Policy Institutes

There are two versions of the fiscal theory of the price level (FTPL); one true, the other false.  The true version holds that if the fiscal authority dominates the policy space, then fiscal deficits could be monetized by the central bank. This version is consistent with the quantity theory of money, because inflation is ultimately determined by excess growth in the money supply.  If money growth were constant, inflation could not occur—that is, there could not be a sustained rise in the average level of money prices. In this sense, Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” cannot be refuted (Friedman 1970: 11).

The second version of the FTPL, the so-called strong version, holds that even if the money supply is held constant, inflation can occur if the fiscal authority is passive.[1] All that is needed is for the public to expect prices to rise. People will then spend their given money balances at a faster rate — increasing the velocity of money — and prices will rise until expectations change. If the fiscal authority is passive, velocity can explode, producing hyperinflation (see McCallum and Nelson 2005). This feature of the strong version is referred to as “speculative inflation” and is independent of monetary policy (Tutino and Zarazaga 2014: 3). The strong version also implies that fiscal action—not monetary reform—is the primary tool for ending a hyperinflation. This version of the FTPL is false: it ignores historical evidence that shows the determining factor in generating hyperinflations is explosive growth in the money supply (or the expectation that such growth will occur); and it fails to recognize that stabilization  results from credible monetary reform.[2]

Expectations about future inflation don’t appear like manna from heaven — businesses and households know that excess money growth causes inflation. They also know that large unfunded government liabilities and budget deficits risk having the central bank monetize debt. Although the strong version of the FTPL assumes away that possibility, history does not.

One notable example is the German hyperinflation of 1921–23, and the rapid stabilization that ended runaway inflation. We will see that it was monetary policy not fiscal policy that enabled the rapid rise in the price level and abruptly ended it.

In their essay, “Inflation Is Not Always and Everywhere a Monetary Phenomenon,” Antonella Tutino and Carlos E. J. M. Zarazaga (2014) use the strong version of the FTPL, as proposed by Christopher Sims (1994), to explain the German experience. They argue that fiscal policy can explain both the hyperinflation and the stabilization of the German currency: it was the passivity of the fiscal authority that ushered in the hyperinflation, while activist fiscal policy ended the inflation. Let us see why they are wrong and why Friedman’s dictum still holds.

The key point that Tutino and Zarazaga (hereafter, TZ) make is that “hyperinflation is fiscal in nature because it can only happen if the fiscal authority—the central government — remains on the sidelines” (p.3). When the government did intervene by introducing the rentenmark, a new currency backed by real estate, prices stabilized, according to TZ, because “the government’s ability to raise revenues from the real estate market … successfully broke the link between mutually reinforcing lower fiscal revenues — implying higher fiscal deficits — and rising price levels” (pp. 3–4).[3]

The problem with TZ’s argument is that the introduction of the rentenmark was not fiscal policy; it was monetary reform. Furthermore, the mortgage-backing of the rentenmark was not sufficient to change expectations of further inflation, but it did help the public accept the new currency. Expectations changed because the public knew there was a legal limit on the total value of rentenmarks that could be issued by the Rentenbank, which was under the jurisdiction of the Reichsbank (the central bank). The backing of the currency by real estate was not relevant for stabilizing prices. There was no official convertibility between the inflated paper marks and the rentenmark, and the latter was not legal tender. The rentenmark was a parallel currency, added to the circulation of existing paper marks.[4]

It is true that 500 rentenmarks could be converted into a bond with a nominal value of 500 gold marks, “which was guaranteed by a legal mortgage on German property and which yielded a rate of interest at 5 percent in gold (actually payable in paper at the exchange rate of the gold mark),” but as Bresciani-Turroni (p. 340) points out, “the stability of the value of the rentenmark could not be due to the possibility of converting the latter into mortgage securities.” The reason is simple:

The market value of the mortgage bonds was lower than the nominal value. The market rate of interest was then much higher than 5 percent… . Besides, the increase of the issues of rentenmarks would continually add to the Government’s burden on interest on mortgage bonds, for which the public would exchange increasing quantities of rentenmarks; and therefore, in a precarious financial position, the uncertainty of the Government being able to continue the payment of interest would increase [ibid.].

Bresciani-Turroni tells us that confidence in the rentenmark was buoyed by the fact that it was a new currency and the public “believed in the efficacy of the mortgage guarantee.” But that confidence “would have been quickly dissipated if the public had been led to expect that, despite the obligation imposed on the rentenbank by decree, the Government would exceed the pre-arranged limit to the issues” (p. 348). It was the limitation on the quantity of money — not the expected revenue from the mortgage securities—that was an important factor in stabilizing the value of money.[5]

It is also noteworthy that the public’s confidence in the rentenmark currency was reinforced by the “constant-value clause,” which obligated those who took out loans from the Rentenbank to repay their debts in the same quantity of gold marks as represented in the original loan. That clause was intended to prevent the speculation that occurred during the hyperinflation when businesses and others took out bank loans in nominal paper marks but repaid them using greatly depreciated marks, thus giving speculators a strong incentive to support runaway inflation (Bresciani-Turroni 1953: 353).

The rentenmark did not begin to circulate until November 16, 1923, and was added to the existing stock of paper marks, which were still the only legal tender. At the same time, the Reichsbank stopped monetizing government debt by ending the discounting of Treasury bills. Bresciani-Turroni (p. 337) calls that monetary reform “a fact of fundamental importance” — yet it too is ignored by TZ.

Even though newly created paper marks could not be used to finance government profligacy, the central bank continued to supply marks for commercial uses. Between November 16, 1923, and November 30, the amount of paper marks in circulation increased from 93 trillion to more than 400 trillion, and reached 1,211 trillion by July 31, 1924. Meanwhile, the quantity of rentenmarks went from 501 million on November 30, 1923, to 1,803 million on July 31, 1924. Consequently, “the stabilization of the German exchange was not obtained by means of contraction, or even by a stoppage of the expansion of the circulation of legal currency” (ibid.).

Most notably, and in contrast to the FTPL as stated by TZ, “The exchange was stabilized before there existed the conditions (above all the equilibrium of the Reich Budget) which alone could assure a lasting recovery of the monetary situation” (Bresciani-Turroni, p. 355).

Germany faced hyperinflation because the Weimar leaders chose to finance World War I reparations and other spending by money creation — rather than cut spending and increase taxes — and to reduce the real value of public debt. Once the monetary printing presses started rolling, it was hard to stop them. Moreover, the Reichsbank was under the influence of the real bills doctrine and met all demands for credit with newly minted paper marks, believing that inflation was unlikely if the bank only discounted short-term bills that reflected real output (Nurkse 1946: 16–17).[6] The problem is that bank credit is expressed in nominal terms. Thus, as prices rose because of rapid money growth, the demand for credit increased and businesses repaid debts in depreciated currency.

What Bresciani-Turroni teaches us is that models like the strong version of FTPL are not sufficient to inform us of the forces that underlie hyperinflation and stabilization. A close study of the policy actions taken in Weimar Germany shows that inflationary expectations are grounded in the credibility of central banks, as well as fiscal authorities. The competing theory that “explosive expectations” can generate runaway inflation without any change in the money supply cannot be supported by the experience of the German hyperinflation. Likewise, there is no evidence to support TZ’s claim that the hyperinflation was ended by fiscal action — that is, backing the rentenmark by real estate revenues. Rather, it was ended by fundamental monetary reform and a credible commitment to return to price stability as well as fiscal fortitude.

