Apr 29, 2020

Jesus Fernandez-Villaverde on Central Bank Digital Currency and the Current Economic Responses to COVID-19

Central bank digital currency could be an important innovation for the future of financial intermediation, financial stability, and the conduct of monetary policy.
David Beckworth Senior Research Fellow , Jesus Fernandez-Villaverde

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Jesus Fernandez-Villaverde is a professor of economics at the University of Pennsylvania, a research associate with the National Bureau of Economic Research, a research affiliate with the Center for Economic Policy Research, and a returning guest to the podcast. Jesus specializes in macroeconomic modeling and economic history among other topics, and he joins Macro Musings to talk about COVID-19, central bank digital currency, and developments in the Eurozone. David and Jesus also discuss the history of central banks and the interacting public, how threatening inflation could become a useful tool for a central bank, and the value economic modeling could add to the epidemiological field.

Read the full episode transcript:

Note: 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.

David Beckworth: Jesus, welcome back to the show.

Jesus Fernandez-Villaverde: Thank you for having me again.

Beckworth: Well, I'm glad to have you back on. And as I mentioned, you do a lot of interesting work in very different areas. So, just remind our listeners, you were working on a huge economic history book, last time we talked, you were near the end, have you finished that?

Fernandez-Villaverde: Well, it was not so close to the end.

Beckworth: Okay.

Fernandez-Villaverde: No, but I wrote a very nice chapter on energy and economic history, in global economic history. I got very interested in the very central role that energy plays in economics, that took me a little bit longer than I wanted. And then actually right before the crisis in the fall, I was writing all the chapters related with demographics, climate, plagues, which turned out to be the case surprisingly...

Beckworth: Great timing.

Fernandez-Villaverde: I was really planning to make a lot of progress this semester. I had a very, very light teaching load this semester and I really hope to have something ready by the end of the summer, but you know, life has changed for everyone. So, hopefully I will have more time during the summer.

Beckworth: Yeah and we'll get you back on the show to discuss that, but what's fascinating to me is you're doing hardcore economic history and this is a huge book and you've done other work too. It's not the first project in economic history, but you're also doing very serious macroeconomic modeling, getting published in top journals, and I mentioned this in the last show. You had a great counter reply to me, but I said you're the one data point that gives me pause about the idea of comparative advantage because you excel at both. I mean, people have to specialize either in being a deep macroeconomic theoretician or an economic historian. You do both, of course your response is, well, maybe I'd even be better at one of them.

Fernandez-Villaverde: Yes, exactly, maybe who knows everyone would be using the Villaverde model everywhere.

Beckworth: Yeah, no, it's great. So, listeners, if you want to check out his webpage, I encourage you to do so. He's deep into models, deep into history, it's a great mix and makes you a better macro economist, I think, if you do have that rich understanding of history. And we talked about it in our last podcast, so we'll put a link up to that for listeners to take a look at it, but along those same lines, you seem to be doing a lot. I mean, you're doing history, you're doing macro modeling. You mentioned you've got into demographics, I saw that paper preparing for the show.

Beckworth: So, you and Chad Jones have a working paper out where you put on your epidemiology hat, you take your modeling skills from economics and you apply them and you help finesse an epidemiological model. And so the paper's title is *Estimating and Simulating a SIRD Model of COVID-19 for Many Countries, States, and Cities.* So walk us through why you got into this and then what did you find in this paper?

Applying Economic Modeling to Epidemiology: Purpose and Results

Fernandez-Villaverde: Okay, so back when I was a graduate student, one of my teachers was Patrick Kehoe, who is now a professor at Stanford. And one day he told me something that I remember as if it were yesterday. He told me, "If you want to learn about something, you need to write a paper on it."

Fernandez-Villaverde: So this is early March, the world as we know it, it seems to be coming to an end. I want to know a little bit more about this stuff. So, I get myself a couple of textbooks on epidemiology and I see these model and I thought, "Well, why don't I write a paper about it?" In a worst case scenario, I will, yes, make a mess out of it, best case scenario I may learn something. And so what have I learned? So, there's this very basic model called SIRD, which I imagine many of your listeners are already familiar with, which is basically Susceptible Infective Recovered Death model, you have different groups of people that switch between these different compartments of the population on and we take it to the data.

Fernandez-Villaverde: And a couple of interesting things that we do is we apply some of the standard tools in econometrics to take it to the data. And basically what we find is one, some evidence of the effects of social distancing, we think we find quite a strong effect in many countries, in many cities like New York or Europe. And we also come up with relatively reasonable measurement of how much we can't relax now social distancing. And our main point is that if you are in New York City, you can probably relax quite a bit because yesterday we had some testing that suggested that maybe as many as 21% of people in New York City already had the infection, maybe a little bit more even today, and also some of the probably worse cases of the spreading have already been taking out from the data while in places like California, they are far away.

Fernandez-Villaverde: So in that sense, I think that one lesson that at least I get out from my paper is the one size fits all policies of some European countries do not make a lot of sense. And there is a lot of regional heterogeneity, there is a lot of space heterogeneity, and any sensible policy needs to take into account why Wyoming and New York City are very different societies on very different levels of infection.

