auction system for the Fed that wouldn’t require regular transfers from the rest of us to Goldman Sachs and UBS. Heck, I can do it and I’m not a halfway decent programmer.
Of course, if you give it some thought, there is no particular reason the Fed’s way to conduct monetary policy has to involve buying and selling Treasuries. It could just as easily be funding social security benefits, placing money in the bank accounts of each American, flinging it from trebuchets or buying geraniums. Buying and selling securities is an inefficient way to adjust the money supply in this day and age, even if it made sense in 1913 when the Fed was established.
What do I mean when I say that buying and selling Treasuries is an inefficient way to conduct monetary policy? Well, its simple. As noted above, the Fed’s current process is a way to transfer funds from you and me to the primary dealers. By selecting how money is put into and taken out of the system, the Fed selects how monetary policy affects the economy.
The haves are less likely to spend an extra dollar of income than the have nots (in economic parlance, the wealthy have lower marginal propensity to consume than the poor), and when the haves do spend money, they generally don’t do it as quickly as the have nots (in economic-ese, the velocity of money is slower when wealthy people have it).
The reason it matters… during a recession, people and companies become more cautious and reduce their spending. That leads to less stuff being produced, less people working, etc., making the economic downturn worse. By pumping money into the economy, theoretically the Fed makes money cheaper, which in turn leads to more money being spent. That’s the theory, anyway.
But because the Fed’s way of increasing the money supply is designed to place more of it in the hands of the primary dealers, the process often doesn’t work very well even leaving out the fact that periodically, another member of this august group turns out to be corrupt, antisocial or incompetent. The money the Fed has been putting into the economy has not been getting spent. Since it isn’t getting spent, it isn’t doing any good for the economy. Rather, its been accumulated, in large part by the very same sectors of the economy that played so big a role in causing the crash. I believe that’s what Lloyd Blankfein was talking about when he said he was doing God’s work.
It is long past time to change the way the Fed operates.
Is there any evidence primary dealers are paying below market prices?
foosion,
I don’t know if anyone has quantified the problem, but I think in general, a market in which there are artificial constraints on the number of suppliers of a good or service leads to higher price.
Mike, that’s the question. I don’t see any good reason to limit this market to primary dealers, but theory would also suggest competition among primary dealers, especially for highly liquid securities, would drive out any above market profits.
foosion,
I’m not so sure… I think theory would also have to take into account the fact that these primary dealers have clients of their own. Say a medium sized manufacturer wants to buy $80MM or so in short term notes. They discuss their financial needs with their friendly neighborhood banker.
Now maybe its because I’m cynical, but I am pretty sure the final allocation of resources between the Fed, the manufacturer, and its bank will be different if a) the bank is a local bank and b) if the bank is a primary dealer which knows what the Fed is planning to auction off the next day.
Mike found some info showing the Primary dealer’s role has been diminished:
From Liberty Street Economics: On December 12, 2012, primary government securities dealers bought just 33 percent of the new ten-year Treasury notes sold at auction.
http://econintersect.com/b2evolution/blog1.php/2013/02/20/primary-dealers-reduced-role-in-treasury-auctions
Regardless PDs are in essence getting a free lunch, and even more free because they are getting interest on reserves. Hold the latter thought on IoR for a moment.
My one nit here is that the Fed is currently just putting reserves into the economy, but not increasing overall net financial assets. The latter only happens because of deficit spending or bank loans (inside money).
Current QE policy is an asset swap – bonds for reserves – pushing long rates down a few bps. It is not really printing money, unless money is narrowly defined only as reserves. QE is removing long bonds – the net result is zero.
Now, I happen to agree with the camp that believes banks do not lend reserves – which explains why Fed actions are not affecting main street. In fact QE is probably deflationary because it removes interest income from the economy.
Now back to IoR. The Fed pays interest on reserves (free lunch) to prevent the short rate from hitting zero, because banks don’t want to hold excess reserves. Banks need credit worthy borrowers to create new loans, and not reserves.
The Fed is mostly helpless right now, just doing what little they can. Only fiscal policy will be effective at this point.
mmcosker,
Thanks.
I think there are two issues being conflated though. There are Treasury auctions, and then there are purchase and sale of gov’t securities by the Fed through the Fed’s NY desk. Only the Fed’s authorized counterparties (i.e., the primary dealers) can play in the latter, but anyone can show up for the former.
If the Primary Dealers are buying less in the Treasury auctions, it may be that it is because they are getting from the Fed is better than ever. I do not know enough to say.
In the end Mike, the federal government does not even need to issue bonds at all – so this free lunch to banks can be eliminated. I believe bond issuance is a holdover from convertible currency times, and a self imposed congressional constraint.
The government could just credit checking accounts for things they purchase (increasing reserves), and forget about issuing any offsetting debt.
Which brings us to the matter of the Fed and the Funds rate, because adding and subtracting treasuries is used to manage the Fed Funds rate. So absent new bond issues the Fed would control the Fed Funds rate by paying Interest on Reserves like they are doing now. Then banks might actually have to lend to earn money, because they cannot simply earn off of risk free rate differentials.
mmcosker,
I’m mostly with you, with provisions for not printing money willy-nilly. As I’ve stated in other posts, we should all be allowed to bank at the Fed. They can misread FICO scores just as easily as B of A, and Ben Barnanke makes less than any executive at a major bank.
