Feb 18, 2019

Peter Stella on Debt, Safe Assets, and Central Bank Operations

A Macro Musings Transcript
David Beckworth Senior Research Fellow , Peter Stella

David Beckworth: Our guest today is Peter Stella. Peter is the managing director of Stellar Consulting and formerly an IMF official, where he led the central banking and monetary and foreign exchange divisions, among other things. Peter has researched and written extensively on safe assets, collateral, and central banking operations. Today, he joins us to discuss this work. Peter, welcome to the show. 

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

Peter Stella: Thank you. Thank you, David, for having me. 

David Beckworth: Oh, it's great to have you on. So back during the crisis and the years after that, those of us who were really into following what was going on, we became familiar with your work along with your co-author, Manmohan Singh. FT Alphaville highlighted a lot of your work. At least that's the medium that let me on to what you were doing. So it was real fun to follow it and to think about these issues. So it's neat to have you on as a guest, have a face to face conversation. I want to hear, what was it like during the crisis, and working at the IMF during this time? What was your experience? 

Peter Stella: So, you might say I was in the right place at the right time, or the wrong time, from the global economy standpoint. I was head of what's called the central banking division, and we were asked, or the IMF was asked to give some feedback or examine the reaction of the major central banks during the crisis. I was asked to head that team for institutional reasons. 

Peter Stella: So we visited some central banks and talked to them and were kind of pressed to think through what they were doing, so that was very interesting. At the same time, my 25 years at the IMF, I had been exposed to countries having banking crises. That's our kind of clientele that we work actively with. I've seen central banks with huge balance sheets, I've been in hyperinflations, I've been in Argentina when inflation was 198 and a half percent in a month. So it's not kind of something I'm reading about, it's something I'm looking at. Of course, I was trained as an economist, but it's another thing to go and be at the supermarket and get nervous because there are no prices anywhere. This was in the 1980s, by the way. 

David Beckworth: Interesting. 

Peter Stella: And you were wondering, do I have enough money to pay? I asked somebody in Spanish and they say, "Oh, well, nobody knows what the price is until you get to the cashier." 

Peter Stella: Literally. So, they would download, batch load different prices every hour or so. I got to see a lot of sort of macro phenomenon up close over 25 years that kind of came in handy when people in the US were saying, "Oh, you know, nobody's ever had to cope with this before. Nobody's ever seen this before." 

Peter Stella: Well, yeah, I mean, I can give you dozens of cases that are relevant for this. 

David Beckworth: So you were well prepared for all of the innovations that took place in the US and the ECB based on experience with these other countries. 

Peter Stella: Yeah, and just a framework of what's important and what's not important. Before I was head of the central banking division, I was head of the division called monetary and exchange operations division. There, I learned from people how monetary policy is executed, how the plumbing works. The FOMC says “raise interest rates by 25 basis points.” Well, how does that happen? Somebody in New York does something, and that's a common problem in many central banks around the world. The policy makers decide something based on their models, and then you've got to make it happen, and sometimes it's really difficult to make it happen because it's not the textbook. You don't just take a first derivative and everything works. 

David Beckworth: It's more than applied math. Well, we want to get into the plumbing and the operational details as we move forward in our conversation, but let me begin our talk today by going back to the pre-crisis period, and you and Manmohan did a number of articles highlighting the money creation process leading up into the crisis. And then we'll move into the crisis, but tell us about what we got wrong and what we got right about this plumbing, this execution of monetary policy, and how money was created. 

Peter Stella: Right. So, sometimes I give an analogy. On one side of my family, they are Irish plumbers in New York City. My mother had an uncle who installed the plumbing and was part of the team installing the plumbing in the Empire State Building. 

David Beckworth: Interesting. 

Peter Stella: So I think a lot of people don't think about plumbing, how it works, until something breaks. And when the plumbing breaks, you don't usually call the architect of the building, you call the plumber, right? Because they're the ones who actually know how to fix things and how they work. 

Peter Stella: And I think in normal times, you don't need the FOMC, you don't need the head of the Fed to understand exactly how the plumbing works. They have models. They can do their job and captain the ship without knowing how the boiler in the ship works, whether it's fueled by coal or oil or something like that. Until the plumbing breaks, and then suddenly, you can have a problem, because people have these mental models of how the world works and they're actually wrong. And it matters, because you're making policy decisions based on a false model. 

Peter Stella: So I think the most important thing, and if your listeners think at the end of this I'm a clown, I'll give them a few facts that they can check and they can contemplate, even if whatever I, however I interpret them you don't agree with. So let's talk about money and the payments system in any advanced country today, or in 2006 or 1996. 

Peter Stella: We're talking about, say, government created money, central bank created money. There's basically two kinds, the physical paper money and bank reserves. So if you look in the United States, we first use the one that we're familiar with, they have a retail analogy. So if the Fed surveys households, how much cash do you hold in your wallet? And the answer is, on last year's survey was $59. So, how often do you make a payment with cash in a day, on average? About one, 1.3 times a day. Obviously you're making cash payments for small amounts. Let's just say the average person holds $60 in their wallet, they spend $20 a day, which is on the high side. Let's say the average adult population in the US, something like 200 million, multiply that by 20, you're getting $4 billion of cash transactions a day. So that's one part of that money, used for payments, about $4 billion. 

Peter Stella: Now, how many gross payments, what's the value of gross payments in a day using bank reserves? I'll answer that question. Through Fedwire alone, $3.5 trillion a day. Okay? $3.5 trillion. If you add in chips, which is a kind of subset of Fedwire, it's the big banks and they make payments among themselves, and then at the end of the day they net everything out and settle through Fedwire. So that's another about $1.5 trillion a day. So we add just those two together, you're getting about $5 trillion of gross payments a day, electronically. 

Peter Stella: Now, you take that in a year, you're getting basically close to $1 quadrillion in payments. Quadrillion is a thousand trillion. 

