Federal Reserve
Can I Speak to Your Supervisor? The Importance of Bank Supervision
In March of 2023, the U.S. banking industry experienced a period of significant turmoil involving runs on several banks and heightened concerns about contagion. While many factors contributed to these events—including poor risk management, lapses in firm governance, outsized exposures to interest rate risk, and unrecognized vulnerabilities from interconnected depositor bases, the role of bank supervisors came under particular scrutiny. Questions were raised about why supervisors did not intervene more forcefully before problems arose. In response, supervisory agencies, including the Federal Reserve and Federal Deposit Insurance Corporation, commissioned reviews that examined how supervisors’ actions might have contributed to, or mitigated, the failures. The reviews highlighted the important role that bank supervisors can play in fostering a stable banking system. In this post, we draw on our recent paper providing a critical review and summary of the empirical and theoretical literature on bank supervision to highlight what that literature tells us about the impact of supervision on supervised banks, on the banking industry and on the broader economy.
Supervision and Regulation Are Distinct Activities
In the economic literature on banking and in discussions of the banking industry, the terms “supervision” and “regulation” are often used interchangeably, but in fact these are distinct activities. “Regulation” is the process of establishing the rules under which banks operate: who can own banks, permissible and impermissible activities, and minimum capital and liquidity requirements. Regulations are subject to public comment and input before they are adopted, and they are published for all to see. “Supervision” involves oversight and monitoring of banks to ensure that they are operating in a safe and sound manner. A key part of supervision is ensuring that banks are in compliance with regulations, but supervision also involves qualitative assessments of banks’ internal processes, controls, governance and risk management—and taking enforcement actions when weaknesses are discovered. While some enforcement actions are public, much of supervisory activity is confidential and not publicly disclosed.
A large body of economic research has focused on the goals and impacts of regulation, but much less research has been conducted on the objectives and impacts of supervision, perhaps reflecting the limited information available on supervisory outcomes. Still, a growing body of empirical research is assessing the impact of supervision on banks and examining how supervision affects the risk-taking, lending, and profitability of supervised banks. We summarize some key findings from this work below.
Risk-taking and Performance
It is difficult to estimate the relationship between supervision and performance because troubled banks get more supervisory attention. So, any simple analysis would probably conclude that more intensive supervision leads to problems at banks. Papers that try to estimate the impact of supervision therefore either try to compare similar banks or employ creative strategies to identify bank characteristics associated with more supervision, but not more risk. Nearly all papers examining the impact of supervision on risk-taking find that more intensive supervision results in reduced risk-taking by banks.
Delis et al. look directly at public enforcement actions, such as cease and desist orders, and find that they are associated with subsequent reductions in bank risk, suggesting that these specific types of supervisory actions are effective in causing banks to change their practices. Other papers instrument for supervision using discrete events or characteristics that result in more or less supervisory attention for particular banks, such as changes in the asset-size cutoff for certain types of supervisory reviews (see Rezende and Wu and Bissetti), distance from supervisory offices (see Hagendorff, Lim, and Armitage; Kandrac and Schlusche, Leuz and Granja), and whether a bank is among the largest in the office responsible for its supervision (Hirtle, Kovner, and Plosser). This research finds that more intensively supervised banks have less volatile income, experience fewer and less volatile loan losses, are less negatively affected by economic downturns, and/or spend more on internal controls than banks subject to less supervisory attention.
In contrast to concerns that supervision may inhibit growth, this reduced risk does not appear to come at the expense of profitability or growth. Most papers that examine this question find that supervision has a neutral to positive effect on profitability, as reflected in equity returns, risk-adjusted returns, market-to-book ratios, or accounting net income. In a previous Liberty Street Economics blog post, we shared our result that more intensively supervised banks do not have measurably lower asset or loan growth rates than comparable banks subject to less intensive supervision. These findings suggest that supervision reduces the risk of bank failure, with little cost to bank profitability. But are there other impacts to consider in weighing the costs and benefits of supervision?
Lending
While more intensive supervision might not reduce bank profitability, it can have effects on other aspects of banks’ activities. The most critical of these is lending. Supervision results in less risky lending, as noted above, but does it also decrease the amount of credit available to borrowers? The papers looking at this question have found mixed results, with some finding that more intensive supervision results in reduced credit supply, while others find that risk is reduced without significantly reducing lending.
The longest-standing research on the impacts of supervision examines how the stringency of the bank examination process affects banks’ lending. In general, these papers find that increased supervisory stringency is associated with reduced loan origination or slower loan growth, though the estimated economic effects of the impact vary. Other studies have found that while supervisory actions such as guidance on commercial real estate and leveraged lending might reduce these types of loans at banks subject to the tighter supervisory expectations, the targeted banks shift into other forms of lending and at least some of the targeted lending shifts to other banks. Some studies find that lending rebounds over time as banks and borrowers adjust to the new approach.
Does Supervision Strike the Right Balance?
In the period after the failures of several large banks in March 2023, many questions were raised about whether more forceful supervision of those banks could have prevented their failure or limited the contagion that followed. Our review does not directly address this specific event but provides some general results about the costs and benefits of supervision. One important caveat to these findings is that they were estimated at levels of supervision prevailing at the time of the analysis. It is possible (and even likely) that the free lunch suggested in the positive relationship between supervision and risk without significant impact on growth may not hold if supervision were dramatically increased from those levels.
Beverly Hirtle is a financial research advisor in Financial Intermediation Policy Research in the Federal Reserve Bank of New York’s Research and Statistics Group.
Anna Kovner is the director of Financial Stability Policy Research in the Bank’s Research and Statistics Group.
How to cite this post:
Beverly Hirtle and Anna Kovner , “Can I Speak to Your Supervisor? The Importance of Bank Supervision,” Federal Reserve Bank of New York Liberty Street Economics, April 15, 2024, https://libertystreeteconomics.newyorkfed.org/2024/04/can-i-speak-to-you....
How Does Supervision Affect Bank Performance during Downturns?
A Peek behind the Curtain of Bank Supervision
Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).
Dropping Like a Stone: ON RRP Take‑up in the Second Half of 2023
Take-up at the Overnight Reverse Repo Facility (ON RRP) has halved over the past six months, declining by more than $1 trillion since June 2023. This steady decrease follows a rapid increase from close to zero in early 2021 to $2.2 trillion in December 2022, and a period of relatively stable balances during the first half of 2023. In this post, we interpret the recent drop in ON RRP take-up through the lens of the channels that we identify in our recent Staff Report as driving its initial increase.
ON RRP Take-up Has Been Decreasing since June 2023…
Source: Federal Reserve of St. Louis. FRED database.
Banks’ Balance-Sheet Costs
As the Federal Reserve expanded its balance sheet in response to the COVID-19 pandemic, it increased the supply of reserves to the banking system and, as a result, banks’ balance sheets also grew. Reserves increased from $1.6 trillion—or 9 percent of banks assets—in January 2020 to $3.2 trillion—or 16 percent of bank assets—over the following three months, reaching a historical maximum of 19 percent of banks’ assets in September 2021. As the chart below shows, bank assets also grew from $18 trillion in January of 2020 to $20 trillion in April 2020, and continued to increase to $23 trillion in May 2023.
As banks’ balance sheets expand, regulatory ratios—such as the supplementary leverage ratio (SLR)—are likely to become tighter for some institutions. Banks react to increased balance-sheet costs by pushing some of their deposits toward the money market fund (MMF) industry—for instance, by lowering the rate paid on bank deposits—and reducing their demand for short-term debt. As we explain in our paper, both effects are likely to have boosted ON RRP take-up during March 2021 – May 2023, as most MMFs are eligible to invest in the ON RRP and do so especially when alternative investment options, such as banks’ wholesale short-term debt—including repos by dealers affiliated with a bank holding company—dwindle.
Likely, these effects have subsided relative to 2022. Indeed, since June 2023, bank assets have hovered around $23 trillion, slightly below their March 2023 peak. Moreover, reserves have been around 14 percent of bank assets since June 2023, below the average of 16 percent observed between March 2020 and May 2023. Since the SLR treats all assets in the same way regardless of their riskiness, large banks’ balance-sheet expansions are particularly costly if they are used to finance safe assets with low returns. Therefore, though bank assets have remained relatively stable, the recent decline in the ratio of reserves to bank assets has likely reduced banks’ overall balance-sheet costs.
…while Bank Assets and Reserves Relative to Bank Assets Have Remained Roughly Constant.
Source: Federal Reserve Bank of St. Louis. FRED database.
Consistent with a decrease in banks’ balance-sheet costs (and an increase in the supply of bank debt), the interest rates at which banks and broker dealers borrow via overnight Treasury-backed repos have increased since the fourth quarter of 2022 and are now a few basis points above the ON RRP rate (see chart below). This positive rate differential pushes MMFs away from investing at the ON RRP facility and into private repos.