German monetary experts, writing in the Dawes Report, viewed the “liquid cover” for the rentenmark as “insufficient to guarantee a permanent [monetary] system.” They argued for the removal of the rentenmark and the introduction of a convertible currency. Their proposal was accepted with the passage of the monetary law of August 30, 1924, which made the reichsmark the new legal tender (Bresciani-Turroni, p. 338). When the monetary law became effective on October 11, 1924,  the Reichsbank abolished the constant-value clause, which was deemed unnecessary as the paper mark was now convertible into the reichsmark at an exchange rate of 1 reichsmark = 1 billion paper marks (1 billion = 1,000,0002), and the rentenmark was convertible into the new currency at a rate of 1 to 1. On June 5, 1925, the legal tender status of the old paper mark ended and it was taken out of circulation (Bresciani-Turroni 1953: 353–54).[7]

In conclusion, one must agree with Willem Buiter (2002: 459) when he says that the FTPL model, in its strong version, “is fatally flawed”—it “has feet of clay.” More telling, by arguing that “inflation is not always and everywhere a monetary phenomenon,” Tutino and Zarazaga undermine the responsibility of central banks to maintain the long-run value of fiat money, which increases the danger of inflation.



[1] For a more formal discussion of the weak and strong versions of the FTPL, see Carlstrom and Fuerst (2000).

[2] By assuming that the money supply is constant, and there is no opportunity for excess money growth by the central bank, the strong version of the FTPL sets up a strawman. It by-passes the dynamic theory of money (also known as “the theory of monetary disequilibrium”), which holds that large increases in the quantity of money relative to the trend rate of real output depreciate the value of money and lead to a subsequent rise in the velocity of money, accentuating the rise in prices and further reducing the real money stock (see Warburton 1966: 4–5). This inflationary spiral will continue until the monetary authority changes expectations by adopting fundamental reform that ends excessive money creation.

[3] The rentenmark was introduced by the decree of October 15, 1923, and began circulating on November 15.

[4] See Bresciani-Turroni ([1931] 1953: 334–37).

[5] The government tried to circumvent the legal limit on the issuance of rentenmarks in December 1923, but “was confronted by a determined refusal by the management of the Rentenbank.” That episode “helped to strengthen confidence in the new money. The limitation of the quantity was then of primary and fundamental importance” ( Bresciani-Turroni, p. 348).

[6] Humphrey (1980) carefully lays out the major fallacies that misguided monetary policymakers, blindsiding them to the dangers of excess money growth, and points to the significance of monetary reform in quickly stabilizing the value of the German currency.

[7] The reichsmark had a fixed gold content but was not convertible into gold until April 1930, at the discretion of the Reichsbank (Bresciani-Turroni 1953: 354).

Bresciani-Turroni, C. ([1931] 1953) The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany, 1914–1923.  Foreword by L. Robbins; translated by M. E. Savers.  London: George Allen and Unwin.

Buiter, W. H. (2002) “The Fiscal Theory of the Price Level: A Critique.”  The Economic Journal 112 (July): 459–80.

Carlstrom, C. T., and Fuerst, T. S. (2000) “The Fiscal Theory of the Price Level.” Federal Reserve Bank of Cleveland Economic Review 36 (1): 22–32.

Friedman, M. (1970) “The Counter-Revolution in Monetary Theory.”  IEA Occasional Paper No. 33. London: Institute of Economic Affairs.

Humphrey, T. M. (1980) “Eliminating Runaway Inflation: Lessons from the German Hyperinflation.” Federal Reserve Bank of Richmond Economic Review (July/August):  3–7.

McCallum, B. T., and Nelson, E. (2005) “Monetary and Fiscal Theories of the Price Level: The Irreconcilable Differences.” Oxford Review of Economic Policy 21 (4): 565–83.

Nurkse, R. (1946) The Course and Control of Inflation: A Review of Monetary Experience in Europe After World War I. Geneva: League of Nations. (Nurkse wrote Part 1 of this report.)

Sims, C. A. (1994) “A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy.” Economic Theory 4 (3): 381–99.

Tutino, A., and Zarazaga, C. (2014) “Inflation Is Not Always and Everywhere a Monetary Phenomenon.” Federal Reserve Bank of Dallas Economic Letter 9 (6): 1–4.

Warburton, C. (1966) Depression, Inflation, and Monetary Policy: Selected Papers, 1945–1953.  Baltimore: The Johns Hopkins Press.

[Cross-posted from Alt-M.org]

I wrote a piece last week for Reason on how the Gary Johnson and Bill Weld campaign seems to be staking out a position I called libertarian centrism – offering classical liberalism as a calm middle path between the spite and faction of left and right. Several polls find Johnson and Weld drawing support about evenly from Hillary Clinton and Donald Trump, in contrast to the expectation in some quarters that as former Republican governors they’d tap more into a GOP voter base. An Economist/YouGov poll (see p. 16) found that Johnson was drawing better numbers from self-identified moderate voters (at 11 percent) than from self-identified conservatives (at 7 percent). In recent weeks, even as the Libertarian Party candidates have met with a mostly frosty reception among big-name conservative politicos, they’ve been spoken of favorably by a number of moderate or pragmatist Republicans, including Mitt Romney, Jeb Bush, and most recently Maine Senator Susan Collins. 

For more on why centrists might like the Libertarian ticket, go read that piece. Brian Doherty, also at Reason, has been looking at a related issue: why have conservatives thus far proved so cool toward Johnson and Weld? Is it the ticket’s scattered, undeniable lapses from ideological correctness? Or its utter refusal to engage in the expected team signaling?

Ask strong conservatives what rankles most about the Johnson/Weld ticket, and you’ll almost certainly hear about how they’re no better than Hillary Clinton on the cake-baking issue – should anti-discrimination law explicitly include exemptions for religious conscience? – and probably also the gun issue, where Weld (though not Johnson) still sometimes shows his Massachusetts roots. 

On both of these issues, I’m in much the same position as Brian Doherty. I wish Johnson could outline a critique of private anti-discrimination laws and was better disposed toward religious-conscience exemptions to them, and I wish Bill Weld were more up to speed about gun issues and more appreciative of how firearms regulation tends to backfire. Still, their positions would not leave them wildly out of step even among median Republican voters, let alone independents. Johnson’s position that the law can properly make a merchant sell you a cake from a display shelf, but not decorate it for you, looks like a fairly standard Republican-governor position at this point in American history. Weld’s melange of views on guns – in his opinion, the Supreme Court was right to recognize an individual right to bear arms in Heller, but he hasn’t abandoned his interest in so-called reasonable regulation consistent with that – is not so far from that expressed by Justice Antonin Scalia, except that while Scalia is remembered for saying “A, but also B,” Weld comes off more as “B, but also A.”

The atmospherics, however, are unmistakable. However strong and principled they may be on spending, taxes, regulation, school choice, subsidies, or a hundred other issues where conservatives and libertarians often see eye to eye, Johnson and Weld keep going out of their way to flip off the organized conservative movement and send it the message: We’re not on your team. And this year, above others, should teach us that team loyalty, group touchiness, and friend-foe identification are powerful forces in politics. 

Someone is responding to the message, or else the polls for Johnson and Weld would not be creeping upward in many polls, past 8 and 9 to 10 and 11 percent, toward the magic 15 percent mark. That someone doesn’t yet include organized conservatives. But there’s still time for them to take a second look.

If you get into the weeds of tax policy and had a contest for parts of the internal revenue code that are “boring but important,” depreciation would be at the top of the list. After all, how many people want to learn about America’s Byzantine system that imposes a discriminatory tax penalty on new investment? Yes, it’s a self-destructive policy that imposes a lot of economic damage, but even I’ll admit it’s not a riveting topic (though I tried to link it to popular culture by using ABBA as an example).

In second place would be a policy called “deferral,” which deals with a part of the law that allows companies to delay an extra layer of tax that the IRS imposes on income that is earned - and already subject to tax - in other countries. It is “boring but important” because it has major implications on the ability of American-domiciled firms to compete for market share overseas.

Here’s a video that explains the issue, though feel free to skip it and continue reading if you already are familiar with how the law works.

