Steve Miran on Regulatory Dominance, Shrinking the Fed’s Balance Sheet, and the Return of Monetarism

Thanks for having me back. It's great to see you again.

Well, not every morning, but often. There's a lot—the role of CEA chairman is really, it's in the name: it's the Council of Economic Advisers, right? And so you're providing economic analysis and economic advice to the president, to other members of the administration, to different parts of the government on a regular basis. Whatever the issue of the day is, whatever the big thing that people are working on, that's what you want to try and analyze, study, and prepare on so you can give them the best advice you can. And it applies from the president all the way on down. Anybody who needed economic assistance on an item that they were working on, I was more than happy to give it.

That's how it works. And yeah, so the CEA offices are in the Eisenhower Building, as you said, and then you just cross West Executive Avenue and you walk right into the West Wing and into the Oval.

And so you're part of the administration, you're part of the White House complex. One of the interesting things about CEA is that you really work on a really wide variety of subjects. In the morning, it's tax policy, and then a little bit later it's tariffs and industrial policy, and then a little bit later it's regulations, and then later on it's healthcare policy and education or something else, right? And so you really are bouncing from subject to subject to subject in a really fascinating array of stuff that you work on. So it really is a very interesting job.

Yeah, National Economic Council, NEC. So CEA and NEC are really the two economic policy components of the White House. And the difference is that the word "advisers" is in the name of CEA. And so CEA is really an advisory body, right? CEA exists to help formulate economic analysis, economic advice, and economic policy, right? And so CEA might be really involved in trying to figure out what a good policy is, how would a good policy be structured, what types of things would we care about, what sort of things could move the needle on the economy, what's going on in the economy, what are the data saying, and where are things likely to go? But CEA is really about providing economic analysis and advice to other people who have actual implementation authority. NEC is about getting things done. And so once a policy is decided, NEC's job is to coordinate the interagency process of implementing a policy. And so, for example, if you think about, let's just call it the CARES Act or the One Big Beautiful Bill Act or whatever, it will have policy directives in that legislation that—some of them have to be implemented by Treasury, some of them have to be implemented by Commerce, some of them have to be implemented by Energy, and some of them have to be implemented by Interior if they're regulations around energy and land use, right? And NEC's job is really to coordinate across all the different agencies to make sure that the policies are being implemented and that each agency is doing what it needs to be doing to implement administration policy. And so NEC is a hands-on implementation job. CEA is a big-picture policy advisory job.

Yeah. So there's been a few news cycles about that building. I have not been in it. The entire Federal Reserve is out of that building for the moment. We were in the Martin Building, although some staff are scattered in some other buildings that the Fed is renting while Eccles is under construction. But I was located in the Martin Building, as was the rest of the board and certain other divisions of the Fed. And the Martin Building is beautiful. It's a very comfortable building.

Some. In the Martin Building, the board members' offices are all on the top floor, and so is the staff cafeteria. The top floor is basically the staff cafeteria and the governors' offices, with a few meeting rooms as well. And the governors' offices are all in a row right next to each other. When I was there, it was then-Chairman Powell—now Governor Powell—then-Chairman Powell's office was in the middle, and then Governor Cook's office was next to his on the right, and then my office was next to hers. And I suppose Governor Powell is now in the office that I used to be in. All the offices are right in a row. And so, yes, on the one hand, you see people, but on the other hand, a lot of people travel a lot, a lot of people are off doing different things, and a lot of people are very busy. So even though all the offices are right there, you'd actually end up seeing people surprisingly a lot less than you might think. It's more a case of regularly scheduled meetings that you have with everyone to catch up and discuss policy, the economy, and policy items. And on top of that, of course, there's the Sunshine Act, which prevents you from meeting with more than a couple of people to begin with. Because if you had four members of the board, you'd have a quorum and then you'd be subject to the Sunshine Act, meaning that you'd have to issue public notice and open it to the public or have some other reason why you weren't discussing policy and therefore it was exempt from the rules of the Sunshine Act. So you can never meet with more than a couple of people at a time. And as a result, most of the things end up actually just being bilateral.