The SOFR-ON RRP Spread Has Been Positive…
Source: Federal Reserve of St. Louis, FRED database.
Monetary Policy
Monetary policy can affect ON RRP take-up by MMFs in two ways. First, the interest-rate pass-through of MMF shares is higher than that of bank deposits; as a result, the size of the MMF industry comoves with the monetary policy cycle as investors switch from bank deposits to MMF shares when the policy rate increases. Though the assets of the MMF industry are at an all-time high, the pace of the increase has somewhat decreased recently, consistent with a slower pace of monetary policy tightening; moreover, the share of MMF assets managed by government funds—the ones most likely to invest in the ON RRP—has decreased since June 2022 by 7 percentage points.
Second, monetary policy can affect MMFs’ take-up at the ON RRP also through its effect on interest-rate uncertainty. Higher uncertainty leads MMFs to rebalance their portfolios toward investments with shorter duration; the ON RRP is one such investment as it is overnight. Indeed, interest rate uncertainty—as measured by the MOVE index—had increased substantially during the latest tightening cycle, raising from 57.3 in May 2021 to 136 in May 2023. Recently, however, the increase has been partially reversed. Indeed, the average level of the MOVE was 125.6 in the first half of 2023 but declined to 117.3 in the second half of the year.
…while Interest-Rate Uncertainty Has Been Decreasing.
Source: Yahoo! Finance.
The Supply of T-bills
A third driver of ON RRP take-up is the supply of T-bills. The Federal Government has expanded the supply of T-bills dramatically in 2023: T-bills outstanding increased from $3.7 trillion at the end of 2022 to $5.3 trillion at the end of September 2023, with a $1.3 trillion increase since June. As the supply of T-bills grows, the investment options of MMFs—and especially of government funds, which represent 83 percent of the industry and can only invest in short-term government debt and repos backed by government debt—expand and, as a result, their investment in the ON RRP dwindles. In our staff report, we estimate that a $100 billion increase in the amount of T-bill issuance reduces the proportion of ON RRP investment in a government-MMF portfolio by 2.3 percentage points, relative to that in a prime-MMF portfolio; since average monthly T-bill issuance went from $1.12 trillion in the period from 2022:Q1-2023:Q1 to $1.53 trillion in 2023:Q2-2023:Q3, this effect on portfolio rebalancing amounts to an additional decrease in ON RRP investment of roughly $350 billion.
Summing It Up
The increase in ON RRP take-up between 2021 and May 2023 was driven by a series of factors: a rise in banks’ balance-sheet costs due to the expansion of the supply of reserves in response to the COVID-19 pandemic, the rapid hikes in policy rates aimed at fighting inflation and the resulting increase in interest-rate uncertainty, and the decrease in the T-bill supply of 2021-22 resulting from the normalization of public debt after the COVID-19 crisis.
These factors have reversed: the Federal Reserve restarted running off its balance sheet after the temporary expansion during the banking turmoil of March 2023; the growth of the banking system waned while the ratio of reserves to asset decreased; the pace of interest-rate hikes slowed down; and the T-bill supply increased again. If these dynamics persist in the months ahead, ON RRP take-up may continue to decrease. Such a steady decline would be consistent with that observed in early 2018, when investment at the ON RRP gradually disappeared as the Federal Reserve continued to normalize the size of its balance sheet and reserves in the banking system became less abundant.
Gara Afonso is the head of Banking Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.
Marco Cipriani is the head of Money and Payments Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.
Gabriele La Spada is a financial research economist in Money and Payments Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.
How to cite this post:
Gara Afonso, Marco Cipriani, and Gabriele La Spada, “Dropping Like a Stone: ON RRP Take‑up in the Second Half of 2023,” Federal Reserve Bank of New York Liberty Street Economics, December 19, 2023, https://libertystreeteconomics.newyorkfed.org/2023/12/dropping-like-a-st....
Banks’ Balance-Sheet Costs, Monetary Policy, and the ON RRP
Monetary Policy Transmission and the Size of the Money Market Fund Industry: An Update
The Transmission of Monetary Policy and the Sophistication of Money Market Fund Investors
Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).
Hey, Economist! Outgoing Advisor Antoine Martin Reflects on How His New York Fed Perch Has Shaped His Work
Antoine Martin, an economist and financial stability advisor in the New York Fed’s Research and Statistics Group, will soon take up a new post at the Swiss National Bank (SNB), as head of its third department covering money markets/foreign exchange (FX). In that role, Martin, who is originally from Switzerland, also becomes one of three members of that central bank’s rate-setting governing board. Readers of Liberty Street Economics will be familiar with his byline, as he has written more than sixty posts presenting new research findings and policy analysis, all with an eye for breaking down the most complicated topics in clear terms. He took a few questions from publications editor Anna Snider about his experiences and future plans as he prepares to move on.
Q: How did your role at the New York Fed change over the years?
I joined the New York Fed in 2005, after spending four years at the Kansas City Fed. I have been in the Research and Statistics Group throughout my time here. After the global financial crisis (GFC) in 2008, I got a lot more involved with policy work, notably with the tri-party repo infrastructure reform, money market funds reform, and the Federal Reserve’s monetary policy implementation long-term framework. More recently, I have worked on issues related to digital currencies and central bank digital currency (CBDC).
Q: What will you cover in your new role at SNB?
A: I am joining the SNB as head of the third department, which is based in Zurich. The SNB has three departments that focus on, respectively, monetary policy, financial stability, and money markets/FX. As head of the third department, my role will be similar to the one held by the head of the Markets Group at the New York Fed. The heads of the three departments also form the policymaking body for the SNB, the equivalent of the Federal Reserve’s Federal Open Market Committee.
Q: What has been your core research focus? Does that thread through all your work?
I was hired by the New York Fed in part for my expertise in the economics of payments. I had also done research on bank runs and the tools available to central banks to try to prevent them. When I joined the New York Fed, and especially after the GFC, two important things happened. First, I realized how much institutional details matter in economic outcomes. Second, I was exposed to a lot of fascinating and difficult policy questions. This had a profound effect on my research. It led me to focus more on policy-relevant questions and pushed me to integrate important institutional details in my analysis. One example could be the “unwind” of tri-party repo transactions, which contributed to the fragility of that market (and which I discussed on Liberty Street Economics in “Stabilizing the Tri-Party Repo Market by Eliminating the ‘Unwind.’”
Q. You have worked a lot on the “how” of monetary policy, thinking about the tools that underlie the Fed’s policy stance. What has it been like to see new tools go from blueprint to implementation?
It was super interesting and very exciting to see an idea, a floor system of monetary policy implementation underpinned by interest on reserves, go from something purely theoretical to becoming a key implementation tool, not only for the Federal Reserve, but also for many other central banks. I started working on floor systems with colleagues from the New York Fed before the GFC. Todd Keister, Jamie McAndrews, and I published our first paper on the topic, “Divorcing Money from Monetary Policy,” in the Economic Policy Review in 2008, before the Federal Reserve could pay interest on reserves. That authority was granted by the U.S. Congress effective October 1, 2008.
Looking back, I find it fascinating how much we had to learn about how a floor system works. A simple theoretical model is extremely helpful in helping us understand the key economic mechanisms that underlie a floor system, but the model has to be adapted to take into account institutional features. For example, I think most people didn’t anticipate that the effective federal funds rate would often trade below the interest on reserve balances (IORB). This development led to the creation of overnight reverse repurchase agreement (ON RRP) operations. Later, when the Federal Reserve began normalizing the size of its balance sheet in 2019, most observers were surprised that reserves would appear to be scarce even though the supply was still about $1.3 trillion (owing in part to frictions in the interbank market that has made it harder for institutions to redistribute reserves among themselves, as my co-authors and I explained in “The Market Events of Mid-September 2019,” also in the Economic Policy Review). Eventually, that led to the introduction of the standing repo facility. Some co-authors and I discussed the evolution of this implementation framework in a four-part Liberty Street Economics series in 2022 that lead with “How the Federal Reserve’s Monetary Policy Implementation Framework Has Evolved.”
Q: You have been a major contributor to Liberty Street Economics since its inception in 2011, with a gift for explaining complex institutional structures, market dynamics, and policy impacts. What readers do you have in mind when you write these?
In my view, one important role of economic researchers at a central bank is to help the public understand what the central bank does. We can do that by describing and analyzing the tools at the disposal of central banks and how these tools are used. We can provide an analytical perspective on the context in which decisions are made and the key trade-offs a central bank faces. As an example, Liberty Street Economics published several posts after the GFC and the events of March 2020 describing the facilities put in place to support the financial system and the American economy.
One of the reasons I have enjoyed working at the New York Fed so much is because I am fascinated by the role central banks play in the economy. When I write blog posts, I am hoping that readers will learn something about the markets in which the Fed operates and the challenge it faces.
