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FinRegRant Episode 3: The Unholy Trinity
Tom Hoenig, Eric Leeper, Brian Knight, and Veronique de Rugy Weigh in on Fiscal and Monetary Policy
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Brian Knight: [00:00:00] Welcome to the FinReg Rant, an audio blog product of the Financial Regulatory Team of the Mercatus Center. My name is Brian Knight, and I'm joined by some esteemed colleagues, Veronique de Rugy, Tom Hoenig, and Professor Eric Leeper of the University of Virginia, Wahoo Wah. And we're going to have a conversation about the, trinity of things that are possibly driving this country's finances into a ditch. So, a cheerful conversation. And I'll preface this by saying, I understand you guys had a really great phone call where this came up and you didn't invite me, and one day I will learn to forgive. But, I thought it was important to surface these issues because, as I understand it, It's not one problem that faces us, it isn't that our fiscal policy is bad, or our monetary policy is bad, or our financial regulatory policy is bad.
It's that they all interact with each other and [00:01:00] risk some sort of cascade of bad. And so with that cheerful note, Vera, let me turn it over to you and, get this conversation started.
Veronique de Rugy: Yeah. Thanks, Brian. Well, I guess I will just add that it's not just that there, there's an interaction between those three things, but it's also that they are treated all the time in the policy world as if they're completely separate.
So this is why I'm I've always, I was very interested in the work of Eric Lieber because he actually. Talks about the interaction between the fiscal and monetary, and I think that Eric you should tell us more about this, but then obviously, someone who's always thought about this.
Is Tom Hoenig, right, who is one of the rare kind of financial people who've actually thought about the interaction of the, those three things together. So I guess then I'll turn it to to Eric to tell us a little bit actually about the the interaction between fiscal and monetary and how.[00:02:00]
Is it that we are totally ignoring that interaction?
Eric Leeper: Well, I like to think about it as it takes two to tango, although I guess once we bring the financial policy into into the discussion it becomes a threesome doing the dance.
Veronique de Rugy: Well, this is 2023.
Eric Leeper: so. In terms of monetary policy and fiscal policy, What even the most basic economic theory tells us is that these policies have to be consistent with each other in the long run. And unfortunately, we have adopted policy institutions where monetary policy is made in a manner that is independent of fiscal policy.
And fiscal policy gets made in a manner that's independent of monetary policy. But unfortunately, the economy [00:03:00] doesn't cooperate with that separation. And that then creates the possibility that the two policies could be in conflict, not just in the short run, which is what does get some attention from policy makers, but also over the longer run.
So, Eric, and
Brian Knight: let me say for the audience, I'm the only lawyer at the table. We're dealing with three PhD economists, so you're going to have to, you're going to have to break this down. Talk to me like you would a small child. When you say the policy is in conflict, what does that mean? Like, in the real world, what are you describing?
Eric Leeper: Well, I think let's take the current policy as an example, and that might be the best way to illustrate it. we Have the Federal Reserve raising interest rates to combat an inflation that almost certainly was generated initially by fiscal policy. And the The 5 trillion of COVID spending that got financed entirely through new bond [00:04:00] issuances.
And what we have seen is that because interest rates have been going up, uh, interest payments on the government debt. Have been growing at an exponential rate. Yeah.
Veronique de Rugy: 40% now. The question 40, it's like 39% according to treasury from last year to this year alone.
Eric Leeper: Yeah. And the rate at which interest payments grows depends on the interest rate.
And because we were starting at a high level of debt, those interest payments are not only growing rapidly, but they're also starting at a high level. And so then the question becomes, well, will the Fed's raising of interest rates successfully bring inflation down? Well, that depends on how those interest payments are going to be financed.
So if Congress steps in and backs the monetary [00:05:00] policy, the tighter monetary policy, by tightening fiscal policy to pay for those interest payments, Then the Fed will succeed. But if what seems more likely, given the current situation Congress just finances those interest payments by selling still more bonds, by borrowing more, then it's unlikely that the Fed is going to succeed and inflation will just stay high.
So that's the sense in which I mean. They have to be consistent with each other. A tighter monetary policy needs to be followed by a belief that fiscal policy will be tighter eventually. And we have no reason at this point to hold those kinds of beliefs.