Let me first underline something that you just said, which is that the paper, as you know—and I like to give credit where it's due—I had three co-authors on the Federal Reserve staff, staff economists who wrote the paper with me: Alyssa Anderson, Alejandro Barberena, and Anthony Diercks. And so the paper, as you're saying, is neutral. It doesn't take a view about what good policy is; it lays out a series of tools. The speech reflects my actual views, and that's just me, right? So it is important both to give them credit for the work that they did, but also sort of say none of the blame for any actual policy view should go to them—only to me. But look, I got interested in this for a couple of reasons. One is we did spend a lot of time at FOMC meetings discussing the balance sheet and short-rate funding markets. It does seem that we're sort of stuck in a bit of a rut with a big balance sheet. And then the third reason is that upon the president's nomination of Kevin Warsh as the Fed chairman, it didn't take a lot of work to realize that he cared very deeply about this issue and has for a very, very long time. That made me start doing research on it, and as I did more and more research, it became a more interesting subject. What started as an observation in the November speech about regulatory dominance blossomed into a bigger research agenda.

Yeah, I think there's a number of folks who have been interested in this for a while, and as you say, things came to a head and there's a moment now to actually accomplish something. And so therefore, devoting work and devoting energy toward it is attractive. I mean, there's probably a billion things that you care about, and if none of them have a chance at actually moving the needle, you're going to direct your resources to where you think you can be effective.

I cited you on the first page.

Thanks. There's a handful of reasons why I think a smaller balance sheet is better economically. The economic ones are that, in general, economists think that markets do a pretty good job of allocating resources, of course, the fundamental welfare theorems of economics. There are times when that fails and there's a market failure and you want a big government intervention. When there's a market failure, you have a case for government intervention. In terms of the balance sheet, you don't really have a market failure that would justify a big government intervention. So the default position of economics—that a smaller government footprint is better and letting markets do their thing is better—is the appropriate position, right? In this case, by having a large intervention, governments have basically disintermediated in funding markets, and many loans, many credits that used to be made from one market participant to another market participant now basically have the government as the counterparty. So the government has cannibalized parts of the economy and is probably doing it less efficiently than markets would, because markets tend to do a better job of this. In general, there's a view that government should have a smaller footprint in the economy, the Fed should have a smaller footprint in the economy, government actions tend to be distortionary, and unless there's a strong justification for reducing a distortion, you should let the market solve something on its own. Then there's a whole set of other consequences too, some of which are political. I think that it's bad for Fed independence to have a large balance sheet. When the Fed starts engaging in large-scale asset purchases out the yield curve, they are interfering in fiscal decisions. The choice of the distribution of public debt—the choice of where the government is going to be borrowing from the public—is traditionally thought of as a fiscal decision for fiscal policymakers. Now, that's fine when the Fed gets involved for monetary policy purposes if it really has to, but it is blurring the line between monetary and fiscal policy. That blurring of the line means that fiscal policy then must take an interest in what the monetary authority is doing and vice versa. It's just better to keep those two things as separate as possible. So it's better for independence from a fiscal perspective. It's also better from a credit perspective, because when the Fed buys QE, it doesn't only buy Treasuries; it also buys mortgages. What the Fed ends up doing is injecting credit preferentially into one sector of the economy over other sectors of the economy, and that's ultimately a political decision. It's a political decision with real consequences. It's no mystery that the Fed was buying mortgages during a pandemic even when home prices were up 20% year-over-year, and they were sort of still saying that's not enough, we need more credit into the housing sector. By buying mortgages, they were directly injecting credit straight into the housing sector above other sectors, and housing got way out of whack as a result. I think the housing market is now unfortunately distorted and messed up for an entire generation in terms of how out of whack those prices got. Very unfortunate. So there are real political reasons why the Fed should stay out of having a large balance sheet, because it's bad for Fed independence. The final reason is it's bad for the Fed itself in the sense that it induces volatility in the Fed's own net equity. If you have a large balance sheet, you're exposing yourself to the risk of losses. We saw in the post-pandemic period how those losses became acute, and the deferred asset position exceeded a trillion dollars, and the Fed had a big hole in its balance sheet as a result of that. Yes, central banks can operate with an infinitely negative capital position if they had to, but in practice, I don't think that's the case. I think it's bad for the reputation of the institution, and I think it's bad for the credibility of the institution if it experiences large losses. Also, those large losses induce volatility in the remittance of profits from the Fed to the Treasury, which of course then have their own set of fiscal implications. Public borrowing will then become more volatile; interest rates then become more volatile because you've induced unnecessary volatility into the stream of remittances from the Fed to the Treasury in terms of operating profits. So there's really a variety of reasons, and this is one of many subject areas in which the argument for a small balance sheet is overwhelming. There's a wide variety of reasons. I think they're good reasons, and I think it would be an improvement in policy if we manage to reduce the balance sheet.