I think that one lesson that at least I get out from my paper is the one size fits all policies of some European countries do not make a lot of sense.

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Beckworth: Okay, very interesting. Now you just finished this paper, you just put it online. So I know I tweeted it out yesterday and today, so it's probably too early to ask if you've gotten any feedback from it, but maybe, let me ask the question this way. Jesus, what do you bring to this model that's value added for an epidemiologist. Maybe an epidemiologist hasn't seen what we have to offer. So what do you add here that that adds a new perspective?

Fernandez-Villaverde: I would say three things. One, econometrics is about fitting relatively complex models to the data. Economists as a profession have been thinking about this for 70 years now. That's an important aspect, we have thought a lot about uncertainty. We have thought a lot about how to assess what are the models may fit the data well, or the model may not fit the data well on. Those were challenges that in natural sciences do not show up that often, and the reason for it is my undergraduate professor of econometrics always made this point. An electron doesn't change his mind about where to go because the policymaker has some plan about the future, agents change their mind about what to do depending on what policymakers are having in mind.

Fernandez-Villaverde: Epidemics are social events, it depends on the behavior of people and the behavior of people is not fixed. It's endogenous and economic researchers have been thinking about this hetereogeneity for many, many decades that endogeneity is not a big issue. Usually natural sciences, so maybe economies have something to add along that dimension.

Fernandez-Villaverde: The second thing, what I believe we can add a little bit is economists have spent a lot of time thinking about parameters that change over time. In fact, a lot of my econometrics research is about that. And again, issues like social distancing is about parameters that change. In natural sciences, they tend to take these parameters as fixed over the time.

Fernandez-Villaverde: And finally we have thought a lot about counterfactuals and how to design counterfactuals when people, as I was saying before, endogenously react to the actions of the government and we actually are working on a follow-up paper that we will review some of these issues. So of course, we are trying to ... sorry if this is getting a little long.

Beckworth: No, this is great.

Fernandez-Villaverde: We are trying to be very humble and we said in the introduction that we are not trying to claim that we are discovering anything new. We are just trying to say, look, you guys in epidemiology have great insights about many things. We think that in economics we also have some ideas about how to model and take dynamic models to the data, especially when agents are reacting to policy decisions. So, maybe there is something to be gained about talking from these two sides of the aisle.

We are not trying to claim that we are discovering anything new. We are just trying to say, look, you guys in epidemiology have great insights about many things. We think that in economics we also have some ideas about how to model and take dynamic models to the data, especially when agents are reacting to policy decisions. So, maybe there is something to be gained about talking from these two sides of the aisle.

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Beckworth: Yeah, no, I think those are great contributions as you mentioned. Just to summarize, so endogeneity how to properly parametrize your model and counterfactuals. Things that ... economists, that's their bread and butter and so bringing that into a setting where maybe it's not as developed might be a big contributions and who knows? Jesus, this might be a highly cited paper for you, just in another discipline when it's all said and done.

Fernandez-Villaverde: Yeah. Yes. Just let me tell you a small anecdote if I may.

Beckworth: Sure.

Fernandez-Villaverde: My mother, when she was working, she used to work with viruses. She was a researcher in a biology lab back in Spain. And we often talk about the statistics she was doing and it was very different from my econometrics. Just because as I was mentioning before, she was studying the virus in a lab and over there endogeneity, time varying parameters, et cetera, never played a role. So the type of statistics she was using were very different from mine. And that's why I may be a little bit more aware of those differences.

Beckworth: Yeah. So you had some background, some context with your mother's work and then ... I mean it's impressive that you, you would sit down and open up several books on epidemiology. That's much more ambitious than I think most economists would be. So that's great. And I hope your paper sees a lot of light and lots of exposure and we'll do our best to promote it here. We'll make a link to it on the webpage for the show today.

Beckworth: Okay. I want to ask a different question. So we're still on COVID-19 but I want to maybe ask you a broader question about this crisis. And my question to you is, first, is it appropriate to think about our response to this crisis as fighting a war? So you might have some people who see this as garden variety recession, maybe a real severe recession, but just classic economic activity, apply normal measures, fiscal policy, monetary policy or another way of viewing this is we're fighting a war and we've got to be all in willing to do things we don't normally do. And that includes running up the debt, maybe tolerating little more inflation than normal, we should be willing to do that. Do you think it's fair to view this effort as fighting a war? And I ask you because you are an economic historian, you've studied plagues, you've studied wars. Is it a proper way for our policymakers to think about the current situation?

Is Fighting COVID-19 Akin to Fighting a War?

Fernandez-Villaverde: To much of an extent, yes. The way I put it is as follows. Think about your garden variety recession. Most of those are problems from demand. So think about 2007, 2008 you have a problem that the financial crisis was and people just don't want to consume too much. So a standard answer is either through monetary policy or through fiscal policy, we can induce a higher aggregate demand and you basically fix the problem. And the situation now is a little bit closer to a war because the problem that you have in a war is that suddenly you take 10% or 20% or even 50% of your labor force and instead of producing pencils, or books or things that we like, they either need to become a soldier or they need to produce weapons, which we don't like in themselves and that's a little bit the situation would have now.