Thomas Hoenig: I agree with that, but I go back a little further in time and I think the Fed has been an enabler of fiscal policy, because as the government has spent [00:06:00] and borrowed to do so, the complement to that has been a very accommodative monetary policy where the Federal Reserve has bought these bonds.
Therefore, relieving the private sector of having to do so. That means putting downward pressure on interest rates during that period, which allowed this very expansionary fiscal policy to go unchecked for years, actually more than a decade, but particularly hard during the pandemic. And that allowed the fiscal spending to go on without any consequences in terms of higher interest rates or obvious crowding out of the private sector.
And now we're in that position where that led to the inflation that you could expect. And the Fed is now the one acting. The question will be, as the pressure builds as the Congress continues to spin and, or continues to have to print money to pay the debt, whether the Federal Reserve stands firm that it will not accommodate that, and interest rates have to go up, or whether it [00:07:00] will collapse in the face of the pressure it's going to see from both Congress and the public as these interest rates go and the Financing of the debt becomes more and more difficult.
So I think the Fed was negligent early on for not saying no and now they're paying the price and I think the U. S. economy will pay the price as well.
Veronique de Rugy: But do you think this is to do with the fact that there was a really strong belief that independently of the Fed's action, interest rates were always going to stay low and as a result, we could get a free lunch.
Thomas Hoenig: I think the Congress was willfully blind about that. It was very convenient to have the Fed there. Why would you disappoint them by not producing more debt and allow them to do their quantitative easing? And I think therein lies a fundamental problem where it served the [00:08:00] Congress's Interest, not to interfere with the Fed, and the Fed was willing to continue to print money even when they knew that the long run consequences, I think, would be adverse.
And we, I think we are going to pay a dear price for that.
Veronique de Rugy: What's interesting and what's interesting but also missing from this conversation is actually one of the things that the two of you have highlighted, and that's the interaction with the financial. sector, because these low interest rates and their belief that low interest rates were going to be lasting forever even though they were historically really an anomaly, right? has led a lot of financial decision on the parts of banks and other and corporate and corporations in terms of how. Indebted. They could they could be so
Thomas Hoenig: well, and I think that is part of the issue in terms of a misallocation of resources, enormous misallocation of resources [00:09:00] over the last decade, not just over the last three years because of zero interest rates.
You set up incentives around that. You set up a, an international as well as a national equilibrium, round zero. And the. The correction of that is extremely painful, and I think that's still lies ahead of us. Eric?
Eric Leeper: Yeah, I was gonna point out something that I think really buttresses the point that Tom made.
Partly because in Europe, in the euro area, this idea that low interest rates were good for fiscal policy was actually made very explicit. There was discussion about how the fact that the ECB had driven interest rates into negative territory gave Italy fiscal space. And and the IMF picked up on those kinds of discussions.
So there was, I think kind of dangerous discussion going on [00:10:00] about the ways in which monetary policy could behave in order to somehow make fiscal policy appear to be more sustainable. And what was missing from that discussion was exactly what Tom brought in. Two aspects of what Tom brought in. One was the resulting inflation.
And the second was that these low interest rates affected private sector behavior in serious ways. So just as governments were induced to become more indebted, So we're private sector entities, and now that's the situation that we face. So that's a really clear example where these three policies interact in a very intricate way, and that we need to be thinking about when we think about policies going forward.
Thomas Hoenig: And I think it's going to get more interesting on the financial [00:11:00] stability side, because one of the things that is occurring right now is the government is going to have to issue, auction off enormous amounts of more debt. I think it's 800 billion this quarter, 800 billion. And one of the issues around that is the so called binding effects of the leverage ratio.
So if the bank primary dealers are the ones who are going to be saddled with bringing onto their balance sheet the excess auction amounts the leverage ratio will impede that. And so now they're going to have this big discussion on eliminating the leverage ratio, which is a signal that we're crowding out the other side.
You have to make room for the government to... to put its debt on the bank's book. So, where is the capital going to come from for the private needs in this economy of ours?
Veronique de Rugy: So, primary lenders are are banks, effectively, right? That have a relationship with the Federal Reserve. Right.
Are they the same that, the Fed kind of puts reserve in? I mean, [00:12:00] can you explain this? Well, the largest banks... Because I've only been trained in fiscal policy. I,
Thomas Hoenig: Well, the largest banks are the primary dealers. So you do an auction, you expect the public to buy. But any of the unsold, if you will securities, the primary dealer puts on their books.
