Central bank expansionism

A keynote talk at the FGV EPGE (Brazilian School of Economics and Finance) 60th anniversary conference, program here. Direct link to my talk here (YouTube).  (I start at about 4:00 if you're impatient). I plan to turn these thoughts in to an essay at some point. All the conference videos here 

The theme: Central banks, and especially the US Fed, are spinning out of control. I trace the history of this expansion, and how little steps taken here and there mushroomed. The decision in 2008 to regulate assets rather than pursue equity-financed banking, and buying huge amounts of assets, are small steps that mushroomed. They are the moment that central banks became the proverbial two year old with a hammer. The end, the natural meaning of "whole of government" approaches, must be the end of central bank independence and their complete politicization. 

Debt ceiling modest proposal -- perpetuities

The debt ceiling dance has started again. Read Treasury Secretary Janet Yellen in the Wall Street Journal. 

A modest proposal: Issue perpetuities.  

The Treasury computes the total amount of debt by its face or principal value, not its market value*. If the Treasury issues a bond that pays $1 coupons each year for 10 years and then pays $100 at maturity, the treasury counts this as $100 additional debt. The Treasury ignores the coupon payments, and how much the bond actually sells for, i.e. how much the Treasury actually borrows, when the bond is auctioned.  

Now you see my answer: Perpetuities have coupons, but no principal. A perpetuity pays $1 forever. In reality, it pays $1 until the Treasury buys it back. 

The Treasury could also issue coupon-only debt, just the $2 coupons for 10 years. Or it could issue debt with huge coupons and small principal payments, $2 a year for 10 years and then an additional dollar in year 10, and say debt increases by $1. But perpetuities are great for all sorts of other reasons, so why not use this opportunity? 

Perpetuities can have fixed coupon payments or variable coupons. The Treasury could sell a perpetual bond whose interest rate equals SOFR (the new Libor), whatever the Fed is paying on excess reserves, etc. If the Treasury wants to borrow short to harvest temporarily low short-term interest rates, then floating-rate perpetuities do the trick. Of course I would rather also take this moment to start borrowing long, locking in absurdly low interest costs. 

The Treasury could lower debt outstanding now, by rolling debt into perpetuities, issuing new perpetuities, and buying debt on the open market, issuing perpetuities in return. Goodbye debt limit. 

Too clever? Maybe. OK, undoubtedly yes. But if economics lunchroom talk can consider trillion-dollar coins, we can talk about perpetuities. Or maybe a serious attempt to do this would bring US treasury accounting into the 1960s, with cutting-edge concepts like market values not face values,  duration not average principal maturity, and interest cost concept that goes beyond coupons, so that the debt limit and treasury accounting is more economically meaningful.  

Disclaimers: 

*I spent some time on google and the Treasury website trying to figure out just how debt subject to limit is calculated, and this is my best guess. If I'm wrong, please write and I'll issue a classic "never mind." 

Yes, I am guilty here of having the same answer in response to different questions. See here on why I like perpetuities for other reasons.  

Why won't banks take your money?

 Banks to Companies: No More Deposits, Please, says the puzzling headline at WSJ. 

Why would bankers not want to take any amount of deposits, park them in reserves at the Fed or short term Treasury bills, charge fees and a slight interest spread, and sign up for an early tee-time at the local golf club? Sure "net interest margin" or other metrics might not look good, but money is money and more money is more money. 

The answer: 

Top of mind for many big banks is a rule requiring them to hold [sic] capital equivalent to at least 3% of all assets. Worried about the rule’s impact during the pandemic, the Fed changed the calculation in 2020 to ignore deposits the banks held at the central bank, but ended that break this March. Since then, some banks have warned the growing deposits could force them to raise more capital, or say no to deposits.

This is a fascinating little insight into the crazy world of our Fed's risk regulation. 

A letter to Yellen

Secretary of the Treasury, and ex Federal Reserve Chair Janet Yellen recently hosted an important meeting of the Financial Stability Oversight Council.  This is the highest level body overseeing financial regulation in the US. It matters. 

Her remarks start smoothly but critically, as one expects of a habitually well-prepared pro. A lot went wrong last year, from the treasury markets to another mutual fund bailout, and so forth. Bravo, it is time to get past celebrating how another bailout blowout saved the world and see if we can avoid another one. 

And then, 

We must also look ahead, at emerging risks. [To the financial system, the FSOC's purview.] Climate change is obviously the big one.

It is an existential threat to our environment, and it poses a tremendous risk to our country’s financial stability. We know that storms will hit us with more frequency, and more intensity. We know warming temperatures might disrupt food and water supplies, leading to unrest around the world. Our financial system must be prepared for the market and credit risks of these climate-related events. But it must also be prepared for the best-possible case scenario: that we begin a rapid transition to a net-zero carbon economy, which also creates potential challenges for financial institutions and markets. On all these fronts, the Council has an important role to play, helping to coordinate regulators’ collective efforts to improve the measurement and management of climate-related risks in the financial system.

Dear.. May I still call you Janet? I have known you for 40 years, since you were kind to a young brash graduate student. In all that time you have always worked for sensible well-reasoned, quantitatively evaluated policy. I don't always agree, but you always have clear, careful and conservative (in the move-carefully sense, not the political sense) thinking behind your recommendations. 

What the heck is going on? Surely you know this is nonsense? 

Unintended consequences

The Dec 14 Wall Street Journal amplifies my warnings on the movement to de-fund fossil fuels by financial regulation, citing "climate risks." 

"The Senate Democrats’ Special Committee on the Climate Crisis recently issued a report detailing how the Fed and eight other regulatory agencies should penalize investment in fossil fuels and promote green energy. They claim financial institutions are underpricing the risk that carbon-intensive assets will become “stranded.”

Mind you, their worry isn’t about how climate change per se would devalue investments, which financial institutions already account for. They want a warning about the costs of government climate policies. “Because Congress has not advanced any comprehensive climate policies in the last decade, the market has not priced in the possibility of significant federal action,” the report notes."