David Beckworth: Blows the mind. 

Peter Stella: So when we talk about payments and money, it's all about bank reserves. The cash component. What did we say, $4 billion, compared to $4 trillion. Now, here's the other kind of crazy thing. So I'm saying, you're making five trillion payments electronically every day. And by the way, this is pretty similar to target, too, in the European union, it's about five trillion euro a day, and in the UK it's about five trillion pounds a day. Just coincidentally, it comes out to be five trillion. 

Peter Stella: So you say, okay, what is the value of bank reserves that's kind of being used to affect $5 trillion in payments a day? And before the crisis, which was normal time, and I'm talking about decades before the crisis, the average amount of all the US banks, the Federal Reserve banks, at the beginning of the day, be about $15 billion. And the amount at the end of the day, $15 billion. So JP Morgan, for example, in 2006 was holding $2 billion in all the federal reserve banks. Biggest US bank at L2, right? 

Peter Stella: So basically you're saying, how does that happen? Well, basically, banks are sending messages electronically at about 40 percent of the speed of light. They're netting out, it's a closed system, what they're transferring funds among each other. So it's just a fact, they were doing five trillion in gross transfers with basically zero balances at the Fed, and the system was working just fantastic. 

Peter Stella: As I say, it's not just the Fed, it's the UK, it's Europe, it's Japan. That's the way modern payments work. So when we think about money or kind of the quantity theory of money, it kind of doesn't resonate with the way the system works in practice. There's something else that's kind of interesting, and then we can move on, but I think it's important to know where I'm coming from. 

David Beckworth: Absolutely. 

Peter Stella: Because this completely changes what most people think, why money is important. It's very important, but you can do everything you need to do with a very small amount. If you look at the Canadian payment system, their balances, all the banks were less than a billion Canadian dollars. We're talking about millions of Canadian dollars. 

Peter Stella: So that sort of payment, that's actually how payments are made. They're made electronically. So we don't need any more money. We don't need more balances to make more payments. If you look at the correlation between balances at central banks in the US and Japan, over time, fact, US banks were holding more balances at Federal Reserve banks in 1951 than they were at the end of June 2008. Just a fact. 

David Beckworth: That's striking. 

Peter Stella: The payments have gone up by 10,000 times. GDP has gone up. So there's a correlation between the volume of payments, that's five trillion a day, and GDP. They move pretty much in unison. But there's absolutely no ... Well, there's actually a negative correlation between changes in bank reserves and any other kind of macro number like credit or GDP. 

Peter Stella: Now, another kind of interesting thing, surprising thing, I suppose, is that during the day in these payment systems, there's a lot of payments going back and forth, and basically they net out during the day. Because it's a closed system, all the banks are members of the Fed and they have to net net zero, essentially. So at the end of the day they're in balances and they have an overnight loan, and then they move on to the next day. But during the day, of course, banks need to make payments, and they haven't received payments. So if they need to do that, a client says, "Look, I need this payment made right now at 11:00 in the morning, I can't wait until 3:00 in the afternoon," so the bank can, and the Fed, it's different mechanisms in different central banks, basically have electronic collateral. You charge your bills and get what's known as a daylight overdraft. 

Peter Stella: So the Fed lends, creates reserves during the day against collateral, and then by the end of the day when that bank gets the payments, receives payments, it repays that daylight overdraft. So if you want to look at sort of the expansion and contraction of the supply of bank reserves during the day, remember I said it would open at about 15 and end at 15. During the day, the typical maximum amount would be something like $150 billion. So if you're trying to equate changes in the money supply and changes in inflation, I'll just tell you a fact. Every day, well, you were doing your job, the Fed would basically blow up bank reserves by a factor of 10 and then contract them by a factor of 10. 

Peter Stella: I'm kind of finished with my facts, the maybe shocking facts, so now we can talk about all kinds of things in a different context. But the bottom line in my view is, please don't tell me we need more bank reserves to make payments. We don't need any more cash. But if you want it, the Fed is happy to give them to you. They're not rationing reserves. 

David Beckworth: This raises some interesting questions. There was this interesting debate now whether we moved to a corridor system or stay with the floor system. One of the observations some Fed officials will make is, "Well, it was just a mess pre-2008. It was this system where banks would have to borrow from the Fed, or there were spikes in the interest rate." 

David Beckworth: And what you're describing is a system that actually worked fairly well. 

Peter Stella: Right. So let's come back to, why do we call them central banks? What's central about the central bank? Well, in the old days, the bank ... In fact, this is still the legal structure of the Fed. Banks joined together, kind of in a co-op, where they would pool their reserves at the central bank. They would go and they'd bring their checks and payments and they would settle payments among themselves. They would just move the reserves around, it's like a clearinghouse model. So in the physical times, we had to have the bank in the US, we would have to be in New York, so everybody could physically bring the thing, it's got to be in a central location. So now we're just doing it electronically. Right now it's like there's one balance sheet. Oddly, the US has 12 balance sheets, but that's, you know, electronically they were consolidated. 

Peter Stella: So that's kind of the basic function of the central bank, is to facilitate payments. Now, we come along to say, okay, so what is monetary policy? And I think one of the big mistakes that academics have made, and people have made in general is to think of the central bank as everything that goes on inside a building. Central banks do different functions. One is this payment system function I'm talking about. And then they do the monetary policy function, they might do some legal regulation function, and so forth and so on. So when we talk about central bank independence, I don't think anyone really argued that Janet Yellen shouldn't have to pay her parking tickets because she's independent. Or that Janet Yellen can do fiscal policy because they're independent. No, no, no. All the argument was about monetary policy independence. 

Peter Stella: We can argue that's a good idea or a bad idea, it's probably a good idea. But what I'm saying is, we have to make a distinction between what we want the central bank to be accountable and independent for, and the other things that, wait a minute, we didn't mean that you could do these other things. So when we come back to this notion that the payment system and say, "Oh, things weren't working well before," I would absolutely argue against that if I know anything. Just the statistics I'm giving you, right? 

