Bair and Reserves for All

I think the Fed's new Overnight Reverse Repurchase Facility is great. Sheila Bair, in the Wall Street Journal, thinks it's awful.

I think it will enhance the stability of the financial system. She thinks it will lead to instability. Well, at least we agree on the important issue.


What is it? Banks can have accounts at the Fed, called "reserves," and these accounts pay interest. In essence, the new program allows other financial institutions, that aren't legally "banks," to also have interest-paying accounts at the Fed. The program involves repurchase agreements, which is a bit silly -- who needs collateral from the Fed? -- but really think of it just as interest-paying bank accounts at the Fed.

I like the Fed's big balance sheet and interest-paying reserves, and I like opening up interest-paying reserves to everyone. I regard this as the first step to putting run-prone short-term financing out of business, by giving depositors a safe alternative. The Federal Government drove run-prone private banknotes out of business in the 19th century. Interest-paying reserves and Treasury floaters can drive run-prone interest-paying money out of business in the 21st. (This is the theme of "Toward a run-free financial system")  Interest-paying money is not inflationary.

Bair does not like it. She is a voice worth hearing.

The mere existence of this facility could exacerbate liquidity runs during times of market stress. ... Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers. 

...Banks could confront a sudden outflow of deposits, particularly those which are uninsured. Even the U.S. Treasury—traditionally viewed as the safest harbor—could see its borrowing costs spike as investors decide that the Fed is even safer.

Ok, a crisis is defined exactly as a time in which investors want to take money out of private short-term debt and hold money -- now reserves. The Fed facility allows them to do that. But, without the Fed facility they can do it the old fashioned way -- put it in banks (preferably, for the investor, too big to fail banks), and the banks then use the money to buy reserves.

In fact, in the crisis, banks had a sudden inflow of deposits for exactly this reason, and contrary to Ms. Bair's prediction. The Fed's new program just takes the bankruptcy-prone intermediary out of that operation. And desirably so in my view.

And she forgets that in the end even reserves are backed by Treasuries. Reserves are Fed liabilities. The corresponding assets are ... Treasuries. (Well, and MBS, but let's not get too complicated here.) If money on net flows in to the Fed, either as reserves or through this new program, the Fed must go off and buy Treasuries. If the Fed does not, the quantity of reserves must decline dollar for dollar with expansion of this new program.

She mentions deposit insurance which is interesting. There is a limit to this business of putting money in to banks who put it in to reserves, giving perfectly safe interest-paying money, and that is deposit insurance. Overnight repo developed in may ways to provide a safer version of "deposits" in quantities larger than deposit insurance allows. And lending to the Fed directly allows for money to flow in to Treasuries without (unneeded in this case) deposit insurance limits too.

But so would holding a money market fund entirely invested in short term Treasuries. Large institutions can also just buy Treasuries directly. Which is exactly what they did in the crisis, driving up prices and down rates -- exactly the opposite of Ms. Bair's prediction.

A flight to quality is a flight to Treasury debt, directly, intermediated by the Fed, or intermediated by the Fed and then by banks.

Treasuries -> Fed -> Banks -> Deposits -> Investor

Treasuries -> Fed -> Investor

Treasuries -> Investor

It's just a question of how many intermediaries are in the way.

Now, Ms. Bair has a more interesting point. By providing an elastic supply of Treasury debt, including cash, intermediated or not, the Government facilitates the "flight to quality." She is advocating that the government stop doing it -- deliberately introduce financial frictions so that investors must hold the private short-term debt that they no longer want.

In that, she is advocating  a radical new approach to financial crises. Since about the mid 1800s in the UK and since the founding of the Federal Reserve in the US, our approach to financial crises has been to drown the system in money.  Bagehot's "lend freely" means exactly what Ms. Bair is decrying, allow investors to hold a vastly expanded amount of government liabilities -- money, reserves or treasuries -- and the government (mostly Fed, but Treasury too) in turn buys their assets or supplies the short term lending they no longer want to do.

Ironically, faced with a more acute liquidity crisis, the Fed would likely have to use the funds it is borrowing through reverse repos to provide a lifeline to the very markets that suffered. For investors seeking safety, the Fed would become the borrower of first resort. For borrowers affected by the resulting diversion of funding, the Fed would become the backstop lender. 

Yes! Exactly as Bagehot, Friedman, and Bernanke said to do!

If you force people to hold something they don't want, then prices, not quantities adjust. As in the crisis, government interest rates hit zero (prices shot up as far as they could) and private rates shoot up (prices collapsed).  A massive demand for money (government short term debt), if not accommodated, leads to deflation. Like in the Great Depression.

Let prices adjust you may say, and perhaps everyone from Milton Friedman to Ben Bernanke who says otherwise is wrong to flood the market with government debt and try to stabilize prices and interest rates. I'm not arguing yes or no here, but recognize the plan for its far-reaching audacity.

The reverse repurchase facility also seems to be at cross-purposes with Congress's efforts to contain the government safety net. After many years of consideration, Congress in 2008 reluctantly gave the Fed authority to pay banks interest on the money they keep on deposit with it. The reverse repurchase facility essentially gives large nonbank financial institutions the routine ability to place money in the functional equivalent of an overnight deposit with the Fed and receive interest. 

Exactly! But this is not a "safety net." In the 1800s Congress also allowed non-banks to hold Federal Reserve Notes, the same thing but that does not pay interest, rather than hold notes issued by banks. The world did not end. We're just doing the same thing with interest-paying money.

Finally, the reverse repurchase facility seems to be at cross-purposes with the Fed's own efforts to address systemic risks emanating from money-market funds, which were subject to disruptive runs after Lehman Brothers collapsed in September 2008. Market pressure should be causing this unstable sector of the financial system to shrink, particularly in today's near-zero interest-rate environment. But by giving money funds a de facto insurance program, the Fed has thrown them a lifeline.

Here Ms. Bair is making another fundamental mistake in my view. Money market funds that hold government debt are completely safe and run-proof. What failed in 2008 were "prime" money market funds that held short term debt issued by risky banks and other financial institutions. Those institutions could not suddenly switch to holding interest-paying reserves, because they'd have to sell all their worthless paper first. The Fed (and SEC) should be loudly encouraging money market funds that hold Treasuries. Because those institutions are exactly the same thing as the Fed's new program!