Tuesday, April 14, 2020

Financial pandemic

The headlines are on the disease, the shutdown, and the hoped-for safe reopening. It's time to pay some attention to the financial side of the current situation, and the Federal Reserve's immense reaction to it.

Disclaimer: do not read in this post criticism of the Fed. Maybe the world would have ended if they had done things differently. But it is important for us who study such things to understand what they did, what beneficial and adverse consequences there are, and how the system might be set up better in  the future.

Big picture: We face an extremely severe economic downturn, of unknown duration -- it could be a V,  U, or L. If it is not a V shaped in months, there will be a wave of bankruptcies from personal to corporate, and huge losses all over the financial system. Well, earn returns in good times and take losses in bad times, you may say, and I do, more often than the Fed does, but for now this is simply a fact.

Our government's basic economic plan to confront this situation is simple: The Federal Reserve will print money to pay every bill, and guarantee every debt, for the duration. And, to a somewhat lesser approximation, to ensure that no fixed-income investor loses money. 

I reiterate, the point of this post is not to criticize. If you are reading economics blogs, you like me probably have a nice work-from-home job that still pays some money. This is not what's going on. From a combination of voluntary and imposed social distancing, the economy is collapsing. As I detailed in an earlier post  20 million people, more than 1 in 10 US workers, lost their jobs in the first month of this shutdown. That's more than the entire 2008 recession. In 3 weeks. 1/3 of US apartment renters didn't pay April rent. Run that up through the financial system. Most guesses say that companies have one to three months of cash on hand, and then fail. We'll look at signs of financial collapse in a bit, that the Fed reacted to. If you want to know why the Fed hit the panic button, it's because every alarm went off.

Pay every bill? Yes, pretty much. This is not "stimulus." It is get-through-it-us. People who lost jobs and businesses that have no income can't pay their bills. When people run out of cash they stop paying rent, mortgages, utilities, and consumer debts. In turn the people who lent them money are in trouble. Businesses with zero income can't pay debts (just why debts are so large is a good question to keep track of), employees, rent, mortgages, utilities. When they stop, paying they go through bankruptcy and their creditors get in to trouble. If you want to stop a financial crisis, you have to pay all the bills, not just some extra spending cash.

And that's pretty much the plan. There will be unemployment insurance, with 100% replacement of wages, for people who lose jobs, so they can pay rent, mortgages, utilities, and consumer debts. The Small Business Administration will make forgivable loans to businesses. Bailout plans are in place to make sure industrial companies like Arlines do not file for bankruptcy. (Much of this money is stuck in snafu, but that's the plan if not the execution.) And, where the big money is, the Fed is propping up corporate bond, municipal bond, treasury, money market funds, and other markets. I'll survey the programs below, this is big picture for now.

Printed money? Yes. Start with the Treasury. The Treasury wants to spend $2 trillion in the first stimulus bill. Where is that money coming from? In normal times, that would mean selling $2 trillion of treasury bond and bills. But who has $2 trillion of extra income lying around that they want to use to buy treasury debt right now? Yes, the new treasury debt has to come from a new flow of savings. Well, you can argue if that's there or not, but you don't have to. The Fed is buying more debt than the Treasury is selling. 

When the Fed buys Treasury debt, it prints up new money, and gives it to the holder of the Treasury debt. (I will say "printing money" as that is clearer. The Fed actually creates new reserves, accounts banks have at the Fed, by flip of an electronic switch. Banks can convert reserves to cash and back at will.)  On net, if the Treasury borrows and spends the money, and the Fed buys the Treasury debt, the government as a whole has printed up new money to spend. That's what's going on now. 

From the March 4 and April 8 Fed H.1 data, we learn that the Fed held $2,502 billion and $3,634 billion Treasury securities on those dates, an increase of $1,132 billion.  From the Treasury debt to the minute page, we learn that debt held by the public (including the Fed) rose from $17,469 billion to $18,231 billion -- a (huge) rise of $762 billion. $9 trillion at an annual rate. The Fed bought all the Treasury debt, printing new money to do it, and then some. On net, the government financed the entire $762 billion by printing new money and printed up another $370 billion to buy back that much existing treasury debt. 