The simple way to think of this eye-glazing topic is that “deferral” is a good policy that partially mitigates the impact of a bad policy known as “worldwide taxation.”

Unfortunately, good policy tends to be unpopular in Washington. This is why deferral (and related issues such as inversions, which occur for the simple reason that worldwide taxation creates a huge competitive disadvantage for U.S.-domiciled companies) is playing an unusually large role in the 2016 election and concomitant tax debates.

Consider the tax controversy involving Apple. The CEO does not want to surrender money that belongs to shareholders to the government.

Apple CEO Tim Cook struck back at critics of the iPhone maker’s strategy to avoid paying U.S. taxes, telling The Washington Post in a wide ranging interview that the company would not bring that money back from abroad unless there was a “fair rate.”

Since the discussion is about income that Apple has earned in other nations (and therefore about income that already has been subject to all applicable taxes in other nations), the only “fair rate” from the United States is zero.

That’s because good tax systems are based on “territorial taxation” rather than “worldwide taxation.”

Though a worldwide tax system might not impose that much damage if a nation had a low corporate tax rate.

Unfortunately, that’s not a good description of the U.S. system, which has a very high rate, thus creating a big incentive to hold money overseas to avoid having to pay a very hefty second layer of tax to the IRS on income that already has been subject to tax by foreign governments.

Along with other multinational companies, the tech giant has been subject to criticism over a tax strategy that allows them to shelter profits made abroad from the U.S. corporate tax rate, which at 35 percent is among the highest in the developed world.

“Among”? I don’t know if this is a sign of bias or ignorance on the part of CNBC, but the U.S. unquestionably has the highest corporate tax rate among developed nations.

Indeed, it might even be the highest in the entire world.

Anyhow, Mr. Cook points out that there’s nothing patriotic about needlessly paying extra tax to the IRS, especially when it would mean a very punitive tax rate.

…a few particularly strident critics have lambasted Apple as a tax dodger. …While some proponents of the higher U.S. tax rate say it’s unpatriotic for companies to practice inversions or shelter income, Cook hit back at the suggestion. “It is the current tax law. It’s not a matter of being patriotic or not patriotic,” Cook told The Post in a lengthy sit-down. “It doesn’t go that the more you pay, the more patriotic you are.” …Cook added that “when we bring it back, we will pay 35 percent federal tax and then a weighted average across the states that we’re in, which is about 5 percent, so think of it as 40 percent. We’ve said at 40 percent, we’re not going to bring it back until there’s a fair rate. There’s no debate about it.”

Cook may be right that there’s “no debate” about whether it’s sensible for a company to keep money overseas to guard against bad tax policy.

But there is a debate about whether politicians will make the law worse in a grab for more revenue.

Senator Ron Wyden (D-OR), for instance, doesn’t understand the issue. He wrote an editorial asserting that Apple is engaging in a “rip-off.”

…the heart of this mess is the big dog of tax rip-offs – tax deferral. This is the rule that encourages American multinational corporations to keep their profits overseas instead of investing them here at home, and it does so by granting them $80 billion a year in tax breaks. This policy…defies common sense. …some of the most profitable companies in the world can put off paying taxes indefinitely while hardworking Americans must pay their taxes every year. …that system creates a perverse incentive to keep corporate profits overseas instead of investing here at home.

I agree with the senator that the current system creates a perverse incentive to keep money abroad. But you don’t solve that problem by imposing unconstrained worldwide taxation, which would create a perverse incentive structure that discourages American-domiciled firms from competing for market share in other nations.

Amazingly, Senator Wyden actually claims that making the system more punitive would help make America a better place to do business.

…ending deferral is a necessary step in making sure…the U.S. maintains its position as the best place to do business.

Wow, this rivals some of the crazy things that Barack Obama and Hillary Clinton have said.

Though I guess we need to give Wyden credit for honesty. He admits that what he really wants is for Washington to have more money to spend.

Ending deferral will also generate money from existing deferred taxes to pay for rebuilding our country’s crumbling infrastructure. …This is a priority that almost all tax reform proposals have called for.

By the way, can you guess which presidential candidate agrees with Senator Wyden and wants to impose full and immediate worldwide taxation?

If you answered Hillary Clinton, you’re right. But if you answered Donald Trump, that also would be a correct answer.

This is a grim example of why I refer to them as the Tweedledee and Tweedledum of statism.

Though to be fair, Trump’s plan at least contains a big reduction in the corporate tax rate, which would substantially reduce the negative impact of a worldwide tax system.

The Wall Street Journal opines on the issue and is especially unimpressed by Hillary Clinton’s irresponsible approach on the issue.

Mrs. Clinton is targeting so-called inversions, where U.S.-based companies move their headquarters by buying an overseas competitor, as well as foreign takeovers of U.S. firms for tax considerations. These migrations are the result of a U.S. corporate-tax code that supplies incentives to migrate… The Democrat would impose what she calls an “exit tax” on businesses that relocate outside the U.S., which is the sort of thing banana republics impose when their economies sour. …Mrs. Clinton wants to build a tax wall to stop Americans from escaping. “If they want to go,” she threatened in Michigan, “they’re going to have to pay to go.”

Ugh, making companies “pay to go” is an unseemly sentiment. Sort of what you might expect from a place like Venezuela where politicians treat private firms as a source of loot for their cronies.

The WSJ correctly points out that the problem is America’s anti-competitive worldwide tax regime, combined with a punitive corporate tax rate.

…the U.S. taxes residents—businesses and individuals—on their world-wide income, not merely the income that they earned in the U.S. …the U.S. taxes companies headquartered in the U.S. far more than companies based in other countries. Thirty-one of the 34 OECD countries have cut corporate taxes since 2000, leaving the U.S. with the highest rate in the industrialized world. The U.S. system of world-wide taxation means that a company that moves from Dublin, Ohio, to Dublin, Ireland, will pay a rate that is less than a third of America’s. A dollar of profit earned on the Emerald Isle by an Irish-based company becomes 87.5 cents after taxes, which it can then invest in Ireland or the U.S. or somewhere else. But if the company stays in Ohio and makes the same buck in Ireland, the after-tax return drops to 65 cents or less if the money is invested in America.

In other words, the problem is obvious and the solution is obvious.

But there are too many Barack Obamas and Elizabeth Warrens in Washington, so it’s more likely that policy will move in the wrong direction.

The last NATO Secretary General, Anders Fogh Rasmussen, hailed from Denmark, which has 17,200 citizens under arms. That position did not allow him to deploy the American military, but it did give him unusual influence over U.S. policy.

Even as the American people tire of trying to solve other nations’ problems, Rasmussen wants the United States to continue its interventionist course. Politico recently interviewed Rasmussen, who promoted an “American-led world order”—at American expense, of course. Rasmussen’s greatest fear is the end of Washington’s unique global role: “What is at stake here is the American role as the global superpower.”

He agreed that Europeans should do more on behalf of their own defense, but offered no strategy to make serious and permanent increases a reality. Rasmussen was critical of Trump’s desire for better relations with Russia, even though in a conflict the Danes would do little to help defeat Moscow.

Rasmussen also complained that the GOP platform eliminated a pledge for military aid to Kiev. He worried: “The West risks losing a democratic Ukraine by undermining our support for the country.” But is the prospect of a “democratic Ukraine,” whatever that means in practice, worth war with Russia?

Of course, Rasmussen contended that it is “in America’s self-interest” to preserve “the international order.” But surely not only America’s interest. How about the interest of Europe, which today can’t be bothered to spend much on its own defense, let alone for operations elsewhere?

Rasmussen is prepared to be quite generous with U.S. lives. Washington has “a special obligation to maintain the world order and promote peace.” Indeed, it is America’s “destiny” to lead.

This sounds like the practiced cant of a con-man who relies on flattery. At the end of World War II, only the United States was able to bolster war-ravaged friends and former foes and confront the Soviet Union. But that world disappeared in 1989, if not before.

