Bank Regulation as Monetary Policy: Lessons from the Great Recession.

• Author: Hanke, Steve H.

For central bankers, financial institutions, and the public, these are extraordinary times. The measures undertaken by the world's premier central banks in recent years are as innovative as they are immense. Despite the attention attracted by these unusual interventions, however, economists and the public alike have struggled to understand the latest practices of monetary policy. Accordingly, the window is open for us to raise the most basic of questions: What has the stance of monetary policy been since the Great Recession?

The historically low interest rates that have prevailed across the developed world since 2008 would seem to furnish an immediate and incontrovertible answer. Rates remain close to zero in the United States and the United Kingdom, while Japan, the eurozone, and other European central banks have experimented with negative policy rates. The stance of monetary policy would appear to be very accommodative, and our question would seem impertinent if there were not several puzzles also accompanying these historically low interest rates. In the United States, Japan, and Europe, inflation has remained well below target levels, even after stripping away the impact of collapsing energy prices. Net investment has been anemic and so has growth.

The prevailing diagnosis of the current anomalous situation puts us in a liquidity trap. Central bankers have given the private sector every possible incentive to induce new investment and stimulate aggregate demand. Extraordinary monetary policy stimulus was helpful, on balance, but not nearly enough. We have tested and broken through the zero bound. Now only fiscal expansion can save us, so blank checks for public infrastructure spending are being readied. Even the anomaly has an obvious explanation and solution, or so it seems.

In this article, we depart from the consensus view by suggesting that growth rates of broad money are a better indication of the postcrisis stance of monetary policy in the United States than the federal funds rate. (1) Viewed from the perspective of broad money--we prefer the unweighted "M4 minus" (hereafter, M4--) aggregate compiled by the Center for Financial Stability (2)--the stance of monetary policy has been relatively tight since the beginning of the credit crisis. Postcrisis legislation and changes to the international bank regulatory regime are primarily responsible for reduced broad money growth. Their combined effect has been to establish bank regulation as the primary determinant of monetary conditions, as opposed to a regime of central bank dominance or fiscal dominance. The Federal Reserve has been able to partially offset the monetary effects of these regulatory changes through quantitative easing (QE). But an unintended consequence of QE has been to divert attention from obstacles to money creation by the banking system. The pattern of bank lending that may be expected to prevail without large-scale support from the Fed's balance sheet has serious implications for any QE exit strategy. (3)

We begin with a taxonomy of broad money and sources of broad money growth. In normal times, broad money expansion is a consequence of actions undertaken by the banking system and the nonbank private sector. An interest rate-targeting central bank generally takes these sources of money growth as given and adjusts the quantity of bank reserves to achieve interest rate outcomes. The flood of bank reserves created by QE has rendered this operating model obsolete (Hanke and Sekerke 2016).

We then go on to describe a series of key developments and regulatory changes that have driven the evolution of broad money since the Great Recession. Each of these developments has tended to reduce the ability of the banking system and the private sector to create money. Quantitative easing, conversely, has allowed the state to replace banks and the private sector as the driving force for broad money growth.

While an expanded Federal Reserve balance sheet has largely compensated the shrinking monetary balance sheets of the banking system and the nonbank private sector, it has created a new conundrum. Bringing QE to an end--without addressing the banking system's ability to create broad money--risks leaving the economy with a stagnating fund of purchasing power. Many bankable projects continue to remain unfunded, especially for smaller businesses and less-wealthy households, reinforcing existing declines in investment, business dynamism, and competition, among other adverse structural trends. A policy to address the economic and regulatory determinants of bank credit creation directly would thus be a linchpin of a successful QE exit strategy.

The Structure of Broad Money

Broad money encompasses the aggregate of purchasing power available within the economy. The aggregate captures all instruments that serve as a medium of exchange and store of value. Monetary instruments share the attribute of "information insensitivity" (Gorton and Metrick 2012), which means their values do not fluctuate away from par with changes in market information. Table 1 shows the composition of the Center for Financial Stability's monetary aggregates, from the narrowest (Ml) to the broadest (M4--) definitions. (4)

The components of broad money (we will focus on M4--) have different origins that determine how they grow. Government-issued money (state money) comprises coins, notes, and hank reserves. (5) Growth in state money is determined by fiscal decisions concerning deficit finance, as well as central bank actions that trade government debt for currency and reserves, base money for foreign reserves, or discount window-eligible collateral for reserves, among other transactions.

Bank money is created by the banking system when banks make loans. Upon credit approval, a borrower receives a deposit balance, created out of nothing more than a book entry by the bank to balance the new loan asset. The borrower thus obtains purchasing power in the form of a deposit. He is free to withdraw that purchasing power in the form of currency, but it is more often the case that the purchasing power remains within the banking system, transferred from bank to bank within the clearing system. Deposits thus circulate as money in their own right, and such transfers of deposits far exceed the volume of transactions in currency. In the United States, nonbanks transacted $203,424 billion dollars in 128 trillion bank-mediated payment transactions in 2014, the last year for which comprehensive data are available. (6) Accordingly, bank money and broad money aggregates are much better indices of purchasing power than the monetary base.

Money-like instruments may also be created outside the banking system by private actors. We term these instruments nonbank private money. Nonbank private money is the recirculation of existing balances as money in the capital markets, generally from the nonfinancial corporate sector. Its primary components are commercial paper and repurchase agreements, which may be held as money balances either directly or via prime money market mutual funds (MMMFs). Nonbank private money was especially notable as a counterpart to "shadow banking" activity in the run up to the credit crisis. Commercial paper, repo, and prime MMMFs were key short-term funding providers for securitization warehouses and dealer inventories.

Accordingly, we distinguish a three-way taxonomy of broad money, instead of the inside/outside money terminology introduced by Gurley and Shaw (1960). Nonbank private money is not easily lumped with money created inside the banking system. Though it originates outside the banking system, it isn't state money and thus it grows by a completely different set of rules. Table 2 shows the relative shares of the three components in the simple sum M4--index, as of certain key dates we will discuss further below.

The bank money/nonbank private money distinction corresponds, in a rough way, to the commercial bank/broker-dealer division present in most large bank holding companies. When securitization markets are active, the broker-dealer business is complementary to cretin creation through the commercial banking business. Loans created by the commercial bank side of the holding company can be purchased by the broker-dealer side using capital markets funding raised in a securitization transaction. Upon sale of the loan, the risk of the loan is cancelled for the commercial bank, but the credit created by the bank remains outstanding as money and continues to circulate within the banking system.

By allowing bank holding companies to transfer "banking book" credit risk to broker-dealer affiliates as "trading book" market risk via securitizations, the precrisis bank regulatory regime encouraged credit creation through bank lending. Rather than bank money, the money created appeared as nonbank...