Public actors in private markets: toward a developmental finance state.

• Author: Hockett, Robert C.
• Position: Continuation of III. The Future Developmental Finance State: Extending the Role of Public Actors in Financial Markets through Conclusion, with footnotes, p. 140-176

1. Market-Making and Market-Moving: "OMO Plus "

   We start by discussing potential extensions of public actors' traditional market-making and market-moving functions. As noted earlier, the FRBNY's open market operations, or OMO, offer a classic example of the government actor making and, more importantly, moving the market for borrowed funds. (125) Generally, public instrumentalities seek to move market prices when both (1) the prices in question bear special systemic significance to the economy at large, and (2) certain market dysfunctions impair the ability of individual private actors to generate stable prices within the range that is considered publicly desirable. (126) In the context of OMO, the price being moved by the FRBNY--the prevailing money rental (i.e., "interest") rate--has critical economy-wide importance. Private actors are not able to keep that rate consistently and reliably within acceptable ranges, in large part due to recursive collective action problems known as credit-fueled asset price bubbles and busts. (127) Importantly, the FRBNY turns over all profits generated through OMO to the US Treasury. (128)

   However, there are at least two additional types of prices that are of critical significance for the national economy: (1) prices of financial assets (other than US Treasury securities) and (2) prevailing wage and salary rates (the price of labor). Keeping these two types of prices within a publicly desirable range can have an enormous macroeconomic effect, both in terms of smoothing boom-and-bust cycles and in terms of ensuring a more sustainable and socially inclusive pattern of national development. In this section, we try to envision an OMO-like market-making and market-moving regime targeting each of these two prices--financial asset prices and labor prices--and to draw broad principles that could potentially inform these approaches.

   1. Open Market Operations in Financial Assets: Why Not?

      Extending the FRBNY's existing OMO mandate to cover market-making in a wider variety of financial instruments seems a logical and operationally straightforward possibility. The FRBNY already runs a well-oiled Treasury bond-trading machine: the Federal Open Market Committee ("FOMC") periodically determines broad monetary-policy targets based on the macroeconomic data at its disposal, and the FRBNY staff devises and implements its trading strategy in line with these targets. (129) In the wake of the latest crisis, the FRBNY also began conducting OMO in certain mortgage-backed securities ("MBS"). (130) There seems to be no principled reason why the same FRBNY trading desk could not start purchasing and selling, pursuant to the same general principles, other financial instruments whose prices both significantly affect macroeconomic trends and are subject to dysfunctional, macroeconomically destabilizing cycle dynamics.

      What might these new Open Financial Asset Market Operations ("OFAMO") look like? In parallel to its existing Treasury bond-trading, the FRBNY would establish a separate trading portfolio replicating the market portfolio. In effect, this would be an index fund reflecting the proportional values of all financial asset classes constituting the financial market as a whole. (131) There is potentially a range of choices in constructing this portfolio. For example, it might be easier to start with making market in publicly-traded securities, in which case the prototype market portfolio could be a broad stock index, such as S&P 5000 or Wilshire 5000. However, this version of an OFAMO fund might leave systemically important asset classes out of the FRBNY's market-moving reach. Thus, it is preferable to seek to replicate the entire market portfolio as closely as possible. (132)

      Once the OFAMO fund is established, the FOMC will conduct its current daily tracking of the nation's financial markets not only pursuant to its macroprudential oversight mandate but also as part of its newly expanded market intervention mandate. If, for example, a particular asset class--such as MBS or technology stocks--rises in market value at rates suggestive of a bubble trend, the FOMC will instruct the FRBNY trading desk to short these securities, in order to put downward pressure on their prices. (133) Conversely, the FOMC will instruct the FRBNY to go long on particular asset classes when they appear to be artificially undervalued. The same process would apply with respect to broader market price fluctuations.

      In essence, the OFAMO mechanism would function as a market-actor alternative and a complement to the currently evolving role of the Federal Reserve as a macroprudential regulator. (134) There are important potential synergies between these two methods of bubble-and-bust preemption. The ongoing regulatory efforts to develop effective macroprudential risk metrics could be used to determine OFAMO trading strategy. By the same token, the market intelligence derived in the course of asset trading would inform the macroprudential regulators' choices.