America’s populous and prosperous allies also benefit from today’s international system. Collectively they possess larger economies and populations than America. They can do much to maintain order and constrain regional trouble-makers.

Rasmussen tried another tack, common among American Neoconservatives. He argued: “it’s in the United States’ interest to actually prevent conflicts while they are still manageable and small, instead of waiting and seeing them grow bigger.” Again, why should only America keep “the lid on” such cases?

Moreover, Rasmussen presumes that Washington officials are capable of discerning potential disasters in advance, acting swiftly and smartly to defuse impending conflicts, showing uncommon understanding in developing solutions, and steadfastly imposing and enforcing settlements. But the results of U.S. interventions have been uniformly bad, often disastrous, leading to successive interventions to fix problems created by the previous effort.

Rasmussen charged President Barack Obama with being “too reluctant to use American force to prevent and solve conflicts around the world.” It is the president’s refusal to use the military that has resulted in “autocrats, terrorists and rogue states” being more influential.

Again, I ask in National Interest, “in what world does Rasmussen live? President Obama actively used the U.S. military, including drones, in Afghanistan, Libya, Pakistan, Yemen, Iraq, and Syria. Where else was there something useful to do, the U.S. knew what to do, the American people would support what must be done, and the end would be peace and stability rather than years more of conflict?”

Even more bizarre is his belief that China, Russia, and terrorists would go away if only America exercised “global leadership.” Unless Washington is prepared to go to war with nuclear-armed powers over stakes they consider vital, such challenges are inevitable. And intervention creates rather than eliminates terrorism.

Policing the globe is not America’s job. Washington should focus on the defense of the United States. What that requires will change over time as circumstances evolve. But America’s chief defense mandate is America.

For those celebrating Brexit as a way to push for freer markets, be aware that there is going to be a fight over this. This is from a Financial Times piece arguing that the UK must ensure that its agriculture industry continues to receive subsidies:

Some free market thinkers believe Britain’s departure from the CAP [the EU’s Common Agricultural Policy] is a golden opportunity to scale back — and even end — agricultural subsidies altogether. They believe the CAP has been hugely distortive because farmers are granted funds according to how much they produce. British farming businesses have therefore been unwilling to innovate, leaving agricultural productivity in the UK lagging well behind that of the US, for example.

Proponents of deep cuts in subsidy also believe they are a sine qua non if Britain is to forge new trade deals with non-EU states. The EU is so heavily committed to agricultural protectionism — imposing tariff barriers on outsiders while subsidising its own farmers — that its ability to sign trade agreements with developing nations has long been restricted. If the UK adopts a different approach, opening up its markets to food exports from, say, Commonwealth nations, it could gain significant new access for UK companies looking to sell services.

Politicians should tread carefully, however. It is in Britain’s interest to maintain a strong farming industry at home and no government should take risks on food security. Farming is an uncertain profession and one that is increasingly exposed to the challenges posed by climate change. That is why most developed countries, whether inside the EU or not, maintain public funding for farming communities.

The right course for Britain is to replace the CAP with a smarter and more innovative system of public support. Instead of subsiding food production, the UK should look to adopt a system of highly specific direct transfers. Future UK governments should, for example, put far more emphasis on paying farmers to tackle specific environmental problems; or to boost training and skills in the workplace; or to invest in research and development projects that boost productivity.

It’s amazing how much effort goes into finding new and “innovative” ways for governments to take taxpayer money and give it to the agriculture industry. No doubt there are better and worse ways to provide that money, and the EU Common Agricultural Policy could be improved, but Brexit offers an opportunity to go beyond the incremental changes suggested above for farm subsidies. That’s why the next few months and years are such an important time for the future of UK policy: There’s a chance to move strongly in the direction of free markets, in agriculture and other sectors. But this article makes clear that there will be people pushing back, and making questionable arguments about “food security,” so it’s important to engage now, while policies are still being decided.

“The president’s presence is already late to this crisis”: that weird phrase comes from yesterday’s widely shared editorial in the Baton Rouge Advocate“Vacation or not, a hurting Louisiana needs you now, President Obama.” It’s not just the man himself who’s missing: it’s his “presence.” “A disaster this big begs for the personal presence of the president at ground zero,” the editorialist insists.

But why? Well, “it’s what chief executives sign up for when they take the oath of office.” Does it help? The Advocate acknowledges that “sometimes, presidential visits can get in the way of emergency response, doing more harm than good,” but that won’t happen in this case. OK, even if it won’t do more harm than good, what good would it do? “In coming here, the president can decisively demonstrate that Louisiana’s recovery is a priority for his administration–and the United States of America.” Or he could demonstrate that by declaring the affected region a disaster area, freeing federal funds for assistance and recovery under the Stafford Act, like he’s already done. Still, “the optics of Obama golfing while Louisiana residents languished in flood waters was striking.”

Perhaps it’s harsh to point out that there’s not a single line of rational argument in the piece—after all, the editorialist is understandably upset about the suffering friends and neighbors have endured over the last week. But for most of the people sharing it, like Governor Scott Walker (R-WI), it’s content-free partisanship, as complaints about presidents golfing invariably are. Here’s the Washington Times grousing: “Obama puts vacation above American people amid deadly Louisiana flooding,” and Howie Carr snarling that while: “In Eastman, Georgia, a cop, a father of three, is murdered in cold blood by a gunman identified as Royheem Delshawn Deeds, who is later arrested in Florida…. Obama golfs at the Farm Neck Golf Club.” I confess I don’t see the connection.

The Drudge Report regularly intersperses an obsession with the president’s golfing habit with various crackpot theories about his real agenda, cheerlessly oblivious to the inconsistency: “He’s a Kenyalinskyite anti-colonialist crypto-Muslim Brotherhood agent with a plan to destroy America. Wait, the SOB is playing golf again? Get to work, damnit!”

But there’s also something going on here that transcends partisanship. Not long ago, the Washington Post pointed to “A growing role for the president: America’s consoler in chief.” It’s the Veep’s job to show up at funerals, and, it’s become the president’s job to manifest himself at disaster areas and other tragic scenes. The first Lexis reference I can find to the president as “consoler-in-chief” comes from an AP story from 1993, “Clinton’s Hugs: Therapy for the Nation,” exploring whether the 41st president’s touchy-feely approach would lead to questions about his toughness. In the years since, those sorts of concerns have vanished, as the “Consoler” role has taken on an increasingly mystical and totemic aspect: “the president’s presence.” As former George W. Bush aide Karen Hughes put it in the Post piece, “the presence of the president has become a visible symbol of the presence of the American people, of their love and their concern and their prayers.”

This is an utterly batty way for people to talk about elected officials, and easy to laugh off: will Donald Trump or Hillary Clinton acquire this numinous aura come January 2017, incarnating our “love and concern and our prayers,” our very presence? That’d be weird.

But there’s something atavistic, and distinctly unsettling, about investing quasi-religious aspirations in a civil officer and fallible human being. And our insatiable demands for executive compassion drive the growth of executive power. When presidents are too slow out of the gate showing that they feel our pain, they often make up for it by seizing more power, as Obama did with the BP oil spill, and Bush did after Katrina. Sending the message: I care doesn’t always stop with photo-ops and FEMA grants.  

The Equation Group was like something out of a Hollywood film: A hacking team of unparalleled sophistication and skill who cracked open computer systems around the world like pistachio shells, yet escaped detection for 14 years until being noticed by the security researchers at Kaspersky Lab last year. They were also widely believed to be affiliated with the National Security Agency—most likely working with or from the NSA’s elite Tailored Access Operations unit.  Last weekend, the world learned that these hackers nonpareil had themselves apparently been hacked, when a group calling themselves the Shadow Brokers (likely a reference to the popular Mass Effect video game series) posted a cache of what they claimed were some of Equation Group’s “cyberweapons,” or computer exploitation tools, on the Web for all to see—along with an offer to sell even more valuable intrusion software they’d obtained to the highest bidder.

