Jeffrey Lacker on the History of Fed Credit Policy and the Four Doctrines of Fed Lending

Jeffrey Lacker is a senior affiliated scholar at the Mercatus Center, and he previously worked at the Federal Reserve Bank of Richmond, where he served as its president from 2004 to 2017. Jeff is also a returning guest to the podcast, and he rejoins David on Macro Musings to talk about the history of the Federal Reserve’s credit policy, as well as a recent Shadow Open Market Committee conference.

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Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Jeff, welcome back to the program.

Jeffrey Lacker: My pleasure, David. Great to be here again.

Beckworth: Jeff, I have to pinch myself and remind myself that I'm working at a place where I can call you a colleague and Tom Hoenig a colleague. I’ve got two Federal Reserve presidents that I get to work with. I’ve got two real experts in-house. So, it's been great to have you at Mercatus. It was great at the SOMC conference we're going to talk about, where you were introduced as someone from Mercatus, as well as Tom Hoenig.

Lacker: Yes, I make sure that everyone knows.

Beckworth: Yes. So, we appreciate you being a part of the team. Glad to have you here. Let's talk about that conference briefly. We're going to talk about an amazing paper that you presented at the conference on the history of Fed credit policy, which is very thought-provoking and raises some good questions, but that was a great conference. It was at Hoover, at Stanford, and a lot went on there. Maybe for the audience— I know we talked about this on a previous show, but remind us what the Shadow Open Market Committee is-

Lacker: Sure.

Beckworth: -and give us your sense of what its contribution has been throughout time.

The Shadow Open Market Committee and its Contributions Throughout Time

Lacker: Yes, so, the Shadow Open Market Committee was founded in 1973 by Karl Brunner and Allan Meltzer and Anna Jacobson Schwartz, who went on and was Milton Friedman's co-author on Monetary History in 1963. It arose because inflation was getting out of control, and they wanted to share, with the public, insights about what was going on with inflation and how the Federal Reserve ought to do a better job of getting on top of it. At the time, a lot of people were blaming other things for inflation— energy prices, unions, things like that, [and] cost-push shocks.

Lacker: The point that they wanted to make was that this is the responsibility of the central bank, especially in '73, because they'd gone off the gold standard in '71. There wasn't that anchor anymore for monetary policy. So, it was up to the central bank to limit the supply of money in order to keep inflation under control. The word shadow comes from the practice, in British politics, of the opposing party forming a shadow cabinet. In fact, there's conversation among the Tories now about doing that, that would keep an eye on what the government was actually doing and critique it, and offer a spirit of constructive, loyal opposition. And I think that was the spirit of the early [Shadow Open Market Committee], and ever since then, in fact.

Beckworth: So, you were a Fed president while the SOMC was operating. So, you were on the inside, they're on the outside. Did you find their contributions useful? Did you follow them while you were actively engaged with the Fed?

Lacker: Yes, I definitely followed them. They had important things to say [and were] always worth listening to. As one of the papers at this conference at Hoover last month made clear, their focus on the responsibility of the central bank, the Federal Reserve, for inflation, was very influential in the '70s, and that helped buttress public support for Volcker's strong actions to bring inflation down. They perseverated on the idea of monetary aggregate targeting, though. They stuck with that a little beyond the useful life of monetary aggregate targeting.

Beckworth: The shelf life had expired.

Lacker: Yes, it had expired, and people were moving to interest rate targeting, but they've got with the program, ultimately. What they had to say about the stance of monetary policy was something I paid attention to. On the other side, on the credit policy side, Marvin Goodfriend was a member of the Shadow Open Market Committee beginning in 2009. Early in the 1990s, he had advocated for a credit accord in which the Federal Reserve left, to the Treasury, doing credit market interventions, and in return, got acknowledgment from the Treasury that the Federal Reserve was responsible for monetary policy and inflation, and as part of that, the Federal Reserve getting an inflation target that was blessed by the administration.

Lacker: In his views, the credit market interventions that we saw in the '70s and '80s had tangled the Fed up in politics that was needlessly sapping its political capital, political capital that it ought to husband and save for protecting its monetary policy independence. He advocated that, and that was influential in 2009. Others within the system were advocating that. In fact, in the spring of 2009, the Fed and the Treasury issued a joint statement on the role of the Federal Reserve and the Treasury in financial stability and monetary policy. So, it had an influence, although we could debate the influence of that statement itself.

Beckworth: You had your paper there. We're going to talk about that in-depth in a few minutes. Were there any panels or presentations that really struck your fancy, that you really appreciated, that made an important point?

Highlights from the Recent Shadow Open Market Committee Conference

Lacker: The panel on fiscal policy, I think, was really important, and timely too, given the fiscal stance and the likelihood, given the campaign pledges on both sides, of further fiscal stimulus and larger deficits going forward. John Cochrane's presentation, in particular— and I'd recommend looking it up on YouTube— was really succinct and very clear.I've seen and read presentations by him of the fiscal theory of the price level for decades now, and I remember, back in the '80s, reading papers about it. But this presentation was intuitive and connected it to current monetary policy stance questions in a way that I hadn't seen, at least in his intuitive way, ever before. So, he's getting much better at presenting it.

Beckworth: Yes. Practice makes perfect. That was a great panel, and correct me if I'm wrong, his point was that the fiscal theory of the price level can explain what we've seen in the price level or inflation. We would expect to see, with a massive helicopter drop, a surge in inflation, and then it comes back down back to target, and so we have a permanent price level shift, a temporary spike in inflation. That's one point he made, right?

