Beware of Woolly-Minded Attacks on the Fed

The biggest threat may come from proposals to limit the central bank’s ability to act as a lender of last resort.

By Alan S. Blinder

Jan. 27, 2015 6:25 p.m. ET 

Welcome to 2015. On the Chinese calendar, it will soon be the Year of the Sheep. On the financial calendar, it looks like the Year of the Fed. Let’s hope the Fed doesn’t get sheared.

As almost everyone knows, this year the Federal Reserve will start to “exit” from its hyper-expansionary monetary policies. But the Fed may also spend the year defending itself against a series of congressional attacks on its independence.

The barrage started on Jan. 12, when a seemingly innocuous provision was tucked into a piece of must-pass legislation, the Terrorism Risk Insurance Act, with no hearings, no congressional debate and, for the most part, no notice. The law now requires that the seven-member Federal Reserve Board include “at least 1 member with demonstrated primary experience working in or supervising community banks having less than $10,000,000,000 in total assets.’’

Now, there is nothing wrong with having a community banker on the Fed board; and President Obama ’s announced nominee, Allan Landon, seems well qualified. The problem is assigning board seats to specific constituencies. What about big bankers? Labor leaders? Home builders? Professors? Democrats? Republicans? As Fed Chair Janet Yellen explained at a congressional hearing in July, this could lead to “earmarking each seat for a particular kind of expertise.”

Yes, the new law could Balkanize and politicize the Fed. For example, what will happen when Democrats realize that virtually all community bankers are Republicans?  
Worse things are on the horizon. Two related proposals that failed in the 113th Congress are slated for a comeback in the 114th. Each would encourage congressional meddling with monetary policy.

The first is the Federal Reserve Accountability and Transparency Act, a bill introduced by House Republicans that has little to do with the worthy goals in its title. The objectionable part of FRAT, as I’ve written in these pages, would require the Fed to adopt a mechanical rule for monetary policy—it strongly suggests a rule invented by economist John Taylor of Stanford University—and then justify any substantial departures from that rule to Congress. The political message is unmistakable: Depart from the Taylor rule at your peril.

As rules go, the Taylor rule is not a bad one. In normal times, it provides a useful benchmark against which monetary policy can be appraised. But what about abnormal times? When the economy departs from “the rules,” do we really want the Fed to stick with the Taylor rule out of fear of congressional browbeating?

The second proposal, called Audit the Fed, is an old standby that has been rejected by Congress several times. Don’t let the name fool you; this is not about accounting. The Fed’s books are audited already. The issue in Audit the Fed is whether Congress, probably via the Government Accountability Office, should “audit” the Fed’s monetary-policy decisions. Now, there’s a great idea: Let’s take an independent agency that has been performing well and have its decisions second-guessed by a branch of government that, shall we say, has not been performing well.

But the biggest threat to the Fed and the economy may come from proposals that would limit, perhaps severely, the central bank’s ability to act as lender of last resort in a financial crisis—something central banks have done for centuries.

Before 2010, Section 13(3) of the Federal Reserve Act gave the Fed carte blanche to lend “in unusual and exigent circumstances,” and the Fed made use of that broad authority in the financial crisis. Many of those emergency loans were political poison—think Bear Stearns or AIG. So, in writing Dodd-Frank, Congress clipped the Fed’s wings. Section 13(3) now bans loans to individual companies; emergency lending is limited to programs “with broad-based eligibility.”

That provision of Dodd-Frank was a mistake, but a small one. Small because, in a truly systemic crisis, many financial firms are likely to be in danger of collapsing and dragging the economy down with them. The Fed could still step in by lending to a group of companies.

But some of the Fed’s congressional critics remain unhappy because such crisis lending might save some financial giants from oblivion, making them “too big to fail.” True—sort of. First, can anyone imagine the Fed stopping a systemic crisis without saving—temporarily—at least some systemically important companies? And second, other parts of Dodd-Frank require that basket-case financial giants be liquidated, not saved, albeit in an orderly manner—that is, not like Lehman Brothers in 2008.