Fernandez-Villaverde: Suddenly all the restaurant workers cannot work or can work much less, even if the government comes and says, "I'm going to give vouchers to everyone to go to restaurants." That voucher is useless because you cannot go to a restaurant. It's about more how we reallocate people within different sectors, how we get the productive capacity back to normal. I mean, that sense that looks much more what you are doing in 1942 right after Pearl Harbor than what it looks in 2007 right after the financial crisis. At the same time, you also want to keep in mind that whatever action you take needs to be sustainable in the long run. And your answer needs to depend a little bit of who you are. So, in the US I am much more optimistic about the ability of the federal government to sustain large programs that for instance in Europe where a lot of countries were already much closer to borrowing constraints.

Beckworth: Yeah. Like Italy I imagine you're thinking of it this time. And we'll come back to the Eurozone a little bit later in the show, time permitting. But yeah, that's my framework too and I think it's a useful way to think about this. And you know, I think some of the concerns that some people are now bringing up, so I think early on there was unity, there was definitely, "Rah, rah, team, let's go, let's do everything we can." There are some cracks beginning to emerge in this consensus we had early on in terms of policymaking and they're around the amount of debt we're incurring as well as potential inflation, but my thinking is, again, you've got to keep the vision straight that we're fighting the war, but secondly, even if you want to start thinking about the numbers, it's true, we're running up a lot of debt, but I also see evidence risk aversion is through the roof as well and probably will be.

Beckworth: There's literature on how people live through a really severe crisis, they tend to take that with them, people who lived in the Great Depression tended to save more afterwards. And I think you may see something like that coming out of this crisis. So, it's not clear to me at least, that we are at the point where we should really be worrying excessively about inflation on the horizon.

Fernandez-Villaverde: I'm less worried about inflation. In particular, I'm less worried about inflation because it will have the "right" redistribution on issues or consequences. What do I mean by that? We know that the coronavirus has very, very different consequences for younger people than for older people. So by subbing shutting down the economy, in some sense, we are making a gigantic transfer to the older generations in the economy. The person who's 25 years old and-

Fernandez-Villaverde: ... she loses her job is implicitly transferred in, but [inaudible] to the person now is 75 years old, getting a Social Security paycheck on being better protected against the coronavirus. So a little bit of inflation that we let out of nominal assets and the nominal income of those that are a little bit older will benefit the real income of those who are a little bit younger.

Fernandez-Villaverde: And in that sense, any strategy of getting out of this crisis needs to think a little bit about those intergenerational transfers. And I'm concerned about this because it was already the case that when you look at most countries, including in United States and the Eurozone, most of the adjustment of the financial crisis was done by relatively younger cohorts. And that's the reason I think many people in their thirties are very unhappy in the political process right now.

Fernandez-Villaverde: And what we cannot really add is people in their thirties to pay a second time for a large crisis in less than 15 years. I don't think that political system will be able to accept that. And a little bit of inflation will go a long way to distribute the loses across generations, I think in a little bit of a fairer way.

Beckworth: Yes. It's particularly tough to be a millennial. You cut your teeth, you hit the labor force during the great recession. Here we are a decade later, and you're going through another very severe… maybe one of the worst, that this country will go through, when it's all said and done.

Beckworth: And you speak to a framework actually, that I like, and that is counter cyclical inflation, which does tend to provide a more equitable outcome. And we'll come back to that a little bit later when we talk about your papers on central bank digital currency.

Beckworth: But in general, are you happy with what you're seeing in terms of what Congress is doing, what the Federal Reserve is doing? Are they being aggressive enough? Should there be more grants? One critique I have, again, this is the fog of war, they're acting quickly as they can, there's political constraints.

Beckworth: But one thing I do see that that does concern me somewhat is that Congress and Treasury, they're really trying to leverage up the Federal Reserve's balance sheet and try to do a lot of heavy lifting through the Federal Reserve because it's effectively off balance sheet. It doesn't count towards the debt. Even though you and I know from the consolidated balance sheet perspective, and in terms of real resources, it doesn't really matter who does it, but it's a way to avoid making tough decisions. It's a way to avoid increasing big numbers to the debt.

Beckworth: And I would like to see Congress do more direct spending, maybe more grants, as opposed to going through the Federal Reserve, which is constrained by law to do lending without losses to target firms with good collateral. So, it really ties the hands of the Federal Reserve and what it can do, and I think Congress should address this problem head on, and be intentional and clear about what it wants to do.

Beckworth: That would be my kind of big critique of what's been done. Again, I acknowledge this is the fog of war and sometimes it's hard to move quickly and they're doing the best they can. But I wonder if you have any kind of broad observations about the policy response so far.

Reactions to the Crisis Policy Response So Far

Fernandez-Villaverde: Okay, so I thought a lot-

Beckworth: Sure.

Fernandez-Villaverde: ...so I'll try to constrain my verbosity and try to sum it up. So, first looking at both sides of the Atlantic, I think the U.S. is responding better. I know there [are] a lot of criticisms always in the U.S., but I think that in general, the U.S. has taken a little bit more of a of a sensible position.

Looking at both sides of the Atlantic, I think the U.S. is responding better. I know there [are] a lot of criticisms always in the U.S., but I think that in general, the U.S. has taken a little bit more of a of a sensible position.

