The Fed Can’t Make Pi
In 1897, the Indiana state legislature proposed a bill to assign a specific value to the mathematical constant pi. The Greek letter π, or “pi,” is often used to represent the ratio of a circle’s circumference to its diameter. According to historical accounts, the legislature debated proposals to set the legal definition of pi equal to 3.2 or a similar constant.
Pi is an irrational number that starts with 3.14159… with decimals that go on forever. It is often approximated as 3.14 for simple calculations, but more decimal places are used in fields such as physics, engineering, and architecture when more careful, complex calculations are required. One can only imagine the consequences of simplifying the value of pi to 3.2: bridges would collapse from buckled arches, engines would fail without perfectly rounded pistons, and artificial heart valves would be impossible to produce.
Congress recently asked the Federal Reserve to do the economic equivalent of setting pi equal to 3.2.
In the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Congress gave the Fed permission to provide “liquidity” loans to municipal governments and nonbank companies. The problem is that loans to municipal governments and nonbank companies are not “liquidity.”
The Fed provides liquidity to the economy in several ways. It influences the supply of money in the economy to meet the quantity demanded. It provides liquidity to financial markets by buying and selling securities. It supports liquidity in the banking system by regulating banks’ liquid asset holdings and lending to them directly when necessary.
Fed lending to nonbank entities, however, does not improve economic liquidity. When the Fed lends to a bank, the bank uses most of those funds by relending them to others such as businesses seeking to expand production capacity or individuals who want to buy homes. In contrast, municipalities and nonbank companies do not usually specialize in making loans. Thus, Fed lending to these entities does not generate liquidity for the broader economy.
The Fed operates as an independent agency, but Congress has placed restrictions on its liquidity provision authority. During the 2008 financial crisis, the Fed created a number of ad hocemergency lending programs, some of which went beyond its statutory authority granted in the Federal Reserve Act. To prevent such actions in the future, Congress amended the Federal Reserve Act in 2010 to require that emergency lending programs be only “for the purpose of providing liquidity to the financial system.”
Because Fed loans must be for the purpose of providing liquidity, the CARES Act designates that loans to nonbank companies and municipalities would be “for the purpose of providing liquidity to the financial system.” In other words, the CARES Act grants the Fed implicit permission to lend to nonbank companies, not by revising the Federal Reserve Act itself, but by redefining the term “liquidity” to be whatever Fed officials chose it to be.
As Lev Menand describes, “If lending directly to business is a way to provide liquidity to the financial system, then any lending meets the requirement and the words added in 2010 have no meaning.”
Like assigning a value of 3.2 for pi, the CARES Act attempts to redefine the term “liquidity” to something other than its actual definition. Such a change may be legally and politically convenient, but it would have negative consequences for the economy.
Fed lending to nonbanks distorts the allocation of credit in the economy. Former Fed Chairs Ben Bernanke and Janet Yellen have argued that the Fed should avoid lending to municipal governments and to nonbank companies. Such actions, they argue, are fiscal policies that raise the Fed’s political profile and threaten its independence.
The Fed, however, is not required to adopt this expanded definition of liquidity. The CARES Act grants the authority to lend to businesses and state and local governments. It does not require the Fed to engage in such actions. Fed officials could adhere to the economic definition of liquidity and curtail their lending to municipalities and nonbank companies.
Most of the Fed’s emergency lending programs are just getting started. While it is authorized to spend up to $2.3 trillion on these facilities, the Fed’s mostrecent accounts show a total balance of only $211 billion, less than one tenth of the total funding available. With only a fraction of the funds distributed, the Fed officials should end these lending facilities in order to maintain the Fed’s independence and limit the damage to the financial system.
The Indiana state legislature can’t make pi equal to 3.2. Likewise, the Fed can’t change the economic definition of liquidity, even if Congress wants it to. Changing the legal definition of liquidity does not change its economic definition. Pretending otherwise will lead to poor economic decisions that are likely to harm the US economy.
Changing the value of pi would be a disaster for physics, engineering, and architecture. Changing the definition of liquidity would be a disaster for the economy.
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