As reported this is at least a refreshing breath of honesty. In all I have read (not everything, it's a mountain) of the BoE, ECB, BIS, OECD, IMF treatment of "climate risk," there is a vague insinuation that climate itself poses a "risk," which is utter nonsense. Beyond nonsense, it is a directive for banks to make up numbers in order to justify de-funding politically unpopular fossil fuel projects. (In case that's not obvious, climate is not weather. The tails of the weather distribution and their minor effect on the profitability of large corporations are better known than just about any other risk, at horizons where bank supervision and risk management operate.) Here, it is at least clear that the relevant "risk" is the risk that Congress or the administrative state will shut down businesses. 

Actually, if taken seriously, honestly and generally, I might be all for it. Yes! Let our financial regulators require that firms and the banks who fund them disclose and account for all of the political risks that future government action might take to harm them -- law, regulation, administrative decisions, and prosecution. Indeed, state every possible nitwit regulation, idiotic tariff (Dec 29 WSJ is a masterpiece of how arbitrary  administrative decisions make or break companies), or ridiculous law or politicized prosecution might harm the company or investment.  Let's make this really tough -- criminal penalties for failing to disclose ahead of time that, say, the government might challenge a decade-old merger, or decide with a secret algorithm that it doesn't like the interest rates you charged or who you hired, or decide (Wal-Mart) to sue you for prescriptions you are legally required to fill. While we're disclosing financial risks, let's disclose the risk that a future Congress might remove the long list of subsidies and protections that your green projects live on. The long lists of well documented potential mischief would be edifying! 

OK, I'll stop dreaming. This isn't serious, it isn't about climate in any vaguely sensible cost-benefit way, it's about fossil fuels. It's about de-funding fossil fuels before alternatives are available at scale, by capturing the regulatory system because the people's elected legislators are not about to do it. (In the US.)

CBDC in EU

I wrote an oped for Il Sole 24 Ore on central bank digital currency, as part of a series they are doing. It's here in their premium edition (gated) here on their blog, in Italian on top and English below. Thanks much to Luciano Somoza and Tammaro Terracciano for translation and inspiring the project.

THE DIGITAL EURO IS A THREAT TO BANKS AND GOVERNMENTS. AND THAT’S OK. 

A central bank digital currency (CBDC) is in principle a very good idea. It offers the possibility of very low-cost transactions to households and businesses, especially in securities and international transactions. More excitingly, CBDC offers us a foundation for an efficient and nimble financial system that is completely insulated from recurrent crises. 

But CBDC poses a puzzle, as it undercuts many of governments’ and central banks other questionable objectives. Central banks want to prop up conventional banks, who benefit from taking deposits. And governments are unlikely to want to allow the anonymity that is the great attribute of physical cash. 

One vision for CBDC basically gives everyone access to bank reserves. Reserves are interest-paying accounts that banks hold at the central bank. When bank A wishes to pay bank B, it notifies the central bank, which just changes the numbers in each account on the central bank’s computer. The transaction can be accomplished in milliseconds, and costs basically nothing. Why don’t we have that? We should.

OECD talk -- rebuilding institutions in the wake of Covid-19

Friday morning I had the pleasure of participating in a session at the OECD, as part of their program on Confronting Planetary Emergencies - Solving Human Problems. I had the tough job of following brilliant remarks by Acting CEA chair Tyler Goodspeed and Ken Rogoff, and discussing great questions all starting at 5 AM. 

FYI here is the text of my prepared remarks. My focus is how to rebuild the competence of our institutions, which failed dismally in this crisis. 

(Update: Video of the event including Tyler Goodspeed's amazing critique,  plus Ken Rogoff's insightful talk. Thanks to Fahim M. from the comment below. Unknown says the audio is available on the main page, but I couldn't find it. )  

Covid and Beyond

John H. Cochrane

Remarks at the OECD, October 9, 2020

I very much appreciate the opportunity to speak today. Looking at some of the background documents, and listening to Tyler, I recognize that our panel is decidedly contrarian to the main views the OECD is pursuing, and those of the stars that you invited for previous panels. It says good things about the OECD that you want to listen to and understand heretical views.

I will try to answer to your question — what lessons should we take from the Covid experience? Many people say that “Covid changes everything.” I do not think the lesson is so radical. But the Covid  experience does, I think, bring to the fore and make urgent underlying problems that we need to address sooner rather than later. My “we” is global, and international institutions such as the OECD have a key role to play in this institutional regeneration. 

My theme is that we witnessed an outcome of grand institutional failure. We must reform our institutions, restore their basic competence, and thereby trust in that competence. We must de-politicize our institutions and insist that they return to the narrow focus of their competence. Trust must be earned. 

This erosion of our institutions has been going on for a long time now. in my view, the populist eruption, as well perhaps as much of the left-wing authoritarian woke eruption, stems from the view that elites don’t know why they are doing. That was laid bare in financial crisis, in many foreign policy misadventures, and laid bare by covid once again.

We are in a "planetary emergency." It is an emergency coming from the decay, or decadence if you will, of our governing institutions. They need to restore basic competence, not to embark on grand new adventures.  

The disease will pass, likely sooner rather than later due to the extraordinary inventiveness of our pharmaceutical and scientific institutions. The heroic efforts of doctors, and the speed with which they have learned to treat covid is remarkable. Diseases always have passed. And economies and societies returned to normal.

Covid -19 is, however, a fire drill, a wakeup call, a warning sign. It is almost perfectly designed to that purpose. It is just serious enough to get our attention, in a way that H1N1, SARS, and Ebola, were not.  But compared to plague, smallpox, typhus, cholera, 1918 influenza, the death rate is tiny.  

There is a virus out there, natural or engineered, that spreads like this one and kills 20% or more of the population. It will come sooner than we think. And we are wildly unprepared.  Ken Rogoff rightly points to a range of other tail events that we are wildly unprepared for. Antibiotic resistant bacteria.   Massive computer failure. Even a small nuclear war. 