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Fernandez-Villaverde: Second, I'm very sympathetic to your argument that Congress should take a little bit of a more of a leading role. But I will argue this has been the case for the last 20 years, for a number of reasons Congress has been delegating a lot of its power to administrative agencies or in this case, to the Fed, because the political system right now is in a crossroad, where it is very difficult to get Congress to do anything.

Fernandez-Villaverde: So, given that, the optimal response, is probably to go through the Fed. Not in the sense that it would be the best that we could do, in an abstract sense, but in the sense that this is actually what can be done during this month. So, in that sense, I'm a little bit less pessimistic, perhaps, than you are, but you're absolutely right. Who knows? Maybe in six months I will have changed my mind.

Fernandez-Villaverde: Also, I think that the one advantage that doing this a little bit through the Fed, is that we need to react as things change during the summer. The Fed may be a little bit more nimble than Congress, so that's buying us a little bit of flexibility down the road.

Beckworth: Yeah, I agree with that. I mean, I think the Fed is definitely nimbler, they have the staff, they have the capacity. I mean, Treasury's got very few people working for it. The SBA, as we've seen, it was overwhelmed by this response, the IRS... I think in general the state capacity in the U.S. isn't where it should be for a crisis, but no one could see this coming. And I agree, given the political constraints the Fed is the solution for now for most of the heavy lifting. But in an ideal world at least, we'd want to see Congress doing more.

Fernandez-Villaverde: Yes. It is interesting that you mentioned a state capability. I actually wrote an op-ed a month and a half ago, precisely about the state capability. And one of the things I expressed concerns over that, is that I see the state capability of the United States as having gone down quite a lot over the last 20, 25 years.

The optimal response, is probably to go through the Fed. Not in the sense that it would be the best that we could do, in an abstract sense, but in the sense that this is actually what can be done during this month.

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Fernandez-Villaverde: There are structural reasons and there are more kind of shortened reasons and that worries me. That worries me because if... There are two different discussions that we can have. One is the discussion about how large the welfare state should be, and the other one is the discussion about how well should you run the welfare state.

Fernandez-Villaverde: And right now… we are not running the state very well. You see that all across the different states, you see that all across different cities. You see that at the federal level. And it's very easy to use your affiliation and to blame the other party, whatever the other party is, for the fault. But I think that evidence is that you see serious lack of governments in all type of institutions across the U.S. By the way, also across all the Western world, and that actually worries me quite a bit.

Beckworth: So state capacity has been declining across the advanced economies, not just in the U.S.

Fernandez-Villaverde: Yes, in a dramatic way. And this is a real problem. This is a real problem for the long run, hopefully if there is something good that can come out of this, is that we realize we need to invest more in a state capability.

Fernandez-Villaverde: I actually made the following argument in a couple of occasions, COVID-19 being as destructive and as a terrible virus as it is, could've been much worse. We could be talking about a virus that spreads at the same speed of this one, but is 10 times more lethal. Given the responses of the Western world, we could be talking now about tens of millions of deaths. So maybe this is a moment where we are going to say, look, this can never, ever happen again and we really need to have a state capability that eliminates these existential crises for the future.

Beckworth: Well, I hope you're right. I hope this is a moment of introspection, looking forward, being willing to build, be more creative, plan for the future better. I mean, I had Alex Tabarrok on the show, and we talked about how difficult it is to plan for events like this. So, he's been a big advocate of preparing better for asteroids hitting earth, but pandemics is very similar thought.

Beckworth: Another area I think that we lack that Alex brought up is solar flares, and our infrastructure in the U.S., our grid is very susceptible as well. But that's just one small manifestation of the challenge of state capacity not being where it should be. So I hope you're right, Jesus, we will come out of this with our heads up and seeing more cooperation and progress in how we govern our country.

We are not running the state very well. You see that all across the different states, you see that all across different cities. You see that at the federal level. And it's very easy to use your affiliation and to blame the other party, whatever the other party is, for the fault. But I think that evidence is that you see serious lack of governments in all type of institutions across the U.S. and this is a real problem. This is a real problem for the long run.

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Beckworth: Let me move now to an area that you have written on, you have several papers with some colleagues and the papers are on central bank digital currency. And this is a great topic, we've had several guests on the show, we've done a bunch of shows on this.

Beckworth: So, I had Morgan Ricks on this show, as I mentioned, and you have developed a paper along with your colleagues. And your colleagues are Daniel Sanches, Linda Schilling and Harald Uhlig. And you've actually got two papers on this, you've got a paper titled *Central Bank Digital Currency: Central Banking For All,* and then you have a second paper titled *Central Bank Digital Currency in a Nominal World.*

Beckworth: And again, this is something that we've talked about a lot on this show and it's come up also in the discussion of what else could the Fed do, so the Fed's been doing lot of things as we've alluded to already, interest rates are zero, it's doing unlimited QE, the forward guidance, it's got an alphabet soup of facilities. And what else could they do? Well, negative rates, maybe yield curve control.

Beckworth: But this would be one big step forward, and you've thought long and hard about this in your paper. And there's several big questions that central bank digital currency brings up, and I just want to outline the outline them now, and we'll come back and discuss them in your findings.

