Andrew Metrick: Thanks a lot for joining us today, Paul. We appreciate it. You’re a great citizen for us at Yale. I want to ask you some questions about what we’ve learned over this last year on your topics of expertise.
First, markets were overwhelmed by transaction flows as the COVID crisis began last spring. In response, some have called for the Federal Reserve to establish a broad repurchase facility to help finance the intermediation of such flows. Others have suggested a shift to central clearing of Treasury trades to ease market pressures in times of stress. What do you see as the best approach for avoiding such periods of market dysfunction in the future?
Paul Tucker: It’s good to join you, Andrew. Thanks for doing this. I think the first thing to say is how serious this was. Afterwards, I saw some American commentators describing the U.S. Treasury market as the most liquid capital market in the world. Well, that’s plainly an exaggeration. I would say it’s meant to be the most liquid capital market in the world. I think what we saw in March was really serious. I think to some extent it could have been anticipated.
I think the solutions are going to have to address a whole bunch of things. There are going to be problems in what economists call the market microstructure, and the ideas of a central clearing house are worth thinking about in that context, provided, and you won’t be surprised to hear me say this, the people are sure they know how to resolve the clearing house without taxpayer money, if it gets into trouble.
But I also think that even if the market microstructure problems are sorted, it won’t be enough because the other thing that became pretty evident in March is that loads of levered traders were out beyond where they could cope, beyond where they should have been. So, that’s a problem about intermediaries, and about a resuscitation of leverage in a world of easy monetary policy, and we’re going to have easy monetary policy for a while.
So, one of the points I really want to emphasize is this, that whereas in the autumn or the fall of 2008 Lehman failed, there was chaos and everyone realized there needed to be huge reform. It became a salient issue that got traction in the U.S. Congress, in the EU Council of Ministers and Parliament, and my own country’s Westminster Parliament. In March, in a way, the global financial system was bailed out before it had cracked. People like me, and I think probably people like you, think there needs to be some reform, but it didn’t feature in the election campaign, and it’s not featuring in popular debates on the other side of the Atlantic. I think that [Federal Reserve Board chair] Jay Powell and incoming Treasury Secretary Janet Yellen need to explain that things aren’t great in the world of finance.
Metrick: Continuing on this point of what happened in March, you’ve spoken in the past, and quite forcefully, about when we see the differences between a liquidity crisis and a solvency crisis, and how we tell that difference. Here, the Fed’s response in the spring took two forms that we saw in the global financial crisis: the provision of liquidity to a wide range of firms and markets, and large asset purchases.
In this case, the purchases weren’t really a QE2 so much as they were intended to ease market functioning. The Fed also established new credit programs to support access to credit, particularly by non-financial businesses.
Do you think those credit programs were appropriate? Why did the Fed need to go beyond the provision of liquidity in this case? What risks do you think these types of programs pose?
Tucker: There’s a lot built into that. Let me go back to the beginning. Central banks can do about half a dozen things. They can stimulate aggregate demand to ensure the economy’s on an even keel and inflation is kind of low and not very volatile. That’s plainly not what the asset purchases were about in March. I think it was a great mistake to call them quantitative easing and treat them as though they’re a monetary policy, because it raises the stakes for them being unwound, and in some jurisdictions actually changes the decision-making process.
The second thing you can do is that you can provide liquidity to markets, which is, I think, part of what they were doing in March and April. I call that market maker of last resort. I don’t think—one can never be sure, but I don’t think they needed to purchase as much as they did in March to stabilize markets.
Mario Draghi demonstrated that in some circumstances you don’t need to buy anything to bring liquidity back to markets. A long time ago, I was the UK debt manager, and I think that in both London and New York, that scale of purchases wasn’t needed to stabilize markets in the sense of restoring their liquidity.
