Note: this post has been shortened from its original version due to an error pointed out by alert readers. Apologies!
The Term Auction Facility is considered within the Fed and by the Street to be a success, even though academic studies have found that the TAF did not achieve its intended goal of reducing risk premia in the money markets (high spreads are a Bad Thing, a sign banks aren’t willing to lend to each other). And there remains the looming, unanswered question of how to wean the financial services industry off such a substantial support.
Of course, now that the Fed is stuck with rolling these loans until the banking industry is healthy enough to remove this prop, the monetary authority has tried to put a good face on the situation, rebranding the TAF as a tool and hinting it might be ongoing. As Vice Chairman Donald Kohn said in a speech Thursday:
I start from the premise that central banks should not allocate credit or be market makers on a permanent basis. That should be left to the market–or if externalities or other market failures are important, to other governmental programs. The Federal Reserve should return to adjusting reserves mainly through purchases and sales of the safest and most liquid assets as soon as that would be consistent with stable, well-functioning markets…
However, the Federal Reserve’s auction facilities have been an important innovation that we should not lose…. The new auction facilities required planning and changes in existing systems, and we should consider retaining the new facilities for the purposes of bank discount window borrowing and securities lending against OMO-eligible paper, either on a standby basis or operating at a very low level when markets are functioning well in order to keep the new facilities in good working order.
That’s nice in theory, but in practice, it’s going to be very hard to wean banks off the TAF. The central bank certainly can’t do it when either the banking system or the economy look weak, and you can be sure banks will howl about possible damage and risk even in better times. As the comic said, when the bank loans you $10,000, it owns you, but if it lends you $100,000,000 in this case, add a few more zeros), you own it.
So why is the Fed looking at broadening the types of collateral it is willing to accept? Perhaps it sees or worries about new problem areas, which in some sense suggests that the TAF hasn’t yet achieved the hoped-for results (indeed, there are signs of continuing money market stress). But persisting in a course of action that is not succeeding is not intelligent. As we noted earlier:
Yet again, the Fed is acting out the cliche, “if all you have is a hammer, every problem looks like a nail.” Central banks know how to deal with liquidity crises; the TAF and its other facilities are well suited for that sort of problem. But fundamentally, the financial services industry is suffering from a solvency problem. Too many of the assets on its balance sheets contain loans to borrowers who lack the ability (and in some cases the desire) to make good on their debts. Forcing interest rates into negative real interest rate territory will only help a portion of the underwater borrowers. In addition, a distortion this severe is almost guaranteed to produce more misallocation of capital, which is not good for the US in the long term. And if the Fed miraculously manages to keep asset values from falling further, it is merely delaying the day of reckoning, and Japan is the poster child of the results of such a Phyrric victory.
Kohn also suggested that not only might the US central bank accept foreign securities as collateral for loans, but that central bankers might set up a joint facility for global financial institutions. While this on one level sounds practical, a creation of such a vehicle represents a serious erosion of national sovereignty:
Globally active banks manage their positions on an integrated basis around the world, and pressures originating in one market are quickly transmitted elsewhere. Central banks should consider how to adapt their facilities to help these institutions mobilize their global liquidity in stressed market conditions and apply it to where it is most needed. That approach will require the consideration of arrangements with sound institutions in which central banks would accept foreign collateral denominated in foreign currencies. Those arrangements are under active study and a number of issues need to be resolved. It is possible that over time, major central banks could perhaps agree to accept a common pool of very safe collateral, facilitating the liquidity management of global banks. The stipulation that the institutions be sound is important: Decisions about lending to troubled banks should be made by home country authorities with knowledge and responsibility.
Dani Rodrik positied that countries cannot simultaneously have democracy, national sovereignty and global economic integration. I wonder which two of those three the US will choose.