Let us look somewhat chronologically at the list of failures in the last year.

Debt podcast and reconciliation

 

The Grumpy Economist podcast is back, with some thought on the debt issues from my last posts here and here.

David Andofatto had some final thoughts at macro mania, with which I mostly agree. Yes a twitter/blog debate in macroeconomics produces agreement! Central points: 

1) For these purposes a large sharp inflation and a default are not much different. In fact, the event I have in mind is most likely an inflation, as the US is likely to choose inflation over default. I don't think I made this equivalence clear in the debt posts. Also, the Fed is just another issuer of interest-paying debt. 

However, I don't think the chance of default or haircut is as remote as everyone else seems to think. They are also related events. Remember, my scenario for a debt crisis posits an economic and political crisis at the same time -- pandemic, recession, war, huge demands on the US treasury. Just how sacrosanct will full repayment of debt be to the US political system? When Chinese central bankers and Wall Street fat-cats are pressing for debt repayment but ordinary Americans are hurting, will our political system really take hard measures to repay the former in full, while throwing everyone's lives into misery via inflation? Maybe, and maybe inflation can still be blamed on speculators and middle-people and the usual bogey-people but maybe not. A haircut on Treasurys is not inconceivable. It could also come via refusal to raise the debt limit, or via a sharp wealth tax. And if people start to fear a haircut coming, they will certainly dump debt immediately, so fear of even technical defaults can spark the inflation.  

2) Yes, a good part of current r<g may well be a liquidity premium for US government debt due to its usefulness in transactions. But the big questions for r<g remain how reliable and how scaleable. Liquidity demand is not very scaleable. For example, if a government is financed only by money and no debt, and money demand MV=PY, then the government can run perpetual small deficits as the real economy Y and hence money demand grow. But if the government sees this situation, says "great, r<g, let's blow $10 trillion bucks," it will soon discover this opportunity does not scale at all. 

In the more reasonable MV(i)=PY that money demand is interest elastic, as the government exploits the opportunity and supplies more M it must pay greater interest on money (interest on reserves, interest on money-like treasurys), eating away quickly at r<g. 

The sensible r<g advocates like Blanchard recognize that r<g does not scale infinitely, and that a rise in r captures its limit. However, the discussion usually goes quickly to crowding out and the marginal product of capital rising. The liquidity effect that depresses US government bond yields is likely much less scaleable than crowding out of the whole US capital stock. 

When you read estimates of how much r rises as debt/GDP rises, pay attention to which mechanism they have in mind. 

Liquidity demand is also more fickle. Money demand can rise and fall quickly. The portion of treasury demand that comes from its use in financial transactions can be undone by different payment and clearing technology. Relying on this poorly understood mechanism for 30 years of r<g to pay off our debt seems a bit risky. US sanctions and regulations are creating a big incentive for others to create such alternative mechanisms. 

3) The government should borrow longer. The Fed can help.  

One of my policy conclusions is that the US government should borrow long-term as households who fear a big rise in interest rates should get 30 year mortgages not adjustable rate mortgages. Currently the Fed is actively undoing the Treasury's meager efforts to borrow long term, by buying up long-term treasury and guaranteed agency debt and issuing overnight reserves in return, and by issuing new debt in the form of overnight debt. 

The Fed could easily introduce term deposits -- reserves that carry a fixed interest rate, rather than a floating rate, and whose principal value varies. The Fed could also engage in fixed-for-floating swap contracts to eliminate the government's exposure to interest rate risk. (Such swap contracts should be collateralized of course, since you don't buy insurance from someone you will bail out if they lose money!) If interest rates rise the Fed will not just rescue the US government from a crisis, but will look like bloody geniuses. Which would you rather as a central banker in a crisis: a huge rise in net worth with which you can bail out the Treasury, or to fight an immense mark-to-market loss? 

Fintech in chains

"Fintech can come out of the shadows" is the title that Wall Street Journal editors gave to  Brian Brooks and Charles Calomiris' oped last week. I have not in a long time seen a title that more utterly contradicts the content of the essay.  For what they advocate is exactly the opposite: Fintech in chains, hemmed in by  the sort of regulatory stranglehold that fintech was created to escape. 

What is fintech? Basically companies that offer  

services—consumer loans, credit cards or payment processing—that banks have traditionally offered.

but, crucially, fintech does not accept deposits. 

The issue? 

The Office of the Comptroller of the Currency determines which companies qualify for charters as national banks or federal savings associations and supervises the activities of those banks.

But not fintech companies, because fintech companies don't take deposits. And that is the legal issue prompting the oped -- Brooks and Calomiris, coincidentally acting comptroller of the currency and chief economist of the OCC, want the OCC to regulate fintech just like banks. (Calomiris is a topnotch economist who normally writes very good papers. ) 

So what's so awful about fintech? 

Strategies for Monetary Policy

Strategies for Monetary Policy is a new book from the Hoover Press based on the conference by that name John Taylor and I ran last May. (John Taylor gets most of the credit.) This year's conference is sadly postponed due to Covid-19. We'll have lots to talk about May 2021.

At that link, you can see the table of contents and read Chapter pdfs for free. You can buy the book for $14.95 or get a free ebook.

The conference program and videos are still up.

Much of the conference was about the question, what will the Fed do during the next downturn? Here we are, and I think it is a valuable snapshot. Of course I have some self interest in that view.

As long as I'm shamelessly promoting, I'll put in another plug for my related Homer Jones Lecture at the St. Louis Fed, video here and the article Strategic Review and Beyond: Rethinking Monetary Policy and Independence here. That was written and delivered in early March, about 5 minutes before the lookouts said "Iceberg ahead." John and I don't put a lot of our own work into the conference books, but it sparked a lot of thoughts.  I am grateful to Jim Bullard and the St. Louis Fed for the chance to put those together.

Monetary policy is back to "forget about moral hazard, rules, strategies and the rest, the world is ending." This is a philosophy that happens quite regularly and now has become the rule and strategy. So strategic thinking about monetary policy is more important than ever.  This is a philosophy very much due to John Taylor.