Then there’s providing liquidity to financial intermediaries. Then there’s steering credit to different parts of the economy. Then there’s underpinning prices or values, or if you turn that ’round, holding down Treasury borrowing costs, which is a different kind of activity altogether. The reason I think this matters is because I care about democracy. I think it matters in that sense, but I also think, just as a former policymaker, it’s really helpful to be clear with the world what it is you’re trying to do, because that forces you to be clear with yourself what you’re trying to do.
So, with the credit facilities, I think they were trying to do two things. The emergency thing, which I completely support, was the economy is slowing down or closing down. We need to help the government get cash to households so that they stay under shelter, food on the table, and get cash to firms so that firms don’t collapse unnecessarily as the economy closes. I’ve just put it that way because those are plainly finance ministry functions, which I think it’s perfectly reasonable for the central bank to help finance in an emergency. But you might also expect, after the market emergency that’s passed, the finance ministry to stand on its own feet a bit more, issuing bonds into the market to pension funds, insurance companies, and others, which hasn’t really happened.
The other part of it is steering credit to different bits of the economy, to regions, to different kinds of business. One has to be very careful with this, how it’s targeted, and recognize that that’s political. And I’m not against it at all. I’m for what was done, but again, I’d like the politics of it to be a bit more upfront, because let’s face it, a lot of ETF people and funds and some private equity people effectively got bailed out by the Fed, and people therefore talked more and more about, this is a supercharged version of the Fed Put. It’s no longer a Greenspan Put or a Bernanke Put, or a Yellen Put. It’s now the Fed Put, and it’s everything.
To the extent that that’s true—of course, I’ve just exaggerated, but to the extent that there’s something in it, it’s expedient in the short run, but costly in the long run because capitalism can’t function on the basis that people in the market have a one-way risk. But it suits the politicians to stand back and let the central bank become the government. You know, if I wanted to be hyperbolic about it, I’d say one of the gravest challenges to the United States is, do you now have government by the Supreme Court and the Federal Reserve? Because actually, it suits Congress, the elected people, to sit on their hands.
I don’t think these are kind of highfalutin things that are for the seminar room. I think they’re big things about who we expect to make choices in our economies. I don’t expect Jay Powell, or when I was in office, Mervyn King and I, to decide we’re going to support this region. We’re going to let another type of company fail. So, again, I support broadly what was done. I feel uncomfortable about the politics of it.
Metrick: These are important themes that you’ve discussed before, and we see that they are in fact timeless, so they come back and they came back with a vengeance in this particular one.
I’m going to ask you now to critique the Fed, and specifically where their most recent stance—or agree, agree or critique—which is that the recent policy is very accommodating, including the September forward guidance calling for inflation to overshoot its 2% objective for a time, and continuation of the very large asset purchase program. Some have suggested these policies could lead investors to reach for yield by purchasing riskier assets and taking on greater leverage. To address that possible moral hazard, should the accommodative monetary policy have been coupled with supervisory measures to limit leverage and risk-taking in trading markets?
Tucker: “Yes” is the bottom line, but let me work up to that. With fiscal policy not set at zero, but set pretty weakly over most of the last 10 years, and given its mandate and function, the Federal Reserve, Bank of England, and ECB haven’t had many choices but to do everything they can to ease financial conditions and try to restore a decent rate of economic growth. In a sense, this is the strategic game that we were talking about a moment ago. I don’t think, by the way, that the rejigging of the Federal Reserve’s regime into a form of price-level targeting is going to make much difference. It might make a bit of difference, but I don’t think it will make much difference. I think the big issue is, what are the instruments to be used?
But that’s not what you asked about. They and their peers elsewhere could have done something to ease the pressure building in financial markets. This is not said with hindsight. In the jargon they could have raised initial margin requirements in certain parts of the capital markets. They could have raised haircuts on certain other parts of the capital markets, repo trades and securities trades. They could have done that partly using their regulatory powers, including powers they were given in the 1930s and they’ve never used. And they could have done that as well through the terms they’ve set on access to the discount window, their own haircuts. But if you take away the jargon, what are these things, these collateral requirements? They’re the inverse of a leverage cap for a trade-up.
