Does the Fed Have the Legal Authority to Buy Equities?

Here is guest post I wrote on the Fed’s open-market operations authority for Confessions of a Supply-Side Liberal, a blog on financial economics (and other subjects) run by University of Michigan economist Miles Kimball:

Greg Shill: Does the Fed Have the Legal Authority to Buy Equities?

This is the second guest post by Greg Shill, a lawyer and fellow at NYU School of Law, on the legal scope of the Fed’s powers in the area of unconventional monetary policy.  His work focuses on financial regulation, corporate law, contracts, and cross-border transactions and disputes, and his most recent article, “Boilerplate Shock: Sovereign Debt Contracts as Incubators of Systemic Risk,” examines the role of financial contracts in the Eurozone sovereign debt crisis. (His first guest post was “So What Are the Federal Reserve’s Legal Constraints, Anyway?”)

As a longtime follower of Miles’ work, it’s an honor and privilege to write for his blog and to put my ideas in front of his diverse and sophisticated audience.  So, thank you, Miles, and your devoted readers.

I.

For the past several years, the Federal Reserve has used many levers to stabilize and stimulate the economy.  One of its most controversial has been the use of so-called unconventional monetary policy, chiefly three rounds ofquantitative easing (or QE, beautifully explained in this clip) from 2008 to 2014. Although the wisdom of these policies has been widely debated, the Fed’s legal range of action largely has not.  In fact, as I have notedpreviously, policymakers and observers have been remarkably quiet about the scope of the Fed’s legal authority to conduct unconventional policy, and when they do describe it they often offer timid visions of the Fed’s powers.

Economists and other observers have often urged the Fed to do more to juice a recovery that was, until recently, broadly disappointing.  These proposals have included not only calls to cut interest rates and launch quantitative easing in the first place (both of which the Fed did), but to target higher inflation, introduce electronic money, conduct direct monetary transfers to the public, extend QE beyond its wind-down in October 2014, and expand the range of assets eligible for purchase under QE.  The Fed of course did none of those more ambitious things, and today, with QE finished and policy normalizing, defining the legal limits on the Fed’s monetary policy arsenal may feel less urgent.  Yet it is a startlingly important question to leave open, given persistent overall weakness in the global economy today combined with the strong likelihood that the Fed will need to consider aggressive and creative measures in the future.

The general question is: in a future recession or crisis, does the Fed have the tools it needs to go beyond what it’s done in the past?  This is one of the most important open legal questions in public policy today…

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So What Are the Federal Reserve’s Legal Constraints, Anyway?

Many in the Federal Reserve—both the Board of Governors in DC and the reserve banks around the country—have come to view low inflation as the main threat to the economic recovery. Fed Chair Janet Yellen is the most prominent advocate of this view, and Chicago Fed chief Charles Evans is among its more prominent reserve bank proponents (see this interview yesterday with the New York Times). The Bank of Japan and the European Central Bank are now laser-focused on the same problem. Those institutions, along with Japanese Prime Minister Shinzo Abe, have staked their reputation on the power of monetary policy to stimulate economic growth, and there are growing calls in and outside the Fed for the US central bank to do more.

Federal Reserve Board of Governors

The basic problem everyone is trying to address is that with inflation expectations low—and they have been very low since 2008—firms and individuals have little incentive to invest or take other economic risks, which means the virtuous cycle of spending and hiring leading to more spending and hiring hasn’t really had the opportunity to get going.

The Fed has sought to address this collective action problem through something called unconventional monetary policy. This has come to mean the use of unusual monetary measures to stimulate demand. The scope of this authority is unclear. I will soon be writing more about it here and at Miles Kimball’s blog, Confessions of a Supply-Side Liberal. Miles, an economist at the University of Michigan, has written extensively on how to combat the so-called Zero Lower Bound problem. This is shorthand for when the economy is stuck in a rut for an extended period and the Fed’s conventional policy channels for increasing demand are gummed up: it can’t stimulate lending by reducing interest rates (because it has already cut them to near-zero) and it can’t juice inflation by expanding the money supply (because people aren’t spending the money in the first place, so merely increasing the supply doesn’t devalue it).

The general question I’ll be looking at is, how far can the Fed lawfully go in unconventional policy beyond what it’s already done. The Fed’s most prominent use of unconventional policy post-crisis took the form of the three consecutive rounds of “quantitative easing,” during which the bank bought US government bonds and government-backed asset-backed securities (Fannie and Freddie mortgage-backed securities (“agency MBS”)). Many economists believe quantitative easing served as a major stimulus to the economy and was particularly helpful given the inadequacy of the 2008 and 2009 fiscal stimulus measures. However, many “dovish” economists and Fed officials (seemingly including Yellen and Evans) want the bank do more.