The last part of my Homer Jones paper delves into just what risks the big thinkers of central banking were worried about on the eve of the pandemic. Pandemic was not in any stress test.  BIS, BoE, FSB and IMF  wanted everyone to start stress testing ... climate change and inequality. This is a story that needs more telling.    

The fire in Treasurys

Just where was the fire that caused the Federal Reserve to buy $1.3 trillion of treasury debt in a month -- financing all treasury sales and then some? I've been puzzling about this question in a few posts, most recently here. Commenter "unknown" impolitely but usefully points me to a nice paper by Andreas Schrimpf, Hyun Song Shin and Vladyslav Sushko that explains some market mechanics. I am still not persuaded that these gyrations motivate or justify the Fed buying these or more trillions of debt, but there is an interesting story here.

Treasury yields

Their first graph shows stock prices and bond yields. As risk and risk aversion rose, as they always do in bad times, stock prices fell and bond prices rose, with yields falling.

Trouble starts on  9 March when "the market experienced a snapback in yields" Look hard at the graph. The blue line rises a bit while the red line continues to fall.

OK, but still -- is it a disaster that the US treasury, that had been borrowing happily at 1.8% in January, must borrow at 0.8-1.2% in March? Is it such a disaster that the Fed must buy all new issues of debt?

"Arbitrage" redux

What caused the "snapback?" here is where the paper gets interesting. Basically a bunch of hedge funds replayed an age-old strategy and got caught. Plus ça change. They bought treasury bonds and simultaneously sold them in futures markets. Since treasury bonds are great collateral they can lever up a small price difference to make a lot with little investment.

But even arbitrage opportunities are not risk free.** Prices that are slightly off can get further off before they eventually converge. And then the hedge funds need to post margin, which they don't have. So, they follow the mother of all financial fallacies -- risk management that consists of selling  positions on the way down, trying to synthesize a put option with a stop loss order. But selling to who? Everyone else is doing the same thing, markets get illiquid in times of stress (no, they've never done that before), so the price difference widens even more.

Treasury Liquidity

So just what was the "disruption" in the Treasury market that so spooked the Fed, that now the Fed is buying more than the Treasury is selling?

A commenter on my last post on corporate bonds points to Treasury Market Liquidity during the COVID-19 Crisis by Michael Fleming and Francisco Ruela at the NY Fed, April 17 .

Michael and Francisco nicely show us the facts. They make no editorial comment at all, except perhaps in the figure titles, so my questions about just how big a problem this is are not directed at them.

Bid-ask spreads widened, to financial crisis levels (when the Fed did not, by the way, intervene.) The plot is hard to read in the far right end in order to compare to 2008. (Suggestion to the authors: focus on the last three months so we can see what was happening, not on the comparison to 2008.) As far as I can make it out, the 5 year spread widened form 0.25 /32 to about 0.4 /32; the 10 year from 0.5 to 1.0 and the 30-year from 1 to 5.

If I read the caption correctly, each of these numbers is 1/32 of one percent of par, 0.03%, so the 5 year spread went from 0.008% to 0.012% and even the 30 year went from 0.03% to 0.16%.

The "order book depth, measured as the average quantity of securities available for sale or purchase at the best bid and offer prices" (my emphasis) declined. There is usually a lot more for sale if you're willing to pay more.

The difficulty of trading includes not just the bid ask spread, but a guesstimate of how much you will depress prices if you sell $100 million in a huge hurry. This price impact went up. But, it is measured as "slope coefficients from ...regressions of one-minute price changes on one-minute net order flow." How bad is it to wait a whole minute to sell $100 million? Also, most traders use fairly complex strategies to minimize price impact. And there is lots to complain about in this measure of price impact. (I prefer autocorrelation measures -- how much did the price bounce back.)

And the absolute value looks to a layperson remarkably small. 7/32 = 0.22%, two tenths of a percent, on the 5 year bond. OK, 0.75% on a 30 year bond which is almost real money. But 30 year bonds are pretty volatile anyway as we'll see in a moment.

Price volatility jumped, especially (actually almost entirely)  for the 30 year bond. The 30 year bond was experiencing 70% annualized volatility, which is 4.4% per day. That puts some of these spread and price impact measures into context. They are orders of magnitude smaller than the daily price volatility.

This is not unique to the Treasury market.  Stock price volatility went through the roof too by the way. Here's the VIX, peaking at 80. The Fed has not yet seen fit to buy stocks, and let us hope it does not do so.

Throughout all these numbers, the steady march from 1, 5, 10, to 30 year bonds is instructive. Longer bonds are more volatile always. "Liquidity" is usually confined to the shorter maturities.

Trading volume was high too. Again you have to squint to see it.

... daily trading volume in the market overall reached a record high for the week ending March 4, averaging over $1 trillion, roughly twice its post-crisis average

What does it all add up to? 

A trillion dollars a week is a lot of buying and selling. What's "disruptive" or dysfunctional about that? This isn't Costco, whose trading volume in toilet paper went to zero after it sold out.

To me, there is a sense of utterly normal in all of this. Supply curves slope up, of everything, including "liquidity."

Obviously, we hit a period of huge uncertainty, divergence of opinion, and liquidity needs. The fundamental, rational, normal, functional, whatever you want to call it, price will be quite volatile, as was the stock price. The fundamental, rational, normal, whatever you want to call it desire to trade will rise as well.

So how does a market react when there is a large increase in the volatility of prices and demand for trading. Well, supply curves slope up -- that demand is accommodated but at a higher price.

Dealers who buy and have to hold securities in inventory for a day or two are more exposed to risk when prices are more volatile, so they buy less other things constant. Bid ask spreads and price impact rise to give them a higher profit, commensurate with that risk. In a time of volatility, there is more asymmetric information, so dealers charge a higher bid-ask spread. This may sound like less of a problem for Treasuries, but there is short term information about future order flows and future Federal reserve actions and even interest rates given the huge macro uncertainty. And the price volatility may be both a sign of trading demand and an inducement to it. If you can spot the direction, there is a lot more money to be made.