While the government hasn’t acknowledged the authenticity of the supposedly hacked files, security experts, including former NSA hackers who’ve spoken to press, agree that the files are the real deal. In fact, they included an exploit that attacks a critical “zero day” (i.e. previously unknown) vulnerability in network routers manufactured by the hardware giant Cisco. That’s particularly disturbing given that the files released this weekend all appear to date from 2013—which means that the “Shadow Brokers,” along with anyone they’d shared the code with—may have had up to three years to run wild on sensitive corporate networks.  Moreover, most experts believe that the offer to “auction off” additional Equation Group tools (pitched in comically broken English) is a smokescreen: The most popular current theories are that the “Shadow Broker” files come from either an NSA insider or a foreign intelligence agency (Russia’s is the leading candidate) that managed to breach a “staging server” used to launch Equation Group attacks. Former NSA contractor Edward Snowden has publicly said that this is not the first time an NSA attack server has been similarly compromised by a foreign adversary—only the first time the hackers have chosen to publicize it.

Whatever the true identity and motives of the Shadow Brokers, there are some clear policy lessons to take away from this.  The first concerns the “Vulnerability Equities Process“—which is how the American intelligence community decides whether and how long to hang on to software vulnerabilities they discover before notifying developers so that these cybersecurity holes can be patched. Back in 2014, federal cybersecurity coordinator Michael Daniel insisted in a post on the White House blog that the process is strongly weighted in favor of disclosure. The government, he assured the public, understands that “[b]uilding up a huge stockpile of undisclosed vulnerabilities while leaving the Internet vulnerable and the American people unprotected would not be in our national security interest.” 

Yet surely by every criterion of evaluation Daniel himself lays out, the Cisco vulnerability—key to an exploit tool codenamed ExtraBacon—was a prime candidate for disclosure.  It’s a high-severity vulnerability that would allow an attacker to effectively monitor all traffic on a compromised network, affecting the leading manufacturer of network routing equipment, and thus leaving a vast number of both American and foreign companies subject to attack. For precisely those reasons, of course, the ExtraBacon exploit would have been of great value to the NSA, and the temptation to at least temporarily make use of it must have been equally strong.  The decision to do so may well have been correct initially.  Yet failing to notify Cisco of such a grave security hole for three full years is simply indefensible—and as we now know, left users and firms alike at the mercy of the malicious actors who had obtained the code. (The past tense is actually inappropriate here: As of this writing Cisco has not yet released a full patch, and many networks will doubtless remain vulnerable for some time even after a fix is available.)  Almost by definition, a process that led to this outcome is dysfunctional.

This hack also ought to give pause to anyone swayed by the government’s assurances that we can mandate government backdoors in encryption software and services, allowing the “good guys” (law enforcement and intelligence agencies) to access the communications of criminals and terrorists without compromising the security of millions of innocent users. If even the NSA’s most closely guarded hacking tools cannot be secured, why would any reasonable person believe that keys to cryptographic backdoors could be adequately protected by far less sophisticated law enforcement agencies? The Equation Group hack is a disturbingly concrete demonstration of what network security experts have been saying all along: Once you create a backdoor, there is no realistic way to guarantee that only the good guys will be able to walk through it.

Twenty-five years ago today I was driving back to Boston from Cape Cod. Two stories dominated the radio news that morning. Hurricane Bob was headed straight for New England, putting my return to Washington in doubt. And Russian hard-liners had staged a coup against Mikhail Gorbachev, who was being held incommunicado in his dacha in Crimea. Eventually I got back to Washington, by a very slow train rather than by plane. The other story had more lasting consequences.

On that morning of August 19, 1991, as the coup plotters issued a declaration of a new Soviet president and seized control of Russian media, supporters of democracy gathered at the Russian parliament. And Boris Yeltsin, the new president of the Russian Soviet Socialist Federal Republic, decided to go out and speak to the soldiers and people outside the parliament building. He climbed up on a tank and rallied opposition to the coup. Two days later it collapsed, and Yeltsin was a national hero. As I wrote when Yeltsin died in 2007:

More than any other man, Boris Yeltsin moved the Russian people from tyranny to a rough approximation of freedom. For that he is one of the authentic heroes of the 20th century.

In a way he personalizes Mikhail Gorbachev’s accidental liberation of the Russian and Soviet people. Gorbachev intended to reform and reinvigorate communism. He brought Yeltsin from the rural region of Sverdlovsk in 1985 to shake up the stagnant party as the Moscow party boss. But Gorbachev set in motion forces that he couldn’t contain. Once people were allowed to criticize the communist system and glimpse an alternative, things moved rapidly–partly because of Yeltsin’s unexpectedly radical leadership.

Two years later Gorbachev and the party hierarchy pushed him out of the Politburo. But he turned around and ran for the Congress of People’s Deputies, won, and then was elected to the Supreme Soviet. He created Russia’s first parliamentary opposition (in the Supreme Soviet) and then won election to the new Russian parliament. Against the continuing opposition of Gorbachev, he was elected to the chairmanship of that body, thus becoming president of the Russian Soviet Federative Socialist Republic.  He stunned politicos by resigning from the Communist Party.

And then in 1991, less than four years after being pushed out of politics by Gorbachev, Boris Yeltsin became the first elected leader in a thousand years of Russian history, winning a popular election for president. Six weeks later he hit his high point. When hard-line communists tried to stage a coup, Yeltsin courageously raced to parliament to rally opposition.  He jumped on a tank to address the crowd, creating one of the iconic images of the collapse of communism.

He went on to effectively dismantle the Soviet Union and to let 14 of the Soviet republics go their own way. He set about freeing prices and privatizing state property, the largest privatization in the history of the world. It was far from an ideal privatization process. But there weren’t many models for wholesale transformation of a communist economy into a market economy. As I wrote in 2007,

Yeltsin wasn’t perfect. He was often boorish and apparently had an excessive taste for alcohol. Despite letting the other Soviet republics go, he launched the devastating war in Chechnya. He unconstitutionally dissolved parliament in 1993; when communist lawmakers defied him, he sent tanks to shell parliament.  But it should be noted that Yeltsin at that time was seeking to defend liberal democracy against a return to communism. Imagine if Nazi legislators had stayed in the German parliament into 1949, resisting Adenauer’s policies and threatening to bring back National Socialism. Would it be undemocratic to call out the military to counter them? Fareed Zakaria’s worry in 1997 that Yeltsin’s creation of a “Russian super-presidency” might be abused by his successors looks all too prescient now. But a reversion to communism would have been worse.

And finally, after becoming the first elected leader in Russia’s history, he became something even more important–the first Russian leader to voluntarily give up power. True, he turned Russia over to Vladimir Putin, making him more like Ronald Reagan, who delivered the United States to the Bushes, than George Washington, who left us in the capable hands of John Adams and Thomas Jefferson.

Still, the words that President Reagan addressed the American soldiers who invaded Normandy could also be applied to Boris Yeltsin: “These are the champions who helped free a continent. These are the heroes who helped end a war.”

For all his mistakes, Yeltsin helped to free a continent and end the Cold War. And 25 years ago today was his finest hour.


Washington long has told the rest of the world what to do. But the world usually pays little attention. When ignored, U.S. officials typically talk tougher and louder, with no better result.

That describes American policy toward North Korea. It would be better for Washington to say less than frantically denounce every provocation. The U.S. and its allies typically respond with angry complaints and empty threats, which only encourages the Democratic People’s Republic of Korea to provoke again.

North Korea recently launched two missiles. It was more of the same, barely worth a second thought.