And so why, because they've agreed to because they're a primary dealer. Now they get, in, in normal times to get paid very well for that. Right. They get a little cut of everything and 800 billion is even in today's world, a lot of money. And so they signed up for that. So they have this agreement to basically And then they'll, they hope to re auction those, re sell those.
But in an environment when there's so much debt being auctioned, And so much coming, too.
Veronique de Rugy: And so much coming. Because I've heard that also, I mean, it's anecdotal, but I, I was talking with with Paul Winfrey, who is at Epic, and he was, we were, he was telling me that he was, It was talking to a lot of investors who were saying that they had no interest in actually buying government debt right now.
And the [00:13:00] primary reason was that they knew how much was coming between the extension of the tax cuts, which apparently they seem to think that it's a done deal, at least for that 90 percent of this is going to be. of the tax cuts are going to be extended. So there's, there are going to be more debt for this.
There's like, obviously, there's just a lot of the potentially, if they put as CBO projects, the entirety of the no benefit cuts for social security and Medicare, and they pay it with general revenue, that means. So there is, And we can see very clearly, right, that there's an enormous amount of, I mean, the federal government is going to have, Treasury is going to have to sell a ton of things.
And they're thinking in the current environment, we actually can see that interest rates could be much higher. So why buy it now when so much more is coming?
Thomas Hoenig: And you understand that one of the reasons for that is the Fed has said, we're not buying anymore. We're shrinking our balance sheet.
And there's more. They're [00:14:00] not in that market anymore. So that means the private sector has to fund all that. And if I'm sitting there saying, wait a minute I know there's a ton of new debt coming out. Why would I buy a longer term bond that's going to decline... in value as interest rates go up and lose money?
Veronique de Rugy: Especially inflation is not, we're not done. Oh, hardly. We're not done, so...
Eric Leeper: yeah, so to maybe put this in a broader context I think it's useful for thinking about these three, the interactions of these three policies. And I'd really like to hear Tom's reaction to this is when we think about the Fed as lender of last resort, lender of last resort is ultimately a fiscal action.
And so, because the Fed is taking on liabilities that are going to end up having to be covered by taxpayers. And and to me that's a [00:15:00] really graphic example of the sort of disconnect that we see in policy from the intricate connections that we see in economic behavior. Yeah. We don't even talk about.
The fiscal consequences of lender of last resort very much because we act as though, oh, well, that's just a Fed thing.
Veronique de Rugy: I mean, it's like the helicopter drop. I mean, it's because of you, Eric, that I realized that thing that I thought was purely, um, a monetary phenomenon was really effectively a fiscal.
Eric Leeper: Milton Friedman was a closet fiscalist.
Thomas Hoenig: And I will, a little bit of the context for that, though, is the idea of linear of last resort was When you have a liquidity squeeze, but you have a solvent institution, the Fed can re discount those assets temporarily for the [00:16:00] liquidity because you're still solvent. But what's happened over time, of course, is that it's become a mechanism to fund insolvent institutions.
That's the fiscal side of it. The Treasury says, well, we'll give 10 percent and you lend the rest. Well, it's actually they're putting 10 percent in and the Fed's putting the rest in as a fiscal action. And that's where you call it mission creep, call it whatever you want. That's where it's out of bounds.
And the effects are you become more dependent on it. So we have the great financial crisis and quantitative easing and bailed out banks and money markets. The last pandemic was we bailed out everything. Yeah. Municipal market, everything else. So that the fiscal role of the Fed has grown with its ability to print money.
Veronique de Rugy: Can I ask, I mean, so why do you guys think it is that We don't, whether it's like, even like, people in the think tank world often, or even in academia, but obviously in, in politics, don't think [00:17:00] about the interaction between the fiscal, the monetary, and the and the financial, even though, Obviously, we have a lot of examples of that, these interactions.
For instance, like the Silicon Valley Bank is a typical case of fiscal, of interaction, right, between these two. And maybe we can recap what these, what how that came about.
Thomas Hoenig: I don't think it's that they're oblivious to it. I think it's not in their interest to pay attention, to, to act on it.
It's not in Congress's interest to. apparently, since they want to get re elected and they think they can buy their re election, to constrain their fiscal impulses. And for the Fed, it is not necessarily in their interest, or certainly from mark, from the market's point of view, Wall Street's point of view, Zero interest rates seem to have done well.