      This point bears particular emphasis in light of objections that we anticipate to the effect that there is no way to distinguish between bona fide asset price changes rooted in underlying "fundamentals," on the one hand, and price changes that amount to "mere bubbles," on the other. (135)

      This familiar view, long associated with former Fed Chairman Alan Greenspan, used to prompt some to argue that central banks and other macroprudential regulators cannot effectively "lean," ex ante, against the "winds" that blow bubbles, but must instead aim to "clean," ex post, the mess left by bubbles after they have burst. (136) While many authorities on central banking and financial regulation argued forcefully against the Greenspan position even before the most recent financial crisis, the crisis itself seems to have finally settled debate in favor of the "leaners," whose view traces back to another distinguished past Chairman of the Federal Reserve, William McChesney Martin. (137) It is now widely recognized among financial theorists, central bankers, and other macroprudential regulators (including now Greenspan himself) that certain proxies for fundamental value--e.g., building costs in the case of housing, or price-to-equity ratios in the case of securities--can be used to identify potentially destabilizing, transitory price rises fueled mainly by excess credit availability. (138) It is likewise now widely understood that sudden growth in credit aggregates can serve as an important indicator of unsustainable, leverage-driven price rises of the kind associated with bubbles. (139)

      It should also be noted that the task of distinguishing "artificial" asset price inflation or deflation from "fundamental" appreciation or depreciation is not qualitatively more difficult than what the FOMC already does and has long done in charting monetary policy. The latter task, after all, requires regularly estimating "natural" potential growth paths for the "real" economy and then targeting "appropriate" monetary aggregates accordingly--i.e., ensuring that an "artificial" value (that of currency in terms of goods and services) is in sync with a "fundamental" one (that of the goods and services themselves). In sum, our proposed OF AMO should be seen as a straightforward extension, a complement, and a fine-tuning of what already is done and has long been done by the Federal Reserve.

   2. Open Market Operations in the Labor Market: What IJ?

      While extending OMO to modulate price swings in financial assets would be a natural extension of the Federal Reserve's current trading activities, applying the same logic of government action to modulating price swings in the national labor market raises very different, and potentially more difficult, operational issues. In contrast to financial instruments, one does not "buy and hold" or "sell" labor. Nevertheless, is it possible to imagine a system of functionally similar, macroeconomic stability-enhancing Open Labor Market Operations ("OLMO") operating much like more traditional OMO?

      In theory, OLMO could stabilize labor markets by operating with respect to wage and salary rates under the same principles as OMO currently does with respect to interest rates. The federal government--perhaps through the Department of Labor ("DOL")--could commit to acting as an "employer of last resort" ("ELR"), as proposed by several economists since the 1950s. (140) It would stand willing to hire, at or slightly below the current federal minimum wage, (141) anyone laid off from a private sector job during an economic recession. (142) As unemployment rates rose, the government would absorb excess labor, maintain consumer purchasing power, and thereby place a floor under the downward spiral. Once macroeconomic growth resumed, the government would shed labor through attrition as private-sector employers bid wages and benefits back up. (143)

      This type of ELR action resembles what we have called market-making activity. Just like a market-maker in securities, the government here offers wages at a "bid" price and "makes" a market for labor by standing ready to pay this price for qualifying labor. (144) In addition, an ELR program would serve as a market-moving device in at least two respects. First, the bid price would effectively function as a labor price target rate, similar to the inflation target currently used in OMO. Second, the ELR program could offer benefits and establish workplace safety standards that would effectively function as benchmarks economy-wide. (145)

      It must be acknowledged, however, that certain practical and administrative difficulties would have to be addressed before any such program could be feasible. First is the question of eligibility. To ensure that the ELR program is functioning as an automatic stabilizer, it would be important to admit into the program only people able to show that they have held jobs prior to the economic downturn, to which their...