However, UN Secretary-General Ban Ki-moon declared that he was “deeply troubled” by the North’s action. The United Nations Security Council met, at which there were “strong condemnations across the board,” according to U.S. ambassador Samantha Power. Pentagon spokesman Gary Ross said Pyongyang should “focus instead on taking concrete steps toward fulfilling its commitments and international obligations.”

Japan’s UN representative, Koro Bessho, called the North’s actions “totally unacceptable.” Japanese Prime Minister Shinzo Abe termed the test “is an unforgivable act of violence toward Japan’s security.”

South Korea’s UN representative, Oh Joon, denounced Pyongyang, contending that the latter’s missile program “poses a clear and present danger to the security of all countries in the region.” The South Korean military warned that the North “directly and blatantly demonstrated its provocative ambition to target seaports and airfields across South Korea.”

Even NATO Secretary-General Jens Stoltenberg joined the chorus, taking the “North Atlantic” Treaty Organization way out of area. He declared that North Korea should “immediately cease and abandon all its existing nuclear and ballistic missile activities” and “refrain from any further provocative actions.”

Imagine, Stoltenberg thought his words would shame into repentance the North’s communist emperor Kim Jong-un. North Koreans seem far more likely to enjoy than regret Japanese ululations over the horrid threat posed by Tokyo’s former colony.

Just what do the allies believe they are achieving? Over the last five years the DPRK has shot off 31 missiles. Every one violated a Security Council resolution. And every one was denounced in equally florid language.

Without the slightest impact on the North’s behavior.

Western whining plays to Kim’s worst instincts. After all, the DPRK ably fills the role of a “shrimp among whales,” far smaller, poorer, and less powerful than South Korea, let alone Japan, China, and Russia. Yet the Kim dynasty has gained the world’s attention, causing wailing and gnashing of teeth in capitals across the world—and now even in the headquarters of NATO, the world’s greatest military alliance.

From the regime’s standpoint, it obviously is doing something right. In fact, observers predict that the North is preparing a fifth nuclear test. Last month Foreign Minister Ri Yong-ho criticized the U.S. for its “never ending nuclear blackmails.” As a result, America “will have to pay dearly a terrifying price.”

Washington cannot count on the PRC to “solve” the North Korea problem. After the latest DPRK provocations, Beijing’s ambassador to the UN, Liu Jieyi, chose not to focus on the North, but instead said “the situation is tense and we need to do everything to de-escalate the situation.” He implied that the U.S. and its allies had provoked the North to arm, noting that “the factors contributing to the tension in the Korean peninsula” are “self-evident.”

As I note in the National Interest: “No one outside of Pyongyang wants the DPRK to develop missiles or nuclear weapons. However, if the allies lack a means to disarm the North, they should stop complaining after every weapons test. Doing so reinforces North Korea’s inflated sense of importance and perception of allied weakness.”

Better would be to greet such tests with silence. Any policy response, such as tightened sanctions, should be adopted with little rhetorical fanfare.

This wouldn’t make the North Korea problem go away. But it might at least stop encouraging the DPRK to do more. The U.S. and its allies should give the North the attention that it truly deserves.

A number of outspoken hawks have praised Hillary Clinton’s approach to foreign policy over the past few months, with at least one stepping up to raise funds for her campaign. This might be surprising if one assumes that hawks tend to support Republicans. It also doesn’t make sense if one believes Donald Trump’s contention that Clinton’s approach to the world is identical to Barack Obama’s, and that Obama is a naïve and foolish dove.

It is not surprising that hawks prefer Clinton over Trump, however, if you realize that Hillary Clinton supported every one of the last seven U.S. military interventions abroad, plus two others we ended up not fighting. Given this, it seems that the members of America’s interventionist class doubt that she would be as reluctant to initiate new wars, or expand the current ones, as her campaign rhetoric has suggested.

For much of her career, Hillary Clinton has been one of the most hawkish Democrats in Washington, and one of the more hawkish American politicians, period (my Cato colleague Caroline Dorminey helped compile an early report card here). Clinton has supported the use of the U.S. military for a range of issues, not simply or primarily to advance U.S. national interests, but also to defend the security of other countries and pursue humanitarian objectives.

As Micah Zenko of the Council on Foreign Relations wrote, “It’s impossible to know which national security crises she [Hillary] would be forced to confront, of course. But those who vote for her should know that she will approach such crises with a long track record of being generally supportive of initiating U.S. military interventions and expanding them.”

As First Lady, Hillary Clinton encouraged her husband to intervene in Bosnia in 1995–1996, and then again in Kosovo in 1999. Two years later, Senator Hillary Clinton voted for the Authorization for Use of Military Force (AUMF) following the September 11th attacks, and then for the Iraq war AUMF in September 2002, a vote she now claims to regret. Notably, she also regrets voting against the Bush administration’s Iraq “surge” in January of 2007.

Perhaps chastened by the Iraq surge vote, Clinton as Secretary of State supported a similar troop increase in Afghanistan in 2009. She initially argued for 10,000 more boots on the ground than the President and Secretary of Defense were prepared to send, before eventually falling in line with Obama’s request. It seems that, if given a choice between more troops or fewer, more is better.

Clinton also pushed to send lethal arms to anti-Assad rebels in Syria, and later for establishing a no-fly zone in Syria, an idea that could have brought U.S. pilots into direct contact with Russian aircraft in contested airspace. And when it came to balancing against Russia directly, she supported the controversial expansion of NATO to include countries like Georgia and Ukraine, and also called for providing financial and military assistance to Ukraine in 2015.

Her support for Obama’s drone wars is by far the hardest to tally in this count because it covers interventions already mentioned (e.g, Iraq and Afghanistan), but also includes at least five other countries in which America is not officially at war; Pakistan, Syria, Libya, Somalia, and Yemen have all been subject to U.S. drone strikes at various times. The evidence during her time as Secretary of State suggests that she is strongly supportive of the use of drones, including sometimes over the objections of American diplomats.

All told, the United States is, and has been, involved in many military operations simultaneously, and Hillary Clinton has supported them, as well as the ones we didn’t undertake. No wonder the hawks like her.

Clinton comes by her instincts partly from the people she trusts on the topic. Secretary of State Madeleine Albright was an influential voice during Bill Clinton’s second term, and she and Hillary Clinton appear to have developed an enduring relationship. More recently, Jack Keane, one of the architects of the Iraq surge, is, according to the New York Times’ Mark Landler, “perhaps the greatest single influence on the way Hillary Clinton thinks about military issues.”

Clinton and her very large circle of like-minded advisors worry that if America takes a step back from trying to solve every local dispute another country might take the reins. After 20 years of war, many thousands of U.S. servicemen and women killed, and trillions of dollars spent, many Americans hope that they will.

And yet, despite such firm public opposition to greater U.S. involvement abroad, Clinton seems loathe to let others take the lead. “We will be left behind,” she fretted, when it appeared that France and Britain might take action against forces loyal to Libyan leader Muammar el-Qaddafi in March 2011. In the end, she prevailed on President Obama to take the lead, and later boasted with a laugh, “We came, we saw, he died.” Given the chaos that has ensued since Qaddafi’s overthrow, and the blame that has fallen so heavily on her shoulders, she might now wish that we had sat out that particular civil war.

More generally, it is possible that Clinton has had a genuine change of heart about the wisdom and necessity of frequent U.S. wars. Perhaps her stated opposition to sending U.S. ground troops to fight ISIS, for example – “that is off the table, as far as I’m concerned” she said on Monday – is driven by more than pure political calculation. Perhaps once she enters the office that she has aspired to occupy for so long, she will be true to the less-than-completely-hawkish stances that she has adopted during this campaign season.

I mostly worry, however, that once Hillary Clinton is freed from the obligation of actually having to campaign for the presidency, she will revert to the foreign policy approach that she has favored most of her public life, and surround herself with advisors equally enamored of the U.S. military’s supposedly magical powers for solving all manner of problems.