We've done well by it. Why wouldn't we encourage it to continue to do that and put pressure on the Fed to keep interest rates low under the assumption that by keeping [00:18:00] them low you stimulate the economy rather than undermine the long run benefits that the economy can bring us all. And I think that's really part of it.
It's self interest primarily.
Eric Leeper: I would add that financial institutions love a policy that everyone is too big to fail.
Thomas Hoenig: Oh, yeah.
Eric Leeper: absolutely. They love low interest rates, right? So it's kind of, we've coordinated on a bad equilibrium.
Veronique de Rugy: Yeah, but isn't it really kind of short sighted and really kind of very risky?
Because if I'm a, if I'm a, let's say I'm a financial institution and I'm thinking I'm going to be bailed out, right? There should be a moment where I'm looking around and I'm thinking, how is it possible that all of these people are going to be able to be bailed out? Especially considering that if there is a need to bail all these places out, it's going to be at a time of emergency where no one's doing well.
Right? Like no, no one's doing well. There's not, there's like, even state and [00:19:00] local government will be like asking for money. There's everyone's, I mean, there's going to be debt everywhere. And I'm just thinking, I mean, it's one thing to be in favor of, too big to fail when it's just you.
Right? But the, if there are a lot of people around, you got to be that at some point you register that it's just simply not possible, and something's got to give.
Thomas Hoenig: I don't know if Eric wants to, I have a response.
Eric Leeper: I was just going to say that it's like a classic bank run problem. That the key there is to be the fastest one to the window. And maybe everyone believes that they'll be the fastest ones. They'll be the first ones there. But maybe Tom has a deeper answer…
Thomas Hoenig: No, that's a good answer. I would add to it that when you think about the issue around too big to fail and I'm going to be bailed out, it's not so much the institution [00:20:00] as the creditor of the institution.
Not the stockholder, but the creditor. The municipal, whatever it is, who, is lending to the bank, the depositors, certainly some of the long term debt holders, almost certainly, they are not looking at that institution as closely as they should be, and therefore, the institution does take on more risk under the circumstances of very low interest rates, and no one, there's no discipline there, there's no one saying, wait a minute, they're leveraged to the hill.
But they say, well, they're leverage of the hill, but I'm going to get my money because the Fed's going to step in or the Treasury's going to step in and bail me out. So they, so you don't get the tightening of the liquidity for the bank early enough. It's when the crisis comes that you have that happen.
Brian Knight: So I want to step in here and ask a question and I never thought I'd do this, but let me defend the banks here for a second. Okay. On the, at least on the financial policy side, aren't we, didn't we incentivize them to take bad risks by [00:21:00] treating, say, government debt, that, low interest government debt, as extremely safe for their, for their capital allocation purposes and all that. And isn't that what did in Silicon Valley Bank is that they held a lot of assets. These assets were considered sort of blue chip assets, but when interest rates go up 500 basis points in a year, turns out you can't and you need to sell your old low interest bonds.
You can't sell them for par. Because someone could go out and buy a brand new one that pays significantly more. And so, isn't that part of it? It's not just, I'm not saying there isn't rent seeking here. There obviously is. But like, isn't this also part of the problem is that we're in this feedback loop where the regulatory environment encourages risk, this type of risky behavior.
Thomas Hoenig: Brian, you're absolutely right. But there's two forms. One is... Monetary policy incentivizes that. I mean, you, zero interest rates, you're baiting the banks to take on this risk. [00:22:00] You the central bank is responsible for that, and yet there's no accountability. Number one. Number two, you're right, you, the risk weighted capital system is a capital allocation system.
It favors some over others, it favors government over loans, it favors securitized assets over commercial industrial loans. It's allocating credit. And it's doing it very inefficiently, and we end up with serious problems. The C the CDO market in the last crisis had very low risk weights on it.
Encouraged them to lever up in those, and so we pay a dear price for it. So, the policy maker is very responsible for repeated crisis. Not just this last one, but the one before it, and the one before that.
Eric Leeper: Yeah, and I think I would add that we don't want to lose sight of the fact that there's an awful lot of moral hazard here at work.