Supply and demand. If trading volume goes up while spreads and price impact are rising, the shock is to the demand for trading. If trading volume went down while spreads and price impact rose, the shock is to the supply of trading services. This event sure looks like a shock to demand, accommodated pretty well by dealers. (I wrote a paper a long time ago called "stocks as money," documenting a similar case of demand for trading)

Where is the evidence that something is wrong with supply, that there is also a shift in the supply curve?

Michael and Francisco wryly note the same point:

High trading volume amid high illiquidity is common in the Treasury market, and was also observed during the market turmoil around the near-failure of Long-Term Capital Management (see this paper) and during the 2007-09 financial crisis (see this paper). Periods of high uncertainty are associated with high volatility and illiquidity but also high trading demand. 

also

Not surprisingly, volatility caused market makers to widen their bid-ask spreads and post less depth at any given price, and the price impact of trades to increase, illustrating the well-known relationship between volatility and liquidity. 

So just where is the fire here? Where is the screaming hole in financial markets that justifies the Fed buying $1.3 trillion treasury securities in a month?

Even if "intermediation" were the problem, why is buying up the whole supply the answer, not both buying and selling, to reduce bid-ask spreads?

The Fed announced:

To support the smooth functioning of markets for Treasury securities and agency mortgage-backed securities that are central to the flow of credit to households and businesses, over coming months the Committee will increase its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion.

How does buying it all up promote the "smooth functioning" of markets?  Is there anything more than
"because of (big financial gobbledygook which you wouldn't understand anyway so it doesn't matter if it makes any sense) we're going to buy a trillion dollars of treasurys?"

Finally, if absolute liquidity in Treasury markets is so important, if the ability to transact at 0.01% or less loss, in minutes, is a crucial social problem, then why not talk about some fundamental reforms to those markets?

As described in this post, roughly half of Treasury securities trading occurs through interdealer brokers (IDBs), in which dealers and other professional traders transact with one another, and roughly half between dealers and clients. Our focus is on the IDB market, and on the electronic IDB market in particular, which accounts for about 87 percent of IDB trading. 

Wider trading would make a lot of sense. Federal debt is carved up into 250 different securities or more. As I argued here, if you want them liquid, rearranging federal debt to only a few securities would make each one more liquid. If "balance sheet space," i.e. inadequate equity financing and regulatory risk-taking constraints, are stopping those with expertise in market making from making more markets, why in heaven's name after 12 years of Dodd-Frank act, capital requirements, essays on equity-financed banking, Volker rule and the rest, don't broker dealers have enough equity capital to let them trade through the covid-19 virus on top of a new cholera pandemic and a war? "Constrained balance sheets" are not a fact of nature, they are the product of 12 years of regulatory failure.

 There is a tendency throughout economics to write, "here is my policy," then "here are the problems that motivate my policy." But if you look at the problems, a lot of other policies would solve them better. Economics is too often answers in search of questions.

So, bottom line, I'm still looking for evidence. I'm willing to give the Fed the benefit of the doubt. All the people I know at the Fed are smart and well-intentioned looking at a lot more data than I am. Just what is it that motivates buying a trillion dollars of treasury debt, and more trillions to come?

Bond liquidity

When the Fed stepped in, were corporate bonds "illiquid," the market "dysfunctional," or were the prices just low, as they should be in advance of a Great Recession with larger bankruptcy risk? Did the Fed "liquefy" the market, "intermediate," grease the wheels, or is it just buying, and propping up prices so that bondholders can dump bonds on the Fed before things get really bad?

I asked for evidence on bond market liquidity in my last post on the topic, "Bailout redux," and Pierre-Olivier Weill passed on a paper he has recently written with Mahyar Kargar, Benjamin Lester, David Lindsay, Shuo Liu, and Diego Zúñiga, Corporate Bond Liquidity During the COVID-19 Crisis.

Here is their estimate of roundtrip trading costs -- if you buy and then sell, how much do you lose in bid ask spread. Feb 19 is the stock market peak.  March 18 is the day after the Fed announced it would lend money to broker-dealers and take bonds such as these as collateral. March 23 the Fed announced it would buy corporate bonds on the secondary market, and buy directly from companies issuing new corporate bonds.

Forbearance

Peter Wallison has a worthy OpEd in the WSJ, "Forbearance." Continuing my earlier thoughts on the financial response here and here, I don't think he goes far enough.

Let me tell a little story. Andy runs a restaurant. To run the restaurant, and live, he has a mortgage, he rents the restaurant space, and he borrowed money to buy to buy the equipment. Bob is retired. While he was working he lent Andy the money to buy the house and the restaurant equipment, and he owns the building. He lives off the income from these investments.

The virus comes and Andy has no income. He has enough savings to buy food for a while, and other current expenses. But he can't pay rent, mortgage, and debt payments. This is the central problem our government faces right now.

One answer: The federal government prints money and lends it to Andy so he can keep paying Bob. You can see a major problem here. Andy has no income. Eventually the restaurant may reopen, but then from the same profit stream Andy has to keep paying Bob and also pay back the loan that kept things going in the lockdown. Hmm.

Kocherlakota on moral hazard

I found a kindred spirit. Narayana Kocherlakota, ex president of the Minneapolis Fed, shares my concerns over the current lending and bailout spree, in particular propping up the prices of corporate bonds.

In its last financial stability report of 2019, the Fed highlighted how many nonfinancial corporations were making use of highly risky debt. The report pointed out that “a number of contacts expressed concern that a U.S. recession would expose highly leveraged sectors … concerns related to nonfinancial corporate debt were cited most frequently, with a focus on the growth in leveraged loans, private credit, and triple-B-rated bonds.” 

The financial stability report, of course, made no mention of pandemics or social distancing. It didn't need to — the risk to the financial system and the economy is posed by any recessionary shock. The coronavirus just happened to be the first one that come along.