The UK is abandoning pretenses. Bank of England to directly finance UK government’s extra spending writes the FT. Rather than have the government sell to the market, and then the bank buy it, the bank will now print money for the government to spend, and the government will print treasury debt to give to the bank in return.

(Who cares you may ask? The US Fed is not legally allowed to buy from the Treasury. The Treasury must sell in private markets to establish the interest rate, i.e. the price of the debt. If not, there is an inevitable temptation to say that markets are "impaired" or "illiquid" requiring too high rates, and thus the Fed buys at artificially low rates and high prices. The laws against inflationary finance are pretty thoughtful.)

The new lending programs are explicitly financed by the Fed printing up new money to do so.

The Fed and Treasury are teaming up to provide trillions to lend money to businesses and banks, and to buy assets including  money market funds, corporate bonds, municipal bonds, mortgages,

Now where do these trillions come from? Answer, in short, the Fed simply prints them up. It prints up the new money, and gives it to a business or bank or uses it to buy assets. 

A bit longer explanation 

In normal times, the Fed creates money (reserves) by buying Treasury bills. It has an asset -- the Treasury -- and a liability -- the money. The money is backed by Treasurys, a good principle of non-inflationary policy. That's the simple version of which  the Fed just did a trillion. 

When the Fed lends money to a bank or a company, the Fed likewise prints up money, gives it to a company, and counts the company's promise to pay back the loan as the corresponding asset. You can see the danger. The Fed is supposed to make only safe loans, to guard against inflationary finance, and to keep the Fed politically independent. Printing money to hand gifts to well connected firms and politically powerful interest groups is dynamite, and an independent agency will not stay independent long if it does so. 

For this reason the Fed and Treasury work together. The Treasury agrees to take the first tranche of losses, so the Fed can say this is a safe loan. Jay Powell was, as usual, clear on this. 
I would stress that these are lending powers, not spending powers. The Fed is not authorized to grant money to particular beneficiaries. The Fed can only make secured loans to solvent entities with the expectation that the loans will be fully repaid
What happens if the loans are not paid back? Well, in the first 5 to 10%, the Treasury takes the loss.  But right now, the Treasury gets its money from the Fed. So it really comes back to printed money anyway. If losses are so severe that the Fed loses a lot of money, the Treasury will have to recapitalize the Fed with a gift of Treasury bills. 

So, if the loans are not paid back, one way or another, we end up with that much more outstanding Treasury debt, either owned by the Fed and money outstanding, or owned by people. 

But this Fed vs treasury business, while important inside baseball for Fed independence and a bunch of issues on how the plumbing works, is really beside the point. The Fed and Treasury right now are, together, printing up trillions of dollars -- $4 -$6 trillion is the current guesstimate, which assumes a short sharp recession -- and handing them out. Most of it is "loans" which the Fed and Treasury hope to recoup. Then they can reduce the amount of money left outstanding. 

Is this really lending? 

As Jay Powell emphasized, the current vision is that most of the current support is lending, not spending. The Treasury kicks in something like $400 billion which really is spending, the anticipated loan losses (companies that don't survive) and forgiveness (programs that promise to forgive the loan if the company meets employment or other goals). The Fed lends $4 trillion on top of that, and gets its money back. The government as a whole has only spent $400 billion when its over, and the new debt (money) is soaked up again by repayment. 

But is this really lending or just spending?  Well, in the short run it's lending, but if the recession lasts more than a few months it will turn in to spending.

Companies have no income but must pay rent, debts, (interest on their corporate bonds and bank loans used to purchase now idle plant and equipment), utilities, skeleton staff, etc. Local governments are in a similar bind. They borrow to cover this cost. What's wrong with that? 

Well, borrowing usually corresponds to a productive asset, to an increase in value. If a bakery borrows to buy an oven, the bakery will make more bread, and use the additional profits on the extra bread to pay off the loan. If it doesn't work out, the oven is a real asset, collateral that the bank can sell to get some of its money back. A city borrowing to build a highway gets more tax revenue from greater activity to pay off the loan. 