David Beckworth: Right. 

Peter Stella: US payment, unbelievably efficient. You can handle this five trillion a day. Nobody even knows. Nobody even thinks about it. And I think, incidentally, that people who manage corporate, bank treasurers, a lot of this is done in Florida. They're in Florida, IT systems, right? It's just an IT system. So it's not part of what we think of as the normal banking business, but it's a big part of the economy and that's what the central bank is supposed to do, make sure that works well. 

Peter Stella: If you look at September 11th, the tragedy, physical destruction of primary dealers and so on and so forth, yes, there had to be some kind of injection of liquidity and all that. But really, it was remarkably resilient, remarkably efficient, robust. It's just unacceptable. I mean, it's absolutely state of the art technology. So this idea that we need sort of crypto coins or something because we don't have enough money is, to me, just ... I don't get it. 

David Beckworth: It's ludicrous. 

David Beckworth: Yeah. So that's the pre-money creation payment system, going into the crisis. So we go into the crisis, 2008, the Fed begins its large-scale asset purchase programs or QE. And you and Manmohan did a number of pieces, I referenced earlier, about the adverse side effects or consequences of that. Tell us, why did those purchases create strain on the financial system? 

Peter Stella: If we want to talk about why I never use the term QE to refer to the US, that's another long story. So the US, in my opinion, never did QE, so they did large-scale asset purchases. So what's the unintended consequence of that? 

Peter Stella: Basically, what you've done is, you've done a debt swap. Let's consider bank reserves as part of US debt. It's a liability of the Fed, and if you dig deep on the US Treasury website, you'll find that the US Treasury considers the federal reserve notes as a liability of the US Treasury. By the way, they're signed only by treasury officials, which could give you pause. Say, well, why aren't we like other countries where the head of the central bank signs the bank notes? Well, actually, if you look at them, they're signed by the treasurer. So they're a liability of the treasury. And I know some people have said, "Oh yeah, but that's not interest-bearing." 

Peter Stella: Well actually it's always been interest-bearing, just a nominal interest rate of zero. Real rate was positive, if you have deflation. It's negative if you have inflation, but it's no different than a treasury bill in that sense, like treasury bill is auctioned usually at a discount, so you make interest. But now in many countries, they're being auctioned at premium, so you're making a negative return. 

David Beckworth: I agree with that point. I think it's fair to say that, even implicitly, I think market expects the treasury to bail out the Fed should something go wrong, so these are liabilities of a consolidated kind of government balance sheet. 

Peter Stella: Okay, great. So basically then, let's put the MBS aside for now. So when a central bank buys treasury securities, it's paying with a different kind of treasury security. So it's a debt management operation. Now, treasuries do debt management operations all the time. They buy bank long-term debt, they issue short-term debt, they issue long-term debt, they buy back short-term debt. Treasuries all over the world do that every day. I mean, that's what a debt manager does. 

Peter Stella: So now we have this other sort of entrant, we call them the central bank or the FOMC, whatever we want to call them. And they say, you know ... Well, let me take a step back. A debt manager is basically trying to sell the debt at the minimum cost. That's their job. 

David Beckworth: Exactly. 

Peter Stella: They need to finance the deficit, they need to roll over the debt, so they're auctioning the debt, seeing what the market wants. Taking the market is given, and talking to the market, say, "Hey, do you want a ten year or you want the ... " 

Peter Stella: They'll sell you what you want, because you're going to get a better lower rate, is the assurance. So the central bank comes along and says, you know, you've given me one thing, and that is I can set the rate on this overnight treasury bond. That's my policy tool. You have the rest of the yield curve, Treasury. I'm going to set this one. 

Peter Stella: Now I'm saying, I want to lower this below zero and I can't. So why don't I try to lower the ten year rate. Well, how do you do that? Supply and demand. I'm going to go out and say I'm going to buy up all the ten year treasuries that are in the market. Okay? What happens? Goldman, hedge funds, pension funds, individual investors say, "Wow, there's a whale in the market, I'm going to eat up all this debt, I'm going to buy it," price goes up, yields go down. That's the simple idea. 

Peter Stella: Now, unlike the US Treasury, so the US Treasury could have done that too, could have said, "We're going to buy back all the ten year debt," well, how does the US Treasury finance that? It's got to issue some other debt. How does the central bank do that? Well, there's only one kind of debt the central bank can issue, and it's called bank reserves. So they, you can say, buy them with money creation, but it's really just a debt management operation. You've consolidated the balance sheets. All you have done is taken the ten years out and you've issued this overnight floating rates thing. 

Peter Stella: Now, I think that was actually a good idea, right? Good idea. But now, we come to the unintended consequence. You've issued, as the Fed, let's say $3 trillion in this instrument. And if you come back to my discussion of the way payment systems work, well, you know what? The market, the society, we only really wanted $10 billion of this and now we've got $3 trillion. So, what are we going to do with this? I mean, it's there. And one of the bad things about bank reserves is, oh by the way, the only people who can hold them are banks. And the treasuries that you bought, they could be held by banks, they could be held by David, they could be held by me. They can be held by anyone, they could be held by the Chinese. So, and use a million dollar word, they're more fungible. Or, ironically, believe it or not, they're more liquid. There's a bigger market for them. Banks that can only trade them among ourselves, and we all have more than we need. So it's not actually that great. 

Peter Stella: And because you've blown up the Fed's balance sheet, you've blown up the banking system's balance sheet. So they've got $3 trillion in assets, let's take JP Morgan, I had $2 billion in Fed reserves in 2007, 2008, middle of the year, that I was doing just fine. Now I've got $500 billion. And I've got to have something on the liability side to finance that, right? 

David Beckworth: Right. 