It’s hard to know how problematic these proposals will be without specific legislation. But, unless the restrictions are meaningless gestures, they must go beyond Dodd-Frank, which already stipulates that emergency loans not be made “to aid a failing financial company,” that there must be enough collateral to “protect taxpayers from losses,” that the Treasury secretary must approve and more. Several members of Congress, led by Sens. Elizabeth Warren (D., Mass.) and David Vitter (R., La.), wrote to Ms. Yellen last summer, expressing their displeasure at the way the Fed is interpreting these and other Dodd-Frank provisions.

Who knows what comes next? For those who believe it is important to have an independent central bank, empowered to do its job, the Year of the Fed looks scary indeed.

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of “After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead” (Penguin, 2013)

January 28, 2015 12:56 pm

Democratising finance: Technology improves access for the masses

Patrick Jenkins and Tom Braithwaite

There are two popular perceptions of Nigeria. To many, it is the beating heart of Africa’s growth story, with GDP expanding by about 7 per cent a year. To others, it is a country in turmoil, with a fragile democratic government desperate to shrug off the mounting atrocities of Boko Haram terrorists.
The rollout of a national ID scheme by President Goodluck Jonathan captures this ambiguity. Electronic chips on the new ID cards store details of the holder’s iris and fingerprints, boosting security. But with the backing of MasterCard, these are also payment cards — and a potential harbinger of access to finance for the masses.
“This is digitalisation, democratisation and financial inclusion all rolled into one,” says Ann Cairns, who heads international operations for MasterCard.
Once it is fully implemented, the project will allow 100m Nigerians to access financial services. It is just one of countless initiatives around the world being touted as proof that digitalising finance can empower people.
Over the next week, the Financial Times in its series “Democratising Finance” will examine the initiatives that are bringing new sources of finance, new forms of currency and new methods of payment to new customers — and ask the question: is the world genuinely being “democratised”, as many of those behind such innovations insist?
Nigeria’s ID scheme is a case in point. To its fans, the project is a slick way to modernise the country, leapfrogging some of the west’s traditional ways of doing things in the process. But it has been criticised by human rights and protest groups. Privacy International, the data protection charity, has raised concerns about the potential abuse of biometric data. And local protest groups have complained about the involvement of a western financial company — the MasterCard branding on the back of the ID card was akin to the branding of people in the 19th century slave trade, they said.

Finance companies, from MasterCard to the biggest banks, dispute suggestions of exploitation. But there is no denying that access to digital technology is helping financiers tap lucrative new markets.

“Making access to finance more democratic is not only about social responsibility — it’s a business model,” says Carlos Lopez-Moctezuma, the Mexico-based head of financial inclusion at BBVA.

The Spanish bank operates in Mexico through a network of 30,000 agents — local shops, pharmacies and post offices. Now in an effort to reach a broader spread of customers, improve efficiency and reduce risk, the bank is trying to shift agents away from traditional cash transactions by encouraging them to turn their smartphones into point of sale devices.

In another initiative, 2.5m customers now have an integrated mobile phone number and bank account number. “It is about using technology to reach more people but also making life easier by understanding what they want,” says Mr Lopez-Moctezuma.

Only a few banks are thinking radically about technology and finance — using big data to analyse customer behaviour, for example, or partnering with peer-to-peer lenders. Many of the biggest advances in bringing financial services to the masses have come from mobile operators and technology companies.