When I began to look at the legal dimension of monetary policy—after all, that policy is conducted pursuant to a legal mandate—I was surprised to find very little in the way of scholarship or (publicly available) policy guidance…

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The Undead Norm of Unenforceability in Sovereign Debt

True story: two years ago, U.S. hedge fund NML Capital seized an Argentine navy vessel in Ghana. NML recently won an important series of rulings in US courts on defaulted sovereign bonds issued by the Latin American nation.

True story: two years ago, U.S. hedge fund NML Capital seized an Argentine navy vessel in Ghana. NML recently won an important series of rulings in US courts on defaulted sovereign bonds issued by the Latin American nation.

As the Argentina sovereign debt litigation hurtles towards its thrilling conclusion (or at least a new phase), I’ve sketched this proposal for a new paper and welcome any thoughts:

The Undead Norm of Unenforceability in Sovereign Debt

Historically, sovereigns have repaid their debts not because they feared court orders if they didn’t but to preserve their good name in global capital markets. Courts played along, tolerating transgressions of their enforcement authority even beyond what sovereign immunity would require. This dance has allowed courts to lend their expressive support to the fiction of enforceability while avoiding the downsides—for courts and markets—that aggressive attempts at enforcement against foreign sovereigns would bring. However, in NML v. Argentina, the latest round of litigation over Argentina’s 2001 default, the SDNY signaled a shift: it issued an unprecedented injunction prohibiting the world payments network from processing Argentina’s bond payments unless the sovereign also tendered payment in full to a group of holdout creditors. This ultimately pushed Argentina into default in July 2014, prompting some legal scholars and the financial press to declare that the episode would seriously impair future efforts to restructure sovereign debt.

In The Undead Norm of Unenforceability in Sovereign Debt, I intend to argue that the NML decision (which was upheld on appeal) is poised to close the gap between the rhetoric of obligation and the reality of enforcement, but only temporarily, and that the systemic effects many fear are unlikely to materialize. NML provides a clear example of some of the dangers I write about in Boilerplate Shock: Sovereign Debt Contracts as Incubators of Systemic Risk: standard terms in private, foreign-law contracts—in this case, a provision known as the pari passu clause—are driving macroeconomic events to a degree that no one anticipated.

However, the magnitude of the harm here will probably be contained. The near-term systemic impact has not been (and was unlikely to be) great in part because, unlike Greece (whose bonds I use as an example in Boilerplate Shock), Argentina is not a member of a monetary union. On a longer horizon, the effects seem even likelier to dissipate. Argentina’s contract-driven default is just the type of salient event that will prod the market to update boilerplate terms, in this case probably by restricting the reach of pari passu in future bond issues and perhaps in existing ones (by adding Collective Action Clauses, for example, which virtually eliminate the holdout problem). This should allow restructurings to continue on the flexible, ad hoc basis on which they currently occur—which is to say, without excessive judicial interference at the enforcement stage. Far from demonstrating that the norm of unenforceable sovereign debt is dead, this episode suggests it can’t be killed.

For this article, I’ll be standing on the shoulders of a rich literature on the Argentina dispute and drawing on research I’ve done at the intersection of commercial law, private international law, and financial regulation. In Boilerplate Shock, for example, I argue that currency and governing law clauses in Eurozone sovereign bonds are magnifying systemic risk in ways no one imagined when they selected those contract terms. In Ending Judgment Arbitrage: Jurisdictional Competition and the Enforcement of Foreign Money Judgments in the United States, I argue that fragmentation in the U.S. judgment enforcement regime post-Erie renders that system ripe for manipulation by savvy judgment creditors via a process I call “judgment arbitrage.”

Undead shares many commonalities with these two articles (particularly Boilerplate Shock). Perhaps most important, together they posit that private contracts—combined with choice of law rules and expansive conceptions of jurisdiction that make it possible to secure and actually enforce judgments based on them—are driving international economic events to a degree that no one anticipated. This is mainly a story of cascade effects, amplified by standardization: the interpretation of a given contract term impacts other actors (whose rights are determined by similar contracts) in the relevant market, and where that market is systemically significant, it can affect the global financial system.

As I suggest above and in the Boilerplate Shock abstract, I think the risk of contract-driven systemic failure (which I call “boilerplate shock”) is far more manageable today in the case of Argentina than in the Eurozone sovereign lending market. Let’s hope the risk does not materialize in Europe either; we already live in pretty exciting times.

Photo: Reuters/NYT