Peter Stella: And if you look at the data, it's actually financed by increase in deposits at the banks. So the banks are caught in this kind of weird squeeze, the banking system has to hold the reserves with the Fed, and they've got finance it, and they really don't want it. They're not making any money on this. And Dodd Frank has introduced some interesting regulations which basically say, by the way, no matter how you finance your balance sheet, you have to pay FDIC charges now, number one. And number two, by the way, we're going to introduce an enhanced supplemental leverage ratio. That says, you're going to have to hold capital against all of your assets, including Treasury bonds. So why do you have to do that? Okay. Regulators said we messed up and you know, risk weighted assets or whatever, we have this fall back to say, well, we also don't want your balance sheet to get too big. 

Peter Stella: Now, the banking industry in 2015 said, wait a minute, this doesn't make any sense. We're holding $2 trillion in deposits at the Fed. Why do we have to hold capital against them? And the regulators say, too bad. I mean, you could look at the federal digest and see this discussion. 

David Beckworth: That's interesting. That's a super safe deposit ... 

Peter Stella: Right, right. 

Peter Stella: So basically, what is the problem? The problem is, you've inadvertently, because this is the only way the Fed can do a debt swap, is with this instrument. And this instrument is inferior to basically every other treasury security. And to look at it a different way, if you went to the US Treasury or any treasury in the world, and you said to them, "I think you're missing out on this great instrument that you could use to finance the deficit." 

Peter Stella: "Oh yeah? What is it?" 

Peter Stella: "Well, it'd be a floating rate overnight security that only banks could hold." 

Peter Stella: I mean, any treasury in the world would say, "Are you out of your mind?" 

David Beckworth: It's a small market. 

Peter Stella: This is not a good idea. We don't want to issue that. 

Peter Stella: So, now we're ... If this had been a temporary thing, if we were going to kind of blow up the balance sheet and then contract it, before running into the problem with the leverage ratio of potentially squeezing out lending, raising the cost of capital for banks unnecessarily. I'm not against increased capital requirements for banks, I think it's a very important lesson out of the crisis. But you have to agree with me, it doesn't make any sense to require banks to hold capital against their deposits at the Fed which they don't really want to have. 

David Beckworth: Yeah, that's hard to understand. 

Peter Stella: So we're going to shrink it back. Okay, I don't care if it's ... We're back to $10 billion, I don't care whether you're including that in the leverage ratio or not. But if we're going to stay at $2 trillion or $3 trillion, something has to happen. And actually, in the UK, in 2016 they carved deposits at the central bank out of the leverage ratio. 

David Beckworth: Oh, they did? 

Peter Stella: Actually, the Basel Committee was not too happy, because they ... 

David Beckworth: So is there any discussion about doing that in the United States? 

Peter Stella: There is some talk about it now, I know that. 

David Beckworth: Banks are probably pushing hard. 

David Beckworth: So in short, what you're saying is the Fed, by doing these large-scale asset purchases, or QE, they effectively drained liquidity out of the system. They took out more liquid assets and put less liquid assets because they can only trade among banks, the reserves. 

Peter Stella: Right. 

David Beckworth: So you would think they would want to do it the other direction in a period of a weak recovery and slow times. In your view, then, what was the net effect of large-scale asset purchases? We had maybe some reduction, arguably ... There's been debate on this, but there's some reduction in long-term yields, long-term treasury rates. But it's offset by this concern you just raised. How do you view the net effect? 

Peter Stella: You have had, I would say, unintended consequences. So the objective was fine. The US Treasury could have done this in a more efficient way. Now, we could argue politically, whatever, is that possible or not possible and so forth and so on. But conceptually, the treasuries could have done this, and in fact, the US treasury did do this. People have forgotten about this, but in 2008, before the Fed started buying anything ... This was under the Bush administration, there was a law passed which enabled the treasury to buy mortgage-backed securities and debts to support the housing market. 

Peter Stella: Now, the difference between what the treasury did and what the Fed did was that the treasury needed permission of Congress to issue the debt, because this was a net increase in treasury debt outstanding. You are issuing treasury debt to buy mortgage-backed securities. The treasury secretary had to declare in the law that this was some kind of emergency. There was a cap on it, it was going to be reviewed by Congress. There were limits. It was a Congressional appropriation for this purpose. And by the way, those securities were bought and subsequently they were auctioned off by the treasury. So the treasury doesn't have any more of those securities any more. And part of it was because it ran into the debt ceiling and it had to reduce, so that's our problem with having a ... It's kind of a gross debt ceiling. 

Peter Stella: But when the Fed is doing it, it actually began doing it in exactly the same way. So before Lehman, the Fed was lending, increasing bank reserves. Well, it was selling from its portfolio treasuries to absorb that liquidity. So the amount of liquidity, and when we say liquidity here, I mean this quantity of bank reserves didn't change at all. People talked about the Fed's balance sheet was blown up. It didn't blow up by a dollar before Lehman. So everything that was put in with one hand was taken out by sales of treasury. But when you think about it, it's just what the treasury would have done. Sold treasuries to the market and taken the money and…David Beckworth: So you view it as a good thing, then, that for every dollar loaned they were selling a dollar of treasury to the marketplace. That was adding liquidity that the treasuries back into the public? 

Peter Stella: Right. So basically, what you were doing, and this period, euphemistically, of the Fed before Lehman, was known in the market as treasuries for trash. Later on it became cash for trash, but before it was treasuries for trash. And that's what the market wanted. They didn't want reserves at this central bank. They wanted treasuries. So they wanted to get rid of their trash collateral, all the MBS that suddenly were not usable for repo finance. So the banks were investing in these and using them to fund them cheaply, as collateral. And then taking the maturity mismatch. And then the market said, hey, wait a minute. I think all these mortgage-backed securities might default. I'm not rolling over my loan any more. 