And I think one of the things that always drives me crazy about policymakers, when they're in the midst of a crisis and you say, Hey, if you do that, it's going to create moral hazard problems. [00:23:00] They, their policy is time consistent, but it's it's not optimal in in a commitment sense. So at the time, bailing somebody out always makes sense, but then that creates the expectation that it's going to happen again. And and I think Silicon Valley was a great example where all the depositors got bailed out. As far as I can tell, only for political reasons.
Veronique de Rugy: And by the way that still, I go back to my previous point while I understand there's a they're incentivized to behave this way.
I mean, you don't need to have like really long term memory to remember that, politicians are fickle and, like Lehman didn't get bailed out, so it was like one gets bailed out, the other one doesn't get bailed out. Why would anyone not actually think that this could be the same in an environment that has even [00:24:00] more debt?
It's even more overextended. Now, yeah, maybe you always believe that you'll be faster, you'll be the one that runs faster than when there's a bear than, your neighbor or whatever. But still, I mean, it's,
Brian Knight: well, I mean, I think what we saw in the case of Silicon Valley is like we were supposed to have erected this whole apparatus that bank bailouts were going to be a thing of the past and a handful of modest sized banks get into trouble.
And the government is invoking the systemic risk exception to all this stuff, and it's rolling out facilities to cover a quote unquote liquidity crunch, when the reality is that the assets just aren't worth what people thought they were, and that's a solvency problem. I mean, if you're a, it seems to me that if you're responding to sort of realpolitik, it does look like, yeah, we're going to bail, our policy is going to be to insulate as best as possible.
Thomas Hoenig: I think the Lehman is a good example though, [00:25:00] Earl, because, um, they bailed out, they got a lot of criticism for bailing, bailing out Bear Stearns. Yeah. So they came to Lehman, they were going to be tough. Yeah. And it fell apart, and guess what? Everything after that was 100 percent guaranteed bailout and the, in this last Silicon Valley, they confirmed that they didn't say, no, they didn't say, Roku, you're going to lose your deposit.
They said, here it is. We're ponying up for you. So it's only reconfirmed or confirmed the view that no one loses anymore. And so you're, the risk, the moral hazard risk that Eric's talking about is only growing every crisis.
Veronique de Rugy: Is there, is there a is there a I mean, is there a sense from you guys that someone is starting to think more about this interaction that exists between fiscal, monetary and financial?
I mean, fiscal and monetary, I never even... I didn't know it existed at all, I mean, [00:26:00] before, before I read Eric's work, and and then the financial stuff, I always thought of it as a byproduct of whatever, when things are going bad, it just, everything goes bad.
But is there, is... What is your sense on whether people are starting to think about it? And if they aren't, what do we do to kind of get people to think about it? Eric?
Eric Leeper: Well, I'll just talk from an academic perspective and maybe Tom can talk more about from the policy perspective. Academically, I think COVID has opened a lot of people's eyes to the monetary fiscal interactions.
Now, there's still an enormous amount of pushback that I get. But, I've been getting this pushback for 30 years from the profession. And I wasn't the first person to talk about monetary fiscal interactions. That, seriously predates my time on the planet. Now, [00:27:00] bringing all three together, there's essentially, I would say, almost no academic research that does that.
There's academic research that looks at pairs of them, um, and part of it is it's an extremely challenging thing to work on, and and we tend to go for the low hanging fruit. Now, It may be that the real world will force the hand of academics, but I wouldn't put money on that. They don't seem to want to...
The main reaction of academics when there's a crisis is to dig their trenches deeper, uh, rather than try to visit other trenches.
Thomas Hoenig: And I would, on a policy point of view, I don't think they're getting any attention at all, because look at the... Look at the last few days. So, Powell pretty much says, we're done raising rates, and that means the next discussion, and they're already out, [00:28:00] is when they're going to cut rates, when are they going to give up quantitative tightening, which is Anathema to what they need to be doing and the market's expecting them.
The market went up. How much? All expecting the Fed to fold. And so I don't think the policy world has caught on yet the fiscal and monetary policy and the fact that all this debt has to be funded and who's going to do it. Yeah.
Brian Knight: Well, so on that cheerful note, we're at time. Thank you all for a wonderful Intellectually stimulating and gosh darn depressing conversation.
And, I look forward to the research that you all are going to do to help get us out of this mess. So, thank you very much. This is Brian Knight at the Fin Reg Rant. Have a good one.
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