Beckworth: But one, what would a Fed account for the public mean for financial intermediation? Two, what does it mean for financial stability? There's a panic, there's a run. And three, what would it mean for the conduct of monetary policy, what should the Fed target, how should it respond, what should be in its reaction function?

Beckworth: Now, before we answer those questions, Jesus, I want to go back to your first paper, the one that's titled *Central Bank Digital Currency: Central Banking For All.* And you provide some rich history in there in terms of central banks allowing people to actually use the central bank as their personal bank. So walk us through the history of central banks opening their doors to the public.

History of Central Banks and the Public

Fernandez-Villaverde: So, if you actually go back and read a little bit about the history of central banks, this idea that the central bank is an institution where the only other banks can do business with, et cetera, is to a very, very large extent, a creation of the 20th century, even more after World War II.

Fernandez-Villaverde: So, when central banks are created in the late 17th century in Sweden and in England, and then in the 18th and 19th century, other European countries and in the United States, they are super banks, in the sense that they are regular banks that are going to do regular checking accounts and savings accounts and intermediation, but they just have some type of privilege. So for instance, the Bank of England will allow you… had the privilege, had the monopoly of issuance of currency notes, first around London and then in most of England. The Bank of Spain had also the monopoly to issue some types of notes. And the First and the Second Bank of the United States had some ability to deal with the Treasury of the United States. But by and large, you could walk into your local central bank branch, and say, I want to open a checking account, and you will be able to do it. And in some countries like Spain, this was the case until 1962.

Fernandez-Villaverde: In the 20th century, central banks become more about conducting monetary policy than about some type of financial intermediation, and then they started disengaging from these activities with the day to day business people or the day to day households. And by the 1990s, I think there was a very widespread consensus that this was the normal way, "normal," to run central bank operations.

Fernandez-Villaverde: Well, turns out to be the case that suddenly we have the internet, and maybe this is a moment where we can rethink that. Can we go back to the 19th century in some sense, where you could have a checking account at the Bank of England or the Bank for Spain or the First Bank of the United States with the difference that now, thanks to the internet, that central bank doesn't need to have 10,000 branches all across the country, you can do everything through the internet. So that kind of opens a whole new area of financial intermediation, and then what I wanted to do with my papers was to think, is this a good idea or not?

Beckworth: Yeah. And you guys have developed some models in there, and we'll talk about the findings in just a minute. I want to go back on your history though, because you have some really neat data for the Bank of Spain, and you're from Spain originally, so you maybe you had an interest and you knew about this.

Beckworth: But I was reading in there, and at one point the Bank of Spain had 75% of all demand deposits, is that right? So the central bank had an overwhelming majority of all checking accounts, demand deposits in the country. And as you said, it went up through 1962. That's pretty mind blowing, I mean, for someone in my age, the generation, you're like, wow, that's hard to believe.

Fernandez-Villaverde: I don't know, but I remember being a small kid, walking with my grandmother on... Apparently my grandfather, which I never met, had a checking account at the Bank of Spain. And she was always very concerned, because after 1962, he had to close that checking account and use a regular commercial bank, and she was always very worried that our regular commercial bank was not as sound as the Bank of Spain.

Fernandez-Villaverde: And I remember walking in front of the local branch of the Bank of Spain that is still existed, but they didn't really do anything at that moment. She would always complain, “Oh, you know, I used to have a checking account over there.”

Beckworth: Interesting.

Fernandez-Villaverde: In that sense I had a little bit of [inaudible] from the beginning. But yes. So let me tell you, in fact, why many countries create central banks. And if you actually read a little bit of the history of the United States, you will see that a lot of the motivation behind the first and the second bank of the United States was about it.

Fernandez-Villaverde: Banks just don't appear by spontaneous generation. You need someone who will push for that bank, and when you are a relatively agrarian economy, or you are a relatively under developed economy, you may not have the private sector, initiative from the private sector, to create that bank.

Fernandez-Villaverde: So you may have, as a government, you may think, "Well, why don't we help create this bank?" The goal of that bank is not really to conduct monetary policy, it's to provide levels of financial intermediation which will not otherwise exist. That was really behind a lot of the central banks of the world. When the Bank of Spain is created, it's not to do open-market operations, it's to ensure there is financial intermediation in the country, and we have forgotten that as economists.

Beckworth: Yes, and it's worth noting that we already do have partial access to the Fed's balance sheet, or just central bank balance sheets in general. You and I have physical cash, which is a claim against the Fed's balance sheet. It's just that we can't have access to the electronic version of the Fed's balance sheets. It's kind of an artificial barrier, if you think of it in terms of that. That being said, people do have legitimate concerns about what effect this might have on financial intermediation, but it's worth considering, at a very fundamental level, we already do have partial access to the balance sheets.

Beckworth: As I was reading your history section, just one other thought, the First and Second Bank of the United States, I read those histories a lot. The Second Bank of the United States, as many listeners will know, was ended because Andrew Jackson did not like it. He did not like the central bank, in fact, his presidential campaign was centered around ending the Second Bank of United States, and he won, took that as a mandate, and he shut it down.