Bailout redux

The greatest financial bailout of all time is underway. It’s 2008 on steroids. Yet where is the outrage? The silence is deafening. Remember the Tea Party and occupy Wall Street? “Never again” they said in 2008. Now everyone just wants the Fed to print more money, faster. (Well, there are some free market economists left. But we're a small voice!)

Maybe the Fed is right that if any bondholder loses money, if bond prices fall, if companies reorganize in bankruptcy, the financial system and the economy will implode. I am not here today to criticize that judgement. But if so, we must ask ourselves how we got to this situation, again, so soon. Once is an expedient. Twice is a habit.  It is clear that going forward any serious shock will be met by bailouts, and the Fed printing reserves to buy vast quantities of any fixed-income asset whose price starts to fall.

Why does the Fed feel the need to jump in? Because once again America is loaded up with debt, because bankruptcy is messy, and because the Fed fears that debt holders losing money will stop the financial system from providing, well, more debt.

This crisis is a huge wealth shock. The income lost during shutdown is simply gone. The question is, who is going to take that loss? Borrowing to keep paying bills, the current solution, posits  that future profits will soak up today's losses. We'll see about that. The CARES act puts future taxpayers squarely on the hook to pay today's bills. But where do those bills go? To creditors -- property owners, bond holders, and so forth. If we're looking around for pots of wealth to absorb today's losses, why are bondholders not chipping in? The biggest wealth transfer in history is underway, from tomorrow's taxpayers to today's bondholders, on the theory that if they lose money the economy falls apart?

OK, but why did America load up with debt again, apparently all "systemically important?" Could the expectation of a bailout any time there is an economy wide shock happens have had something to do with it? Will we do anything when this is over to stop companies from once again loading up with debt -- especially short term debt -- and forcing the Fed's hand again?

Meantime, anyone who hoarded some savings in the hope of profiting from fire sales, in the hope of providing liquidity to "distressed markets" has once again been revealed as a chump. Will we do anything to encourage them? Will lots of debt, private gain, taxpayers take the losses,  be the perpetual character of our financial system.

"You can't worry about moral hazard in a crisis," they said, and they didn't. At least last time there was some recognition of moral hazard, and a promise to clean up the moral hazard with reform. Will there be any such effort this time? Is anyone even thinking about the enormous moral hazard we are creating with these precedents? Will  the financial system perpetually a four-year-old on a bicycle, a parent running closely behind with one hand on the seat? Will the "Powell put" on fixed income grow ever larger? Or will we, this time, finally cure the financial system so it can survive the next shock?

A bailout 

Small but symbolic: The federal government just bailed out the airlines -- or more precisely airline stockholders, bondholders, unions, airplane leaseholders and other creditors who would lose in bankruptcy.

 "big airlines will receive 70% of the money as grants—which won’t be paid back—and 30% as loans. The cash comes with strings attached: Airlines must give the government warrants amounting to 10% of a given loan’s value that can be swapped for stocks; they cannot lay off staff until September; and they face restrictions on dividends, buybacks and executive compensation."

Oh, and as the article makes clear, this only gets us maybe through the summer. Anyone want to take a bet that planes are full again by September?

The big banks got bailed out in 2008 — or more precisely, the stockholders, bondholders and creditors of the big banks got bailed out.  Never again, they said. Again.

Now, one can make a case that big banks are “systemic,” that if their bondholders lose money the financial system collapses. Just how are airline bondholders “systemic?” What calamity falls if airline bondholders don’t get paid in full?  Just why is a swift pre-packaged bankruptcy not the right answer for airlines? This seems like a great time to renegotiate airplane and gate leases, union contracts (some require the airlines to keep flying empty planes!) fixed-price fuel contracts and more.

If taxpayers have to give airlines cash grants don't we get some reassurance this doesn't have to happen again? Even I would say, no more debt financing. You can see the instinct in "restrictions on dividends, buybacks and executive compensation." Democrats in Congress wanted "stakeholder" board seats, carbon reporting, and more. Why not go full Dodd-Frank on them? Detailed regulation of their financial affairs, stress tests to make sure they can survive the next time? Like banks, the existing airlines might not end up minding so much a return to the 1970s status as regulated utilities. Or, more likely, like GM, we just forget about it, let them load up on debt again, and pretend there won't be a 2030 bailout?

The Fed's big artillery

The real action is at the Fed. The Fed is buying commercial paper, corporate bonds, municipal bonds. The Fed is explicitly propping up asset prices. The Fed is also lending directly to companies. The current guesstimate is $4 trillion, with $2 trillion already accomplished. More is coming.

It started "small" On March 17, the Fed bailed out money market fund investors, buying the “illiquid” assets of those funds so that the funds could continue to pay out dollar for dollar.  Recall that in 2008, the Fed and Treasury bailed out money market fund investors, buying assets to stop a run on money-market funds' promise that you can always cash out at $1. Never again, they said. Fixed dollar promises must be backed by Treasuries, other funds must let asset values float. Again.

On March 17 the Fed also announced it will buy commercial paper.  “Directly from eligible companies.” Yes, the Fed prints reserves to lend directly to companies that can issue A1/P1 commercial paper.

"By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. " 

Why are companies borrowing long term by rolling over commercial paper? Didn't we learn anything about rolling over short term debt in 2008? Are we going to follow up by putting a stop to that? Why don't companies have more equity financing, on which they can just stop paying dividends?

"Investors" you say, it's not all the Fed. Read carefully. "By eliminating much of the risk..." The Fed props up prices, and removes risk. Then private investors will come in. The markets won't ride that bike without the Fed's hand on the saddle, apparently. Why do we bother to have private markets?

On March 17 the Fed started to lend again to primary dealers. These are the traders, much maligned by the Volcker rule.

The PDCF will offer overnight and term funding with maturities up to 90 days...Credit extended to primary dealers under this facility may be collateralized by a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities. 