Having spent the last month or so pouring over writings on last-resort lending,* and especially writings dealing with the recent crisis and its aftermath, with the particular aim of discovering the best means for supplying last-resort credit when it’s called for, and for not supplying it when it isn’t, I’ve reached a number of tentative conclusions that seem worth reporting. I report them despite their tentative nature so that I might be convinced sooner rather than later that I’m barking up the wrong tree, and also because, if I’m actually on to something, I might get others to help me flesh-out my ideas.

I hasten to add that I regard any need for last-resort lending as reflecting, not the inherent shortcomings of private financial markets, but the debilitating effects of misguided regulatory interference with the free development of those markets. Some of the least regulated banking systems of the past, including systems that lacked central banks, were also famously crisis-free, or close to it.

Modern banking systems are, sadly, a far cry from those ideal arrangements. It’s quite impossible, for that reason, to suppose that we might safely dispense altogether with central bank last-resort lending, without first undertaking other, major reforms. In the meantime, we can strive to  reform last-resort lending arrangements, so that they might lower the risk of future crises, instead of making them more likely by contributing to moral hazard, or by otherwise misallocating credit.

A False Dichotomy

Conventional wisdom has it that contemporary central banks must perform two fundamentally distinct duties. According to it, they are, first of all, responsible for implementing monetary policy, meaning that they must manage the aggregate supply of liquid reserves so as to reach various short- and long-term macroeconomic targets. But they must also serve as sources of “last-resort” credit when doing so serves to prevent or contain financial crises.

This established dichotomy of central bank duties has in turn informed a corresponding division of central bank facilities, with one facility or set of facilities serving for the implementation of “ordinary” monetary policy, and the rest devoted to supplying last-resort credit. In the United States, until the recent crisis, ordinary monetary policy was implemented by means of open-market operations conducted with a limited set of counterparties, known as primary dealers, and administered by the New York Fed. Last-resort credit, in contrast, took the form of discount-window loans, administered by each of the twelve Federal Reserve Banks, for which most depository institutions were eligible. Separate ordinary and last-resort liquidity-provision facilities were also standard in other systems.

Although the recent crisis witnessed extraordinary modifications of central bank liquidity-provision facilities, both in the U.S. and elsewhere, and although some of these modifications have become permanent, the conventional dichotomy of duties and facilities has survived, if indeed it has not been reinforced. The most obvious consequence of the crisis consisted of the creation of various new, though mostly temporary, last-resort lending facilities, aimed at supplying emergency credit to institutions that could not or would not get it from established facilities. The new facilities were sometimes open to counterparties to which established facilities were closed; or they were prepared to accept collateral that those facilities would not.  In some instances, such as the Fed’s Term Auction Facility (TAF), the new facilities dealt with the usual counterparties and collateral, but did so in a manner calculated to avoid the “stigma” attached to ordinary last-resort borrowing.

But for all the ingenuity that went into these novel lending facilities, and all the good they may (or may not) have accomplished, I fear that their establishment may cause the wrong conclusion to be drawn from the crisis, namely,  that more or perhaps broader but nonetheless specialized last-resort lending facilities are needed if future crises are to be avoided. The proper lessons to be drawn, IMHO, are dramatically different. They are, first and most fundamentally, that the conventional dichotomy of central bank duties is a false dichotomy ; and,  second, that the problem with traditional central banking arrangements is, not that they lack adequate facilities for emergency lending, but that they rely on such facilities at all, instead of having properly designed facilities for the implementation of “ordinary” monetary policy.

To be more specific, the conventional dichotomy, though it may have had some merit in the now-distant past, when implementing “ordinary monetary policy” meant little more than maintaining the gold standard, while last-resort lending was a largely independent matter, is false when applied to modern fiat-money arrangements. A fiat-money issuing central bank has but one fundamental duty to fulfill. That duty consists of supplying cash, meaning currency and bank reserves, in amounts sufficient to meet macroeconomic targets, and doing so efficiently, that is, so that newly created cash is assigned to those parties that are willing to pay the most for it.

Special Last-Resort Lending Facilities are Inherently Inefficient

Does it really matter whether we think of central banks’ fundamental responsibilities as consisting of two separate duties, or of a single duty performed efficiently? It matters a great deal, because supposing that central banks have not one but two duties to perform, and then encouraging them to employ separate facilities for each, actually makes the achievement of an efficient allocation of credit, including efficient last-resort lending, highly unlikely, if not impossible. This follows from the fact that, taking its “ordinary” monetary targets, and the amount of new reserve creation needed to achieve them, as given, a central bank operating multiple facilities, each catering to different sets of counterparties or dealing in different sorts of collateral, and offering credit on different terms, must allot specific portions of the credit to be created (some of which may be negative, as when last-resort loans are “sterilized” by open market sales) among the various facilities. Such allocations are bound to be somewhat arbitrary, if not flagrantly so. And even if the allocations were somehow correct, the facilities themselves, in so far as they offer credit on implicitly (if not explicitly) distinct terms, would likely favor certain eligible counterparties over others. Finally, because counterparties do not all compete with one another for the same pool of funds, the ultimate allocation of those funds may be inefficient even when all face similar terms.  Think of holding the Olympics at two facilities, with half the teams competing at one and half at the other, and you get the idea.

Instead of suggesting the need for multiple liquidity-provision facilities, the view that central banks have no responsibility save that of implementing “ordinary” monetary policy, but doing so efficiently, points to the desirability of assigning as large a role as possible to the price mechanism as the means for allocating newly-created cash among competing applicants. That goal is best accomplished by means of a single facility for auctioning credit, at which numerous eligible counterparties could compete for available central bank credit on equal terms. Under this arrangement, the central bank, once having set the terms of the auction, would have no other duty to perform save that of determining the aggregate amounts of credit to be auctioned. “Last-resort lending,” instead of being a distinct central bank duty, would become an incidental counterpart of ordinary monetary policy, consisting of that part of auctioned credits taken up by liquidity-strapped counterparties that chose to take part in auctions only as a last-resort. In short, there would be last-resort borrowers, but no last-resort lending operations as such.

Achieving “Flexible” Open-Market Operations

So much for the theory. Can the ideal I’ve sketched-out be achieved in practice?  I believe that it, or something very close, can be achieved, and without any great difficulty, both in the U.S. and elsewhere. As the present Federal Reserve System is in many respects among those furthest removed from the sort of system I think desirable, I’ll outline the basic steps required to move from the present system to what I’ll call a system of “flexible” open-market operations (or Flexible OMOs, for short). Some of the proposals are very similar to ones I originally suggested several years ago, so I encourage readers to consider the arguments I offered in defense of that earlier plan.

First, the Primary Dealer System — the system that confines the Fed’s ordinary open-market dealings to a small set of counterparties — should be abolished. Instead, all commercial banks presently eligible for discount window loans, and all Money Market Mutual Funds, should be able to take part along with existing Primary Dealers in the Fed’s ordinary credit auctions.

Second, while continuing its traditional practice of confining its outright or “permanent” open-market purchases to U.S. Treasury and agency securities, the Fed should stand ready to accept other sorts of collateral, including all collateral that is presently accepted as security for its discount-window loans, while assigning appropriate “haircuts” to riskier collateral, in its temporary open-market purchases or repos. (A “repo” or “repurchase agreement” is essentially a security purchase accompanied by a commitment of the seller to repurchase the security for an agreed-upon price after a specific  — and generally quite brief — period of time.)

Third, the Fed should offer “term” (30 or even 60-day) repos as well as the more usual overnight repos, as the former are more helpful in tiding-over liquidity strapped firms during financial emergencies.