The key to economic activity is demand. Demand has been largely ignored by our politicians. They assume that consumers are going to magically increase spending while their incomes are flat and their jobs are at risk. Consumers have just emerged from an orgy of debt accumulation that artificially increased demand in return for a cut of future earnings plus interest. US companies selling into domestic markets will not hire if demand is slowing or at risk. Government stimulated demand is ridiculed. That leaves foreign demand which has been offset by massive trade deficits for several decades. Unless we reverse our trade deficits, increase wages, allow for massive new debt accumulation or increase government spending, nothing is going to change. If you really want to have less debt at the personal and public levels, the only place you can go is international. Every trade agreement we have signed since Nafta has increased our trade deficit with those nations. Who benefits from these massive giveaways to corporations? Not the people.
http://www.google.com/search?q=$10000+bill&ie=UTF-8&oe=UTF-8&hl=en&client=safari#biv=i%7C1%3Bd%7CqAZtkT2zThO3NM%3A
As long as the U.S. dollars serves three (separate? only?) functions as foreign sovereign reserve currency, the unit in which important commodities are priced, bought and sold (e.g. Oil and cocaine), and the worldwide vehicle of choice for ‘flight to safety’ we need SOME large denomination instrument out there. And printing up more Benjamins or even Chases ($10,000 bill linked above) just leads to embarrassing pallets of money flying in and out of foreign airports or landing on foreign docks.
And unless I am seriously misinformed (and God knows THAT happens) a good piece of this licit and illicit action is transacted in T-Bills. I mean the Chinese and Japanese are not holding onto a combined $2.6 trillion or so in Treasuries because they are luvin’ ROI at the lower bound, and you can say the same about ‘Oil Producing States’ and ‘Caribbean Banking Centers’ which show high up in the top ten of Treasury’s ‘Major Foreign Holders of Treasuries’.
I have asked before in slightly different contexts what is the minimum amount of such foreign held U.S. government debt needed just to keep world commerce functioning and reasonably stable. Because in some sense that ‘debt’ is not exactly a ‘liability’ as such, particularly at current interest rates. This question would become all that more acute if we just played MMT games and stopped issuing bonds. I mean even Chase’s might not be enough in the modern world economy, we might have to start issuing Wilson’s ($100k) or even a new set of denominations starting with the $1,000,000 (a Reagan?) and maybe ending with the infamous $1 trillion platinum coin (the Friedman? Just for the irony involved?).
I mean not everything is about the Fed, it’s Regional Banks and the Too Big to Fail U.S. Member Banks and Primary Dealers, the regular Treasury Bond and such things as TIPS fill more roles than just U.S. Central Bank operations.
The Primary Dealer system has evolved so that it provides the mechanisms by which the US Treasury could easily borrow over $100 billion a month for 4 years, no sweat. No other possible system could accommodate a Monday announcement by the Treasury that it was going to issue $25 billion in Cash Management bills on that Thursday.
The US government and the Fed and the banking giants and near giants who are the PD’s all gain from the arrangement. The Treasury gets the money it needs. The Fed gets power and the PD’s get power and profit and the go ahead to manage the financial markets and a free pass on any criminal liabilities.
The moment to change the system was when the deficit was nominal from say 98-01. But such a change was the exact opposite of what anyone wanted so it was never mentioned. Except by the crackpot right and the gold bug types. The perpetually disrespected, with good reason, opposition which makes any mention of reform verbotten in polite circles.
Mike, Isn’t one of the arguments against discontinuing IOR’s the possible negative impact this may have on Money Market Funds? I seem to recall a temporary “FDIC” approach to protecting MMF’s when the financial crisis first reared its ugly head. Has the guarantee been extended or expired? Anyone know? Until short term bond rates increase it would seem that MMF’s would be susceptible to a run if IOR’s are discontinued prematurely. I don’t support the policy, but I think that under the current circumstances, I don’t see an alternative. Without a meaningful fiscal side stimulus, (very unlikely), I’d expect the Fed to continue the current policy. It will not have the desired effect of monetarists, but it will keep the boat afloat. Oh, what a tangled web they’ve woven.
Nanute the removal of IoR would drive the fed funds rate to zero. Of course that effects many things. IoR’s purpose is to create a rate floor at the fed’s target rate, especially with QE creating lots if reserves.
I guess I kinda knew this but this clarifying explaination kinda made my jaw drop to the floor. Two things… if the government actually worked for the people like it could utopia almost seems possible… Keynes might have been right … we’d all be working 16 hour work weeks… but it doesn’t work the way it should and things like this if commonly understood would have masses in the streets instead of watching American Idol. OK maybe they wouldn’t go to the streets but I bet they’d hit the pause button for a good few seconds.
I did actually once write a letter to the Fed asking for a direct loan.
Dear Mr or Mrs or Ms. Federal Reserve Board Person,
Can I please borrow about $20,000 dollars at the discount rate? I need to buy a new car and I understand the banks are supposed to lend me money for this purpose but I’d rather go directly through the Federal Reserve because the banks are charging much higher rates then you guys. Please send me an application for a loan or any other necessary paper work to make this happen. Or if I have to be a depository institution please send me the proper paper work so I can apply to become one. I have lots of friends that need loans too and if I can get money at the prime rate then I could help them out. If this works out I am thinking that maybe I will borrow more and quit my reguar job. It’s very hard making a living doing something actually productive now a days and it looks like they are having such a good time on Wall Street re-investing the free money you guys give them.
I really think your program needs to open up to all citizens so we can all make money re-investing the cheap or free money you have. Thank you very much for your consideration in this matter. I plan to tell all my internet friends about the great deals you guys offer so they can apply for some cheap or free money too…. I really think this will help out the rest of the middle class economy because it seems to be working so well for Wall Street Banks and other banks you work with. Again thanks for everything. You’re doing God’s work.
Thanks George Balella
PS Tell Ben I said Hi!
great article and being read downunder!!