But there is no economic value to these loans. These are consumption loans, stay-afloat loans, preserve-the-business loans. They are loans against future profits, but not additional future profits. They are a transfer of the franchise value of the firm to the lender. 

So, first, the firm clearly at some point is better off shutting down than promising its entire profit stream to a lender just for the right to reopen someday. Second, the government, already inclined to forgive, say, student debt, has every reason to forgive these "loans" as well. The business "loans" explicitly promise forgiveness if the government keeps workers on board. When we are in a sluggish recovery, and businesses are saying "well, I would hire more people, but we have all this extra debt because we took Fed loans to keep our employees fed while we were shut down," let's see just how tough the government is going to be on repayment. 

So, in a matter of months, these loans turn to gifts. The $4 trillion Fed lending package winds up as $4 trillion permanently added to Treasury debt. 

Does this mean inflation? 

You would think that, if the Fed and Treasury are going to print up something like $1 trillion a month of money to pay everyone's bills and prop up markets for the duration, we would be heading for inflation, soon. 

No, or at least not immediately. Reserves pay interest. Reserves are just another form of Treasury debt. (Reserves that pay interest is one of the best innovations of recent decades, and Kudos to Ben Bernanke and everyone else involved.) 

So why does it matter? Couldn't the Treasury just print up Treasury bills, sell them for reserves, hand out the reserves, collect loans in due time and retire the Treasurys? In the short run it does matter, which should send a few shivers up our spine. Apparently the Treasury had a hard time finding willing buyers. So printing up the reserves directly made a difference. So, the Fed ends up with a loan "asset" on its balance sheet against reserves, rather than the Treasury with that loan as an asset on its balance sheet against Treasury bills. Conveniently, also, reserves though equivalent to Treasury debt are not counted in the debt limit along with many other contingent liabilities. 

In the long run it does not matter. The Fed and Treasury print up reserves, lend it to Joe's Laundry; Joe pays his mortgage; the mortgage company pays its investors. If those investors are happy sitting on reserves (bank accounts backed 1:1 with reserves on the margin), it sits. If they are not, which would be the beginning of the inflationary process, the Fed can just raise the interest rate on reserves until they are, really really transforming reserves to Treasury debt. Or the Fed can give them some of its stock of Treasurys and so on up the reserves. 

With abundant interest-paying reserves, reserves and Treasury debt are almost exactly the same thing, and in roughly functional markets, what matters is their total supply, not reserves alone. Inflation is a danger, but from the total quantity of government debt, not its split between reserves and  bills. Inflation comes basically if the US hits a debt crisis. 

(That is, so long as the Fed pays market interest on reserves, and lets the market basically have as much or as few reserves as it wants. If the Fed, and Treasury, start worrying about interest costs of the debt, and do not pay interest on reserves and do not allow people to convert to Treasurys, then inflation comes sooner. )

But we're looking for sure at raising US debt from $22 trillion to $27 trillion, likely hitting 150% of GDP if this is a short and swift recession. It could be much larger if the recession goes on a year or more. Is there a demand for that much more treasury debt in the long run? Is there a flow of that much new saving that people are willing to park with Uncle Sam? How much more can markets take? So the chance of a global sovereign debt crisis and inflation is not zero -- but not centrally from the fact that it's currently financed by printing money. I'll come back to this issue in detail later. 


First, how long can this go on?

As you can see, the viability of this whole plan depends on a short recession. The Fed is printing up something like $1 trillion per month. If the recession ends up being L shaped, those numbers will ramp up as reservoirs of private cash dry up. A few large company bailouts, a few more "dysfunctional" markets turn to the Fed to buy everything, and so on. The  IMF wants  $1.2 trillion to bail out emerging market economies. After 3 weeks. That will get worse. State and local governments, already facing pension crises, are gong to be toast when sales and income tax receipts collapse. Bear Stearns, Fannie and Freddy, AIG...