Let's translate. You're the trading desk at, say Goldman Sachs. You want to buy stocks, as you think people are dumping in a hurry. Great, that's what traders are supposed to do: "provide liquidity." But, sadly, you're in the habit of of funding trading activity by borrowing money, short term. And you can't do that right now. So the Fed will now lend you the money to buy stocks, and will take the stocks as collateral! It's almost as if the Fed is buying stocks -- except you get the gains, and if you go under, the Fed gets the stocks! (A friend in the securities industry say nobody is bothering to investigate and price high grade corporates. The Fed is setting the prices.)

Again, the Fed is between a rock and hard place. Yes "balance sheets are constrained." Trading firms don't have enough equity to take on additional risk. The natural buyers at asset fire sales are constrained out of the market. Bail the Fed feels it must. But this is exactly what happened when the Fed first lent to broker/dealers in 2008! Why in the world are we in this position, 12 years after that crisis?

On March 20, the Fed expanded into state and municipal markets. The mechanism is the same: Fed lends to a financial institution, which buys the assets, and then gives the Fed the assets as collateral for the loan. Once again the point is  "enhance the liquidity and functioning of crucial state and municipal money markets."

On March 23, the Fed rolled out real artillery. Ominously, Treasury markets appeared "illiquid," so the Fed has stepped in buying $1.3 trillion in the first month -- more than the Treasury issued.  The Fed is funding Treasury borrowing with newly printed reserves.  The Fed now buys mortgage backed securities.

And now.. corporate bonds. This is well past 2008.

the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.

Translation: The Fed will buy new corporate bonds, thus directly lending to corporations. And it will buy  outstanding bonds.

Why would it do that? Well, to "provide liquidity." This is a word that ought to set off BS detectors. Yes, there is such a thing as an "illiquid" market. There is also such a thing as a market whose prices are dropping like a stone. Sell all you want but at 50 cents on the dollar. "I wish I had sold at yesterday's prices" is not illiquidity. You have to pay people a lot to take risk right now. Which is it? Hard to tell. There are ways to tell, of course. For example, illiquid markets have negative price autocorrelation -- a low price today bounces back. I am not aware of the Fed having applied this or any other test. (Research topic suggestion.)

Again, I don't want to criticize, but there sure is a danger of propping up prices under the guise of "illiquidity." The Fed's view that if the Fed takes all risk off the table "liquidity" will reappear is also pretty close to taking risk off the table so prices will rise.

The Fed is already buying new bonds from companies to finance their new expenditures. Propping up prices of existing bonds is a way to let old bondholders cash out at high prices, now before the deluge. Just why can't old bondholders even take mark-to-market losses?

And, if corporate bondholders need to be bailed out in this way, are we going to do anything about it going forward? Do you get to buy junk bonds, high interest municipal debt, and the Fed will let you out if anything bad happens?

Wrap up

OK, I haven't even gotten through March and the Fed is just getting going. Let's wrap up.

The Fed has felt the need to take over essentially all new lending in the economy. The Fed is also propping up most fixed-income prices. The Fed is deliberately removing risk from holding these assets.

Once again, I will be told, "this isn't the time to think about moral hazard." But having done this twice, the first time with huge protest, the second time as if it is perfectly normal, this is the pattern, and the moral hazard is there. The economy will load up on debt, especially short term debt. People will not keep stashes of savings around to provide liquidity or jump on buying opportunities. And the need for bailouts will be larger in the next crisis.

"But the Fed made money in 2008" you may retort. And it has a half chance of making money again. If the recession wraps up in September and these "loans" get paid back, it will do nicely. If the recession goes on a year and all these "loans" go sour, it will not look so pretty.

Yes, in 2008 the Fed and treasury successfully operated the world's largest hedge fund, printing money to buy low-price assets. But is this really the function of the Federal Reserve? Do we want it driving private hedge funds out of the liquidity provision business, by its ability to print rather than borrow money, and by the off-balance-sheet put that the US taxpayer will in the end take losses if this massively leveraged portfolio doesn't work out?

Where is the outrage? Where are the financial economists? Where is the reform plan so we don't do this again? At a minimum, can we say tha  the government could stop subsidizing debt, via tax deduction and regulatory preference for "safe" (ha!) debt as an asset?

Hello out there? In 2008, everyone was writing financial crisis papers. Now everyone is playing amateur epidemiologist.

Finance colleagues, you have a bigger crisis and intervention to study, and a deeper set of regulatory conundrums. Is everyone just too scared of sounding critical of the Fed? Get to work!

The Fed and Treasury's actions are telling us we are on the verge of financial apocalypse. Let's wake up and look at what's coming, especially if it doesn't all get better by September.

Some links 

This post continues from Financial Pandemic.

I had planned a longer post on the details of many of these programs, but this is long enough.


A great explanation by Robert McCauley in FT. Section heads include  1) Acting as a lender of last resort to securities firms, 2) acting as a lender of last resort to investment funds, 3) acting as a securities dealer of last resort, 4) acting as a securities underwriter of last resort and finally 5) acting as a securities buyer of last resort.

A simple tweet storm by Victoria Guida

Via the indefatigable Torsten Slok,

Financial Policy During the COVID-19 Crisis MIT opeds on financial affairs

A great list of policy trackers.

Financing Firms in Hibernation During the COVID-19 Pandemic

The Yale Financial Stability Tracker and especially the Finance Response Tracker are very useful list of what's going on.

Fed Intervention in the To-Be-Announced Market for Mortgage-Backed Securities
by Bruce Mizrach and Christopher J. Neely is a very nice description of what's going on there

The United States as a Global Financial Intermediary and Insurer by Alexander Monge-Naranjo. More contingent liabilities waiting for Uncle Sam bailouts.

A data set of international fiscal responses

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. 

Questions. 

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.

Strategic Review and Beyond: Rethinking Monetary Policy and Independence

March 4, I was honored to give the Homer Jones lecture at the St. Louis Federal Reserve. Link here

Strategic Review and Beyond: Rethinking Monetary Policy and Independence.

I used the opportunity to put lots of thoughts together in condensed form, on how the Fed and other central banks should approach monetary policy, financial regulation, and ever-expanding mandates.  The link is to the html version. It will appear in prettier form in the April St. Louis Fed Review.

