On Monday I wrote about central bank swap lines in the context of the Federal Reserve’s recent international actions. I suggested then that their expansions of central bank swap lines while fast and prudent, will not be anywhere near enough to stop the rest of the world from going into crisis as a result of the worldwide collapse in demand. Today I want to make a proposal for how the Federal Reserve actually can respond adequately to this crisis in their international monetary policy.
First, let's step back and look at the big picture. The problem, both domestically and internationally, is to compel certain economic entities to not cut payroll, others to send supplementary payments and thus prevent falls in aggregate income. The Federal Reserve’s conventional tool for doing this is lowering interest rates. We can debate on how effective this is to compel spending in different times and places (i.e. whether increasing debtors disposable income and compelling loan origination always far outweighs reducing creditors disposable income).
However, this debate is moot when the Federal Reserve can’t lower interest rates any further (setting aside negative interest rates) and there aren't economically advantageous ways of spending funds across industries, regardless of the interest rate. The Federal Reserve can lower spreads between private borrowing rates and the government “risk free” rate such as when it buys corporate bonds in the Primary and Secondary Corporate Credit Market Facilities, but that can only carry it so far. What it needs is entities willing to actively increase direct support spending and make supplementary payments as long as they’re backed by the federal reserve.
State and local governments are an obvious candidate locally as they are still government entities but constrained by their financial constraints. This is in essence federal reserve supported fiscal policy. However, who can the Fed look to internationally? As you may have predicted based on the title, I think the entity to engage in this kind of fiscal policy is the IMF.
Why the IMF? It is an existing multilateral institution at least partially controlled by poorer countries (though structured by wealthy countries). It has deep involvement with economic issues and the fiscal policies of nations. Most importantly, it has an international “money” it issues called Special Drawing Rights which in the past it has distributed to members based on their percentage share of IMF shares. In April 2009 they issued 183 billion SDRs which was equivalent to 287 billion dollars. Andres Arauz, Ecuador’s former minister of knowledge, has a proposal (along with David Adler) to do just that today. The issue with the proposal, at the scale necessary, is whether the IMF could handle attempts to redeem SDRs in dollars. If the SDRs can’t settle your dollar denominated obligations, we’re back to square one.
This is where the Federal Reserve can step in. by providing unlimited swap lines to the IMF, they can make sure SDR holders can always redeem SDRs for dollars and the dollar shortage can be permanently eased. This way every country can spend as necessary to respond to the Coronavirus health emergency without balance of payments related deaths stacking on top of those directly from illness. Ideally this program wouldn’t lean on the discretion of the Federal Reserve or the dollar, but taking away the power of the United States to decide who lives and dies globally is a project for another day.
Some may read this and say “this is all well and good but does the Federal Reserve have the legal authority to offer swap lines to the IMF or engage in purchases of SDRs?”. This is certainly an open question. However, swap lines themselves are subject to legal controversy. The Federal Reserve’s authority to engage in swap lines rests primarily on a legal memorandum issued by the Federal Reserve’s general counsel Howard Hackley in 1961. In fact, as Hackley plainly states it:
There is, of course, no provision of present law that specifically refers to foreign currency or foreign exchange operations by the Federal Reserve System : and, accordingly, it cannot be said that there is explicit and clear authority for such operations
Hackley’s memorandum constructs the legal authority to create swap lines from multiple separate authorities granted to the Federal Reserve by the Federal Reserve Act. Some of the legal issues he dealt with at the time are less relevant today (such as gold transactions) but two core issues remain.
- Authority to Open Foreign Accounts
- Authority to acquire Foreign Exchange
Authority to Open Foreign Accounts
Section 14(e) of the Federal Reserve Act plainly states that the Federal Reserve has the authority
“[t]o establish accounts with other Federal reserve banks for exchange purposes and, with the consent or upon the order and direction of the Board of Governors of the Federal Reserve System and under regulations to be prescribed by said board, to open and maintain accounts in foreign countries, appoint correspondents, and establish agencies in such countries”
There’s no reason why this authority couldn’t extend to opening and maintaining an account with the International Monetary Fund, If, since the IMF is headquartered in the United States, there were some problems with opening an account there, it could open an account in one of the IMF’s many foreign branches.
Authority to Acquire Foreign Exchange
The Federal Reserve’s capacity to acquire foreign exchange mainly came from section 14.1 of the Federal Reserve Act where its stated that:
[a]ny Federal reserve bank may, under rules and regulations prescribed by the Board of Governors of the Federal Reserve System, purchase and sell in the open market, at home or abroad, either from or to domestic or foreign banks, firms, corporations, or individuals, cable transfers
The term "cable transfers" itself suggests dealings in foreign exchange, since cable transfers are, of course, a medium through which the Reserve banks may acquire or dispose of holdings of foreign currency in the form of balances with foreign banks.
This means that cable transfers are a claim on foreign currency that are used to debit or credit balances with “foreign banks”. We will return to this point later on.
The key problem with using this to justify purchases of liabilities directly from central banks that issue them (that is, swap lines) is that kind of purchase can hardly be considered the “open market”. These legal issues were put to bed when the bolded phrase was inserted into section 14.1(b) by legislation in 1980:
“To buy and sell, at home or abroad, bonds and notes of the United States, bonds issued under the provisions of subsection (c) of section 4 of the Home Owners' Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States, including irrigation, drainage and reclamation districts, and obligations of, or fully guaranteed as to principal and interest by, a foreign government or agency thereof, such purchases to be made in accordance with rules and regulations prescribed by the Board of Governors of the Federal Reserve System”
If SDRs are seen as “fully guaranteed” obligations of the IMF and the IMF is considered a “foreign government or agency thereof”, then this section grants the authority for the Federal Reserve to purchase Special Drawing Rights. If it isn’t, there is one other way for the Fed to justify purchases of SDR: using the IMF’s own definition of SDRs. Per its website:
The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. SDRs can be exchanged for these currencies.
If U.S. law accepted these claims, then SDRs clearly could be considered cable transfers for currencies the IMF doesn’t issue. Thus, purchasing SDRs from the IMF would still be considered purchases on the open market of cable transfers. Finally, we’re not totally dead in the water if SDRs are considered cable transfers but can’t be purchased directly from the IMF. This is a problem Hackley had already considered explicitly:
If cable transfers purchased from the Treasury had previously been acquired by the Treasury from the International Monetary Fund solely for purpose of sale to the Federal Reserve bank, such a transaction might be criticized as a device for accomplishing directly what could not be accomplished' directly, i.e., direct acquisition of cable transfers by the Reserve bank from the IMF ; but, again, any such criticism would, in my opinion, relate to policy and not to legal validity.
Thus, the exchange stabilization fund could serve as a kind of “clearing bank” to run the swap lines through and thus still facilitate unlimited support
Thus, there are strong legal arguments to be made defending setting up swap lines with the International Monetary Fund to facilitate them engaging in a global fiscal policy program and easing balance of payments pressures. Such a program, combined with tightening crossborder financial transactions, could make adequately responding to this crisis possible around the world. U.S. policymakers are responding to this crisis with a “whatever it takes” mentality when it comes to U.S. citizens. It's critical that we bring that attitude to the rest of the world’s Coronavirus problems. As long as the U.S. has the dominant global currency and other countries don’t have the institutions to use fiscal policy to ameliorate the crisis to the degree that is warranted, it has a moral obligation to provide the currency it can create effortlessly. A swap line for the International Monetary Fund would accomplish that in an administratively simple way. It’s the right thing to do.