Lacker: Yes. That's right, but the underlying theme is that the economics of a monetary policy innovation— raising rates more than expected or cutting rates more than expected— depends crucially on what change that makes in what people expect for future federal deficits or surpluses. You can't really tell what the shock is going to do until you know or make some presumption about what that expectation about future fiscal stance does.

Lacker: The traditional monetarist model, in which only money matters— It embeds Ricardian fiscal policy so that any shocks to fiscal policy are offset by future taxes. That's a polar case and not necessarily the one that you think is going to hold. Then, there's all sorts of stuff in between there— Pure bond-ism, the opposite of monetarism, right? The point is that you've got to pay attention to what's going on with the expected fiscal surpluses.

Beckworth: Absolutely. I think if you really want to know, what is a helicopter drop, [then] you've got to look at fiscal policy and monetary policy, like you're saying, and Eric Leeper, who's also a colleague of ours here at Mercatus-

Lacker: I know. I’ve known him for a long time.

Beckworth: -another great person on board, he did a great paper for us where he showed pretty convincingly that the public understood— it was communicated and it was understood that this was, effectively, a helicopter drop. These stimulus checks, these injections, were not going to be backed up in the future by tax increases or cuts in government spending.

Lacker: Yes. Classic case.

Beckworth: So, clearly, we had a helicopter drop, $5 trillion or so, pretty large relative to GDP. So, we should expect to see something happen. And I've had these debates on Twitter or X now, and some on Bluesky, but how much was supply versus demand? I'm like, "If you inject that much nominal spending, [if] you increase the dollar size of the economy that much, [then] there has to be price pressure somewhere tied to aggregate demand pressures."

Lacker: Yes, for sure.

Beckworth: You can't escape it, and that's what Cochrane showed.

Lacker: Was it Marshall who said that asking whether it's supply or demand is like asking which blade of the scissors does the cutting?

Beckworth: Yes.

Lacker: So, yes, there were supply shocks, but keeping inflation under control means throttling back demand correspondingly.

Beckworth: Yes. So, that was a great panel. There were a number of other people on that panel— Patrick Kehoe, Deborah Lucas, Charlie Plosser. I really liked Patrick Kehoe's presentation, too.

Lacker: Oh, his talk was great.

Beckworth: The punchline, and again, I've mentioned this before on the podcast, is keep your fiscal powder dry.

Lacker: Right.

Beckworth: Because we might be coming into a war in the near future. Hopefully not, but if we do-

Lacker: Shocks, yes.

Beckworth: -do we have the fiscal capacity? We may not.

Lacker: Yes, very concerning.

Beckworth: So, great panel. This is online. In fact, your paper that we're going to talk about is online. We'll provide a link to that and a link to the SOMC conference as well. Let me mention a few panels that I enjoyed. I enjoyed the operating system one with Loretta Mester, [and] she came on the podcast after she had that great presentation.

Lacker: Yes, I listened.

Beckworth: -Bill Nelson. It was great. But one other one that I want to bring up— because there's been a recent development [and] I want to get your take on this. So, there was a panel on frameworks. Now, I bring that up because, as we know, the Fed framework review is soon upon us. In fact, I'm surprised that it hasn't been announced yet. We're getting close to the end of the year.

From FAIT Back to FIT?

Beckworth: But last week, Jay Powell sat down with a reporter and, among other things, she asked him, what about the framework review? And to me, he dropped a bomb. To me, [it was] a big revelation, pretty shocking, although I did not see anything written about it. The only person mentioning it on Twitter was me. And that was that he said that the base case was an ordinary reaction function where the Fed does not commit to overshooting in the future if they have undershot their target. Wow. That's saying that we're going to take FAIT, flexible average inflation targeting, and return to FIT, flexible inflation targeting.

Beckworth: I guess I was shocked on several levels. One, they're going to abandon 20 years of research on makeup policy, level targeting, all of that from the late 1990s, in Japan, up to 2019. Two, it just seems so sudden. It seems that we just adopted this in 2020, and you're going to throw this out the window? It seems very jarring for the Fed, which is typically very conservative. It makes small moves and gradual moves, not sudden 180-degree moves.

Lacker: I have mixed feelings about that statement of his. On the one hand, I do think that the tilt of the 2020 framework towards the employment mandate away from inflation targeting, the expressed willingness to countenance overshoots— I do think that contributed to the mistake they made in 2021 of just waiting way too long and focusing too much on policy and forward guidance, hanging themselves up on, are we at full employment or not?

Lacker: On the other hand, when we adopted an explicit framework in 2012, we felt as if we were codifying decisions made in 1995 to target inflation at 2%. And the idea was a sort of quasi-constitutional document, something that would be relatively timeless, tweaked only in minor respects over time, and would serve as something that would guide people in forming expectations about policy 5, 10, 20 years ahead. The idea of doing a review every five years is fine, but if you make wholesale changes every five years, it becomes less of an anchoring document than it does an expression of the current zeitgeist about policy conduct.

Beckworth: Yes. In fact, we had a previous podcast with you where we talked extensively about the 2012 consensus statement and the adoption of the original inflation target. So, this needs to be more of a gradual process. I have mixed feelings, too. On one hand, I do agree with you. Some of the changes made probably contributed to the failure of FAIT to handle the inflation stress test, as some people put it.