Q: In recent years, you’ve been a guide for those interested in making sense of digital currencies and asset tokenization. How did you get drawn into this subject? How do you see these technologies fitting in to the financial ecosystem?
Given my background in the economics of payments, it felt natural for me to become interested in digital assets and cryptocurrencies. And, of course, it is also a very important issue for central banks, many of which operate at least some payment systems in their economy.
A lot of claims have been made suggesting that crypto- and/or digital currencies are going to transform the financial system. So, with my colleague Michael Lee, we tried to understand how these new systems work, how they might benefit consumers, how they could allow financial institutions to provide better services, and how they might be used by central banks to implement better policies. We wrote about these issues on the blog (see, for example, “Hey Economist! What Do Cryptocurrencies Have to Do with Trust?” and “Bitcoin Is Not a New Type of Money”).
It is still not entirely clear whether or how new technologies will change the payment landscape. While a lot of attention has focused on cryptocurrencies, like Bitcoin, they are rarely used for payments. Instead, instant payment systems have led to profound changes in the payment landscape in some countries. In Sweden, for example, Swish contributed to a dramatic decline in the use of cash. In Brazil, Pix usage has exceeded expectations and contributed to financial inclusion. With the availability of the FedNow Service, we can hope that instant payments will develop further in the U.S. as well.
Q: You speak (at least) three languages—English, French, and German—plus the tongues of math and economics. Which do you use most and how will that change in your new position?
Saying that I speak German is a bit of a stretch. Even though I took German through high school, I forgot most of what I knew. I have been studying it intensively in the last few months and I am excited to have a chance to become fluent in that language. I think that an important aspect of communication is to know your audience and I will have to adapt in my new role. So, I will probably speak a little bit less in math and in English and a little bit more in German and in French.
The Market Events of Mid-September 2019
How the Federal Reserve’s Monetary Policy Implementation Framework Has Evolved
Bitcoin Is Not a New Type of Money
Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).
Are central banks too reliant on SWIFT for domestic payments?
Central bank settlement systems are the the tectonic plates of the payment system: they are vitally important to our lives, but we never see them in action. All of a nations' electronic payments are ultimately completed, or settled, on these systems. If they stop working, our financial lives go on pause, or at least regress to older forms of payment.
In this post I want to introduce readers to a crucial feature of these payments tectonic plates: their reliance for domestic settlement on SWIFTNet, a financial messaging network used by banks and other financial institutions to communicate payments information. Think of SWIFTNet as a WhatsApp for banks, but exclusive and very secure.
This reliance – or over-reliance – is best exemplified by a recent decision by the European Central Bank. The Target2 settlement system has long been the bedrock layer of the European payments universe. All domestic payment ultimately get tied-off on the system. Since it was introduced in 2007, Target2 has been solely reliant on SWIFTNet for sending and receiving messages.
When the European Central Bank replaced Target2 with T2 earlier this year, it modified the system to have two access points: it kept SWIFTNet but added a competing messaging network, SIAnet, to the mix. As one commentator triumphantly put it, "SWIFT’s monopoly for access to the T2/T2S system is broken."
SWIFTNet is owned by the Society for Worldwide Interbank Financial Telecommunication, or SWIFT, which is structured as a cooperative society under Belgian law and is owned and governed by its 11,000 or so member financial institutions. Whenever SWIFT gets mentioned in conversations, it tends to be associated with cross-border wire payments, for which its messaging network is dominant. However, for many jurisdictions, including Europe, SWIFT is also integral to making domestic payments. It's this little-known local reliance that I'm going to explore in this post.
The dilemma faced by central banks such as the European Central Bank is that SWIFTNet is an incredibly useful messaging network. It is ubiquitous: most banks already use it for cross-border payments. And so the path of least resistance for many central banks is to outsource a nation's domestic messaging requirements to SWIFT, too. However, this reliance exposes national infrastructure to SWIFTNet-related risks like foreign control, sanctions, snooping, and system outages.
Financial messaging 101
Before going further, we need to understand why financial messaging is important. For a single electronic payment to be completed, a set of databases owned by a number of financial institutions, usually banks, must engage in an intricate dance of credits and debits. To coordinate this dance, these banks need to communicate, and that's where a messaging network is crucial.
Say, for example, that Google needs to pay Apple $10 million. Google tells its banker at Wells Fargo to make the payment. Wells Fargo first updates its own database by debiting Google's balance by $10 million. The payment now has to hop over to Google Apple, which banks at Chase. For that to happen the payment flow must progress to the core of the U.S's payments system, the database owned by the Federal Reserve, the U.S.'s central bank.
Along with most other U.S. banks, Wells Fargo has an account at the Federal Reserve. It communicates to the central bank that it wants its balance to be debited by $10 million and the account of Chase to be credited by that amount. Once Chase's account at the Federal Reserve is updated, Chase gets a notification that it can finally credit Apple for $10 million. At that point Apple can finally spend the $10 million.
This entire process takes just a second or two. For this "dance of databases" to execute properly, the Federal Reserve, Chase, and Wells Fargo need to be connected to a communications network.
The sort of messaging network to which the central bank is connected, and the stewardship of that network, is thus crucial to the entire functioning of the economy.
Proprietary messaging networks or SWIFTNet?
The Federal Reserve is somewhat unique among central banks in that it has built its own proprietary messaging network for banks. All of the 9,000 or so financial institutions that use the Federal Reserve settlement system, Fedwire, must connect to the Fed's proprietary messaging network to make Fedwire payments. To make international payments, however, U.S. banks must still communicate via SWIFTNet.
Let's flesh the story out by trekking north of the border. Whereas the Federal Reserve has no reliance on SWIFTNet, Canada's core piece of domestic settlement infrastructure, Lynx, relies entirely on SWIFTNet for messaging.
For example, if Toronto Dominion Bank needs to make a $10 million to Scotiabank, it enters this order into SWIFTNet, upon which SWIFT forwards the message to Lynx, which updates each banks' accounts by $10 million and sends a confirmation back to SWIFTNet, which tells Scotiabank that the payment has settled.
For payments nerds, this network setup is called a Y-copy topology. The network looks like a "Y" because the originating bank message is relayed from the sending bank via SWIFTNet, the pivot at the center of the Y, down to the settlement system, and then back up via SWIFTNet to the recipient bank. It is illustrated below in the context of the UK's payment system, with the CHAPS settlement system instead of Lynx, but the idea is the same.
A Y-copy network topology for settling central bank payments in the UK [source]
The upshot is that the Federal Reserve controls the messaging apparatus on which its domestic settlement depends, whereas Canada outsources this to a cooperative on the other side of the ocean.
Many of the world's small and middle-sized central banks have adopted the same Y-copy approach as Canada. This list includes Australia, Singapore, New Zealand, Nigeria, UK, Sweden and South Africa. However, some members of this group are starting to have second thoughts about fusing themselves so completely to SWIFT.
Removing the single point of failure
The European Central Bank is at the vanguard of this group. Prior to 2023, the European Central Bank was in the same bucket as Canada, relying entirely on SWIFTNet to settle domestic transactions.
With its upgraded T2 system, Europe doesn't go quite as far the Fed's model, which is to build its own bespoke messaging network. Rather, European banks now have the option of either sending messages to T2 using SWIFTNet, or they can use SIAnet, a competing network owned by Nexi, a publicly-traded corporation. SIAnet stands for Societa Interbancaria per l'Automazione, a network that originally connected Italian banks but has now gone pan-European.
The reason for this design switch is that European Central Bank desires "network-agnostic connectivity." This dual access model will make things more complex for the European Central Bank. If a commercial bank originates a SIAnet message, the central bank will have to translate this over to a SWIFT message if the recipient bank uses SWIFTNet. Nevertheless, the European Central Bank believes this dual structure will offer more choice to domestic banks.
The ECB also hints at the enhanced "information security" that this new setup will provide, without providing much detail. The UK's recent efforts to update its core settlement layer sheds some extra insights into what these security improvements might be. Right now, the UK's core settlement system, CHAPS, can only be accessed by SWIFTNet, much like in Canada, so that all domestic UK payments are SWIFT-reliant.
In its roadmap for updating CHAPS, the Bank of England is proposing to allow banks to access the system via either SWIFTNet or a second network, which doesn't yet exist. The idea is to enable "resilient connectivity" to the core settlement layer, especially in periods of "operational or market disruption." Should SWIFTNet go down there would be no way for financial institutions to communicate with CHAPS, and the entire domestic economy would grind to a halt. A second network removes the "single point of failure" by allowing banks to re-route messages to CHAPS.
The Bank of England also highlights the benefits of competition, which would reduce the costs of connectivity.
This sounds great, but there are tradeoffs. Using a a single network for both domestic and international payments is valuable to the private sector because it offers standardization and efficiencies in banks' processing. Adding a second option will also complicate things for the Bank of England, since it will have to design and build a system from scratch, much like the Fed did, which could be costly. Either that or it will have to find another private option, like the ECB did with SIAnet. This second network may not be as good as SWIFTNet which, despite worries about resiliency, has been incredibly successful.