The conclusion

Should, and can, the Fed stimulate with strongly negative rates, immense QE asset purchases, and an arsenal of forward guidance speeches? I think not. What sort of target should it follow? A price-level target. The Fed should get out of the business of setting the level of nominal rates and target the price level directly. Price-level control will be much more effective with fiscal policy coordination. The Fed should offer a flat supply curve of interest-paying reserves, open basically to anyone, though the Treasury should take up much of that role directly. 

Going forward, the Fed and its international counterparts should disavow the temptation toward ever-expanding mandates and economic and financial dirigisme that would take them to "macroprudential" policy, discretionary credit cycle management, asset price targeting, and exploiting regulatory power to embrace social and political goals… today on climate change and inequality, perhaps tomorrow on immigration, trade restriction, China-isolation, or whatever the smart set at Davos wants to see. Only limited scope of action to areas of agreed technocratic competence will salvage the Fed's, other central banks', and international institutions' useful independence.

Of course this effort arrives with spectacularly bad timing, as nobody is talking about anything but the Covid-19 virus. Still, life does go on, and I don't see anything that is directly contradicted by current events. And perhaps you want to read and think about something other than virus crisis, and issues we will go back to thinking about when it's all over.

In the final section (see the footnotes too) I discovered that our international institutions, BIS, IMF, FSB, and so forth were busy dragging banks into the partisan warfare over green new deal style climate policy and forced redistribution. I took a dim view of that. First of all, the idea that climate and inequality present financial risks is just fanciful. Most importantly these are political minefields that will doom independence.

I think this section holds up well. That the worthies who look in to the future and spot risks to the financial system, and drag banks into accounting for them via stress tests and regulatory accounting, found climate change and inequality the biggest run-provoking risks they could think of, not even mentioning pandemic, tells you volumes about the whole technocratic project.

If you like to watch videos, here is the actual lecture somewhat shorter than the written version.

Fed Bombshell

The Fed just announced "extensive new measures to support the economy." What's this all about?

The PMCCF will allow companies access to credit ... This facility is open to investment grade companies and will provide bridge financing of four years. ... The Federal Reserve will finance a special purpose vehicle (SPV) to make loans from the PMCCF to companies. The Treasury, using the ESF, will make an equity investment in the SPV.

When the Fed buys a Treasury bill, it creates new money with which to buy the bill. It simply increases the amount of reserves, which banks can freely transform to cash, so you can think of it as printing up money to buy the bill. Why doesn't this cause immense inflation? Well, the Fed backs the money with the bill. The overall quantity of government debt has not changed, just the composition.

When the Fed lends money to a bank or business, it looks the same as a matter of accounting. The Fed prints up money, figuratively, and gives it to the bank or business. The loan then counts on the Fed's balance sheet just like the Treasury bill as an asset backing the money.

But there is a difference. Banks and businesses can default. That "asset" may be worthless. Printing money and giving it to business and counting the loan as an asset leads to all sorts of problems.

That's why the Fed is funneling this through the Treasury. The Fed prints up a dollar, gives it to a "special purpose vehicle" along with the Treasury, and the Treasury is supposed to take the risk of default. That is, in my view, appropriate. The Fed cannot stay independent if it lends to specific risky businesses, and takes on the risk they won't pay back.  The Treasury is politically accountable.

Overall, though, the government is printing money and handing it out to businesses. Functionally it is the same as if the Treasury borrowed money, lent it to business, and the Fed bought the Treasury bills. But it happens faster, and gets around the debt limit and lots of other interference.

This post refrains from judgement. I just thought it useful to explain what's going on.

Implementing Federal lending

The central problem now is how the Federal government can lend money to businesses that need it -- without a budget blowout. I proposed letting people borrow from the IRS which has a pretty good mechanism for getting repaid. Martin Lowy has a more detailed suggestion along these lines:

• Credit for any business that needs it, so long as the business’s history suggests that it will have the capacity to repay, given enough time.
• A simplified underwriting system based solely on filed tax returns. Bank-style underwriting is a cumbersome process that would impede the flow of credit and would tend to make it subjective and political—and therefore a subject of criticism all along the way.
• A repayment period of something like 36 months that begins a few months after the crisis has passed. A business cannot begin to repay until it has had some time to get back on its feet.
• Use of the income tax mechanism to enforce repayment so that no new bureaucracy is required and so that the system will be seen as fair, rather than based on subjective criteria.
• A mechanism to assure that recipients of these loans will continue to use them in part to continue to pay their employees.

The devil is always in the details. Just what rules are overstressed IRS employees supposed to implement to judge if a "business’s history suggests that it will have the capacity to repay, given enough time?" Just what is the final "mechanism?" Once again, that we have entered this crisis so unprepared means it is unlikely a measure like this can be rolled out in the needed days, let alone weeks or months. Still, it starts to flesh out a good idea -- or at least a better idea than enormous stimulus checks and bailouts all around.

Update: Lowy responds by email:

• Who may get credit? Loans would be extended to any business that filed an application, but limited in amount by the business’s historical sales and profits as reported to the IRS.
• In what amount? The size of advances would be a percentage of the revenue and taxable income of the applicant. The lesser of one twenty-fourth of gross sales or one-sixth of taxable income. No subjective criteria.
• Period for repayment. Depends on the length of the crisis. If the crisis/credit advances last 4 months or less, 36-months; longer crisis, longer period for repayment.
• Application process. Electronic only. Simple facts. Promise to repay. TIN. Account to send advances to. Amount requested per month. All based on last annual tax filing.
• Employee compensation certification. Certify that in each pay period after receiving a credit, applicant would pay every employee who was on the payroll on February 15, 2020 at least 75% of the average amount paid to that employee in the last four pay periods before that date.
• Interest rates. 5% per annum, except if the business was borrowing at a higher rate—then that higher rate.
• Collateral. None.

I (Lowry) welcome additional questions about the details.