Peter Stella: So what do you do? Well, you offload them to the Fed, you get treasuries, and then people are willing to lend you against treasuries. And there are countries, Norway, for example, where the government, the central bank did not get involved at all, in this exact same process. So what happened in Norway was the government had a special auction, arranged by the central bank. The government issued three year bonds and did a collateral swap. Basically took the mortgage-backed securities and the three years that the thing was unwound. So you didn't get all this confusion about creating money and all this stuff. It was done completely on the treasury's balance sheet. 

Peter Stella: In countries where they have a really clear distinction between monetary policy and fiscal policy, they had the treasury do it. But coming back to why it's better, yeah, basically because the market, everyone, was better off with a treasury bond or treasury bill. Shorter duration, because you're trying to influence the yield curve than bank reserves. They're just not as useful as people think. We don't need more bank reserves to make payments. We don't need them. They're absolutely unnecessary. And they have the inefficiency of not being fungible. 

Peter Stella: Now, if you look at the reverse side of this, suppose you want to unwind. If you were the US Treasury and you had done this, so you had issued short-term debt and bought long-term debt, when you want to unwind the impact on the yield curve, you could do it in a thousand ways. You could issue three year, two year, one year, eight year, ten year, 11 year, fixed rate, floating rate. As a government treasury you don't say, "Oh, I want to unwind this yield curve." 

Peter Stella: I think the Japanese have a nice term for this, it's called yield curve control. So this is really what it was all about. So we want to unwind this. You're the treasurer of the United States ... I made a presentation to the US Treasury, I had some props in front of me. You don't turn around and open the safe and look in and say, "Hey, what did we buy ten years ago? We have to sell that to unwind." 

Peter Stella: Of course not. You'd just dematerialize, you buy back securities that just disappear. But when the FOMC wants to unwind the portfolio, they're turning around, opening the vaults, which we call this SOMA portfolio, system open market account portfolio, saying, "Oh yeah, if we want to unwind, we have to sell what we bought three or four years ago." 

Peter Stella: That's kind of crazy. I mean, it's like no degrees of freedom there at all. 

David Beckworth: It's a very inefficient way of doing this. 

Peter Stella: Right. And you absolutely don't want to do it in the opposite way. You don't want to start selling, dump ten year bonds on the market. You want to do it very, very gently. So instead of doing that, I mean the Fed can't do it that way. The treasury could do it perfectly. So instead they're adopting, let's do this in a way that's like watching paint on the wall dry. We'll let them mature over time, and then we won't re-buy them ... 

David Beckworth: Very slow, yeah. 

Peter Stella: And you're just saying, why? You're saying that that's exactly the optimal sequence? I mean, it can't possibly, right? Can't optimally be the sequence to just do it the way they're doing. 

David Beckworth: Well, let me ask you a related question. There's this literature, and a lot of discussion during this time as well, on the safe asset shortage problem, which predates the crisis. In fact, some would argue contributed to the crisis, and the argument basically is that there's just a dearth of safe storage vehicles globally, and so the world goes looking for it and we're one of the best suppliers of it and we first supplied treasuries, when they ran out we provided private label, which really wasn't so safe. And so, do you view then these large-scale asset purchases as adding to an existing problem, or creating their own problem? 

Peter Stella: I have to smile now. When the crisis was happening, I was still at the IMF. And basically, in any other country in the world, if the genesis of the crisis is your financial markets, you have kind of a banking collapse, you have a fiscal collapse, whatever. But in this situation, people ran for the safest assets around, which is US treasuries. So the best performing asset class in 2008 was US treasuries. So it's kind of crazy. But yes, so we're very ... I say we, the United States is really good at producing lots of safe assets. So having a big debt actually is not so bad. People talk about seigniorage and all that. It's really, exorbitant privilege, if we can use Barry Eichengreen’s term. It's not so much that we can print money, because I'm telling you, we don't print any money. $15 billion, that's nothing. That's literally the case, right? Not making it up. But the exorbitant privilege is, yeah, everybody loves the US treasuries. Use them as collateral, they trade all over the world. This super liquid market, the legal system is perfect. Hopefully Congress won't have a technical default. 

Peter Stella: That's fantastic. We're in the business, let's say, the great things, America, Hollywood, we produce lots of films and all that stuff- 

David Beckworth: I'm with you on this, yeah. 

Peter Stella: And we produce this thing, it's called safe asset, and we might not appreciate it, but the rest of the world… It's what makes the financial system work. $10 billion of bank reserves is not what makes the financial system. It's the trillions of dollars of treasury that's floating around that makes it work. 

David Beckworth: I completely agree with your point about… we provide a valuable service to the world. We're the banker to the world, of sorts.  Everyone looks to us and until the international monetary order changes, they need us. We've joked before on this show that one of our comparative advantages is exporting debt. 

Peter Stella: Absolutely. 

David Beckworth: It's a hard sell to Congress, maybe politically, but the world needs us. And this is, I guess, the Triffin dilemma that has been brought up in the past, that the world needs us to run these deficits, even though we don't need to run the deficits, they need us to run deficits. 

Peter Stella: I mean, you remember the panic when it looked like Clinton was going to repay the debt, it's like, oh, what are we going to do? How are we going to do monetary operations? 

David Beckworth: Yeah, what would have happened? What if we do pay off our national debt? Would that create chaos financial markets? 

Peter Stella: This is a question that I've looked at in the framework of developing government debt markets in countries that don't have government debt markets. There's this debate about, does the government have to be first or could the private sector do it. Let's say you're taking a case like Singapore, huge government surpluses, we want to have a domestic debt market. I think in the US, railroad bonds were kind of that triple-A thing at some point. Of course, they went bankrupt, but anyway. 