When CHAPS went down earlier this year for a few hours, for instance, it wasn't SWIFT's fault, but the Bank of England's fault. The same goes for a full day outage in 2014.
Comparing a V-shaped network topology to Y-Copy in an Australian context [source]
The type of settlement topology that the UK is proposing is known as "V-shaped," since all messages are sent directly to the central bank settlement system for processing via any of a number of messaging networks, and then back to the recipient bank. The difference between a V-shaped topology and Y-copy is visualized in the chart above in an Australian context, but the principles apply just as well to the UK.
Sanctions and "the SWIFT affair"
The decision to make domestic payments less dependent on SWIFTNet is much more easy to make for outlier nations like Russia. SWIFT is based in Belgium and is overseen by the Belgian central bank, along with the G-10 central banks: Banca d’Italia, Bank of Canada, Bank of England, Bank of Japan, Banque de France, De Nederlandsche Bank, Deutsche Bundesbank, European Central Bank, Sveriges Riksbank, Swiss National Bank, and the Federal Reserve. That put SWIFT governance far out of Russian control.
You can see why this could be a problem for Russia. Imagine that only way to settle domestic Russian payments was by communicating through SWIFTNet. If Russia was subsequently cut off from that network for violating international law, that would mean that all Russian domestic payments would suddenly cease to work. It would be a disaster.
Needless to say, the Central Bank of Russia has ensured that it doesn't depend on SWIFTNet for communications. It has its own domestic messaging network known as Sistema peredachi finansovykh soobscheniy, or System for Transfer of Financial Messages (SPFS), which was built in 2014 after the invasion of Crimea. Prior to then, it appears that "almost all" domestic Russian transactions passed through SWIFTNet – a dangerous proposition for a country about to face sanctions.
Mind you, while Russia has protected its domestic payments from SWIFTNet-related risk, it can't do the same for its international payments. SWIFTNet remains the dominant network for making a cross border wire. There is no network the Russians can create that will get around this.
I'm pretty sure that most larger developing states and/or rogue nations have long-since built independent domestic financial messaging systems to avoid SWIFTNet risk. I believe China has done so. Brazil has the National Financial System Network, or Rede do sistema financeiro nacional (RSFN). India also has its own system, the Structured Financial Messaging System (SFMS), built in 2001. India is even trying to export SFMS as a SWIFT competitor.
The Japanese were typically way ahead on this. The Bank of Japan built its messaging network, the Zengin Data Telecommunication System, back in 1973, several years before SWIFT was founded.
The last SWIFTNet risk is snooping risk. This gets us into the so-called SWIFT affair. After 9/11, the U.S. intelligence agencies were able to pry open SWIFT through secret broad administrative subpoenas. They had the jurisdiction to do so because one of SWIFT's two main data centres was located in the U.S.
To ensure data integrity, SWIFT had been mirroring European data held in its data centre in Belgium at its U.S. site. That effectively gave U.S. intelligence access to not only SWIFT's U.S. payments information, but also information on foreign payments sourced from Europe or directed to Europe. Worse, it also provided spooks with data on domestic European payments. Recall that the European Central Bank's Target2 settlement system, which settles all digital domestic payments in Europe, was entirely reliant on SWIFTNet for communications.
When the U.S.'s snooping arrangement was made public by the New York Times in 2006, it caused a huge controversy in Europe. SWIFT tried to placate Europe by building a third data warehouse in Switzerland to house Europe's back-up data. But the precedent was set: SWIFT is not 100% trustworthy. And that may be part of the reason why the European Central Bank chose to downgrade its reliance on SWIFTNet when it introduced its new system, and is surely why other nations want to entirely hive their domestic systems off from it.
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In sum, central banks face a host of complicated decisions in how to bolt on messaging capabilities to their key settlement systems. SWIFTNet is a top notch network. However, too much SWIFT-related risk may be perceived as having negative implications for national security. For large nations with extensive banking industries, building a proprietary domestic messaging alternative seems to be the preferred option. It also seems to be the default choice for rogue states like Russia.
Another alternative is to fallback on using multiple independent networks for access, of which one is SWIFTNet, and thus mitigating exposure to SWIFT-related problems. This is the approach taken by Europe and the UK.
For smaller nations that comply with the global consensus, like Canada, the calculus is different. Building an alternative communications network is likely to be costly. The risk of sanctions and censorship are negligible while the benefits of using a high-quality ubiquitous network for both domestic and foreign payments messaging are significant. Given these factors, it may be worthwhile to bear all SWIFT-related risks and adopt the Y-copy model.
Crypto adoption in America
Source: America Loves Crypto
You may have recently come across the America Loves Crypto marketing campaign, sponsored by Coinbase, the U.S.'s largest crypto exchange. In an attempt to promote the voting power of crypto owners, the website makes the claim that 52 million American adults currently hold crypto, which constitutes 20% of the U.S. adult population. If true, that's a massive voting block.
As the source for its 20% statistic, Coinbase cites an online survey of 2,202 adults that it commissioned from Morning Consult last February, which among other questions queried respondents for how much crypto they currently hold.
If you've been following other sources for cryptocurrency adoption data, Coinbase's 20% statistic seems... questionable?
To see why, let's dig into U.S. crypto adoption data. What follows is a quick rundown of what the best surveys have had to say about Americans crypto ownership. Later on in the article I'll get into who they are, how much they own, and why they hold it.
1) The granddaddy of all U.S. payments surveys is the Federal Reserve's Survey and Diary of Consumer Payment Choice, or SDCPC. The SDCPC is a long-running data collection effort that tries to paint a comprehensive picture of U.S. consumers' payment preferences and behavior. It fortuitously began to incorporate crypto-related questions way back in 2014, although crypto is just a tiny portion of the incredible amount of data collected by the SDCPC.
The Fed's SDCPC is run through the University of Southern California's Understanding America Study panel. In its 2022 iteration the SDCPC polled more than 4,761 participants. Notably, the SDCPC includes both a survey and a 3-day diary portion. Diaries are more labor intensive to administer than surveys, but provide better information since they minimize recall bias.
The SDCPC found that 9.6% of American adults owned cryptocurrency in 2022, up from 9.1% in 2021, and far higher than the 0.6% it polled back in 2015. However, that's far less than Coinbase's 20% claim. Only one of these numbers can be right. Which one is it?
The SDCPC's historical findings are in the table below.
U.S. cryptocurrency adoptions rates. Source: Federal Reserve's 2022 Survey & Diary of Consumer Payment Choice
2) The Federal Reserve publishes another survey that also sheds light on U.S. crypto adoption. The Fed's annual Survey of Household Economics and Decisionmaking (SHED) examines the financial lives of American adults and their families, and is therefore more general than the Fed's SDCPC, which is focused exclusively on payments.
The Fed's SHED is administered by Ipsos using Ipsos's KnowlegePanel panel. In 2022, 11,667 participants completed the SHED.
The SHED only began to include questions about crypto in 2021. It finds that 10% of Americans used cryptocurrency during 2022, where "using" is defined as buying, holding, or making a payment or transfer with crypto. This amount was down from 12% in 2021 (see table below). The number of Americans who held cryptocurrency as an investment, a narrower definition than "using", fell to 8% in 2022 from 10%.
Source: Federal Reserve's 2022 SHED
The SHED's 8-10% number neatly confirms the SDCPC's 9.6% finding while disaffirming Coinbase's 20% statistic.
3) The next decent source for crypto adoption data is tabulated by a group of four economics and finance researchers using quarterly surveys of the Nielsen Homescan panel, comprised of 80,000 households. With response rates of 20-25% per survey, that represents data from 15,000 to 25,000 respondents.
Weber, Candia, Coibion, and Gorodnichenko (Weber et al) found that at the end of 2022, the fraction of all households owning crypto had risen to 12%. The black dotted line in the chart below shows how ownership rates have changed over time.
Source: Weber et al (2023) using Nielsen Homescan Panel data
4) The fourth in our survey of crypto surveys was conducted by the Pew Research Center using its American Trends Panel. In a March 2023 survey of 10,701 panelists, Pew found that 17% of American adults have "ever invested in, traded, or used" a cryptocurrency. This is a very broad category, and would presumably include someone who casually bought $25 worth of bitcoin back in 2015 and sold it three days later, and has never touched it again.
Drilling in further, of the 17% who have ever owned or used crypto, 69% report that they currently hold some, which works out to a 2023 ownership rate of 11-12% among American adults. That's not too far off the two Fed surveys and Weber et al, but significantly different from the Coinbase result.
5) A fifth source of data comes from Canada, which serves as a decent cross-check against U.S. data given that both countries are quite similar in terms of culture and geography. Of the two key Canadian surveys, the first is the Bank of Canada's long-running Bitcoin Omnibus Survey (BTCOS), administered by Ipsos, which amalgamates participants from three different panels.
