The credit crisis was caused by a long period of negative short term interest rates, excessive money supply growth, reckless credit expansion, insufficient reserves and over leverage. The regulatory process became hopelessly ineffective and co-opted. Key safeguards that had been in place since the 1930's were brought down through conscious and well-funded lobbying.
The banks think that they have established the principle that if they overborrow enough, if they are reckless enough, if they expand enough, they become "too big to fail" and their losses will be borne by the taxpayers and all holders of the currency, while they keep their personal profits and bonuses.
The Fed would like to introduce some 'turbo-charging' to that money-printing machine, cry 'Fiat!' and unleash the dogs of leveraged credit expansion and monetary inflation. The final link will be a directly funding capability between the Treasury and the Fed, which although not legal is not yet technically sanctioned by the US Uniform Code of Law. But if the Treasury can monetize debt directly such as in the Paulson plan for Fannie and Freddie purchases that point may be moot for quite some time. This is going to be interesting.
Divorcing Money from Monetary Policy
Authors: Todd Keister, Antoine Martin,and James McAndrews
New York Federal Reserve
Many central banks implement monetary policy in a way that maintains a tight link between the stock of money and the short-term interest rate. These procedures require the central bank to set the supply of reserve balances precisely in order to implement the target interest rate.
Because reserves play other important roles in the economy, the link can create tensions with other objectives of central banks. For example:
The imbalance between the intraday need for reserves for payment purposes and the overnight demand leads central banks to provide low-cost intraday loans of reserves to participants in their payments systems, exposing central banks to credit risk and potential moral hazard problems. (This is like worrying about having dirty dishes in the sink while hauling toxic sludge into the house by the truckload, if one considers the dodgy debt the Fed is bringing in from the investment banks through Special Facilities. As for their concerns about moral hazard, these financial swingers have the moral sensibilities of a billy goat. - Jesse)
The link between money and monetary policy prevents central banks from increasing the supply of reserves to promote market liquidity in times of financial stress without compromising their monetary policy objectives. (This is the issue, the punchline. The bank wants to be able to flood the market with liquidity at will without it showing up in the short term interest rates and money supply figures. Since they have eliminated M3 that takes care of the top end. They basically would like to free themselves from even nominal restraints on printing money. - Jesse)
The link also relies on banks facing an opportunity cost of holding excess reserves, which leads them to expend effort to avoid holding these reserves and thereby makes the monetary system less efficient. (Yes we have seen the high efficiency that has been gained recently by insufficiently low reserves and high gearing of leverage. Let's increase it now that we think the worst has past to see if we can get lucky again - Jesse)
Keister, Martin, and McAndrews consider an alternative approach to monetary policy implementation—a “floor system”—that can eliminate these tensions by “divorcing” the central bank’s quantity of reserves from its interest rate target.
By paying interest on reserve balances at its target interest rate, a central bank can increase the supply of reserves without driving market interest rates below the target.
The authors explain that a floor system allows a central bank to set the supply of reserve balances according to the payment or liquidity needs of financial markets. By removing the opportunity cost of holding reserves, the system also encourages the efficient allocation of resources in the economy.
A version of the floor system was recently adopted by the Reserve Bank of New Zealand; this option for monetary policy implementation will be available to the Federal Reserve beginning in 2011.
Divorcing Money from Monetary Policy - NY Fed - pdf download