Peter Stella: So what the government of Singapore did, this kind of gets back to this issue with the debt. They decided to issue a ton of government debt. So let me take a step back, if you look at the balance sheet of the central monetary authority of Singapore, gigantic foreign reserves on the asset side, like 200 percent of GDP, I don't know ... What's on the liability side? Well, it's like foreign exchange swaps. This is different kind of derivatives to finance that, they could issue some of their own bills. But then they said, well, we'd like to develop a corporate debt market in Singapore, in Singapore dollars. We want to base that off the government yield curve, which is the normal way all the things are priced. 

Peter Stella: So the government decided to issue, I don't know, 50 percent of GDP in government debt, and just keep the money at the central bank. You just say, "Well, why would they do that?" 

Peter Stella: Well, they're trying to develop the debt market. Like, the market wanted this debt, they were able to issue it, and it basically replaced these other interest-bearing liabilities of the central bank. So in Singapore, the central bank pays interest on that deposit equivalent to the interest the government is paying on its debt. There's zero fiscal cost. Some other countries do this, Mexico, Israel. Government debt is issued in a gross sense to make the market more liquid. We don't have that problem in the United States, but if you did, you're issuing debt simply as a public good to the financial system. 

David Beckworth: That's interesting. 

Peter Stella: You don't need it, and Singapore's the classic case, right? You say, "Oh, they've been running surpluses for 30 years, why are they doing it?" 

Peter Stella: No, they're doing it precisely to provide the market a liquid benchmark, so the corporates can price their debt off the sovereign risk…. 

David Beckworth: That's a tough argument to make though, again, I think…. 

Peter Stella: Well, in the US, I think we have enough debt, we don't probably have to do that. Although when you come back to the safe asset shortage, and I've talked to some people in the German treasury and the ECB about this, but if you're in a situation ... The German government right now can issue, I think it's five year bond at minus 40 basis points. So basically what the market is saying to you is, treasury, I will pay you for you to give me a five year bond, and as a treasury, you can go to the ECB, take the cash, you sell the bond, take the cash, buy Euro bank notes and lock them up in a vault. You make zero. 

Peter Stella: It's a money maker, right? For the tax payer. So how do you explain that unless there's some kind of artificial shortage of German debt or Swiss debt or other debt? One of the biggest contributors to the safe asset shortage is Swiss National Bank. The Swiss have bought, it's been foreign exchange intervention, so they've created Swiss francs and they've bought Euro bonds, German bonds, Japanese bonds, US bonds, they've taken them out of circulation. So they're a big contributor to this. But all of the large-scale asset purchases have taken really fungible, valuable collateral out and replaced it with this- 

David Beckworth: Reserves. 

Peter Stella: …Thing that we don't really want. In terms of exiting, for example, Swiss National Bank can issue its own debt, and I suspect that that's how they are going to exit is starting to issue their own debt. The US is not going to do that, the ECB has a political problem with doing that. Although they could do that, the ECB could do that. 

David Beckworth: Well, let's talk more about that. You've suggested as a path forward a way to improve operations in the United States and elsewhere, and you have several articles, they're very interesting, about this. You've suggested that the US Treasury issue bills to the Fed, to the central bank, that they can use in their operations. Tell us why and how that would help. 

Peter Stella: Okay. So, this is not an idea I came up with on my own. This is a proven, tried and tested strategy that's worked wonderfully in Mexico and Israel and some other countries. And basically, if I can just step back, where were they coming from? So the typical emerging market crisis country was afflicted by what a lot of people call original sin. So they couldn't issue domestic debt in their own currency, we all knew that. So Mexico couldn't issue peso debt, Israel couldn't issue- 

David Beckworth: Because no one would want to buy it. 

Peter Stella: No one wants to buy it, right. 

Peter Stella: So we've kind of gotten really far. The successful countries, Chile and Mexico, Brazil, they're now able to issue domestic debt. Now, what happened during the crisis when they couldn't issue domestic debt, they had a banking crisis. The central bank created all of these reserves, and instead of leaving them in the market, which of course we now understand, this didn't make sense. It would have put a run on the currency and all that. They just manufactured their own debt out of thin air. 

David Beckworth: The central bank. 

Peter Stella: The central banks. So the Bank of Israel issued debt ... I mean, basically you can go down two dozen central banks that issued their own debt. Because there was nothing else. 

David Beckworth: So just to be clear, the central bank was issuing its own treasury bill-like debt- 

Peter Stella: Absolutely. 

David Beckworth: In addition to the government issuing its own treasury bills. 

Peter Stella: The government wasn't issuing its own treasury bills because of the original sin. 

David Beckworth: Oh, okay. Oh, I see, I see. 

Peter Stella: So there was no market, so the central bank in a crisis created the market, so to speak. 

David Beckworth: Interesting. 

Peter Stella: And that's not a good time to be issuing debt, right? When the whole world is falling apart, your country is falling apart. So basically the banks, you know, it was basically, "Here. Here's all this local currency," and the banks would say, "Oh, okay, I'm going to buy dollars from you, central bank." 

Peter Stella: Central bank, "We don't have any dollars, so here, take these interest-bearing obligations. 

David Beckworth: Did they take it willingly? Was it kind of pushed on them? 

Peter Stella: Yeah, it was either like, "Take this or go bankrupt," basically. But typically they were very bad instruments. It would be like you or me just suddenly saying, "Okay, I've got to issue a bond and sell it," you know, you've given pretty good terms. 

Peter Stella: So basically, as you've got out of that problem, treasuries started issuing domestic debt, but there was an incumbent in the market, it was the central bank. So you have a bifurcated market. In fact, if you look at Chile today, if you consider central bank debt a sovereign debt, which I do, basically 50 percent of the domestic sovereign debt is obligation of the central bank and 50 precent is obligation of the treasury. 

David Beckworth: Very interesting. 

Peter Stella: So that's inefficient, right? You're kind of dividing the pool of liquidity into two, and there's all kinds of problems with that. So one of the things that I've been doing maybe the last ten years or so most, is trying to unify domestic debt markets. Basically what it involves is issuing treasury debt to buy back central bank debt. I mean, that's a big picture. 