The 2022 BTCOS polled 1,997 Canadians and found an ownership rate of 10%, down from 13% the year before (see chart below). This constitutes a lower bound to ownership rates since it only includes bitcoin owners. The 2022 BTCOS also finds that 3.5% of Canadians own dogecoin and 4% own ether. However, it's not possible to add these amounts to the 10% bitcoin ownership number since many respondents own multiple types of crypto.
Source: Bank of Canada 2022 Bitcoin Omnibus Survey
The second Canadian survey of note was carried out by the Ontario Securities Commission in 2022 to explore Canadian attitudes towards crypto assets. Conducted with Ipsos, the survey polled 2,360 Canadians in early 2022. It found that 13% of Canadians currently own any type of cryptocurrency, including crypto ETFs, which are legal in Canada but illegal in the US.
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So there you have it. The two Federal Reserve surveys put crypto ownership at 9.6% and 8-10% respectively in 2022, while Weber et al peg it at 12% using Nielsen Homescan data. Pew has American crypto ownership at 11-12% by early 2023. And in Canada, the Bank of Canada calculates bitcoin ownership to be at 10% by the end of 2022, while the Ontario Securities Commission pegs total crypto ownership at 13% in early 2022, before much of crypto imploded.
Given this range of data, the 20% adoption rate that Coinbase's Morning Consult survey trots out is a glaring outlier and probably deserves to be thrown out. The American crypto owner is a potentially sizeable voting group, but not as big as Coinbase would like us to believe.
For what it's worth, I've found a few other odd things with Coinbase's Morning Consult survey that further adds to my skepticism. Morning Consult reports that 8% of respondents currently own a cryptocurrency called USDC, down from 10% the quarter before (see here for more). The survey also says that 5% currently own Tether. USDC and Tether are stablecoins. To anyone who follows crypto closely, the idea that 1 in 10 Americans own any particular stablecoin is absurd. Given that Morning Consult has surely got this wrong, perhaps through a sampling error, that makes you wonder about the quality of their overall work.
However, even if we ignore Coinbase's Morning Consult survey, the 9.6% adoption rate found in the bellwether SDCPC is still breathtakingly high. In just fifteen years, crypto has gone from a strange niche product to something that is being held by tens of millions of Americans.
What additional facts do we know about America's crypto owners?
Size of holdings
Going through the SDCPC data, the majority of Americans who own crypto only have a little bit of the stuff. Out of all U.S. crypto owners surveyed, 45% owned just $0-200 worth of crypto in 2022. This is illustrated in the chart below. The median quantity of crypto held was $312. Given such small amounts, I doubt that these crypto owners qualify as durable crypto adopters, as opposed to folks who've jumped on the bandwagon when they saw a Superbowl ad from Coinbase, bought some dogecoin, and have since stopped paying any attention.
The SDCPC data suggests that 1 in 4 crypto owners are what I call crypto fundamentalists, holding more than $2,000 worth of crypto. Given that 90% of Americans don't hold any crypto at all, two in every 100 Americans qualifies as a crypto fundamentalist.
This skewed distribution of crypto ownership is confirmed by survey results from Weber et al and the Nielsen Homescan panel. An outlier group of hard-core owners, representing around 8% of all crypto owners, allocates their entire portfolio to crypto (see chart below). By far the largest group of crypto owners is comprised of small dabblers who put just 0-5% of their portfolios into crypto.
Source: Weber et al (2023) using Nielsen Homescan Panel data
Reasons for ownership
Why do Americans own cryptocurrency? Despite being labelled as "currencies," cryptocurrencies are not generally used as a medium for making payments. Price appreciation is the dominant motivation for owning them.
When the SDCPC survey queried participants in 2022 for their "primary reason for owning virtual currency," the most popular answer (at 67%) was investment (see chart below, orange rows). The second most popular reason (21%) was "I am interested in new technologies." It was rare for respondents to list any sort of payments-related use case as their primary reason for ownership. As for lack of trust in banks, the government, or the dollar – all of which are common cryptocurrency themes – these were rarely mentioned in 2022 as a primary reason for ownership.
Interestingly, Americans crypto owners were not always so obsessed with price appreciation. In 2014, the SDCPC found that American crypto currency owners tended to offer a much broader set of motivations for owning crypto, including lack of trust, cross-border payments, and to make purchases of goods and services (see chart above, blue rows).
The dominance of investment as the motivating reason for owning crypto is echoed in Weber et al's analysis of Nielsen Homescan survey data. Respondents were allowed to give multiple reasons for owning cryptocurrency, the most popular reason (see chart below) being to take advantage of "expected increase in value." The desire to use cryptocurrencies for international transfers was almost nonexistent, as was the desire to be "independent of banks."
Crypto owners don't care about making international transfers, private purchases, or being "independent of banks," as the chart shows.
What they want is "increase in value."
This is a fairly reliable data source: 80,000 households participating in the Nielsen Homescan Panel. pic.twitter.com/0oBfATgFoY
— John Paul Koning (@jp_koning) June 22, 2023
The Fed's SHED survey isolates the same pattern as the other two surveys (see table below). Of the 10% of Americans who report using cryptocurrency in 2022, most do so as an investment. One small difference is that the SHED reports that around 2% of all survey participants used crypto to send money to friends of family in 2022. This suggests the transactional motive, while not primary, may be somewhat more prevalent than the previous two surveys suggest.
Source: Federal Reserve's 2022 SHED
Types of cryptocurrency held
What sorts of crypto were popular with Americans? Using Nielsen Homescan data, Weber et al found that of the 11% of survey
respondents who are crypto owners, 70% held bitcoin while just over 40%
held ether and dogecoin respectively.
Around 11% of American households owned crypto in 2021, according to a Nielsen Homescan survey of 80,000 households.
Of this 11%, 4 out of 10 households held Dogecoin.
So around 6 million US households owned Dogecoin in 2021, which is just nuts. pic.twitter.com/31FjTbfqBE
— John Paul Koning (@jp_koning) July 4, 2023
This distribution is echoed in the Fed's 2022 SDCPC. Almost 65% of all crypto owners surveyed held bitcoin (the data is here), making it the most popular type of cryptocurrency. Meanwhile, 44.8% held ether and 38% held dogecoin, a coin that was originally created as a joke in 2013. That works out to around 4-5% of all Americans who are in on the joke.
Crypto bros
There's a reason that people throw around the term "crypto bro." Without exception, all of the U.S. surveys find that cryptocurrency owners tend to be young, male, and have a high income.
The same goes for Canada, where in 2022 there were three male bitcoin owners for every female. The Bank of Canada has also regularly tested bitcoin owners for their degree of financial literacy using the Big Three questions method, and finds that they tend to have lower financial literacy than non-bitcoin owners.
The prototypical Canadian bitcoin owner in 2022 was a young university-educated male, employed at a high-income job, and lacking financial literacy. pic.twitter.com/N3hQX4AWes
— John Paul Koning (@jp_koning) September 28, 2023
Interestingly, in addition to isolating the crypto bro pattern – the tendency for crypto owners to be young, male, and wealthy – both the Pew survey and the Fed's SHED (see table below) find that U.S. crypto owners are more likely to be Asian, followed by Black and Hispanic, and least likely to be White.
The Fed's SHED survey dug deeper into usage by demographics, and found that while "investment" remains the driving case for owning crypto, and that the rich use the stuff proportionally more than the poor, certain demographic groups tend to rely on it more than others for making transactions. Specifically, the SHED finds that among low income families, 5% report an investment motivation for holding crypto while 4% report a transactional motivation.
Source: Federal Reserve's 2022 SHED
All of this data suggests to me the existence of three American crypto archetypes.
The most dominant crypto archetype is the young wealthy male crypto dabbler, most likely non-white, who holds a few hundred bucks worth of doge or some other coin in order to gamble on prices going up. Coinbase's America Loves Crypto campaign makes the claim that "the crypto owner is a critical voter," but I suspect this doesn't hold for the dominant dabbler archetype, who probably doesn't have much attachment to their casual $50 bet on doge or litecoin or bitcoin, and thus can't be assembled into a voting block for crypto-related cause.
Another archetype is the much rarer crypto fundamentalist, a young male who has committed most of his savings to crypto. I suspect these are the types I encounter on Twitter, who evangelize and debate crypto to anyone who'll listen. This may be a small group, but they are also the most likely to vote for crypto-related causes.
Lastly, there seems to be a very small group of low-income people who are using crypto for actual transactions, the original use-case that Satoshi Nakamoto intended when he introduced the first cryptocurrency back in 2008.
Ben Bernanke and the natural rate of interest
From Professor Bernanke to Governor Bernanke to Chairman Bernanke to Ben Bernanke, Blogger. Quite the progression!