Beckworth: But I also am a believer, as you know, in makeup policy of the right kind. If you have a massive collapse, a great depression, [then] you want to make up for that. No, we don't have those very often, and maybe 9 times out of 10, it's not necessary, but it will be interesting to see what happens going forward. Let's talk about your paper that you presented there. This was, for you, of course, the highlight of the conference, even though you loved the fiscal policy panel. The title of your paper is, *From the “Lender of Last Resort” to “Too Big to Fail” to “Financial System Savior”: Federal Reserve Credit Policy and the Shadow Open Market Committee.*

Beckworth: So, you do talk about the Shadow Open Market Committee a lot, but I want to focus a lot on the credit policy, the history of it, the evolution of it at the Federal Reserve, [and the] big changes that happened over your lifetime, and while you were at the Fed, even. So, maybe give us the motivation for this paper, and then give us the executive summary, and then we can jump in and work at different sections of the paper.

*Federal Reserve Credit Policy and the Shadow Open Market Committee*: Motivation and Summary

Lacker: There's been so much written and studied about the conduct of monetary policy, different theories of how to do monetary policy. The stunning thing about 2007, '08, and '09 was the huge scale of the Federal Reserve intervention in credit markets, and the scale is just off the charts compared to what went before. Before August 2007, discount window lending was maybe $200 million at the most in any given week, [and] usually much less, like $50 million or so. There were occasional interventions. September 11th was an example, but for the most part, very tiny, little function for a while, at least going back into the mid part of the 20th century. Then, there's this just explosion.

Lacker: So, when I stepped down, I wanted to use my time to learn more about what happened and understand better how it fit into the evolution of Fed credit policy, and in particular, I call them doctrines, the doctrinal aspect of it. So, what's the philosophy? What's the model underlying what you think Federal Reserve credit policy should do and how it should be done? And so, I went back to the founding of the Fed and beyond and I tried to trace out the history of those ideas and I identified a set of discrete practices and doctrines. Then, I looked at the 21st century practice against that, and sure enough, things shifted a bit, and I tried to understand what those shifts were about.

Beckworth: You used the term— 2007 was this large discontinuous shock or break.

Lacker: It was.

Beckworth: It wasn't a smooth transition. It was pretty sharp.

Lacker: I think so. Yes, it was a discrete change in Fed practice.

Beckworth: So, this is about credit policy at the Federal Reserve. As you mentioned, [there is] a lot written on monetary policy, [but] your focus is on credit policy. Maybe we should define the difference between credit policy and monetary policy.

Breaking Down the Difference Between Credit Policy and Monetary Policy

Lacker: Yes, it's important to be clear about the distinction, and just to get the language straight, too, in what I'll be talking about. So, central banks issue liabilities, monetary instruments that are their liabilities. For the Fed, it's hand-to-hand currency, paper currency, and the reserve balances that banks have, and those liabilities are unique in the economy. They have special properties. They give you the right to do special things. And the central bank has a monopoly on those, and because of that, monetary policy is special.

Lacker: So, monetary policy consists of changes in the quantity of monetary liabilities of the central bank that are accomplished by buying or selling government securities. Because the central bank is an arm of the government, it's a power that the Constitution gave to Congress and Congress has delegated to the Fed, it's a government function. So, when the Fed expands the money supply through exchanging money for other government debt, other government obligations, that's pure monetary policy. Credit policy, on the other hand, is an extension of credit to the private sector, or acquiring a private IOU or obligation, holding fixed the monetary liabilities of the central bank— so, offsetting that with the sale of a Treasury security.

Lacker: In the old days, as I'll talk about, the Fed would do discount window lending, and it would sterilize it. That's the word for it, sterilizing— offsetting its effect on the monetary liabilities of the Fed. QE— so, quantitative easing, large-scale asset purchases that purchase Treasury securities— that's pure monetary policy. Purchasing mortgage-backed securities to the extent that the issuer of the mortgage-backed security is a private entity— and you can debate that about Fannie and Freddie now— but to the extent that, in 2009, it was viewed as a private entity, that's a combination of monetary policy and credit policy.

Lacker: The credit market interventions in late 2008 were a combination. They were extensions of loans. Plus, we let it affect the reserve supply and the monetary base. That's the clean break there. Quantitative easing of any given magnitude can be done all with Treasuries if you want. To the extent that it involves agency mortgage-backed securities or some other credit program like corporate bonds or whatever, you should picture the monetary expansion being accomplished via Treasuries, and then the Treasuries being sold, and the proceeds being used to extend credit to the private sector.

Lacker: That private sector credit extension— it's clearly kind of a fiscal policy. It's selling government debt, it's selling Treasury securities, and using the proceeds to lend. That's something that you would think the Constitution gave to Congress, but because the Federal Reserve has this lending authority left over from its founding, it has the ability to do an end run around the Constitutional appropriations policy and do this fiscal policy.

Beckworth: That's why it's been called the only game in town when Congress won't do its job. Sometimes it's pushed or forced to do things. Let me flesh this out a little bit more with you. So, what about the notion of interest, which you mentioned earlier? We've gone from focusing on monetary aggregates to interest rates. How would this definition, which I think makes a lot of sense— Basically, any allocation of funds to the private sector, one way or the other, is that you're doing credit policy versus just focusing on government securities.

Beckworth: But what about interest rates? The Fed often signals, works through interest rate changes. In fact, one of the panelists at the fiscal panel at the SOMC talked about [how] the Fed keeping rates, say, below market levels would be a subsidy to the public, and she called that fiscal policy. Could pure monetary policy also have some elements of this, or would you maybe classify that differently?

Lacker: So, the interest that the Fed pays on reserves is part of the terms and conditions under which they issue these monetary liabilities. It's issuing a monetary liability, bank reserves, that have the property that it pays the state at interest. I call that monetary policy. That's just the nature of the instrument they're issuing.