Peter Stella: So again, we come back to this idea of what we should have, the one sovereign debt manager. It's the treasury, they're going to manage the debt, we're going to get the central bank out of the debt management business, like issuing their own debt. So Mexico did this very successfully, for example. 

Peter Stella: What I see in the big balance sheet countries, the new big balance sheet, so called advanced countries, is you've suddenly done the similar thing to what the other central banks did, in a crisis, you issued all this new kind of debt. I say new in the sense that, okay, yeah, there was like $15 billion, but it wasn't being used for the payment system, right? So you've issued this new kind of instrument, which isn't the best instrument. I'm not saying all of this was dumb. You had to do it, right? Lehman is Sunday, on Wednesday you've got to do something. 

Peter Stella: I'm not saying that they should have come up with some magical formula that no one else came up with 20 years ago when they had their crisis. And as I said, if it's going to shrink back, I don't care. It's not a big deal. But if you're going to keep it big for a long time, well, what these other central banks did was, they found a way to issue these tradable debt instruments that could be traded not only by banks, but by everyone. It makes sense. So this whole idea of having huge bank balances forever, just doesn't make any sense. 

Peter Stella: So when you talk about, I wrote a few things on helicopter money, and one of the, sort of ... People agree, okay, helicopter money is actually fiscal policy. The problem is, okay, that it has to be a permanent thing. So we have to have monetary injection, it's got to stay there forever. And then we're like, "Oh, that interferes with central bank independence," all that stuff. Well, it turns out, it's very implausible that you would ... I mean, nobody would want to hold massive amounts of bank reserves forever. But people would want to hold US treasury debt forever. I don't think the US Treasury is ever going to pay off its debt. So if you want to do helicopter money, you don't need to use money, you use bonds. You just give away bonds. 

David Beckworth: So how would this work with the Fed? Let's use the Fed. If Jay Powell is listening now, if Steve Mnuchin is listening now, how would this work? 

Peter Stella: Okay. So, basically what I want ... Let's sit together and say, this is our sovereign balance sheet. And we're going to look at the maturity distribution of our sovereign balance sheet. The US Treasury, for decades has had a nice yield curve, and they're issuing just whatever. Then all of a sudden, right, this big spike, like overnight liability appears. You're just saying, "Hey, this doesn't make sense. This can't be the optimal ... We were going along for 30 years, the optimal distribution kind of looked like a bell curve or whatever, now it's got this big spike there." 

Peter Stella: So, take that spike, let's color it red, because it's under the control of the Fed and everything else is blue. Just say to, Powell says to Mnuchin, "Look, that stuff, that's for you to manage. You should be managing that. We shouldn't be managing that. You distribute it along the yield curve the way you think is the best way." 

Peter Stella: Simple. 

David Beckworth: So would the treasury then just deposit ... How would that actually take place? Would the treasury create these bills, notes, bonds, based on their preference and then send them over to the Fed? 

Peter Stella: Right. So it's kind of like who has the paint brush in their hands. Is it the Fed or the Treasury? And we could argue independence and all that. So let's say we want the paint brush to be in the Fed's hands. So the Treasury says to the Fed, "Okay, you've got this," again, we're going and opening the safe. "You've got this collection of ten years and five years and eight years and whatever. I'm going to do a swap with you. I'm going to give you 30 day treasury bills for the whole amount." 

Peter Stella: So I'm giving you this molding clay, the artist analogy. Clay. You want them all to run off in 30 days? You can. But you're not. You can roll them over for 30 years. I mean, that's what the Fed was doing before. It was holding treasury bills and would just roll them over and roll them over. The portfolio's only getting bigger. So you're not constrained to ... There should be absolutely no connection between how and how fast you roll off the balance sheet and the bonds that you happen to have bought in 2009 and 2010. There should be absolutely no connection. 

Peter Stella: So you say to the Fed, "Here's the 30 year treasury bills." 

Peter Stella: Roll them over for 30 years, 20 years, 15 years, roll them over now. You have complete ... You can duplicate what you're doing, but you can do like a million other things. You can speed it up, slow it down, the markets aren't going to freak out. 

David Beckworth: So you would do this to reduce the balance sheet, but in a much more efficient manner. 

Peter Stella: Right. 

David Beckworth: Okay. 

Peter Stella: I mean, basically it gives you a million degrees of freedom to do it faster. What I'm certain of is that it would work. People would suddenly say, "Oh, yeah, this makes sense." 

Peter Stella: But it's just coming back to, no treasury would ever have done an operation like this. 

David Beckworth: This has been experimented with in a similar form with the supplemental financing program during the crisis, is that right? 

Peter Stella: Right. 

Peter Stella: So, by the way, this is the brilliant thing. If you want to be proud of the US policymakers. So literally, Lehman, I think was September 15th. Files for bankruptcy on Monday or whatever. AIG goes into conservatorship on Wednesday, September 18th, I think it is. US Treasury issues like a three-sentence press release on that day, but the world is falling apart, I mean literally, people are circulating memes of cats falling out of windows, whatever. So nobody's paying attention to this little press release of the US Treasury. 

Peter Stella: So the US Treasury announces the supplementary financing program. What's the purpose of this? It's to help the Fed manage the balance sheet consequences of its recent interventions. Okay, let me translate that. As I said, up to that Monday, the Fed had been injecting bank reserves to certain institutions with one hand, then selling treasuries with the other hand and withdrawing those bank reserves from the market. Why? Because the Fed funds rate target was whatever it was. 200 basis points. 

Peter Stella: So you had to keep demand and supply in balance with that $15 billion number. So, that's what you were doing. After Lehman, that didn't have enough treasuries to absorb it. They didn't want to broadcast that at the top of the Empire State Building, "Hey, we can't absorb all this money that we're creating." 