Fourth, to allow counterparties to bid for credit using different sorts of collateral, the Fed should adopt a version of the “product mix” auction originally developed several years ago by Paul Klemperer, and  employed since by the Bank of England in its indexed long-term repo operations (ILTRs). Klemperer’s procedure allows bidders to submit multiple mutually-exclusive “sub” bids for a desired amount of credit, each offering different sorts and amounts of collateral. Then, as an article in The Economist explains,

Having received a set of bids for different goods, at various prices and quantities, the auctioneer in Mr Klemperer’s set-up then conducts a proxy auction on bidders’ behalf to see who should get what, and what the price should be. Because nothing is revealed to the bidders and they know they cannot influence this process, their best bet is to tell the truth. What is more, since the auctioneer has price information for a range of quantities, it is possible to see how prices change as supply does.

For details, including explanations of how the auction avoids adverse selection problems, readers should consult the linked sources. The bottom line, though, is (in The Economist’s words again) that the auction design serves to “provide accurate information on individual banks’ demand for liquidity and the prices they are willing to pay for it.” What’s more, the Bank of England has discovered that it can “use the pattern of bids in each auction to assess the extent of stress in the market,” and to thereby “inform its decisions on the size and maturity of future operations.” In other words, Flexible OMOs serve, not only to make last-resort lending redundant, but to help guide ordinary monetary policy, making it less likely that monetary authorities will err by incorrectly gauging the aggregate demand for liquidity, as Federal officials did, with tragic results, in 2008.

Finally, the Fed should permanently close its discount window, which will have become redundant once Flexible OMOs are provided for.

Flexible OMOs, and Central Bank Discretion

Superficially, the changes I’ve proposed may appear to award the Fed more powers than it has enjoyed in the past, by allowing more counterparties to engage in open-market operations with it, using previously unacceptable collateral. But the impression is mistaken, for a number of reasons.

First of all, as I’ve already noted, Flexible OMOs are meant to render all “emergency” lending operations and facilities, whether actual or potential, redundant. That means that they eliminate the rationale, not just for ordinary discount window lending, but also for lending targeted at specific banks deemed too “Systematically Important” to fail, as well as direct lending to non-banks under the Fed’s current 13(3) authority. By opening access to the Fed’s ordinary credit auctions to numerous counterparties, including all those institutions, whether banks or non-banks, that play a prominent role in the payments system, Flexible OMOs should make it possible for any of these counterparties that is for any reason unable to secure needed liquidity from private sources to apply directly to the Fed for it, and, by outbidding rival applicants, to get it. What’s more, by dealing with the Fed’s ordinary credit-creation facility, rather than with any facility explicitly devoted to last-resort or “emergency” credit provision, firms will avoid any risk of finding themselves stigmatized, and therefore worse off, than they might be if they refused central bank credit altogether.

Second, by having all counterparties compete for credit offered through a single facility, according to common terms, the reform eliminates opportunities for favoritism that arise when different counterparties must deal with different facilities operating under different rules.

Third, by eliminating distinct last resort lending operations, Flexible OMOs make it unnecessary for authorities responsible for such operations to coordinate their efforts with those of separate central bank authorities charged with conducting ordinary monetary policy operations. The elimination of multiple authorities also reduces the risk of shirking, by placing responsibility for adequate aggregate liquidity provision firmly on the shoulders of a single decision-making authority — here, the FOMC.

Fourth, Flexible OMOs should rule-out any future resort to ad-hoc emergency lending facilities, establishing instead a stable and predictable arrangement for central bank liquidity provision, meant to meet both ordinary and extraordinary liquidity needs. The existence of fixed arrangements for liquidity assistance, combined with the competitive pricing of such assistance, allows prospective borrowers to prepare themselves in advance for potential liquidity shocks, while ruling-out moral hazard.

Fifth and finally, Flexible OMOs simplify central bank decision making, by reducing it to two components, namely (1) the determination of aggregate credit amounts to be auctioned, and (2) the setting, and occasional re-adjustment, of various auction parameters, including collateral haircuts. Credit allocation, including its allocation to solvent firms faced with a liquidity shortage that have sought funding from the Fed only as a last resort, is otherwise automatic. There would be no practical distinction, indeed, between the Fed’s conduct during episodes of financial distress and its conduct on other occasions. The only changes would be in the unusual counterparties taking part in the Fed’s auctions, the wider range of collateral types offered, and the higher-than-usual interest rates implicit in winning bids.

The relatively automatic nature of last-resort credit provision under a system of Flexible OMOs makes such a system a natural counterpart to rule-based, if not fully-automatic, systems for determining the scale of central bank aggregate credit creation, such as the proposals of Scott Sumner, David Beckworth, and others for targeting nominal GDP.


Although my proposal may seem radical, its various elements are far from being without precedent.  As I’ve noted, the Bank of England already employs product-mix auctions to allocate funds among competing bids involving different sorts of collateral. The ECB, for its part, has always accepted a relatively wide range of collateral in its ordinary (short-term) open-market operations; it also conducts those operations with numerous counterparties. The ECB was, for both of these reasons, able to cope with the first year of the financial crisis without having had to make any changes to its operational framework. The Fed itself has, finally, occasionally and temporarily resorted to unorthodox open-market operations, involving a larger number of counterparties, a wider range of securities, and different repurchase terms. To supply liquidity in connection with Y2K, it extended the term of its its repurchase agreements, while also offering to purchase a wider range of securities. More recently, in September 2013, it established a special overnight reverse repo (ON-RRP) facility, through which it deals, not with its usual set of primary dealers, but with money market mutual funds, GSE’s, and a broader set of commercial banks. More recently still, it began undertaking sizable term (as opposed to overnight) reverse repos using that facility. During the late 1990s and early 2000s, when confronted with what was then a looming shortage of Treasury securities, the Fed also gave serious thought to the possibility of permanently expanding the list of securities it might purchase, both in its repo operations and outright.

What distinguishes my plan for Flexible OMOs from these precedents is that it envisions a single facility only, supplying both ordinary and last-resort credit, and doing so in a way that relies to the fullest extent possible upon market forces, rather than decisions by bureaucrats, to achieve an efficient allocation of liquidity among competing applicants. By allowing a broad set of potential applicants, using a wide range of eligible collateral, to compete for available funds, not only in private markets, but, when necessary, at a single Federal Reserve facility, Flexible OMOs actually serve to minimize the Federal Reserve’s credit footprint, and to thereby prevent it from taking part in deliberate credit-allocation exercises for which fiscal rather than monetary authorities ought to be responsible.

Back to Bagehot

At first blush, the reforms I’ve proposed may also seem inconsistent with received wisdom regarding the principles of last-resort lending. But they are actually far more faithful to that wisdom, particularly as formulated by Walter Bagehot, than existing arrangements. Consider Bagehot’s seminal statement of now conventional last-resort lending principles, as found in Lombard Street:

First. That [last-resort] loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it… .

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer… No advances indeed need be made by which the Bank will ultimately lose. … If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security — on what is then commonly pledged and easily convertible — the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.

Allowing that there is only a trivial difference between repos and securitized loans, there is after all little difference between what Bagehot recommends and what Flexible OMOs would provide for. Indeed, they make for a more certain commitment to the principle of making last-resort credit available both “largely” and at suitably “high” rates, for the auction procedure itself assures that, in times of extraordinary need, high rates are bound to prevail. If you ask me, it’s not my proposed reform, but the dizzying array of emergency lending facilities seen in the course of the recent crisis, with all the opportunities for inefficient credit allocation they entailed, that would have struck Bagehot as odd.


Such are my thoughts, so far, on reforming last-resort lending.  Like I said, I may be barking up the wrong tree. For that reason, I especially welcome critical comments pointing out how my proposed reform might go wrong. If those comments come with alternative suggestions for improving on what I’ve proposed, all the better.


*Apart, that is, from a portion spent pouring port in Porto, Portugal.

[Cross-posted from Alt-M.org]