Saturday, March 14, 2020

"Pay For" Questions Don't Make Sense on Fed Policy. Do Any?

The Fed announced further measures today designed to stave off the continued plummeting of prices in financial markets. Overall, the Fed has announced over $1.5 trillion in market operations so far. In response, numerous commentators who support robust free public services questioned the apparent hypocrisy of the lack of scrutiny over how such spending is to be financed when it comes to the financial sector. The question doesn't make a whole lot of sense, however, when you consider the difference between when the Fed spends money and when the federal government does it.

What Is the Fed?

The Federal Reserve Bank of the United States, more commonly known as the Fed, is the central bank of the United States. Although central banks had originally sprung up more or less organically well prior, the Federal Reserve was set up specifically in response to a series of financial panics in the early 1900s. Like with previous iterations of central banks, the Fed was designed to enable the financial sector to find a lender during financial panics and to enable the government to find a willing lender for debt-financed fiscal policy.

The central bank is set up like any other with the exception that, for all practical purposes, it has the sole authority to create money from nothing. Technically the Treasury controls the printing presses of physical currency. the Fed, however, is capable of creating liquid lines of credit that can be redeemed for cash, hence effectively "creating money." Rather than simply giving money away, however, the Fed spends the money into the economy either by buying financial (and sometimes physical) assets or by writing loans.

The Fed primarily deals in two kinds of loans. First, there are loans to the government which result in the creation of Treasury Bonds, Bills, and Notes. Second, there are loans to banks that have accounts at the Fed. Typically, these are overnight loans designed to hold banks with a negative balance sheet over until the next day when they are paid back. However, during the current health crisis, the Fed has been issuing two-week loans.

Why Doesn't the Fed Just Give Away Money?

Why the Fed lends rather than outright gives away money makes more sense when you consider the Fed's other duty, taming inflation. Inflation is a general rise in the rate of prices and is generally attributed to enthusiastic business activity (namely, enthusiastic bank lending and asset purchasing) outpacing the production of actual goods and services. This is bad because it means that people's incomes will allow the purchase of fewer and fewer goods as prices continue to rise. In this instance, the Fed is tasked with intervening to slow bank lending activity.

Because the Fed sets minimum reserve requirements, banks need to have a certain portion of their outstanding loans (mortgages, business loans, etc.) financed by their deposits or other cash on hand (really just electronic credit though they do need some of this in cash) so that they can meet their deposit demand obligations. Although banks can increase their cash on hand by issuing additional stock (which might not look good for them), for the most part, banks keep their books balanced by taking short-term loans from other banks or, as a last resort, the Fed.

To cull inflation, the Fed seeks to reduce the overall availability of credit in the banking system by reducing private bank reserves. However, the Fed cannot simply steal money from the balance sheets of private banks. Instead, the Fed sells assets from its own reserves, collecting "money" from banks and other market actors where it blinks out of existence. Hence, if the Fed simply "printed money" by dumping liquidity into the market rather than lending it, it would have no assets with which to "buy" the money back for the sake of monetary policy.

Why Does the Government Borrow from the Fed?

Technically, the Treasury can print money autonomously to distribute into the economy. So why does it generally only print money to meet the Fed system's credit obligations? The answer lies in how money comes to hold value. There are a lot of different approaches to answering this question, but the implications are roughly the same for what we are discussing here. The most common explanation is that money retains its value by being able to purchase goods and services. Put another way, the portion of the money supply you have entitles you to an approximately proportionate claim on the goods and services produced in the economy.

At the microeconomic level, this works by virtue of increased spending driving shortages, leading business owners to increase their prices. If this happens in a large number of sectors, these additional costs can be passed onto other businesses, causing a general rise in prices. In addition to the Fed tools mentioned above to take money out of circulation, the federal government can increase taxes to cool inflation and take money out of circulation.

All this is to say that, barring the treasuring printing money for the government to distribute as cash, spending does not create the obligations for the Fed that it does for the government. In buying assets and holding loans from both banks and the government, Federal Reserve spending creates financial assets that bolster the Fed’s reserves, guaranteeing the Fed’s ability to stabilize the monetary system, and maintaining confidence in the value of the dollar.

The government on the other hand does not receive assets when it spends money. The purpose of government spending is to provide services to people directly through government contractors or distributing means of payment directly to consumers. In either case, unlike the Fed, the government does not create an obligation to pay back the money it spends or require the transfer an asset to the government in exchange for fiscal expenditure. Thus, for the Fed, there is nothing to “pay for” because the money is conditional on repayment.

Why Is the Fed Increasing Bank Liquidity?

In normal economic circumstances, businesses regularly take on certain amounts of short-term debt and open lines of credit to cover expenses that may occasionally be in excess of fluctuating income. Larger businesses can issue their own debt instruments called bonds which, like the loans the government takes from the Fed, are sold as financial instruments. Businesses use the proceeds from issuing bonds to pay for improvements that they expect, combined with normal inflation, will increase their income and their ability to pay the bond holders.

These are not normal economic times. Major sports leagues are suspending their seasons, movie sets and Broadway musicals are shutting down, and entire school systems are moving online if not suspending classes altogether. The economic activity that provides the incomes to finance the normal debt load held by US corporations. Because of these suddenly overwhelming debt obligations, businesses are seeking to open new, indefinite lines of credit in order to cover their regular expenses, as well as increasingly demanded paid sick leave policies.

Because of the reserve limits on lending, banks are finding themselves increasingly strained, unable to safely lend to new clients and possibly meet demand for deposits. The Fed is buying assets and extending credit to banks in order to ensure that banks can in turn extend credit to businesses. Alternatively, the banks could purchase assets, pushing financial markets up. Either situation would be preferable to the mass sell-offs and bankruptcies that could result if the credit system seizes up.

Is the Fed Policy Good?

The main problem with relying on monetary policy in this situation is that it works by compounding the problem it aims to solve. Namely, Fed policy induces banks to provide money to pay for business debts by loading businesses with more debt. This policy will continue only for as long as the banks are willing to play along and extend additional lines of credit. This explains the Fed’s unconventionally longer loans than typically extended to banks. And though the Fed could theoretically buy and cancel consumer debt to free up flagging worker incomes for other expenditures in addition to creating bank liquidity, there are no signs the Fed will pursue this path.

Attempts at expansionary monetary policy to stave off a recession like the Fed is pursuing is often likened by economists to pushing on a string. Because the Fed cannot guarantee increases in the incomes of businesses outside of taking on additional debt, it also cannot guarantee that banks will opt to lend to them. Government spending, however, has the ability to guarantee incomes both to businesses and consumers. And while fiscal policy means the creation of government debt obligations, it is unlikely (some say impossible) that the government would ever be forced to default on its debt since the agents who would do that have portfolios which, like the overwhelming majority of financial instruments, are largely denominated in dollars. Hence, to bet against the dollar is to bet against their own assets.

Rather than whether we can “pay for” fiscal policy, however, we may need to be asking what it is that fiscal policy will pay for. Unlike a standard recession, where worker spending power is not sufficient to support the current level of production, the social distancing and sick leave coerced by COVID-19 has caused a dip in production that can’t be resolved by simply increasing incomes. Solving this crisis will require us to rethink the relations of production and possibly of property. As municipalities and other jurisdictions suspend evictions and utilities shut-offs, the notion of what it means to own things will be challenged. As production is reorganized to accommodate the realities of this plague, we must engage the fundamental question any economic system must answer: who produces what for whom, and how?