I enjoyed reading Ben Bernanke's blog post today. But it doesn't appear everyone thinks like me. I noticed some have criticized Bernanke for using the concept of the equilibrium (or natural) rate of interest, or the real rate of interest consistent with output at its potential level and with stable prices.
Now, I realize that the equilibrium real rate is unobservable and varies through time, which means it's subject to uncertainty. However, we could say the same thing about the concept of potential output, yet few would deny it is a useful concept.
In fact, most people are aware of the concept of "output gap", the difference between potential output and actual output. The corollary concept for the real interest rate is the "interest rate gap", the deviation of the actual policy rate from the real equilibrium rate.
This is essentially what Bernanke was driving at in his post today. Simply, the interest rate gap is a measure of the stance of monetary policy: a large (small) gap means monetary policy is loose (tight).
Back in the Keynesian era, policymakers used the concept of the "full employment surplus" (FES), or the budgetary surplus consistent with full employment, as a way to illustrate how the actual budget deficit wasn't being caused by a lack of tax revenue or out of control government spending but rather was caused by the weakness of the economy and the lack of output due to unemployed and idle resources. I view the interest rate gap in a similar way. Whereas the FES provided a useful measure of the stance of fiscal policy by highlighting the difference between the actual "surplus" (or negative surplus in the case of a deficit) and the FES, the interest rate gap provides a useful measure of the stance of monetary policy.
But don't get me wrong. In no way does any of this mean that central banks should be rigid in adjusting their policy rate to track the estimated equilibrium real rate.
As far as I'm concerned, central bankers should use their judgement and consider all information, not just their estimates of the real equilibrium rate and interest rate gap. For instance, if a central bank's estimate of the real equilibrium rate shows it is rising, yet inflation isn't, it may not be the right time to increase the policy rate.
Similarly, if a central bank's estimate of the equilibrium rate shows it is remaining stable, yet unemployment is rising, it may be entirely justified for the central bank to keep its policy rate at the same level or even to reduce it. I'm of the same view when it comes to the concept of the natural rate of unemployment: using it properly requires good judgement.
A final note on Bernanke's comment about how large deficits tend to increase the equilibrium real rate given that government borrowing diverts savings away from private investment. One thing I noticed is that Bernanke carefully added that this would occur "if everything else stays equal". In other words, this means he's not denying that a different (or even, opposite) effect could occur if other forces are at work.
For instance, the opposite effect could occur if budget deficits, by sustaining business activity, reduce default risk on corporate bonds and subsequently narrow the spread between the yields on corporate and government bonds, thus helping to reduce the cost of capital to the private sector. In such a scenario, budget deficits have effectively "crowded-in" private sector spending. I doubt Bernanke would deny that budget deficits could have such an effect.
The Federal Reserve Bored
Paul Krugman points out possibly the biggest challenge to sensible, rational policy making and debating these days:
The Times has an interesting headline here: Richard Fisher, Often Wrong but Seldom Boring, Leaves the Fed. Because entertainment value is what we want from central bankers, right? I mean, Janet Yellen is such a drag — she just keeps being right about the economy, and that gets old really fast, you know?
It really is too bad that it's these 'entertainers' -- they range from the likes of Rick Santelli and Larry Kudlow to the establishment types like Fisher -- get such media attention. I mean, it's not like decent analysis doesn't exist, especially since the appearance of websites like Vox and the increased popularity of economics blogs.
Anyway, in other news, I've had very little time to blog these last few months but I intend to get back into it in earnest fairly shortly so stay tuned.
To follow me on Twitter, just look me up @circuit_FRB.
When the Fed supported a Job Guarantee policy (and the economist who made it happen)
Circuit here. I'm back from a few months hiatus following the birth of my second child, a baby girl. Thanks to all readers for your continued interest in this blog.
A few weeks ago, Rolling Stone magazine ran a piece by Jesse Myerson supporting the idea that the government should guarantee a job to anyone who is willing to work. In their recent work, Dean Baker and Jared Bernstein also give support to this policy proposal. Randy Wray, Warren Mosler and other modern money (MMT) economists have been pushing for this idea for a long time. On the center-right and right, the idea is being promoted by Peter Cove and Kevin Hasset.
This is good news. I certainly welcome a good debate on this idea. That said, it's too bad that commentators who are skeptical of the idea simply dismiss it as a non-starter for policymakers.
This, of course, is overstating the case somewhat. It's worth recalling that in the 1970s none other than the Chairman of the Federal Reserve supported the idea that the federal government should be the "employer of last resort". Here's the former Fed Chairman Arthur Burns back in 1975:
I believe that the ultimate objective of labor market policies should be to eliminate all involuntary unemployment. This is not a radical or impractical goal. It rests on the simple but often neglected fact that work is far better than the dole, both for the jobless individual and for the nation. A wise government will always strive to create an environment that is conducive to high employment in the private sector. Nevertheless, there may be no way to reach the goal of full employment short of making the government an employer of last resort. This could be done by offering public employment -- for example, in hospitals, schools, public parks, or the like -- to anyone who is willing to work at a rate of pay somewhat below the Federal minimum wage.
Burns
With proper administration, these public service workers would be engaged in productive labor, not leaf-raking or other make-work. To be sure, such a program would not reach those who are voluntarily unemployed, but there is also no compelling reason why it should do so. What it would do is to make jobs available for those who need to earn some money.
It is highly important, of course, that such a program should not become a vehicle for expanding public jobs at the expense of private industry. Those employed at the special public jobs will need to be encouraged to seek more remunerative and more attractive work. This could be accomplished by building into the program certain safeguards -- perhaps through a Constitutional amendment -- that would limit upward adjustment in the rate of pay for these special public jobs. With such safeguards, the budgetary cost of eliminating unemployment need not be burdensome. I say this, first, because the number of individuals accepting the public service jobs would be much smaller than the number now counted as unemployed; second, because the availability of public jobs would permit sharp reduction in the scope of unemployment insurance and other governmental programs to alleviate income loss. To permit active searching for a regular job, however, unemployment insurance for a brief period -- perhaps 13 weeks or so -- would still serve a useful function.
The idea was even supported by one of the most respected names in economics at the time: Franco Modigliani. When asked to comment on Chairman Burns's proposal during a testimony before the Congressional Banking committee in 1976, Modigliani said the following:
...the idea of a public employment program as an employer of last resort, which is an alternative to unemployment compensation, strikes me as a very sound idea (p. 110).
Interestingly, the economist who got Burns and the Fed to put serious thought into the idea of a job guarantee was another well-respected contributor to US public policy during that period: Eli Ginzberg.
Job Creation through Public Service Employment
Eli Ginzberg was a Professor of Economics at Columbia University and author of numerous books on human resources and manpower economics. He was also -- in the language of Harold Wilensky and organizational sociology -- a "contact man", a person who provides ideas and furnishes intelligence to decision-makers on the political and ideological tendencies in the society at large. Ginzberg played this role throughout his career as presidential adviser for many administrations and through his affiliation with the Manpower Demonstration Research Corporation (MDRC), which recently marked its 40th year of operation.
Ginzberg was an institutional economist in the tradition of John M. Clark and Wesley C. Mitchell who believed fervently that "people, rather than physical or financial capital, were the principal source of productivity and wealth" (1987:107). For this reason, Ginzberg believed it was critical for the government to eliminate unemployment as quickly as possible through the use of a publicly-funded jobs program.
Another reason why Ginzberg believed the government ought to be employer of last resort is that he understood that economies sometimes face a shortfall in jobs that makes it impossible for all unemployed workers to find work:
Just as reality has mocked the ethos of equality of opportunity for many minority children, the counterpart doctrine that adults are responsible for their own support and that of their dependents has been undermined by the continuing shortfall in jobs. The existence of high unemployment rates make it socially callous, even reprehensible, for a society to continue to affirm the doctrine that all adults who need income should work and then not provide adequate opportunities for many of them to fulfill this imperative.