When I was in office, I was once in a meeting between the Financial Stability Board, the G20 thing, and a bunch of top Wall Street people, and people from the City as well. They were arguing—I was slightly late for the meeting and someone was arguing for zero initial margin requirements. My side of the table was quiet, and I interrupted, actually. I said, “Could you just remind me what a zero initial margin requirement is in terms of leverage?” Of course, it’s infinite. They were kind of slightly embarrassed, it turned out, to be pushing for that idea.
I think that over the past five, six, seven, or eight years there hasn’t been sufficient focus on the incentives to shift activity outside of the re-regulated banks into the traded markets. That can be a very good thing. I’m a huge supporter of capital markets, but then to build your own bank in the capital markets with liquidity mismatches, and in particular with excess leverage—I think that’s what we saw blow up in March on both sides of the Atlantic.
I do think that something could have been done about this. I once had a conversation with a former Fed boss many years ago about why they never used their margin requirement tool. And they said, well, they’d done studies in the ’70s or something, that they kind of wouldn’t work. I said, “Yeah, well, that’s about the equity markets. You’re not restricted to the equity markets. This may be non-linear. It might work if you set the minimum requirements higher.”
The argument I’m making here is that there’s finance going on here and also political economy; in a world where the fiscal policymaker won’t act and relies on the monetary policymaker to do everything, but the monetary policymaker almost inevitably stimulates froth in financial markets, as well as spending in the economy, then there is some good in raising collateral requirements in financial markets.
And that would in turn probably get people on Wall Street and around Wall Street to say to Congress, “Maybe you should be using more fiscal policy and a little bit less of the Federal Reserve. We’d like lower haircuts and more public spending, or lower taxes or something.” I think they’ve missed a trick on this. This isn’t with hindsight, and I think it’s a great shame and it’s a great pity that no one has tried this.
“We’re awaiting our Paul Volcker moment. The moment where finally a Fed leader…says, ‘I am going to break the back of this excess leverage psychology which grips our financial markets.’”
It’s something I hope will resonate with you, Andrew, and the people that are listening here. On this financial stability stuff, we’re awaiting our Paul Volcker moment. The moment where there is finally a Fed leader, or a Bank of England leader, or ECB leader that says, “I am going to break the back of this excess leverage psychology which grips our financial markets.”
Metrick: I look forward to sharing with you some of the work I’m doing with [former Federal Reserve Board member] Dan Tarullo now on exactly this topic. I think you’ll find we’re in complete agreement. Dan wanted to use some of those margining powers in his role at the Fed. He, and I know you were part of it too, had conversations with the FSB on how to put some of these things into place. In the United States, extra complication is while the Fed has some of those powers, the SEC has others of them.
Metrick: And we need to somehow make sure that they’re coordinated, which has got its own political economy.
Tucker: There’s a kind of design problem here, but I think it goes deeper than that because the Bank of England, I’m pretty sure, has those powers, because I’m kind of one of the key architects of the powers that they have, and they didn’t do it either.
I slightly feel that this is like the 1970s, in the monetary field, where people haven’t quite got their head either around the economics or around what their powers are, what actually they could do, and that the world doesn’t end, thinking back to the ’70s, if you raise interest rates to lean against inflation. I don’t think the world would end if we raised collateral requirements sometimes to constrain leverage in the capital markets.
Metrick: So, I think maybe you’ve answered my next question, which is the right way to be handling these financial stability risks is through those types of macroprudential tools. But there’s also another view. And indeed, in the framework review that the Fed just had, they indicated they could adjust monetary policy in response to concerns about financial stability risks.
I think you’ve already talked a bit about this. [Former Federal Reserve Board member] Jeremy Stein used to say, “Monetary policy gets into all the cracks, and thus, we should perhaps use it for a lot of these different things.” What’s your view? Should monetary policy be used to deal with financial stability risks in addition to the standard monetary policy stuff?