Where is the limit? Perhaps the peasants with pitchforks, remarkably absent so far, will revolt. Perhaps the willingness to hold interest-bearing reserves or US Treasury debt will find its limit after $10 trillion. Or $20 trillion.

At some point, people who bought risky, high return debt, and earned nice returns on the way up, will have to bear some of the genuine economic losses. There is no magic. Government debt is paid back by taxes. (If you think that law has been repealed by MMT or r<g, I'll disabuse you of that in an upcoming post.) Trillions will be spent. Either taxpayers pay it, or creditors pay it. 

Second, isn't there a bit of moral hazard here? Now, you may say, nobody asks about moral hazard in a foxhole. But at some point we have to address the moral hazard. Half of these interventions were things done in 2008, and we said no, never again, we'll pass a mountain of regulations to control moral hazard. Remember "no more bailouts?" Especially money market funds? And here were are, one week into it and airlines are too big to fail and money market funds need the Fed to stop from breaking the buck. At a minimum we can look at what the Fed has done, remark on how the post 2008 controls on moral hazard failed, and at least think about how we might avoid being in exactly the same  pickle in 2032.  We can also once again Monday morning quarterback and suggest how things might be done in a way to diminish the moral hazard. At least we can get a better playbook for next time.

I will look at both these issues in detail in upcoming blog posts.


  1. When you say "reserves pay interest" don't you mean treasury debt pays interest, because that's the asset the Fed holds and paid for with reserves? Only assets have the means to pay interest.

    1. Banks can deposit reserves - so-called "excess reserves", because they aren't required - at the Fed, and the Fed pays the banks interest on those reserves. The Fed's reserve liabilities are assets of banks, just like all debt is one party's liability and another party's asset.

    2. It's part of sterilization - it helps prevent the money supply causing inflation because the Fed is paying IOR to banks as an incentive to hold on to those reserves versus lending it out with higher risk. By putting that crimp in hampers the flow of ER out into the greater economy, but helps banks heal their balance sheets. The Fed always pays.

  2. "Where is the limit?"

    Nah, this is fine. Analysis of how monetary stuff works on government debt is perfect. But what's 150% of GDP? UK post WWII had 220%, and survived. Belgium had 120% with no war, and came down from that. Japan is roughly at 200% and seems to be surviving.

    The idiocy is the high level of debt, not the new debt. Ask Alex Hamilton.

    Besides, what have future generations ever done for me? :-)

    1. But there is a limit no? Greece and Italy hit that limit. India in 91 hit that limit. Objectively, there is some number where bond holders dump treasuries because they have no faith that any taxable amount will pay the debts back.

    2. Yes, there is a limit. I'm just guessing the US is nowhere near it.

  3. You can't keep socializing private losses and expect no pitchforks.

  4. So, by locking down the economy we might save an unknown number of lives, although that unknown number seems to be shrinking rapidly.

    But there is no doubting we are implementing a deep economic depression and wrecking our financial system.

    Sorry, I cry uncle. I throw in the towel. I don't care what it takes, we have to go back to work. Destroying an economy is not an option.

    End the lockdowns and let's run the gauntlet.

  5. I agree with Dr. Cochrane's overall point here, but it seems that he conflates two separate lending programs.

    - The Paycheck Protection Program, targeting small business (generally < 500 employees). This program was authorized for $350 billion - though there's already talk that number needs to increase - and is routed through banks as SBA-guaranteed (i.e., Federally-guaranteed) loans. These are explicitly stated to be forgivable loans for businesses that maintain payrolls. To be clear, the intended structure is that banks aren't taking on risk. The intent is that they are essentially just administratively running a program for Treasury spending (and the Treasury will clawback some of that spending if small businesses don't use it for the intended purposes).

    - Fed lending of $4+ trillion for larger businesses and the muni market that's backed by $450 billion of Treasury money. The Treasury money takes the first losses on these loans. These are - at least as of now - *not* forgivable loans per their terms. Dr. Cochrane raises the valid point that political pressure may change these terms down the road and push toward debt forgiveness.