Although the US experimented with federally financed job creation in the 1930s and again in the 1970s, the record in retrospect must be viewed as equivocal. Most students believe that on balance the New Deal was right to put large numbers of the unemployed to work on governmentally financed programs rather than to keep them on the dole as the British did. (1987:162)
Ginzberg
On this last point concerning whether income transfers or guaranteed work should be the centerpiece of US social policy, Ginzberg's view was informed by the work he did during the Great Depression. Here's how Ginzberg summarized the conclusions of a 1947 book entitled The Unemployed that he co-authored on the topic of unemployment during the Great Depression:
The principal lessons I extracted included the superiority of work relief over cash support...; the cause of unemployment being rooted in a shortfall in demand for labor, not in the inadequacies of the unemployed; the centrality of work and self-support for the integrity of the individual worker, his family, and the community. By the time our investigation was concluded, [we] were convinced that no society concerned about its security and survival could afford to remain passive and inert in the face of long-term unemployment. We argued that in the absence of an adequate number of private sector jobs, it was the responsibility of government to create public sector jobs. (1987:111)
Ginzberg also believed that guaranteed work for those who are able and willing would find greater acceptability among Americans than a policy that would require government providing a guarantee income to everyone. According to Ginzberg, providing guaranteed income to everyone would conflict with the powerful American ethos of self-reliance and the American population's highly favorable view toward the culture of work:
There is no simple way, in fact, there is no way to square the following: to provide a decent minimum income for every needy person/family in the US, given the differentials in living standards, public attitudes, and state taxing capacity, and at the same time avoid serious distortions in basic value and incentive systems that expect people to be self-supporting through income earned from paid employment. (157)
For this reason, Ginzberg believed that a job guarantee should play a key role in social policy:
Accordingly, I would like to shift the focus from welfare to work, from income transfers to the opportunity to compete, from dependency status to participation in society. In advocating this shift toward jobs and earned income and away from unemployment and income transfers, the planners must focus on two fundamentals: the developmental experiences that young people need in order to be prepared to enter and succeed in the world of work; and the level of employment opportunities that a society must provide so that everybody able and willing to work, at least at the minimum wage, will be able to do so. (157)
In the 1970s, Ginzberg held the position of Chairman of the National Commission for Manpower Policy, a government-mandated commission that produced some of the best policy-oriented research on the topic of public service employment, including an excellent paper entitled "Public Service Employment as Macroeconomic Policy" by Martin Neil Baily and Robert Solow (1978) that explains how public service employment (PSE), while not necessarily more stimulative than the normal kind of fiscal policy (e.g., government spending on goods and services and tax measures), can be a perfectly sensible policy if the program is well-administered and the jobs that are created provide useful social output:
Solow and BailyWe conclude that the main advantages of PSE over conventional fiscal policy are: (a) that it can be targeted to provide jobs for hard-to-employ groups in the labour force, and for especially depressed cities and regions; (b) that PSE employment, correctly targeted, may be slightly less inflationary than the same amount of ordinary private sector employment, so that total employment can safely be a little higher with a PSE component; and (c) that PSE can be coordinated with other forms of social insurance -- public assistance and unemployment insurance, for instance -- to make them perhaps more effective and certainly more acceptable to public opinion. (1978:30)
Solow later revisited the issue of public service employment in Work and Welfare (1998), in which he argued that any attempt to reform the welfare system in order to get the unemployed back to work would only succeed if every able and willing worker is given access to a job through public service employment and/or by offering incentives to businesses to hire the unemployed.
The Deal
It was in the 1970s that Ginzberg persuaded Chairman Burns to call on the US federal government to become the employer of last resort. Here's Ginzberg's account of how he was able to get the Fed Chairman to support the job guarantee:
I made a deal with Arthur Burns when he was the head of the Federal Reserve, that I would try to control the amount of money we asked for from the Congress for manpower training if he would come out in favor of the government as the employer of last resort. And he did it. It took him a year, but I negotiated with him and he did it.
A final word. Although Ginzberg supported the idea of a job guarantee, he fully recognized the high budgetary cost that such a policy would entail and the practical challenges facing public administrators in terms of successfully implementing a public service employment program. To address these concerns, he believed the government authorities should make improvements to the program using trial and error and cautious experimentation. But the key, he would argue, is to ensure that the jobs created through these measures provide productive social output:
There is no big trick to put more and more people on public service employment. If that is the only thing that one is interested in, obviously, the Federal Government can create the money by fiat and put more people on public service employment. The question is what are the short- and long-run implications of doing that in terms of keeping our economy productive, competitive and innovative....So I do not think it is just jobs; it is productive jobs and that is another way of saying that the Federal Government can go only part of the way in terms of assuring that we have a productive economy.
References
Baily, Martin N. and Robert Solow, "Public Service Employment as Macroeconomic Policy", National Commission for Manpower Policy, 1978
Ginzberg, Eli, The Skeptical Economist, Boulder and London: Westview Press, 1987
National Commission for Manpower Policy, "Job Creation through Public Service Employment: An Interim Report to the Congress", 1978
Solow, Robert, Work and Welfare, Princeton, NJ: Princeton University Press, 1998
On the (ir)relevance of the money multiplier model: The Fed view
It has long been known within the Federal Reserve System -- especially among economists who worked in the FRS in the 1970s and 1980s when much of the research agenda was directed at issues of monetary control -- that the money multiplier model of money stock determination is not the most realistic (or useful) way to understand how central banks conduct monetary policy.
Here is the former Fed Governor, the late Sherman Maisel, during a conference on the theme of 'Controlling Monetary Aggregates' in 1971:
It is clear that, as a matter of fact, the Federal Reserve does not attempt to increase the money supply by a given amount in any period by furnishing a fixed amount of reserves on the assumption that they would be multiplied to result in a given increase in money [...]
Many unsophisticated comments and theories speak as if the Federal Reserve purchases a given quantity of securities, thereby creating a fixed amount of reserves, which through a multiplier determines a particular expansion in the money supply. Much of modern monetary literature is actually spent trying to dispel this naive elementary textbook view which leads people to talk as if (and perhaps to believe) the central bank determines the money supply exactly or even closely--in the short run-through its open market operations or reserve ratio. This incorrect view, however, seems hard to dislodge. (1971:153, 161)
Briefly, the money multiplier is basically a relationship between deposits (D) and reserves (R), D = mR, (or M = mB) where m is called the money multiplier (or M is money stock and B is the monetary base). According to the model, if banks keep excess reserves to a minimum and reserve requirements are applied to all deposits, then the multiplier can be constant and the central bank -- if it retains control of the volume of reserves -- can control the amount of deposits (Goodfriend and Hargraves, 1983:5). However, if the central bank does not exercise control over the amount of reserves, the multiplier model is inoperable and cannot be exploited for monetary control purposes.
The Classic Fed View
In the US, the Fed's inability to control the quantity of reserves in recent decades (before October 2008) is said to be because of the introduction of lagged reserve requirements in the late 1960s and the Fed's almost continuous use of an interest rate operating procedure.
Former St. Louis Fed economist, R. Alton Gilbert, discussed the impact of lagged reserve accounting on Fed operations in his article "Lagged Reserve Requirements: Implications for Monetary Control and Bank Reserve Management" (1980):
[Lagged reserve accounting] breaks the link between reserves available to the banking system in the current week and the amount of deposit liabilities that banks can create in the current week. If banks increase aggregate demand deposits liabilities in response to an increase in loan demand, they are under no immediate pressure to reduce their deposit liabilities...Under LRA, the Federal Reserve tends to adjust total reserves each week in response to the total deposit liabilities that banks created two weeks earlier. (1980:12)
With lagged reserve requirements in effect the volume of reserves is determined by banking system demand. Reserve demand is simply accommodated and required reserves serve only to enlarge the demand for reserves at any given level of deposits. Under LRA, the change in R occurs as a result of changes in D, the exact opposite of the money multiplier model.
Former Richmond Fed economist, Marvin Goodfriend, discussed the relevance of the money multiplier model when lagged reserve requirements are in effect in his paper "A model of money stock determination with loan demand and a banking system balance sheet constraint" (1982):
...[T]he discussion has shown that the money multiplier is not generally a complete model of money stock determination and is actually irrelevant to money stock determination for some monetary control procedures. Specifically, the money multiplier is irrelevant to determination of the monetary aggregates if lagged reserve requirements are in effect. (1982:15)
As for the other institutional factor relating to the Fed's use of an interest rate operating procedure, Robert Hetzel of the Richmond Fed highlighted the following in his paper "A Critique of Theories of Money Stock Determination" (1986):
Deposits and reserve demand are determined simultaneously with credit creation. As a consequence of defending its rate target, the monetary authority, by creating an infinitely elastic supply of reserves, accommodates whatever reserve demand emerges...In a regime of rate targeting, neither the quantity of reserves nor the desired reserves-deposits ratio of the banking system exercises a causal role in the determination of the money stock (1986:6) [...]
Interest rate smoothing by the monetary authority makes reserves and the money stock endogenous...Since [Chester] Phillips (1921), reserves-money multiplier formulas have been derived from a model of the banking sector summarized in the multiple expansion of deposits produced by an injection of reserves. The existence of markets for bank reserves, however, renders this model untenable. Phillips' model assumes that the individual bank is constrained by the quantity of its reserves and that its asset acquisition and deposit creation are driven by discrepancies between actual and desired reserves. Given the existence of markets for bank reserves, such as the fed funds and CD markets, however, individual banks are constrained by the price, rather than the quantity, of reserves they hold. (1986:20) (emphasis added)
A succinct and detailed discussion of the problems associated with multiplier models of money stock determination is found in the excellent article "Understanding the remarkable survival of multiplier models of money stock determination" (1992) by former Fed economist, Raymond Lombra:
Assuming textbook authors reveal their intellectual and pedagogical preferences and beliefs, a careful survey of the leading intermediate textbooks in money and banking and macroeconomics reveals a uniform and virtually universal consensus – the multiplier model of money stock determination is widely viewed as the most appropriate and presumably most correct approach to the topic...Since such consensus is not, in general, an enduring characteristic of monetary economics, one is tempted to “let sleeping dogs lie”. The problem is that the multiplier model, whether viewed from an analytical or empirical perspective, is at best a misleading and incomplete model and at worst a completely misspecified model. (Lombra, 1992:305) (emphasis added)
Lombra's article is especially useful because it groups together the different critiques of the multiplier approach into two categories (the article discusses a third set of critiques relating to the predictive accuracy of multiplier models but this issue is less relevant for this post).