Beckworth: I guess one lesson for us today, going forward, just to be mindful of, is a central bank, like the Second bank of the United States, where people could go deposit their funds, they did have an account there. It becomes a political firestone, right? Andrew Jackson was upset for a reason because the Second Bank had this privilege and survived crisis. His banks didn't, and he lost money at his local banks. I think you could see similar dynamics politically emerge in the future if we're not careful, if we don't think through these things.

Beckworth: One of the reasons central banks probably are independent is to avoid going into this area where they know it's going to get political really quick if everyone has access to its balance sheet. With that said, let me step back for just a minute, and I realized that we haven't defined what a central bank digital currency is, so maybe you could just give us your definition of what a central bank digital currency is.

What is a Central Bank Digital Currency?

Fernandez-Villaverde: Okay, so there're actually, I will say, two different versions. One will be what we call an account-based central bank digital currency. This means you can log into the webpage of the Federal Reserve System, you can create an account. That account will have, some deposits will be, yes, electronic money, and you can use that checking account to undertake payments like you will be able to use your checking account in your regular bank.

Fernandez-Villaverde: This is, I don't know, you have a checking account with Wells Fargo, it will be exactly the same except that now it's the Fed. The other difference is that there will be some extreme versions of this central digital currency that will be a full substitute for cash. Other versions do not really have cash... Sorry, they keep the cash. The second possibility is to have something that is called a token based central bank digital currency. These will be, if I can say it a little bit loosely, something like a federal government issued Bitcoin.

Fernandez-Villaverde: It could be some type of blockchain except that now it's sponsored by the Federal Reserve System, and you participate in the blockchain or some other type of aggregate ledger, and you use that coin to transfer and undertake payments. The first one is, in some sense, much, much closer to just moving your checking account from your regular private bank to the Fed. The second one will be like generalizing Bitcoin at the higher level.

Fernandez-Villaverde: My suspicion is that most policy makers are thinking about the account-based central bank digital currency because a token-based central bank digital currency just opens too many issues that I don't think they are very beneficial, and can be quite detrimental, so let me then stick with the account based.

Fernandez-Villaverde: The account-based central bank digital currencies, as I was saying, the same way that you can walk into your local commercial bank and say, "Hey, I'm David," or, "I'm Jesus, I want to open a checking account over here." You will be able to do that with the Fed. It will be through the Internet, and should we allow this? Should the Fed offer these deposit facilities to all residents in the United States? That's what we are trying to think... to bring this to paper something a little bit about the consequences.

Beckworth: Yeah, and I think that version is what is getting most of the popular attention. I know academics are exploring more the Bitcoin version, but again, going back to my friend Morgan Ricks, in his paper with his co-authors, his paper received a lot of attention. In fact, Senator Elizabeth Warren added it to a bill, and in fact, the early version of the Cares Act that went through, the Democratic version of it, actually had a Fed account in it.

Beckworth: It got struck out before the Cares Act passed, but this idea has garnered a lot of support, at least on the left, so I think you're going down the right path looking at this version of it. Let's start with your first paper, *Central Bank Digital Currency: Central Banking For All.* You build a model in it, so tell us a little bit about the model, and tell us what are the conclusions, what are the insights you get from it?

The Central Bank Digital Currency Model

Fernandez-Villaverde: Okay, so let me first point out that, like all papers, you become open. Models have strength and weaknesses. The fact that I have a model and I'm going to develop some ideas in that model doesn't imply there are many other aspects of reality I may be forgetting, okay?

Fernandez-Villaverde: Economics is built on abstraction. I mentioned this, many of your listeners may be familiar with this, but others may be a little bit less familiar with that idea. The framework, the modeling framework we are going to take is something called the Diamond–Dybvig model, which is a little bit the workhorse of modern banking theory. It was proposed in the early 1990s by Diamond and Dybvig. There has been, I don't know, maybe 10,000 papers using variations of that model.

Fernandez-Villaverde: We thought, "Look, this is the model that everyone understands, that everyone loves or hates depending on your position." The good thing is that, in that way, your results will be very transparent. Everyone will be able to see them right away. This is a model that highlights the role of financial intermediation and maturity transformation. At the end of the day, when I explain this to my undergrads, I always tell them that this is a model of *It's A Wonderful Life.*

Fernandez-Villaverde: You remember when there is this bank run, and people are asking, "You used to work for his money... for good money." [inaudible] It is in the house of this person, or it's in the house of that other person, so you basically have short-term deposits in the bank, and what banks do is they package those short-term deposits, invest them in long-term projects, and that transformation of maturity allows society to achieve things that otherwise would not be feasible.

Fernandez-Villaverde: Then we basically modify the model by introducing a central bank, and we ask the question, "Well, if this central bank allows these checking accounts, it will transform all the maturity transformation in the economy. Do we get a better, or worse, or the same outcome that if we had not allowed that?" The first result that we get is what we call an equivalence result. It basically says that a central bank that is open to all, and this is going to be very important, as long as it's not fiscally backed, that means it doesn't have extra sources of revenue from the government, will it be able to deliver exactly the same allocation that commercial banks?"