    1. The PPP is going to need to expand greatly. Last I looked, the average loan was $65k which would mean only 1 in 6 small businesses would be able to get funding. And even with that, the program is only two months. Does anyone think we'll be even close to normal in two months, especially in industries such as retail, hospitality, and tourism?

    2. Yikes! PPP is a effectively a grant program. How about at least turning it into a lending program. You know on the theory that the resources should be repaid at some point? Suppose we go in for another $350. That would then be TARP sized. Recall that (except for the car companies) all the TARP money was paid back with interest. The monetary and economic consequences of $700BN in grants should not be hidden behind cute phraseology. And we may never be back to "normal" in the restaurant industry. Does that then mean that all restaurants should be guaranteed a steady stream of grant funding ad infinitum? When does it end exactly?

  6. “The Fed actually creates new reserves . . . by flip of an electronic switch. Banks can convert reserves to cash and back at will.” Don’t a lot of these reserves, in fact, get converted to currency? When the Fed creates lots of new reserves, doesn’t that result pretty soon in the Mint’s actually creating a lot of new currency? The banks don't just keep the new reserves on deposit with the Fed, do they?

    1. As highlighted in this blog post, not if the reserves pay market interest. For a few illustrative examples, see this great staff report from Keister and McAndrews at the New York Fed: https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr380.pdf

  7. "If losses are so severe that the Fed loses a lot of money, the Treasury will have to recapitalize the Fed with a gift of Treasury bills." This technically is not correct. The Fed credits itself with a deferred asset that "represents the amount of net earnings the Reserve Bank will need to realize before remittances to the Treasury resume." In essence, if reserve banks take losses they plug a number into their balance sheet to keep capital and surplus from going down. See 11.96 Accrued Remittances to Treasury / Deferred Asset, in the Federal Reserve Accounting Manual for Federal Reserve Banks at https://www.federalreserve.gov/aboutthefed/files/BSTfinaccountingmanual.pdf.

    1. We call it legerdemain (the old definition, not the Blockchain link).
      It is properly a term applying to accounting tricks, often affecting balance sheets.
      Within government agencies, where the Unit of Accounting is "what the Treasury uses"; it is what the Fed "monetizes" (liquidity, market-maker) in its ledgers.
      It is what used to be the name of a silver coin. And of course today it is just a name.

      Debit, credit, assets, liabilities. "We" owe it to "our government" which owes it to the Fed which owes it to itself. Pretty good.

    2. And then the Fed just stops remitting any profits to the Treasury until it is re-capitalized? Interesting economic trivia.

  8. Wonderful post. Great description of the nefarious "I'll issue and you buy" collusion that keeps the whole perpetual motion machine going. Look around people - right now who is in a net saving mode to buy our debt? Hmmm???

    I really look forward to future posts that follow up on the final point about not shielding every debt investor and every company from absorbing and dealing with a shock - economic or biological. Money funds are ground zero here. Remember after 2008 when we all said "never again". Well guess what - AGAIN! All those prime funds holders that earned another 5 basis points just got taken out at par by the Fed again!

    And of course it goes much further. Take a look at commercial paper - CPFF. Look at total issuance over the past 6 weeks in FRED- any sharp drop off or market freeze?? Nooo. That market is operating quite reasonably iunder the circumstances. But now the Fed is subsidizing A1/P1 to the tune of 100bps and split rated CP is out in the cold.

    And how about equity investors? Equity holders get to hold the bag while every debt investor under the sun gets a bailout? Really? Is that necessary to "preserve the financial system"?

    The blog has eloquently commented on how these pandemics will invariably return and we can't continue to respond by shutting off the economy for 3 months each time. I think you should pair that message with the corresponding insight that the answer to every future pandemic can not be to provide a government funded bailout to corporations and debt investors as well.

    1. "And how about equity investors? Equity holders get to hold the bag
      while every debt investor under the sun gets a bailout? Really? Is that necessary to "preserve the financial system"?" Excellent point! The Fed's TBTF policy encourages this moral hazard. The incentive is to assume excessive debt risk, believing the taxpayer will get the bill.

