Should you borrow money in order to invest it? Good question. Talk with your financial advisor. Do not forget to include the Federal Reserve in your considerations.
Since 1934, the Federal Reserve has had authority to limit how much you can invest in stocks using credit. Today, and since 1974, it has held to a 50% “margin” level, a cap on credit applied to your stock purchases.
The authority was first given to the Federal Reserve on the theory that the 1920s stock bubble was pumped up by credit-leveraged speculation and that the Depression of the 1930s was driven by the air coming out of the balloon. That theory has since been debunked over and over again—the primary sources of the decade-long Depression coming from a combination of bad monetary policies at the Federal Reserve, trade contracting protectionist policies, and unending financial regulatory experimentation by the Roosevelt administration that kept investors on the sidelines as the rules kept changing.
The Federal Reserve fell out of love with its margin authority, an interest not revived even after Congress in 1992 also gave the Fed authority to set margins on derivatives. The Federal Reserve has not touched margin levels for over 40 years.
But the margin authority remains. Word is that the Federal Reserve is giving that authority a relook. It could be that with the return of economic turmoil the Federal Reserve has recognized that it has shot nearly all of its policy ammunition in the last 8 years or so. With short term interest rates still barely above zero, and the Fed’s balance sheet now counted in trillions of dollars, it is not clear what more the Fed could do with its usual tools to affect markets. They have loosened the valves about as much as they can.
You cannot fault the experts at the Federal Reserve for rooting around their toolbox and wondering whether there is some useful way in which the margin tool could be employed. It is a good idea for any regulatory agency to review periodically its policies and authorities. Perhaps the review will confirm the negative conclusions from many previous reviews. Presumably, that is how the Fed gave up the once widely held and now widely rejected real bills doctrine that encouraged deflationary monetary policies in the 1930s.
Details of the Federal Reserve’s inquiry are sketchy. If the Fed is considering margin authority to control market volatility—the original purpose of the authority—there is scant evidence that raising margins reduces volatility and some evidence that it might actually increase it by reducing market participation.
If the Federal Reserve is interested in limiting the availability of credit, there is evidence of that result in past decades from raising margin requirements. It is a good question to what extent succeeding developments in financial markets have altered that impact.
There is some indication that whatever the Federal Reserve does with margin, it might yet again exclude trading in government securities. Most recent financial regulations do that, whether you consider Basel capital and liquidity rules, the SEC’s new money market mutual fund rules, and the variety of regulations affecting collateral, to name only some. All of these favor Treasuries, and all have the effect of concentrating financial investment in Treasuries. That may not be a problem until there is a problem, as was the case for a decade with similar favorable regulatory treatment for investments in mortgages.
That could lead to a bigger problem. With so many rules pointing financial players to Treasury debt instruments, particularly as protections against regulatory risk, what happens when the economy heads toward recession? Although it may seem like it, there is not an infinite supply of Treasury debt, especially the short-term instruments so highly favored by regulators and regulation. When financial times get iffy, how might those who have a supply be willing to part with their short-term Treasuries? And those who need them, where will they go? These are very liquid instruments for those who want to sell them, but what about those who will want to buy them? Who will make up the sell side when holding them becomes essential? Treasury and Federal Reserve officials generally answer such questions with, “not to worry.” Maybe that is a policy that needs some review, too.