Beckworth: So, even if it's giving some kind of extra transfer of funds to the public by buying up--

Lacker: Well, it's not obvious that a transfer to the public is the right way to think about that. At the margin, banks hold all of these reserves. Any given bank has to be indifferent between holding the reserves-

Beckworth: And holding a Treasury.

Lacker: -and holding something else.

Beckworth: Yes. Well, let me do a scenario. You're a bank and you hold a Treasury security, right? And let's say you could earn a better return at the Fed. The Fed's going to offer you a rate that you currently can't get, say, in money markets. Now, I know that, eventually, arbitrage would bring those things equal.

Lacker: Yes, well, that's the thing. If that's true, if rates are inferior elsewhere, [then] those rates are going to have to go up to get people to hold those things, right?

Beckworth: Okay. We'll leave it at that, then, okay. So, credit policy, monetary policy— I think it's pretty clear for the broad contours of it, and that's important as we think through these different periods and these different doctrines that you have, that you've outlined. Let's go ahead and take a look at these periods and begin with the theories or the understandings behind the different uses of credit policy at the Fed. So, you come up with four doctrines of Fed lending, and let's start with the very first one, very basic one, the classic lender of last resort, and this is tied to the founding of the Federal Reserve. So, tell us about that.

The Four Doctrines of Fed Lending: The Monetary Stability Doctrine

Lacker: Before the Fed was founded, under the National Bank era from the 1860s on to 1914, the money supply consisted of these notes that national banks were entitled to issue. There was no central bank. And the issue of those notes— those were high-powered money. That was the equivalent of the monetary liabilities of the central bank now. The monetary basis, it's also often called. So, that was a cumbersome thing. They had to buy Treasury securities posted as collateral. The Treasury would take plates off the shelf and print the notes for the bank, send the notes to the bank. Expanding that was very cumbersome and very costly.

Lacker: So, at times where the money demand was higher than normal, there would be a stringency. Even apart from banking panics, interest rates were about 100 basis points higher in the fall when people wanted currency to move money to market than they were in the spring and the summer. Then, on top of that, if you had some worries about the solvency of a bank, people would pull their money out of a bank. They would shift from deposits to money, because we had a fragmented banking system. There wasn't another bank in town sometimes.

Lacker: That shift from deposits to money would have this adverse effect on what's called the money multiplier. So, if you think of the stock of money as the hand-to-hand currency people have plus their deposits in banks, the stock of high-powered money supports that, but it's more than one-for-one, because you issue more than $1 of deposits for $1 in high-powered money or notes that you have in your vault. When people drain out of the banking system, those notes drain out of the banking system, the overall money supply has to contract, unless there's somebody around to increase the supply of high-powered money, to increase the supply of those notes.

Lacker: Under the National Bank Act, it was really cumbersome and costly to do, and that's why there were these scrambles for cash and banking panics in the late 1800s. This was well understood, this problem. It was called the elasticity of currency. We didn't have an elastic currency, and so the first line of the title of the Federal Reserve Act is to furnish an elastic currency. And the idea was that the Federal Reserve would be there to increase the supply of Federal Reserve notes in bank reserves when the demand surged, and so prevent this monetary instability.

Lacker: Of course, this is exactly what Walter Bagehot had in mind when he wrote, in 1873, what people have come to call the lender of last resort, although he never used that phrase. The idea actually goes back earlier to Henry Thornton, who wrote in 1802. There were a couple of banking panics in the 1790s, and he wrote very perceptively and at great length about the economics of how the central bank should conduct policy. It's considered the first modern treatise on monetary economics and monetary theory.

Lacker: The whole point of the lending they were advocating, the whole point was to increase the supply of money. That was the whole point, to increase the supply of high-powered money to offset a decline in the money multiplier caused by people shifting out of deposits into currency, and this is exactly the problem in the 1930s. This is exactly what the Fed failed to do, according to Friedman and Schwartz. They didn't increase high-powered money to offset a dramatic collapse in the money multiplier because of the shift from deposits to currency.

Beckworth: Yes, and to be clear, this first doctrine, you actually call it the monetary stability doctrine. I started with lender of last resort, but really it was about monetary stability, having the elastic currency.

Lacker: Right.

Beckworth: I'm glad that, in your paper and just now, you mentioned Henry Thornton. As someone has told me, everything's in Thornton. You think Milton Friedman was the first monetarist? Actually, it was Thornton. You think Bagehot was the first one, the central bank policies? It was in Thornton. So, go back and read that.

Lacker: Here's a little tip, though. His friend, Francis Horner, wrote a review of this book in The Edinburgh Review, and it's actually much clearer than the book.

Beckworth: Oh, okay.

Lacker: And he starts off by saying, "This is poorly written. I'm going to explain it all."

Beckworth: So, if you want the cliff note, well-written version-

Lacker: Yes, Francis Horner's review in The Edinburgh Review.

Beckworth: -get his. Okay, I will mention, too, while we're on this first doctrine— and it's linked to the classical lender of last resort notion— that you have another paper that we'll also provide a link to in our show notes, and it's called *Last Resort Lending: Classical Thought Versus Modern Federal Reserve Practice.* So, it kind of touches on what we've just been covering.

Lacker: Yes. This phrase, lender of last resort, started being invoked a lot after 2008. Some scholars documented a huge spike in the central bank official references to Walter Bagehot starting in 2009. It's this appeal to the notion that back in the mystic chords of memory, there's a 19th-century tradition of central banks playing the role of being what's called the lender of last resort. But that's a misunderstanding, really, of what Bagehot and Thornton were talking about for the Bank of England back then, because it had to be unsterilized lending.