Vodafone’s M-Pesa service — a relatively low-tech money-transfer scheme launched in 2007 using mobile phones and on-the-ground agents — dominates in Kenya, Tanzania and beyond. Similar schemes have spread across Latin America.
Vikram Pandit, the former chief executive of Citigroup and now a financial technology investor in a range of whizz-bang start-ups, is full of admiration. He says that M-Pesa might be simple in comparison with cutting-edge “fintech”, but it is fulfilling a gaping need. “The most fundamental needs of the poor are not ‘which stock can I buy?’ It’s just matching inflows and outflows of their lives and almost all of them come down to payment systems.”
Not everyone is so upbeat. Arjan Schutte, another fintech investor and founder of Core Innovation Capital, says: “I’m a bear on the mobile phone. It should be the great democratiser. [But] how old a story is M-Pesa? Come on! In 10 years no one else has been able to leapfrog over the consumer finance infrastructure. There’s nothing even close. There’s no story to tell at scale other than M-Pesa.”

In the west a different form of “democratisation” is taking place, whereby ordinary people who would once have had no access to key parts of the financial-services market can suddenly find themselves enfranchised. Online platforms that use “big data” analysis to judge credit risk are widening the pool of people who can borrow money (though it may also allow risk to be so finely assessed that some people will become unfinanceable or uninsurable).

New psychometric testing is doing the same in emerging and developed markets alike.

Mr Pandit believes in the need to “democratise the disparity” between US billionaires who can earn 20 per cent on a big M&A deal and the 2 per cent return available to most Americans. And sure enough, online platforms that give access to “crowdfunded” equity investments are rocketing in popularity.

In the past it wasn’t really possible for individuals to lend to businesses unless they had £100,000 or more available. Now they’re on an equal footing with big institutions - Samir Desai, chief executive of Funding Circle
But it is the broadening and deepening of the crowdfunded debt market that has been one of the most striking trends of recent years. From Shanghai to London to New York peer-to-peer lenders — online platforms that match people looking to invest money with individuals and companies that want to borrow it — are doubling or tripling in size every few months.

In a sign of the excitement around the industry, one of the world’s biggest, Lending Club, floated with a valuation of more than $5bn.
Samir Desai of Funding circle

Samir Desai, pictured, chief executive of British P2P lender Funding Circle, says that there are clear benefits for borrowers who might otherwise be unable to find the money they need but also for lenders looking for worthwhile investment opportunities. “In the past it wasn’t really possible for individuals to lend to businesses unless they had £100,000 or more available. Now they’re on an equal footing with big institutions. That is true democratisation.”

Others are less sure. Marshall Wace, a hedge fund group that is backing a P2P venture, thinks the “peer” funding element that has underpinned the sector to date will steadily institutionalise so that big asset managers and banks become the main funders of lending on these platforms. “There’s a romantic idea about peer-to-peer,” says Simon Champ, who heads the firm’s P2P operation. “But it is not only about democratisation. It’s also about the replacement of an outdated, 300-year-old business model, with a new, more efficient one.”

As one user of Lending Club commented: “Success drew in institutional players, with high-speed computer programs to buy loans in seconds. So, a good deal for borrowers, and institutions — not so sure about retail investors.”

Some regulators and commentators are also concerned that the P2P market has been tested only in a low interest rate environment. When rates rise, defaults increase and investors get burnt, there could be a popular backlash.

Few would dispute that technological innovation is benefiting the masses in much of the world, aiding financial inclusion from the most basic payment services to the most sophisticated investment strategies. But if this is democratisation, it is unlikely to be a painless process.

As Abraham Lincoln said of the impending US election in 1864: “It’s the people’s business . . . If they turn their backs to the fire and get scorched in the rear, they’ll find they have got to sit on the blister.”

Why did the Swiss franc spike? Blame the locals

Matthew C Klein


There is a straightforward answer to the question in the headline: more money has been trying to get into Switzerland than get out, which didn’t affect the exchange rate as long as the Swiss National Bank bought foreign currency. As soon as they stopped, the exchange rate adjusted to balance the new set of flows. But a detailed look at the gross flows in and out of the country provides a more nuanced and interesting picture.