Peter Stella: Because everyone's, "Oh, there's going to be a hyperinflation." 

Peter Stella: It's totally wrong, but ... You don't want to be yelling fire when there's ... I mean, you've already yelled fire, right, you don't need to sort of throw gasoline on the fire. 

Peter Stella: So, what happens? What happens in that case? That's when you come back to my 25 years at the IMF, I say, okay, you can do it this way, this way, this way. So, what happened? There was discussion on ... The timing might not be quite right, discussions in New York that I, let me say, became aware of while I was at the IMF. They were discussing issuing their own debt. So the idea was, "Hey, we don't have enough treasuries to absorb all this money. If we don't absorb this money, Fed funds rate is going to plummet," which it did, actually. It went below the target. Bill Poole was one of the few people in kind of real time who noticed that and said, "What's going on here? Is the Fed secretly cutting rates, not telling anybody?" 

Peter Stella: No, it was simply an arithmetic fact, they couldn't absorb the reserves. So one option was, okay, we issue our own debt. New York Fed issues its own debt, absorb those reserves, and we get into the Chile… whatever. 

David Beckworth: Yeah, sounds like Mexico. 

Peter Stella: And now you talk to people in New York Fed, you get different stories on that. One is they said, "Well, it wasn't illegal for us to do it." 

Peter Stella: The other, Simon Potter said, "No, no, this was a dumb idea. We fragment the debt market." 

Peter Stella: I said, "Simon, absolutely. I've been dealing with this for ten years all over the world." 

Peter Stella: So anyway, they didn't do that. So what happened? They had to have had a conversation with the treasury. Treasury said, "Okay, we are going to issue cash management bills and keep that money in a special account at the New York Fed." 

Peter Stella: So the only reason we're doing this, we're going to pay interest on them. Of course, interest rates at that time were really, really low. But treasury says, "I'm going to do that for you, I'm going to keep the money at the New York Fed to keep the supply of bank reserves manageable by you." 

Peter Stella: And the Treasury, I mean, it was a fantastic agreement, in my opinion. My years of looking at fighting between treasuries and central banks, that they did this so quickly and in such a clever way. I think they should be extremely proud that they did this. It was purely to assist the Fed. So the US Treasury was issuing debt that it didn't need. Paying interest on it. But enabling the Fed to maintain this. 

Peter Stella: And so from zero, obviously this program didn't exist before, so we had a zero balance in these special cash management bills. We went up to about $565 billion. Cumulative stock. So it's really remarkable, but it comes back to your point, US Treasury, I mean, that's the strong point. People want to… that, so we can do that. Almost no other country could do that, right. Just go from, "Oh, we're going to issue another $565 billion in debt in six weeks' time," which is basically... It's really amazing. 

David Beckworth: And your proposal, though, is to kind of make this official, or make it more of a permanent feature of what we do in the US. 

Peter Stella: Right. So again, maybe this is my idea, but it's based on practice of other countries. But if you look carefully, somewhere around 2010, I think, Ben Bernanke gave a speech. This was very far in advance, talking about how this will be unwound, and he says, "Well, we could resume this program." 

David Beckworth: Oh, he actually mentioned that. 

Peter Stella: He actually says that. Right. 

David Beckworth: Fascinating. 

Peter Stella: And I think if he ... 

David Beckworth: Too bad. 

Peter Stella: He taught me at Stanford, I can't pretend to be grading him, but to me, that's an A plus answer right there. 

David Beckworth: Sure you can. 

Peter Stella: The other ways, oh, okay, it's like a B answer. Yeah, you can do it that way. But that's the A plus one, and you actually have done that. 

David Beckworth: Right. So you have experience, they know. 

Peter Stella: And other countries have done similar things like that. So, my kind of argument, by the way, because people are going to say, "But you're issuing a lot more debt," whatever. My claim is, and there's evidence for this claim, is you're either financing this part of the balance sheet by paying interest on reserves at a rate above money market rates, or you're issuing treasury bills, which everyone wants. Not just banks can hold, everybody wants. 

David Beckworth: Yep. 

Peter Stella: You're going to sell them at a lower interest rate than the interest rate on reserves. So you're going to save the taxpayer money. Everybody's going to be happy. Banks are going to be happy because they can shrink their balance sheets. In other words, get all the dead wood off, the reserves on one side and the liabilities financing the reserves, to get rid of that. The global financial markets are happy, because they get more treasury bills they couldn't hold before. Which the German tax payer, they should be doing this too, but anyway. But they're not doing it, so let's do it. And tax payers should be happy. The only loser in this is actually the FDIC, because right now, the FDIC is collecting insurance premium on deposits that are backed by reserves at the Fed, which is kind of nonsense. 

David Beckworth: But overall it's a very positive message. It's a very, a lot of winners, and a definitely more efficient outcome. 

Peter Stella: Yeah, and I think, you know, I can't put myself in President Obama's shoes, but would have been nice for him to have said, "By the way, the crisis is over. We shrunk the Fed's balance sheet back to where it was. It's over, it's done." 

Peter Stella: But we're still kind of keeping this thing going and I think there's a lot of people now who suddenly, now that the balance sheet is big, think, "Oh yeah, let's think of a reason why we should keep it big," because it's giving them more power and more influence that ... Then we get into this, in a democratic society, shouldn't it be the Treasury who's managing the country's debt, not kind of the Treasury and the Fed? 

David Beckworth: Your proposal, though, is very, I think, a promising idea. 

David Beckworth: Our time is out, unfortunately, but I think we ended on that great note there, that this is an idea that we should consider, and over the next six months as the Fed is considering its operating methods, its targets, maybe it's something they should put on the table. 

David Beckworth: Our guest today has been Peter Stella. Peter, thank you so much for coming on the show. 

Peter Stella: Thank you, David. 

David Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app, and while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening. 

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