Fernandez-Villaverde: Okay, so this is basically saying, at the end of the day, the Fed is not going to be able to do anything worse or better than commercial banks, and the intuition is very simple. Basically, the Fed is going to be disciplined by commercial banks. If the Fed is offering a service that is much worse than commercial banks, no one will bank with the Fed, so it will be irrelevant, whether or not the Fed has checking accounts will be irrelevant. If the Fed is trying to offer a better service, it's not going to be able to do it because where do the funds come? The competition will force banks to offer the same type of service, so there is no reason why the Fed can't do any better.

The Fed is not going to be able to do anything worse or better than commercial banks, and the intuition is very simple. Basically, the Fed is going to be disciplined by commercial banks. If the Fed is offering a service that is much worse than commercial banks, no one will bank with the Fed, so it will be irrelevant, whether or not the Fed has checking accounts will be irrelevant. If the Fed is trying to offer a better service, it's not going to be able to do it because where do the funds come? The competition will force banks to offer the same type of service, so there is no reason why the Fed can't do any better.

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Fernandez-Villaverde: Now, this result will break down under two situations. One is when commercial banks have some type of monopoly power, and then the Fed can break into that monopoly power. How much monopoly power banks have in the US or in the large economies? A little bit, but I don't think it's such an important issue. I'm hoping to discuss this concern. The second one is if the Fed starts to get some type of fiscal backing from the government, because then the Fed will be able to do other types of maturity transformation.

Fernandez-Villaverde: Let me give you a very simple example. Imagine that Senator Warren is able to convince the Senate to pass this legislation. Three months later, she comes up with idea that if the Fed is going to engage in this type of central banking, and you are making a deposit, and it happens to be the case that you are a firm, and that firm has achieved some goals in terms of climate change and CO2 reductions, you are going to get 25 extra basis points on your interest, and the Congress is going to pay for those 25 extra basis points. That's when the equivalence results break.

Fernandez-Villaverde: What my concern is, is that the political process is going to regenerate exactly those type of transfers, and it's not going to be, in most occasions, "Oh, I'm going to give money to the people I like." Most of the attempts at providing extra transfers are going to be very well intentioned. They are going to be, "Oh, you are a firm that reduces CO2, I'm going to give you some special advantages. If you are a firm that makes progress in gender equality, I'm going to give you this extra money. If you are a firm that achieves some diversity goals, I'm going to give you this extra money." Before you realize, Congress is really directing maturity transformation and departing quite a lot from standard market forces.

Fernandez-Villaverde: For those who think that this is an abstract concern, I will put two pieces of information. Again, I come from Spain. We used to have a very, very large public... no, let me say it correctly, government-owned banking sector, and the investment and material transformation of these government-owned banks was hugely determined by the political process. I can tell you this story for the next 10 hours of your show. Second, because I have already seen numerous letters written by academics and even economists in Europe right before the COVID-19 crisis that the European Central Bank should bias all its lending facilities towards firms committed with climate change goals. Before you realize, as I was mentioning before, you are going to have a whole investment portfolio that is going to be dictated politically.

Beckworth: Yeah, so every election, portfolios will swing one way or the other based on who's in power, and that concerns me. I agree. Right before this crisis broke out, I was worried about all the push for using central banks to promote green investments as opposed to providing financial stability. The politicization of finances, you see it everywhere. I mean, there was a call not so long ago to restrict credit card use for gun purchases, for example, which you might be sympathetic to that, but if that's the first chip to fall, what's next? What's the next unpopular transaction you could target?

Beckworth: I think your point is well taken. It's easy to see the central bank opening up its balance sheet becoming very politicized. In fact, the baseline case, in my mind, probably wouldn't last very long, if at all. You'd quickly ended up in this worst case. But let me ask the question about the baseline scenario where there is no special fiscal backing for the central bank. In the baseline case, if there's no fiscal backing for the central bank, nothing special about it, why would the central bank even be offering services? Why would anyone want it? If it's no different than any other bank, right? Why would it even emerge and take that role?

Fernandez-Villaverde: Okay, so the second part of the paper then moves to address that question.

Beckworth: Okay.

Fernandez-Villaverde: In the basic Diamond–Dybvig model, you have something called bank runs, which is basically an equilibrium where people want to redeem their savings, their deposits, too early, and that forces the liquidation of long-term assets. The advantage of a central bank is that because of a number of reasons, and I can explain those later if you want, it's going to be a little bit better to avoid some of those bank runs. The idea will be that that central bank, as long as it could protect itself against political interference, will give extra stability to the financial system by lowering the probability of having a bank run.

Fernandez-Villaverde: There is a positive case for a CBDC. What you need to do is make a judgment call that while that our system goes beyond what I can prove in terms of a feeling of what is going to be a more serious consideration in real life. The political pressure that you can get from the system, from Congress or the presidency trying to interfere with the action of the Federal Reserve System, or all of the advantages that you are going to get out of avoiding financial crisis with a higher probability.

Fernandez-Villaverde: That's a judgment call, and I can perfectly see some of your listeners coming up with two different conclusions in that judgment call.

Beckworth: That is one of the big appeals of this, right? That you would have a super safe checking account. You would never have to worry. Like your grandmother, right?

Beckworth: You'd never have to worry about the ability of redeeming your account if you had your money, your funds parked at the central bank. And there's been lots of calls for people who are un banked right now. This would be great for them. So there's a strong argument to make in terms of that.