In the heady days of 2010-2012, when it seemed as if the European Project was always one secret weekend meeting away from exploding in a fireball of poisonous politics and innumerate economics, Switzerland looked like a nice place to put your money. It was especially attractive if you were a resident of a stressed euro area country worried about wealth taxes, bank failures, currency re-denomination, or all of the above.

The result was capital flight from Greece, Spain and elsewhere into Switzerland. That led to a collapse in the value of the euro relative to the Swiss franc, which in turn inspired the Swiss National Bank’s imposition of a “floor” on the exchange rate to prop up the single currency. As the situation in Europe switched from rapidly getting worse to gradually getting worse, these inflows stopped.

One way to see this is by looking at the size of the SNB’s foreign currency portfolio, which, during the period of the exchange rate intervention, grew whenever the country experienced net inflows:

As you can see, the size of the foreign reserve portfolio was basically unchanged from late 2012 through mid-2014, which may explain why the SNB felt the franc wouldn’t appreciate as much as it did when the floor fell out from under EURCHF.

That said, you can see that foreign reserves started growing again around six months ago, perhaps in part due to rich Greeks getting increasingly worried that a political party that aims to “destroy the basis upon which [the oligarchs] have built, for decade after decade, a system and network that viciously sucks the energy and economic power from everybody else in society” could come to power.

Those foreign sources of capital may have played a role, but according to a new report from Deutsche Bank, the main source of upward pressure on the franc over the past few years has been coming from Swiss residents who have been pulling money home from abroad, not from foreign residents trying to get into Switzerland:
It has been the lack of domestic demand for foreign assets rather than foreign demand for Swiss ones that has caused the lack of Swiss financial outflows. Swiss residents’ purchases of foreign deposits and foreign debt instruments are CHF 400bn and 250bn below pre-crisis trends respectively. 
In effect, since 2012 the SNB have been holding the floor not against foreign speculative or safe-haven inflows, but the country’s own residents. At a less conceptual level, a Swiss corporate that previously recycled its EUR or JPY export earnings by buying EUR fixed income has simply been transferring them into CHF deposits instead.
First, look at the cumulative flow of “other investment” into Switzerland and the supply deposits held at Swiss banks by foreigners. As you can see, both have been falling thanks to the easing of the euro crisis and the crackdown on tax evasion:

Unless those trends suddenly reversed, which seems unlikely, something else must be at work.

Until the crisis, Swiss residents bought a ton of foreign assets. Importantly, those assets were almost always denominated in foreign currency, which means that changes in those holdings ought to immediately flow through to the exchange value of the franc:

Since 2008, however, Swiss residents stopped buying additional foreign bonds and have sold their foreign equities:

As DB puts it:
For the franc, the fact that pressure has been generated by a lack of capital outflows rather than speculative inflows explains the mystery as to who was buying Swiss assets with exceptionally low yields and relative calm in the global environment. The answer: nobody.
The corollary is that the vast majority of the growth Swiss bank liquidity has come from residents, rather than foreigners:

While Deutsche Bank doesn’t draw this conclusion, their finding supports the view that the franc has been undervalued rather than overvalued.

If you know that your currency is overpriced you want to buy as much foreign stuff as you can while the purchasing power is there, if for no other reason than to hedge against the eventual return to normalcy. The same logic also applies to petrol states when the oil price is high, or companies making acquisitions with overvalued shares.

By contrast, if your currency is underpriced, you lack purchasing power commensurate with your real output, which means you will buy less stuff than you otherwise would. We’ve previously argued that Switzerland’s persistently large current account surplus and unusually low level of real consumption per person, not to mention the market action, were signs that its currency had been suppressed below its “fair value” by the SNB. The fact that Swiss residents had stopped buying foreign assets like they used to also suggests that the real purchasing power of the franc fell a lot after 2008, despite the nominal appreciation of the currency.

Bottom line: Swiss exporters who resent the change in their terms of trade shouldn’t blame inflows from frightened Europeans for an “overvalued” currency, but their fellow citizens, who have stopped sending quite so much capital abroad as they used to.

