Most people care far more about the prices of things they purchase—food, housing, health care, and the like—than the price of gold. Not coincidentally, professional economists display a remarkably explicit consensus against forcing the central bank to adopt a policy that fixes the price of gold.

Yet, there are still powerful people who think that the United States would benefit if the central bank’s sole purpose were to restore a gold standard. With the nomination of gold standard advocate Judy Shelton to be a Governor of the Federal Reserve, we feel compelled to take these views seriously. So, here goes.

Several years ago, we emphasized that a gold standard is incredibly unstable. In this post, we address the mechanics of how the U.S. central bank would run the system. In our view, it is incumbent on any gold standard advocate to answer a series of practical questions: What gold price are they proposing? How much gold would the Federal Reserve have to acquire and hold to make the scheme credible? Will the Fed be able to lend to banks and operate as a lender of last resort?

Our answers highlight the operational challenges. Since the Fed initially would commit to holding a particular dollar value (that is, the product of price and quantity) of gold, we need to consider price and quantity together. With the smallest balance sheet we can imagine, our best guess is that the Fed initially would have to triple its gold holdings, driving the price of gold up by two thirds (to about $2,600 per ounce). Then, to maintain the gold standard, the Fed would still need to purchase one-third of world gold production each year. Without gold holdings over and above this minimum, the Fed would not be able to lend at all, much less without limit as it can under a pure fiat money standard….

Has P2P lending already hit the wall?

The two biggest U.S. P2P lenders, Prosper and Lending Club, started operations in 2005 and 2007, respectively. Over the past decade, their business has grown so that they now originate more than $10 billion in loans per year. The public information provided by Lending Club gives us an opportunity to judge how they are doing. At first, P2P lending returns appear remarkably high (adjusted for volatility), but growing evidence of adverse selection highlights how difficult it will be to sustain growth.

When we last wrote about P2P lending, we suggested that profitability might be a consequence of the booming economy (see here and here). We concluded that one would need to see performance in a recession before judging P2P’s long-run potential. That is, when you are making consumer loans, it is relatively easy to make money as the unemployment rate falls from 10% to 3.5%. However, profitability over the course of an entire business cycle, including periods when joblessness is rising, is an entirely different story.

Well, maybe there is no need to wait….

Foreign Exchange Trading: 2019 Edition

Every so often, new data provide us a glimpse of parts of the world that few people ever see. Last week, the BIS’s Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives Markets in 2019 provided just such a view. The headline is that average daily foreign exchange (FX) turnover, adjusted for double counting, is $6.6 trillion per day. That is, nearly 8% of global GDP changes hands in FX markets every day! (For a summary, you can listen here.)

Numbers of this magnitude raise a host of questions. In this post, we explore three: first, who is shifting such large volumes of currency around, and what motivates them? Second, history teaches us that disruptions in FX markets can destabilize the broader financial system: are there signs of emerging risks? Finally, what do we learn about the relative position of the U.S. dollar?

To anticipate our conclusions, the fraction of trading involving nonfinancial entities is relatively small, so the bulk of these transactions (like those in most financial markets) are between intermediaries. In addition, there are hints of growing systemic risk in the FX settlement system, so we need to remain attentive. Finally, no other currency is threatening the dominance of the U.S. dollar—at least, not yet….

Monitoring the Monitors

Disclosure is a fundamental pillar of our market-based financial system. When information is accurate and complete, asset prices can reflect both expected return and risk. Yet, having information is one thing; using it appropriately is something else entirely. To evaluate the relative merit of a large number of potential investments, most people (including us) rely on specialists to do the monitoring: Independent auditors vouch for the accuracy of financial statements. Credit rating agencies tell us about the riskiness of bonds. Various brokers and specialized firms rate equities. And, for mutual funds, there are several monitors, of which Morningstar is the most prominent.

But, when the specialists fail to do their jobs, disaster can strike. Examples abound: auditors failed in the case of Enron; equity analysts overvalued technology firms during the dotcom boom; and rating agencies’ inflated assessments of structured debt contributed substantially to the financial crisis of a decade ago (see here). So, there is cause for concern anytime we see evidence that key monitors are falling short.

This brings us to the recent work of Chen, Cohen and Gurun (CCG) on Morningstar’s classification of bond mutual funds. They argue that mutual fund managers are providing inaccurate reports, and that Morningstar is taking them at their word when better information from standard disclosures is readily available. In this post, we describe CCG’s forensic analysis, but we don’t need to postpone our conclusion: if we can’t trust the monitors, then markets will not function properly….

Monetary Policy Operations Redux

On September 17, the overnight Treasury repurchase agreement (repo) rate spiked to 6%—up from just 2.2% a week earlier and the highest level in more than 15 years (see DTCC GCF repo index). Oddly, this turmoil occurred at a time when the Fed had begun lowering its policy rate for the first time in more than a decade and market participants anticipated further policy easing ahead.

What led to this sudden disruption in short-term funding markets that been relatively calm in recent years? Had the Fed lost control? In our view, the explanation for the sudden rise in overnight interest rates is straightforward: the shrinkage of the Federal Reserve’s balance sheet that began in October 2017 reduced the aggregate supply of reserves gradually to where banks’ demand for reserves was insensitive to interest rates. Consequently, large temporary fluctuations in the supply of reserves that would have had virtually no impact even a few months ago, triggered sizable upward interest rate fluctuations.

Consistent with this view, the Federal Reserve recently took action to prevent a recurrence of the September disorder. At an unscheduled video conference meeting on October 11, the FOMC agreed to additional regular purchases of Treasury bills at least into the second quarter of 2020. The goal of this balance sheet expansion is to maintain reserve balances at least as high as their level in early-September before the turmoil began.