Lacker: Bagehot and Thornton, they didn't care what assets the Bank of England acquired. In fact, acquiring government securities was fine with them. It's just that they took for granted that lending was what the Bank of England did to manipulate its note supply. The reason for that is that these constitutional constraints around the bank lending to the government meant that any lending by the bank to the government had to be approved by Parliament.

Lacker: So, buying government securities was sensitive for the Bank of England, and they just presumed that they would do it this way, but they didn't care who they lent to. This wasn't about alleviating credit constraints in any sector or anything. It was about increasing the note supply. So, it really ought to be called the monetary instrument supplier of last resort. That's a better phrase than lender of last resort.

Beckworth: So, Bagehot is kind of like the Bible for central bankers. It's kind of like Bagehot went up on Mount Sinai, got this from God, brought it down, and ever since, central bankers have been using it. What you're saying is that the modern translation of this central bank Bible is really a poor translation. We need to go back to the original text and see what Bagehot actually wrote.

Lacker: Yes.

Beckworth: Okay, so, that's the first doctrine, the monetary stability doctrine. Then, we get into the real bills doctrine, and that's pretty consequential for the Great Depression, right?

The Four Doctrines of Fed Lending: The Real Bills Doctrine

Lacker: Yes, it is. So, remember, they're under the gold standard, and the idea is that the Treasury sets the price of gold versus dollars, and instead of everyone using gold, paper notes are this way to do without all of that costly gold in the money supply, but you have to get the supply right. If you overexpand the money supply, you're going to cause inflation and you're going to go off the gold standard, right?

Beckworth: Yes.

Lacker: The price isn't going to line up. So, everyone wanted to know, how are we going to guide this beast? How are we going to decide on how much lending to do? And the doctrine that was hit on, and it actually goes back to the 1800s as well— We can talk about that if you want, but it's a digression— But the idea was that the Fed would bring about an appropriate money supply if it confined its lending to discounting short-term commercial paper that arose from real transactions in goods and services.

Lacker: So, trade credit— having to do with, a manufacturer makes something, he wants to sell it, he's not going to get his money for 90 days, he issues some paper, [and] it's endorsed by a bank. That's the basic idea, that it arises out of trade, and that was to distinguish it from loans to dealers on the stock market, so-called call loans, to finance inventories of stocks and bonds and things, which was viewed as speculative, inflationary finance. But the doctrine is a mess.

Lacker: If you go think about it carefully, it doesn't take long to realize, first of all, that you're tying the money supply to a nominal quantity, so if the price level goes up, both of them go up. Then, the second [is that] money's fungible. You can post one thing as collateral and use the money for something else. Then, third, one transaction can give rise to multiple instances of trade credit or commercial paper being issued. This was understood within the Fed in the '20s, but one wing of the Fed adhered to this [and] were really stuck on this, and they were in control in the early '30s. To their mind, they thought policy was really easy in '31 and '32, and it wasn't. Interest rates were 4% or 5%, at least, and the inflation rate was minus 9%.

Beckworth: Yes, so, the real rates were through the roof.

Lacker: Right. So, they didn't realize how tight policy was. They were taking misleading signals, and they were worried about speculation reemerging.

Beckworth: Now, to be fair to the advocates of the real bills doctrine, you can see why they might follow it, but ultimately, it's wrong. They think that they're tying the amount of money to the real economy, right?

Lacker: Right.

Beckworth: They think, "Okay, we don't want too much money to exceed the amount of goods," but, really, they weren't. They were tying it to a nominal quantity, as you mentioned, because commercial bills could fluctuate.

Lacker: Yes, it's crazy.

Beckworth: And I've heard some people say that the real bills doctrine was ultimately pro-cyclical, that during booms, you create more and more money, because-

Lacker: There's more activity.

Beckworth: But then, it also reinforces the downside, right? If there's less real activity— you're in a recession, less commercial bills— well, the Fed's not going to do anything because there's less real activity to go after.

Lacker: And it ignores the interest rate. That's the key thing. It ignores it. It doesn't give you any guidance on how to set the discount rate.

Beckworth: How consequential do you think the real bills doctrine was to the Great Depression versus, say, the gold standard or just getting other things wrong?

Lacker: Yes, that's a good question. I don't have a sharp, controversial view on that. I think that the money supply data that Friedman and Schwartz charted out so carefully— I think that's very compelling evidence that you have to put the monetary contraction at the center of things. Now, there's been scholarship about what happened to nominal wages and how they remained elevated while monetary— there's other pieces to the story, but I think that the monetary contraction has to be a big piece of it.

Beckworth: Yes, you’ve got to get your theory right or there are going to be big consequences. So, yes, for sure, it was a part of the story. Okay, so, we have the real bills doctrine. Now, when was that abandoned? Was it [during] the Great Depression?

Lacker: In the '40s.

Beckworth: Okay, we learned our lesson.

Lacker: Yes. Fed staffers were giving public statements sort of pooh-poohing it, and then the Fed actually, officially disavowed it in a letter to Congress in 1963. I guess some congressmen were still sniffing around about it.

Beckworth: Okay, so, they put their hands on the stove, so to speak, with real bills doctrine. They got burned pretty bad and were like, "Okay, we learned our lesson. Real bills doctrine is not a great way to go." Now, I noticed in your paper that you cite Richard Timberlake's book on that, so that's a really good--

Lacker: Yes, it's co-authored with Tom Humphrey, a former colleague of mine, the late Tom Humphrey. He was a history of thought guy. He came to the bank in the '70s, and he wrote the first of the modern wave of articles about lender of last resort in 1974, so it's like the [inaudible] paper that resuscitated Bagehot and said, "Here's what Bagehot said, translated for modern doctrine." He was great. He knew the British classical economists and the French backwards and forwards. We'd have FOMC briefings, and he would go back to Ricardo and tell us what Ricardo would do about a price shock.