Fanatics, Charlatans, and Economists

Jean-Marie Guéhenno

JAN 27, 2015

Recession Economic Growth Inequality

DAVOS – Throughout the world, it seems, crisis is gripping national politics. In election after election, voter turnout has hit historic lows. Politicians are universally reviled. Mainstream parties, desperate to remain relevant, are caught in a vice, forced to choose between pandering to extremism and the risk of being overwhelmed by populist, anti-establishment movements.
Meanwhile, not since the end of World War II has money played such an important role in politics, trumping the power of ideas. In the United States, for example, the sound of billions of dollars flowing into election-campaign coffers is drowning out the voices of individual voters. In parts of the world where the rule of law is weak, criminal networks and corruption displace democratic processes. In short, the pursuit of the collective good looks sadly quaint.
The trouble began at the end of the Cold War, when the collapse of a bankrupt communist ideology was complacently interpreted as the triumph of the market. As communism was discarded, so was the concept of the state as an agent around which our collective interests and ambitions could be organized.
The individual became the ultimate agent of change – an individual conceived as the type of rational actor that populates economists’ models. Such an individual’s identity is not derived from class interests or other sociological characteristics, but from the logic of the market, which dictates maximization of self-interest, whether as a producer, a consumer, or a voter.
Indeed, economics has been placed on a pedestal and enshrined in institutions like central banks and competition authorities, which have been intentionally separated and made independent from politics. As a result, governments have been confined to tinkering at the margins of markets’ allocation of resources.
The 2008 global financial crisis, the resulting recession, and rapidly widening income and wealth inequality have punctured the glib triumphalism of economics. But politics, far from rising to take its place, continues to be discredited, as mainstream leaders – particularly in North America and Europe – call on economic theories to justify their policy choices.
The pursuit of individual attainment is the hallmark of our time, eclipsing the collective dimension of human destiny. And yet the deep human need to be part of a group has yet to disappear. It lingers, but without a credible outlet. National projects ring hollow, and the so-called international community remains an abstraction. This unfulfilled desire for community may be felt particularly acutely by young people – including, for example, young jihadists.
Indeed, nationalist politicians and religious leaders have been the first to spot the vacuum, and they are rapidly filling it. Pope Francis, Vladimir Putin, Abu Bakr al-Baghdadi, and Marine Le Pen have little in common. But they share one insight: There is a deep longing for the creation of communities defined by shared values, not functional needs.
The crisis of national politics has consequences that echo far beyond the borders of individual countries. National chauvinism and religious fundamentalism are here to stay, and with them the terrorism that extremists of all stripes embrace, because both phenomena are ideally suited to the age of the individual: They provide imaginary answers to personal angst, instead of political answers to collective challenges. These movements’ amorphous nature – often channeled through charismatic leaders – allows each individual to project onto them his or her dreams, making them difficult to counter within the framework of traditional politics.
But this strength can also be a weakness. When tasked with managing territories and governing populations, these movements begin to face the same bothersome logistical and organizational constraints as their rivals. As a result, bureaucracy is constantly at their heels, leaving them in perpetual need of upheaval and renewal.
If politics is to retake the field of values from the fanatics, the charlatans, and the economists, it must be rebuilt from the ground up. More than half of the world’s population now lives in cities, and any political renaissance must counterbalance the appeal of vast virtual communities with resilient urban societies. Citizens must become reengaged with the political process, educated in public affairs, and provided with real (not merely virtual) platforms to air their differences and debate alternative views.
Furthermore, institutions that provide bridges between states and the global community, such as the European Union, must be strengthened and refocused. In particular, their technical functions must be clearly distinguished from their political roles.
But, above all, politicians must stop trying to shore up their diminished credibility with the pretense of economic science. Politics begins where contemporary economics ends – with ethics and the attempt to create a justly ordered society.