In the remainder of this post, we discuss the evolution of the supply and demand for reserves in recent years. We argue that, because no one—including the Fed—knew the precise level of reserves at which the demand curve would become inelastic, an episode like the one on September 17 was virtually inescapable as reserve supply declined. If our diagnosis of the cause is correct, then recent actions should help put the issue to rest. Yet, given the inevitability of the event―that the day would come when shrinking reserve supply hit the inelastic part of the reserve demand curve―the Fed could (and should) have been prepared. If so, it could have avoided even a temporary dent in its well-deserved reputation for operational prowess….

The Federal Home Loan Banks: Two Lessons in Regulatory Arbitrage

There is an important U.S. government-sponsored banking system that most people know nothing about. Created by an act of Congress in 1932, the Federal Home Loan Banks (FHLBs) issue bonds that investors perceive as having government backing, and then use the proceeds to make loans to their members: namely, 6,800 commercial banks, credit unions, insurance companies and savings associations. As the name suggests, the mission of the (currently 11) regional, cooperatively owned FHLBs is “to support mortgage lending and related community investment.” But, since the system was founded, its role as an intermediary has changed dramatically.

With assets of roughly $1 trillion, it turns out that the FHLBs—which operate mostly out of the public eye—have been an important source of regulatory arbitrage twice over the past decade. In the first episode—the 2007-09 financial crisis—they partly supplanted the role of the Federal Reserve as the lender of last resort. In the second, the FHLBs became intermediaries between a class of lenders (money market mutual funds) and borrowers (banks), following regulatory changes designed in part to alter the original relationship between these lenders and borrowers. The FHLBs’ new role creates an implicit federal guarantee that increases taxpayers’ risk of loss.

In this post, we highlight these episodes of regulatory arbitrage as unforeseen consequences of a complex financial system and regulatory framework, in combination with the malleability and opaqueness of the FHLB system.…

The Costs of Inefficient Regulation: The Volcker Rule

By creating a new regime to limit threats to the U.S. financial system—including heightened scrutiny for systemic intermediaries and a new resolution framework—the Dodd-Frank Act (DFA, passed in July 2010) has made the U.S. financial system notably safer. However, DFA also included burdensome regulations that, in our view, reduce efficiency while doing little to improve resilience. The leading example of such a provision is DFA section 619, known as the Volcker Rule. As Duffie noted before regulators began to implement the Rule (see the citation above), it is not “cost effective.”

Ultimately, the need to focus on this overly complex and relatively ineffective regulation distracts both the government authorities and private sector risk managers from tasks that really would make the system safer. Not only that, but cumbersome rules almost surely increase pressure to ease regulation more broadly. This leads policymakers to scale back on things like capital requirements and resolution plans that we truly need to ensure financial system resilience.

In this post, we briefly describe the Volcker Rule, highlighting its complexity, its tenuous links to risk management, and its apparent negative impact on the financial system….

Should Students Borrow?

As summer ends, 17 million students head to college. Nearly 40 percent are borrowing to do it. Over the past 15 years, the number of people with student loans nearly doubled and now stands at roughly 45 million―that’s about one in four adult Americans. Furthermore, the amount of debt has virtually tripled to just over $1.5 trillion, so the average loan is something like $35,000. Politicians, reporters, and researchers characterize this as a crisis. Is it?

Our answer is yes. While the majority of those with student loans are able to handle them, a large fraction cannot. Despite the strong labor market, nearly 7 million people, or more than 15 percent, are over 90 days late on payments or in outright default (see here). Since virtually all of this debt comes through federal programs, the government has created the problem. What should policymakers do about it?

Replacing LIBOR

Publication of LIBOR―the London Interbank Offered Rate―will likely cease at the end of 2021. This is the message U.K. Financial Conduct Authority (FCA) CEO Andrew Bailey sent in 2017 when he announced that, after 2021, the FCA would no longer compel reluctant banks to respond to the LIBOR survey. Given the small number of underlying LIBOR transactions, and the reputational and legal risks banks face when submitting survey responses based largely on their expert judgement, we expect that most banks will then happily retreat. In just over two years, then, the FCA could declare LIBOR rates “unrepresentative” of financial reality and it will vanish (see, for example, here).

Most financial experts know this. Yet, LIBOR remains by far the most important global benchmark interest rate, forming the basis for an estimated $400 trillion of contracts (as of mid-2018; see Schrimpf and Sushko), about one-half of which are denominated in U.S. dollars (as of end-2016; see Table 1 here). While the use of alternative reference rates is increasing rapidly, to beat the LIBOR-countdown clock, the pace will have to quicken substantially. In the United States, the outstanding notional value of derivatives linked to the alternative secured overnight reference rate (SOFR) jumped from less than $100 billion to more than $9 trillion in just the past year (see SIFMA primer). Yet, this amount still represents a small fraction of outstanding dollar-LIBOR-linked instruments.

In this post, we examine the U.S. dollar LIBOR transition process, highlighting both the substantial progress and the major obstacles that still lie ahead. The key goal of the transition is to ensure that the inevitable cessation of LIBOR does not trigger system-wide disruptions. Unfortunately, at this stage, count us among those that remain deeply concerned….

Just say no to exchange rate intervention

Whenever possible, policymakers should explore a broad set of options before responding to challenges they face. However, when the President and his advisers recently discussed foreign currency intervention, we hope everyone quickly concluded that it would be a profoundly bad idea.

Before we get started, it is important to explain what foreign currency intervention is and how it is done….

Commentary

Money, Banking, and Financial Markets