Tucker: Two things. First of all, on Jeremy’s thing, he’s a great friend of mine, and I’m also a great admirer of his. I don’t think this is the wisest thing he’s ever said, which is only worth mentioning for how often it’s repeated. I don’t actually think it’s true in a world of cross-border finance. If exchange rates adjusted absolutely perfectly to relative changes in interest rates, then it would be true, but I don’t think it is true. It may be true for the United States that monetary policy will get into all of the cracks that affect credit conditions in the United States. But I don’t think it’s true for other countries because people would just borrow from the neighboring country in a different currency.
But even if Jeremy’s right, I don’t think that’s the way to go. I think financial stability tools, including dynamic margining requirements, should be tried first. There’s a higher-level point here about policymaking, which is that we shouldn’t overload monetary policy with lots of different objectives until we have convinced ourselves, not just in the classroom but in the real world, that the other tools that we have do not or cannot work in the real world.
I think the grownup thing to do is to leave monetary policy focused on stabilizing aggregate demand, and most of all, anchoring medium- to long-term inflation expectations, and then seeing whether we’ve got tools to do these other things.
I think we have. I might be proved wrong. And then, yes, someone like me would say, “OK, well then, maybe we need to retreat to using monetary policy to do it.” But to automatically conclude that monetary policy is the right tool to use when you haven’t tried these other things is, I think mistaken. I think in this respect—and this is going to sound rather harsh—I thought that in this respect, I thought that part of the Fed review is a pretty poor piece of work because it doesn’t get into, well, are there other options?
This is partly an institutional dynamic. There are dynamics that push everything to being done in the FOMC [Federal Open Market Committee]. Look at the number of regional presidents that talk about financial stability and regulatory policy, some of them very intelligently. They have not got powers delegated by Congress. They have not. Maybe they should have, but they haven’t. The FOMC does much of, or even all of, monetary policy. The Fed Board needs to stand up, and we need to be much more conscious of it as a macroprudential body.
Metrick: Now, the Bank of England, of course, is a very different design. So, I wondered there, given the way that they’re set up now with various committees in the UK, how would you recommend this problem be solved there?
Tucker: I think, if a body in the UK was to dynamically vary minimum margin requirements or haircut requirements or something else, that would be a job for the Financial Policy Committee. I think it’s a pity that they didn’t do so. Because they had similar problems in their government bond market to New York’s problems and the Treasury bond market. London, too, seems to have permitted excess leverage to build up again, outside in the penumbra of the banking system, and they seem not to have used the tools that they have. They haven’t been slow on other things. They did various things to try and cool the housing market, more than I actually think they probably needed to do.
So I think this goes back to maybe in London, we’re not in the 1970s, but we’re still in the 1980s or the equivalent of monetary policy. Well, you’ve got an institution, you’ve got some instruments. Use them, but build a case for using them, and explain how you use them; do the research, take it to your parliamentary testimony.
“I don’t yet see a willingness to really try to preserve financial stability, even after the last crisis.”
So I don’t yet see—not just the point about the Bank of England and the Fed—I don’t yet see a willingness to really try to preserve financial stability, even after the last crisis. We hear too much about, “Well, we’ve improved the resilience of the banks.” Since I am one of the people, among plenty of others, who can take credit for that, I think it’s important for people like me, and Dan, [former governor of the Bank of England] Mervyn King, and others to say, “Well, that can’t be the end of it. That’s not enough.”
Metrick: Well, thanks very much, Paul. This was great as usual. It’s wonderful that you come back to talk to our students and to all of our other stakeholders here at Yale, and to share these interesting thoughts. We’re looking forward to the next book.
Tucker: Thanks, Andrew. It’s great to talk to you, and you do a wonderful job in Yale. It’s really important for the world that you have this center focused on financial stability and looking at it properly.
Metrick: Thank you, Paul. Have a good day.
Tucker: See you. Take care.