Beckworth: That would have been a rich experience. I know Richard Timberlake from my days at the University of Georgia, because he went there, and George Selgin made me read his history book, which is really good, on the Federal Reserve.

Lacker: Yes, it is. It is really good.

Beckworth: Alright, so, that's the real bills doctrine. Let's move to the other doctrine you have that follows it, and that's Warburg's mercantilism. Explain that.

The Four Doctrines of Fed Lending: Warburg’s Mercantilism

Lacker: This is sort of a sideshow. Paul Warburg was a German financier, came to America. He worked on Wall Street in the 1900s, and he advocated the founding of the Federal Reserve or a central bank for the US, and the reason was [because] he wanted to move trade finance from Europe to the United States. At that time, if an exporter or importer in the United States was, say, buying something from Brazil or something, they issued trade credit. They issued a bill to finance it, but they issued it in London or Paris rather than in the United States. And so, he thought that this was an affront and wanted the business to move to New York. He argued that foreign central banks backstop their commercial paper market, and so we need a central bank to backstop our commercial paper market— essentially provide free insurance. So, it seems like mercantilism to me.

Beckworth: Well, I think it's the start of an important story. I've had Lev Menand on here before, and he has written extensively about the rise of the Eurodollar market in the '50s, and you mentioned this in your paper as well, [and] I think that same mindset is behind it. We want the dollar to be the dominant trade currency, and even Arthur Burns— some of the banks that he bailed out were tied to Eurodollars and commercial paper as well. All the way to the present, and I'm getting ahead of myself here, but a lot of these facilities that are set up during 2008-

Lacker: Commercial paper is really important.

Beckworth: -and then in 2020— the Fed did it because it wanted to preserve the global dollar system from collapsing, not just in the US, but overseas. So, I wondered, to some extent, if we unleashed a beast that we can't control, and there's a question I was going to save until the end, but I'll throw it out here. But to some extent, is the Fed pushed into a corner with these facilities now that the global dollar market is so big? I don't think it justifies the balance sheet getting as big as it has, but you can see why maybe they're reluctant to be more conservative, because if they don't, then the Eurodollar market crashes overseas.

Lacker: I think there's something to that. I think the Fed's relationship has always been avidly interested in money markets and their health and has intervened— Penn Central in 1970 with the commercial paper market was a big example. So, it's always been important to the Fed and how it views its mission. There's an element— this is an oxymoron, but it's financial-industrial policy. So, [it’s] industrial policy in the sense of placing a bet on attracting and retaining a certain industry, but it's the financial sector instead.

Beckworth: You can see that, even today, we call it financial statecraft. We use the global dollar system, not just to get cheap financing on our debt, which is great to pay off the bills we've got coming in, but also to put sanctions on terrorists and stuff. So, I wonder, to some extent, again, does the Fed have to do this in order to maintain this tool? And it is a form of mercantilism or industrial policy. It's a great analogy.

Lacker: I think it has a broader effect on just the Fed's perceptions of what markets are doing, and we can talk about that. It influences later stuff.

Beckworth: Okay, but this is great. I'm glad you brought up the Warburg mercantilism. I think it's part of this longer story that we're still seeing the repercussions [from] today. So, what is the time period where this is an important part of the story, then? What would you say?

Lacker: Mercantilism, well, the Warburg thing— he failed to bring these trade credit things over, but by the '50s, the effort had fallen flat, and they didn't really need to, because banks used reserves as their buffer stock. What Warburg was envisioning was a system where banks accumulated these trade credits, and they would buy and sell them in a liquid market in order to adjust their liquidity buffers. Instead, banks were using Treasury securities in the '50s. And so, I think the Fed realized that we don't really need to push hard on that string.

Beckworth: So, another part of the money market emerged that met the need. Alright, that brings us closer to the present. And of course, everyone's been waiting for this one: too-big-to-fail. I think you also use the term Reluctant Samaritan. Tell us about that.

The Four Doctrines of Fed Lending: Too-big-to-fail and the Reluctant Samaritan

Lacker: So, a lot has been written about too-big-to-fail. It's really a situation in which central banks feel compelled or do— we see them intervene to prevent large financial institutions from failing. On the flip side of that, there's an expectation out there that it would happen, and that influences behavior on the other side. And so, there's this moral hazard that goes along with it and an implied safety net, an implied extent of implicit backing for the financial sector. I had some economists look at this for 1999 and measure, what fraction of financial sector debt is either explicitly guaranteed by the government via deposit insurance or the pension benefit guarantee corporation, for example, or implicitly guaranteed because of the precedent set by too-big-to-fail bailouts in the late 20th century or official policy statements?

Lacker: The answer was 45%. Just a huge swath of the financial sector is running on an implied guarantee, and the extent to which that lowers borrowing costs is something that's gotten a lot of empirical investigation. Another obvious implication is that the kind of investments in a large financial firm that would induce Federal Reserve intervention to support and delay the closing of a large financial institution are short-term wholesale funding, uninsured claims. This tilts the playing field. If you look at a large financial institution’s capital structure, it tilts the playing field in favor of the kind of funding that makes them the most fragile. So, it sort of induces fragility, to some extent, and that kind of induced fragility is something that I think is underappreciated. People talk sometimes as if the fragility we sometimes see, which strikes some people as excessive, and you could debate how you should measure whether it's excessive or not, but some people view it as you take it for granted that it's inherent in the financial sector, but we haven't done that experiment. We haven't seen that.

