An Essay on the Fed and the U.S. Treasury: Lender of Last Resort and Fiscal Policy

My recent article, An Essay on The Fed and the U.S. Treasury: Lender of Last Resort and Fiscal Policy, in the Harvard Journal of Law and Public Policy explores the evolution of my thinking on risky emergency lending, focusing primarily on non-banks. Like the famous 19th century British economist Ricardo, who recognized his views on machinery had undergone considerable change, the same can be said for my views on lender of last resort.

The Federal Reserve (the “Fed”), in 2020 during the COVID-19 pandemic, established lending facilities with potentially significant credit risk, largely within the framework of Section 13(3) of the Federal Reserve Act. While it appeared to the public that these were independent Fed programs, in fact the lending to non-banks was controlled, and was largely determined, by the Treasury statutory approval power, required by the 2010 Dodd-Frank Act amendments to Section 13(3).

While I opposed this change at the time, and later in my book Connectedness and Contagion (M.I.T. 2016), out of concern that it would put an undesirable obstacle, perhaps politically motivated, in the way of an effective Fed response to a crisis, I have since changed my view. My article argues that Treasury control of lending to non-banks is usually a fiscal decision, due to credit risk, and should be made by the elected government, not by an independent agency. And it should be the Treasury’s role, as advised by the Fed, to determine when there is significant credit risk.

In the case of loans to non-financial institutions, as was done in the pandemic for corporations issuing public debt or for small and medium businesses, credit risk should be assumed per se. Otherwise, when determining whether loans pose significant credit risk, the relevant authorities should consider whether loans are adequately collateralized and whether the lending takes place in an economic turndown or crisis where there are serious questions about the ability of borrowers to repay.

If the Treasury determines there is significant credit risk, the Treasury should have full control of and responsibility for the lending decision. To allow the Treasury to serve this function, Congress should approve standing authority for the Treasury to engage in, or backstop, emergency lending. This authority could take the form of a standing emergency lending facility, funded with a fixed appropriation by Congress. Alternatively, it could take the form of congressional approval for the Treasury to guarantee loans made by the Fed, acting in its capacity as an agent of Treasury.

While the Fed may advise the Treasury on the design of a facility and serve as its operational agent to provide Treasury funds through the financial system, any such facilities should be identified as those of the Treasury. Unlike the current approval system, where it is unclear whether the Treasury and/or Fed is actually responsible for the design of facilities, it would be clear that the success or failure of the facilities lies with the elected government.

If the Treasury determines there is not significant credit risk, the Fed should make the lending decision without control or approval of the Treasury, as part of its normal role as liquidity supplier and lender of last resort.

When it comes to banks, the Fed should have more leeway. If the Fed determines loans to banks have significant credit risk, the Fed should be required to get Treasury approval, accompanied by an indemnity protecting the Fed against loss, resulting in the government taking on the credit risk. If the Fed determines that there is not significant credit risk, the Fed should have full control of the lending operation without the necessity of Treasury approval.

This approach requires new legislation. In the shorter term, there should be much fuller disclosure of the actual role of the Treasury in the design and operation of emergency lending facilities that are labelled as Fed facilities.

My proposal requires that the Treasury be responsible for risky lending. I reached this conclusion with a certain amount of regret. If I were to choose which party, as between Congress, the Treasury, and the Fed, would be most likely to adopt the best policies in an emergency, it would be the Fed because they are independent and expert. Indeed, that is why I was critical in my book of the restrictions, like the requirement for Treasury approval, imposed on the Fed by the Dodd-Frank Act. And there is a lot to complain about how the Treasury used its approval power during the pandemic, as my essay details.

But we do not have a government entrusting action to experts or philosopher kings. Nor should we.

The complete article is available for download here.