If I can add one thing, there very clearly is a justification for intervening on monetary policy in terms of changing the interest rate—short rates, right? If you go back to basic economics, in a world of no distortions where all prices are flexible, you don't have involuntary unemployment and monetary policy has no role, right? That's a real business cycle type of model. Once you go down the route of introducing rigidities into the economy, as all the New Keynesian economists do, you start to get those rigidities leading towards market failures and distortions that introduce involuntary unemployment and open a role for monetary policy to be countercyclical, for it to fight recessions and to restrain inflation when inflation is too strong. And so these principles still work in monetary policy, right? If you have a market failure, if you have a credit crisis in the housing sector or the banking sector or somewhere else, and then you're at the zero lower bound and there is a good reason for doing QE, fine, do it, right? But if you don't have a really, really good reason for doing it, you shouldn't do it just because, right?

It's like antibiotics: you use them when you're sick; you don't use them when you're not.

So let me step back a little bit. There's about $3 trillion of reserves—a little bit more than $3 trillion of reserves—on the balance sheet of the $6-plus trillion that you mentioned, right? And of course, there's currency and the Treasury's account as well, and a few smaller items. But the reserves that exist—you mentioned my work on the regulatory dominance of the balance sheet—basically, as a result of the way that the regulations are set and the implementation framework was set, banks hold more reserves than they need for liquidity purposes because, A, they are afraid of drawing down the reserves when they actually need the liquidity, so they hold extra, they hold precautionary buffers and buffer stocks in reserves; and B, there are stigmas against accessing the Fed's liquidity facilities: the discount window, standing repos, intraday credit, and daylight overdrafts. The $1 to $2 trillion figure is what you could do if you take steps to reduce demand for reserves. If you take steps to reduce demand for reserves, you can then reduce supply of reserves as well without causing undue stress in the short-term funding markets. If demand shifts left, you can shift supply left too without changing prices, right? Simple Econ 101. So our calculations were that you could do $1 to $2 trillion of reserve reduction by taking steps to reduce demand for reserves while remaining in ample reserves. In an ample reserve framework, if you took the step to go out of an ample reserve framework and go back to scarce reserves, you could go way beyond $2 trillion of reserve reduction, right? Before the GFC, there were $50 billion of reserves or something like that supporting a balance sheet of $800 billion, right? That was a huge disparity versus where we are now. And the reason is because daylight overdrafts were there. When banks didn't have enough reserves to hit their day-to-day reserve requirements, there wasn't a stigma about borrowing intraday credit, so they could make up the extra reserves with borrowed reserves from the Fed. In a scarce reserves regime, you can do that. You can shrink the balance sheet even beyond the $1 to $2 trillion we suggested. Can you go all the way back to $50 billion? Probably not. But can you go materially below a trillion? Absolutely. But you have to be willing to deal with the associated funding market volatility that comes with that, right? And that's a decision the Fed will have to take when it decides whether or not it wants to reduce the size of the balance sheet. The $1 to $2 trillion is what you could do within ample reserves before leaving ample. If you want to leave ample, then you can go a lot further.

And that to me is what I was alluding to earlier. This used to be a conversation people simply wouldn't have. But now, people who support ample reserves as well as scarce reserves are both willing to discuss shrinking the demand for reserves as a starting point. To go to the next level, though, as you mentioned, would be to go to a scarce reserve system.

I would agree with you. If you change the remuneration on reserves to zero, banks are not going to want to hold any, right? And if you're remunerating reserves at some competitive interest rate, then they're not going to mind holding them, right? That's what we have now: we have IORB, and banks are very, very happy to hold huge reserve portfolios because they get compensated for doing so, especially if their deposit...