    2. I'm glad someone mentioned this. Debt holders should be bailed out due to contagion ( this time financial) but equity holders should get wiped out. Then during passive times, we all bemoan about why companies don't raise enough funds through equity.

      Was it always taken as given that bondholders should be bailed out during a crisis?

      In fact, when did mass bailouts become a defacto policy?

  9. Spot on. In effect, the Fed buys the Treasury's debt when it buys bonds previously sold to the public. There is no way out of this coming inflationary spiral. Two trillion being offered by the Treasury will be met with a bidder's strike. Hence, rates have to rise to account for anticipated inflation. With few bidders, money gets printed. Either way inflation will be anticipated by future lenders and current bond holders dumping assets. How severe remains to be seen. Gold has risen and traders are shorting bond futures. From a fiscal POV, the CPI will rise because the discount rate will increase.

  10. Thank you for the post! I found it helpful from my layperson perspective. Would you please clarify this statement?:

    > So, the Fed ends up with a loan "asset" on its balance sheet against reserves, rather than the Treasury with that loan as an asset on its balance sheet against Treasury bills.

    This "loan 'asset'" you speak of is a T-bill, right? If so, it makes no sense to talk of the Treasury holding T-bills "against Treasury bills". It would be like lending money to yourself. Clearly, I've misunderstood something.

  11. Fiat currency is not money. I know everyone says money when they mean fiat currency. Hardly one soul in a million even remembers what real money is. But this blog is a place for insight, for truth and for clearing up misunderstandings.

    You cannot print money, but you can print fiat currency. Fiat currency is just tokens that allow the receiver to get control of someone else’s assets. Printing it just enables some people to take assets from others. It is redistribution. And because the “peasants” always lose, they eventually go for the pitchforks. Meanwhile, the economy becomes a madhouse, saving is for fools and we head for lower living standards.

    1. I totally share your preferences in the choice of names for the Unit of Accounting. We could call the dominant Federal Reserve Accounting Unit Dollar by the acronym F.R.A.U.D. but that would be too suggestive of lacking trust.
      But the "functional currency" law of 1986 takes care of that for US taxpayers.

  12. Are you telling that this pandemic can be a chance for inflation?
    Great blog post though, liked it!

  13. Quote..."With abundant interest-paying reserves, reserves and Treasury debt are almost exactly the same thing, and in roughly functional markets, what matters is their total supply, not reserves alone. Inflation is a danger, but from the total quantity of government debt, not its split between reserves and bills. Inflation comes basically if the US hits a debt crisis."

    Reserves and T-bonds are almost the same thing for a private bank but at the Federal Reserve they are on opposite sides of the balance sheet. I wouldn't necessarily total two numbers from opposite sides.

  14. You persist in using the metaphor of "printing money." You acknowledge this is somehow wrong, that using the printing metaphor is just a shorthand for what really happens. That seems lazy and inaccurate. It perpetuates misconceptions about what money is, which is not primarily the printed bills you have in your pocket. You may think that everyone knows this and as a professor you may be right about the people you know and people who read this blog. In the other 95% of the population you will not find many people who understand money as a digital phenomenon. When marijuana started to be legalized I worked on several business plans to bring it to market. I felt like my primary job was to keep people from using unhelpful vocabulary. The most obvious was to get rid of the street term "marijuana" in favor of "cannabis." Also, people would want to say thing like "An investment in marijuana yields the 'highest' returns while reducing pain in people with 'chronic' illnesses." Today these things don't get said much anymore, not because of my efforts, but because of the efforts of a lot of people who were sensitive to language and wanted to change the way people thought. If you want to be in business it's best not to sound like Cheech and Chong. (I no longer work in that field.)

    I understand that even on this page you have people wanting to make political or philosophical distinctions about what "money" is. I'm not interested in that, but the printing metaphor is always misguided unless you are talking about the cash you have in your pocket, and economists are rarely interested in that. Thank you for what you do.


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