The first set of critiques identified by Lombra is that the multiplier model "is not structural but rather is a reduced-form", a point first made in the 1960s by proponents of the "New View" (including James Tobin in "Commercial banks as creators of "money")*. Lombra summarizes this critique as follows:
Succinctly stated, the critique emphasizes that the multiplier approach abstracts from the short-run dynamics of adjustments by banks and the public, leaves the role of interest rates implicit rather than explicit, and proceeds that the movements in the monetary base (or reserves) are orthogonal to fluctuations in the multiplier. The multiplier model, it is argued, implies that deposit expansion is quantity constrained through the Fed's control over the sources of bank reserves (chiefly, the Fed portfolio of securities). One of the most forceful and articulate crafters of the critique, Basil Moore, concludes that "as a result, the money multiplier framework is of no analytical or operational use".
The consensus view of the staff and policymakers within the Federal Reserve, as revealed in numerous publications, embraces much, if not all, of the critique advanced by Moore and others. In particular, the Fed adheres to the view that the system is equilibrated through the movements of interest rates, which through their effects on bank revenues and costs, determine banks' and the public's desired asset and liability positions. In this view, money is controlled by using open market operations to affect interest rates which in turn affect demand and thus the uses of bank reserves (chiefly, required reserves). (307)
The second set of critiques discussed by Lombra concerns the issue of the endogeneity of reserves, that is, the notion that the quantity of reserves is in practice determined by the banking system:
This contention, which is related to the lagged reserve accounting scheme...and the Fed's interest rate operating procedure in effect for virtually all of the post-Accord period, implies the multiplier model is completely irrelevant for the determination of the money supply. (308)
Lombra's article concludes with a discussion on why, despite these important flaws, the multiplier approach continues to be popular among economists. The reason, he argues, is that when applied to longer term horizons the models track monetary growth reasonably well:
The model lives on with model-builders who are confirmed adherents to the Law of Parsimony and skilled in the use of Occam's Razor. The high correlations and identities so tightly linking reserves (or the base) and money over the longer run provide all the comfort most empiricists need to proceed as if the concerns noted above matter little. (312)
Still irrelevant?
Recently, Fed economists Seth Carpenter and Silva Demiralp concluded in their paper "Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?" that the money multiplier is not a useful means of assessing the implications of monetary policy for money growth or bank lending in the US.
Not only does their paper discuss the institutional factors that render the money multiplier inoperable (including those discussed above), it also demonstrates empirically that the relationships between reserves and money implied by the money multiplier model do not exist.
These conclusions should, however, be viewed with caution given that the period under investigation in the paper ends in 2008, just prior to the Fed's shift toward the use of unconventional monetary policies.
Interestingly, Robert Hetzel now believes that the money multiplier model has actually gained relevance since the Fed started with its large-scale asset purchases in 2008.
Here is an excerpt from Hetzel's recent book, The Great Recession:
Starting in mid-December 2008 when the FOMC lowered its funds-rate target to near zero with payment of interest on bank reserves, the textbook reserves-money multiplier framework became relevant for the determination of the money stock. The reason is that the Fed's instrument then became its asset portfolio, the left side of its balance sheet, which determined the monetary base, the right side of its balance sheet. As a result, from December 2008 onward, the nominal (dollar) money stock was determined independently of the demand for real money. Although the reserves-money multiplier increased because of the increased demand by banks for excess reserves, the Fed retained control of M2 growth. Even if banks hold onto increases in excess reserves, the money stock increases one-for-one with open market purchases. (2012:237) (emphasis added)
In other words, Hetzel is saying that, as a result of its ability to determine the monetary base (B), the Fed now exercises considerable control over the change in deposits (D). And by doing so, Hetzel is suggesting that the Fed -- in one way or another -- is currently exploiting the money multiplier framework.
Here's a chart that appears to support Hetzel's claim:
The chart shows that since 2008 changes in B -- resulting from Fed asset purchases -- are clearly associated with changes in M**. For the period prior to 2008, there is no such relationship.
Hetzel's claim about the relevance of the multiplier approach could help to explain why some commentators have found causal relationships between changes in the monetary base and other variables for the period since December 2008.
For instance, Market Monetarist proponent Mark Sadowski recently pointed to empirical evidence that changes in the monetary base have had some causal role since December 2008:
I’ve done Granger causality tests on the monetary base over the period since December 2008 and find that the monetary base Granger causes the real broad dollar index, the S&P 500, the DJIA, commercial bank deposits, commercial bank loans and leases, the PCEPI, and 5-year inflation expectations as measured by TIPS.
So what's the bottom line? Does this mean the money multiplier model is now relevant?
On the one hand, I'm not convinced the model is entirely applicable (for instance, the textbook treatment implies that banks keep excess reserves to a minimum, which is obviously not the case today). On the other hand, it's unlikely that Hetzel is somehow wrong here.
Fortunately, I don't think it matters much one way or another, unless perhaps you are a Fed technician or an econometrician. What does matter is that the Fed currently exercises control over the monetary base. This, in itself, is a significant development for understanding the policy options now available to the Fed.
One thing is for sure, this recent development provides an excellent illustration of a crucial point often highlighted in Raymond Lombra's work:
The specific procedures ("policy rule") employed by the Fed and the reserve accounting regulations governing bank reserve management play a crucial role in determining causal relationships and system dynamics. (1992:309)
------
* The 'New View' focused on the role of assets, both real and financial, and the relative price mechanism in monetary analysis. From an operational standpoint, it contended that the Fed has little control over the money stock and that the money stock plays only a minor role in the transmission mechanism linking Fed actions to the real sectors of the economy.
** It's clear that the monetary base is not pulled upward due to increased deposit creation by banks.
References
Carpenter, S and S. Demiralp, Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?", Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.2010
Gilbert, R.A., Lagged Reserve Requirements: Implications for Monetary Control and Bank Reserve Management", Monthly Review, Federal Reserve Bank of St.Louis, 1980:
Goodfriend, M., A model of money stock determination with loan demand and a banking system balance sheet constraint", Federal Reserve Bank of Richmond Working Paper, 1982
Goodfriend, M. and M. Hargraves, A historical assessment of the rationales and functions of reserve requirements, Federal Reserve Bank of Richmond Working Paper, 83-1, 1983
Hetzel, R., A Critique of Theories of Money Stock Determination, Federal Reserve Bank of Richmond Working Paper, 86-6, 1986
Hetzel, R., The Great Recession: Policy Failure or Market Failure, Cambridge University Press, 2012
Lombra, Raymond. Understanding the remarkable survival of multiplier models of money stock determination, Eastern Economics Journal, Vol 18, No 3, 1992
Maisel, S., Controlling Monetary Aggregates, Federal Reserve Bank of Boston Conference Proceedings, 1971
Tobin, J., Commercial banks as creators of "money" 1963
Deficit spending got the US out of the Great Depression: Paul Samuelson on helicopter money
Paul Samuelson, circa 2008 (see here at 1:31):
I'm full of sensible heresies. How do you think we got out -- in Roosevelt's time -- got out of that depression? How do you think the pernicious Adolf Hitler -- inheriting about the same, at least one third unemployment -- got out of it? And both of us got out of it in about the same number of years as you are getting to 1939. If you look at Mrs Schwartz's analysis of that, it's completely remote from the truth.
This is not how it happened, but this is equivalent to how it happened: somebody invented helicopters. And somebody went to the printing press and printed-off millions and billions of legal tender. And then those helicopters flew over the poorer rural regions and the slums of the city. And it wasn't a problem of whether the money was going to be saved or wasn't going to be spent. It had nothing to do with pump-priming...It had nothing to do with jump-starting. [...] It was not a Federal Reserve operation.[...]
Now, Mrs Schwartz and her collaborator, who's name I forgot at this moment [laughter], would say "well that helped to keep the M up". That's a joke! [The banker] didn't go out and start making new loans. He acquired more Treasury certificates, which had a yield of essentially zero.
So we never got out of the Great Depression? Yes, we did. We did it essentially by deficit spending [...]
The rest of this excellent discussion is well worth a careful listen.
Addendum : An ingenious reader has created a direct link to this excerpt on You Tube (see here). 2013-11-07