Beckworth: It's a true counterfactual.

Lacker: Yes, exactly. We've seen a system that runs with— after the crisis, it was up to 60%, and we don't have a financial sector where we've been able to see what inherent fragility is like.

Beckworth: So, you're saying that the too-big-to-fail problem manifests itself in the funding structure of these big banks, and increasingly-

Lacker: Plausibly.

Beckworth: -it encourages them to rely on really-

Lacker: -Short-term.

Beckworth: -runnable liabilities as opposed to more stable deposits.

Lacker: Exactly. Right. So, this got started in the '60s. In 1951, the Federal Reserve Treasury Accord— that gave the Fed the ability to do monetary policy independently— It operated through open market operations. The discount window was a little nuisance on the side. Late in the day, some bank would, instead of an overdraft, get a discount window loan. So, its use dwindled and became just tangential to monetary policy. It became, I call it, a vestigial appendage. But then, in the mid-'60s, the FDIC, the Federal Deposit Insurance Corporation, and then later the Office of the Comptroller of the Currency, the regulator of national banks, started asking the Fed to lend to failing institutions in order to allow them to delay closing the institution while they looked around for a merger partner or found some other resolution to it. And the Fed lending had the effect of letting uninsured creditors get their money out. That practice started small. It got big in 1974 with Franklin National Bank. Then, it just went on from there. Continental Illinois in '84 was a famous case, and so on and so forth.

Beckworth: So, we are socializing the losses but privatizing the profits for those who are fortunate to have the profits.

Lacker: And the Fed never articulated its policy like, "No, we're not going to do this again," or, "Yes, we're always going to do this." They left it ambiguous. As a result, they go into each crisis, and they would like people to have believed that they wouldn't. It would be better for incentives if people think that they weren't going to get bailed out. But on the other hand, the calculus of political and other costs and benefits often leads them to intervene. Now, on that side, there's a fear that if there's turmoil as a result of a financial institution failure, they could be blamed for it. Regulators could be blamed for not preventing the losses or preventing the failure. On the other hand, they could be blamed for bailing out a big financial institution. So, the reluctance of the Reluctant Samaritan was because of this balancing act of these two opposing political risks for the Fed, but the reluctance seems to have gone away lately.

Beckworth: So, it's the Willing Samaritan. Okay, so, that takes us through these four doctrines— the monetary stability, the original doctrine, then real bills doctrine, then Warburg's mercantilism, and then the Reluctant Samaritan, or maybe it's the Willing Samaritan now with the rise of too-big-to-fail. You also call the Fed the sell-side savior. Would that fall in the same bucket or is it distinct?

Lacker: We came into the great financial crisis in 2007 with this too-big-to-fail, what I call the Reluctant Samaritan, [and] the practices that led up to that, but this shift occurred starting in '07. In August '07, under Ben Bernanke, the Fed made this aggressive set of initiatives to try and encourage banks to borrow from the discount window. It was widely publicized. The Fed cut the discount rate. It sent Don Kohn and Tim Geithner to talk to the clearinghouses, banking organizations to try and encourage them to not feel stigmatized borrowing at the window.

Lacker: They organized a group of four big banks, the four largest banks, to go borrow at the discount window to demonstrate that no stigma was involved, [and that they] shouldn't be ashamed of borrowing at the discount window, and it failed. Discount window borrowing did nothing, and it went up to $7 billion and then fell. Banks were borrowing at the Federal Home Loan Banks, and borrowing there went up by a couple hundred billion in the second half of 2007. The Federal Home Loan Banks— government-sponsored enterprises— their mission had changed over the years. They issued debt that was just paid a smidge over Treasury, so they were able to borrow very favorably, because being a creature of Congress, they were widely viewed as too-big-to-fail.

Lacker: They were collective of their members, so they were run by the member banks, effectively. That's their governance structure. And they lent on very flexible, all sorts of different terms. They were providing swaps and options and all sorts of stuff, structured financing. So, they were lending short-term and long-term to their members, and it was much cheaper than the Fed's discount window. So, there was a good reason that the Fed couldn't get the discount window out the door.

Lacker: But the key thing is that that was so visible. It had to have had strong incentive effects. Between August '07 and August '08, banks could have raised more capital. I cite the example in there of Lehman Brothers, that had an equity offering. They got $30 billion in subscriptions, people signing up to— they took $5 billion. They could have taken another $5 or $10 billion, and this is true all down the line. Banks were still paying dividends. They could have raised capital. The cost— it would have been costly to them, but in weighing the costs and the benefits, it just had to have been on their mind that the Fed seems pretty eager to support us, and we have this 40, 50-year history of too-big-to-fail. Let's take a risk and keep our capital thin.

Beckworth: So, there is this path dependency, this history that really is shaping the industry. So, let's move forward into solutions or ways to improve the system going forward. You've outlined your thoughts on this. Why don't you share it with the audience?

Solutions for Improving the System Moving Forward

Lacker: Sure. There's two core problems. One is just the doctrine that came in in '07, this appeal to the inherent fragility. I think we have to recognize that the support for that is pretty limited, and in the crisis, I was shocked that there wasn't more interest in that. There are models of financial sector and credit market behavior and outcomes, and in some of them, there's a role for government intervention. In some of them, there's a constructive role for central bank lending. In others, there isn't. It's a little delicate. You’ve got to check, do these assumptions apply or not?

Lacker: No one seemed interested in that. There was just a broad sense that markets were inherently fragile and intervention was warranted. I think we need to really put that under a microscope and test that and maybe back away from that premise for intervention. I think that the problem that got us here with too-big-to-fail was a commitment problem, the Samaritan's dilemma, and I think the way out of the commitment problem is in the Dodd-Frank Act.

Lacker: There's this provision about resolution planning, so-called living wills. Through that, the regulators of large financial institutions could preposition, prepackage how they would resolve an institution without providing the kind of subsidies and backstops that they generally do. They could require the banks to submit plans. They do require banks to submit plans for how they'd be resolved in the event of a failure, but they could require that those plans don't use any government resources, don't use FDIC lending, don't use discount window lending.

Beckworth: So, currently, they do include-?

Lacker: They do allow that. Yes, they do. What's happened is that that provision, which was envisioned as a way to help regulators stand tall and tough in a crisis and not bail out these institutions— Instead, it's been used as a way to make the FDIC's life easier in the event that they do have to rescue a large financial institution. But then, with Silicon Valley Bank in 2023, they don't use orderly liquidation authority. They just go in the way that they usually do.

Beckworth: Was that ever considered for Silicon Valley Bank?

Lacker: I don't know. That's a good question.

Beckworth: So, you mentioned 2023 [and there is] also 2020. On one hand, we see the Fed getting more involved in credit markets than ever before. So, they had the facility for bonds, even some state, municipal bonds.

Lacker: Yes, munis.

Beckworth: So, on one hand, you might say, "Wow, there is more credit engagement going on." So, at some level, Jeff, it seems like you're fighting an uphill battle. But on the other hand, no banks collapsed during 2020. Why do you think that is? Is it because there was such generous support from the federal government, from the Fed, to household incomes, so they were able to pay all of their bills, and banks never suffered? What is your sense of that?

Lacker: In 2020, the stimulus programs, the relief programs, put a lot of money in bank accounts, and most people left it there. They weren't going to spend it all. As the permanent income model of consumption tells you, they weren't going to spend it all right away. A lot of them just left it there. So, banks were flush from funding. But at a deeper level, coming out of 2008, the largest dozen or so banks were viewed as virtually public utilities, that there's no way they would let one go down after 2008. And so, they're in a stranglehold of regulation but viewed as equivalent to investing in T-bills.

Beckworth: So, the relative stability of these big banks during 2020 was, one, the generous support from the federal government, from the Fed, that indirectly benefited them. But also, [it was] some of the regulations that came out of Dodd-Frank and the way it was viewed as a public utility.

Lacker: Yes, the regulators react. So, take a step back and look at the sequence of the cycle that you can see in the too-big-to-fail era in the latter part of the 20th century. There's a crisis, there's an intervention in a particular institution. Then, coming out of that, they've set the precedent that that is going to get support. So, coming out of Continental Illinois in '84, for example, it was commercial bank liabilities for the largest 11 internationally active banks. So, let's say the largest dozen, but commercial banks. So, going into '07, the financial safety net, what was perceived to be implicitly guaranteed, just extended to banks, not to bank organizations, so, not to the holding company and other affiliates of the holding company in the bank.

Lacker: After '08, it was extended to the whole banking organization. It was the largest 12 banks, for sure. There was the SCAP program, which went down to, I think, 18 or 19 banks. So, those were treated as too-big-to-fail in 2009. And there was this program that, if they didn't have enough capital, we're going to measure their capital really rigorously. If they didn't have enough, [then] the Treasury would inject some. If they needed some, [then] the Treasury would give them time to raise it privately. If they could raise it privately, [then] the Treasury promised not to raise any more capital, not to inject any more capital, or dilute current shareholders.

Lacker: So, there was that group. But then, they left this open question. What about other large regionals? And it turns out that the ones that got into trouble in 2003, if you look at the scale, they were right below the size of the SCAP banks. They were at the bottom end of the range of SCAP banks. So, the story is one of an expanding financial safety net that leaves an ambiguous, fuzzy border, and leaves an open question about institutions just beyond that border. And so, there's always a crackdown. There's always a reaction that regulators and legislators too, sometimes, [to] try and prevent the emergence in the safety net of the risks that gave rise to the last problem.

Lacker: So, big banks don't do much mortgage lending anymore or do it very differently than they used to. But then, there's this pushing of risk out beyond the safety net because of the crackdowns in the safety net, and there's this risk beyond it where people aren't looking as closely. And I think that's the story of SVB and First Republic and all. They were ambiguous. It wasn't clear that they were big enough to qualify as too-big-to-fail given the precedence from 2009. And so, there was a run there. Now, we know that they're in the safety net, and this happens. Regulators just keep expanding the safety net when a problem emerges on the fringe, and so we get it bigger and bigger. Then, in 2020, it was really stunning to go into the corporate debt market and the muni market. Those were considered beyond the pale in '08, just beyond. There's like no way--

Beckworth: So, what's next, Jeff? What's the next beyond the pale that we will breach?

Lacker: I can't— I can't predict it.

Beckworth: Does the stock market become like the Bank of Japan?

Lacker: Who knows? I have no idea.

Beckworth: Okay, well, with that, our time is up. Our guest today has been Jeff Lacker. His paper is titled, *From the “Lender of Last Resort” to “Too-big-to-fail” to “Financial System Savior”: Federal Reserve Credit Policy and the Shadow Open Market Committee.* Be sure to check it out in the show notes. Jeff, thanks for coming on the program once again.

Lacker: My pleasure.