Beckworth: Let's transition to your second paper where you develop this argument even more. And the second paper is titled *Central Bank Digital Currency in a Nominal World.* And you really wrestle with this bank run problem. Tell us how this paper is different and what insights you get out of it.

The Bank Run Problem: More Key Insights

Fernandez-Villaverde: So the first paper, everything is real. All the contracts are real contracts illuminated in real units. So I give you one banana, and you're supposed to return to me two bananas tomorrow because the basic Diamond–Dybvig model is a real model. However, most contracts in life are nominal contracts. I don't know if you have a mortgage, but if you do you probably owe your bank, I don't know, $1,000 a month. You don't owe-

Beckworth: I have that. Yes.

Fernandez-Villaverde: And you probably don't need to pay them 1000 bananas. You need to pay them $1000. So what we wanted to say is can I extend the Diamond–Dybvig in such a way that most contracts are nominal, and then go over then the whole reasoning before but in nominal terms. And this of course makes a huge difference because in the first model the central bank is forced to give you back bananas. And if the central bank doesn't have enough bananas, yes it can be the central bank, but it cannot feed you the banana.

Fernandez-Villaverde: So think about the banks under the gold standard. You are the Bank of England. This is September. So if I recall correctly the United Kingdom left the gold standard on September 11, 1931. This is September the 10th, 1931. You are running out of gold. But now that everything is nominal, is not real, I don't need to give you gold. I need to give you a currency. I can always print more currency. In fact, since it's digital the only thing I need to do is call the guy in IT and tell him to put a little more in the account. So that's it. And so that completely changes the situation and that consequently completely changes the characterization of the bank runs. So now this is very interesting because what is going to happen is the central bank can always honor its debts, its nominal debts. But it will generate inflation because I'm putting one more zero of course this is going to have a consequence in terms of the price level going up.

Fernandez-Villaverde: And what we show is under what I think is a set of reasonable policies by the government precisely, by threatening to create inflation after a bank run, you deter households from engaging into this run. And that really delivers a lot of financial stability. So by moving from a real model to a nominal model, we strengthen the case in favor of a central bank digital currency. Now, all the political considerations we discussed before are still there, but it's easier for a central bank doing nominal contracts or nominal deposits to avoid bank runs. And to me that was a very interesting result because before we brought the paper, we brought the paper in February, I didn't even have this intuition whatsoever. If someone had told me this on February the first I will be like oh wow, that's interesting. I never thought about it. And that's why I like this paper a lot. I think I learned something that I didn't know at the beginning of the semester.

What we show is under what I think is a set of reasonable policies by the government precisely, by threatening to create inflation after a bank run, you deter households from engaging into this run. And that really delivers a lot of financial stability. So by moving from a real model to a nominal model, we strengthen the case in favor of a central bank digital currency.

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Beckworth: And that's why we do models, right?

Fernandez-Villaverde: Yeah.

Beckworth: Sights fall out of the models you wouldn't have seen otherwise. And it also makes a stronger case for the central bank issuing digital currency. And as I mentioned to you before the show, when I read this what screamed at me was this is effectively nominal GDP level targeting because if you were threatening to raise inflation when there's a real shock, negative, real shock, that's exactly what nominal GDP targeting does. So I was pleasantly surprised to see something like nominal GDP targeting fall out of your model. And this goes well with the recent research on nominal GDP targeting as a great risk sharing device.

Beckworth: But the way you frame it, it's more than just that. It's a signal, it's a discipline. It keeps spending stable in the first instance so people don't run. And that's almost like a forward guidance rule you have in this paper.

Fernandez-Villaverde: Exactly. So we don't make the explicit connection about the nominal GDP targeting. And I guess that when we revise the paper we should make it because I agree with you 100%. But yes, it really helped me thinking a little bit more about how important is the fact that nominal contracts really do make a difference in ways that go a little bit beyond your boring new Keynesian model with the sticky prices and sticky wages. So I've written I don't know, maybe two dozen papers using new Keynesian models and it's always about you cannot adjust your prices that much. Blah, blah, blah, blah, blah, blah.

Beckworth: Right.

Fernandez-Villaverde: But this is in some sense a little bit much more fundamental. And the fact that their contracts are nominal and you have financial intermediation really pushes you in a full completely different wall. And maybe some economies will say well, we have known that since 1930 and we'll agree with that. But it's the realization. When it comes from your model it's a little bit of an epiphany that is different than when you're sitting in class and your professor is telling you when you're in the first year graduate classes. I don't know. I don't know if it happens to you or not, but whatever circumstances comes with my own paper suddenly you're... oh, now I understand what they were telling me when I was a freshman in economics courses.

Beckworth: Right. No. Sometimes you have to educate yourself the hard way, working it through a model, thinking through something. But no, I completely agree with you and I had Evan Koenig from the Dallas Fed. And he's written on a related area. He's written on nominal income targeting, nominal GDP targeting as a form of risk sharing. And he came onto the show and he's worked on these models too and he goes, one of the big challenges that we face in our profession is kind of the workhorse new Keynesian model. It's all about output price stickiness. There's some wage stickiness as well in there, but often it's the Calvo pricing model. So it's all about price rigidity as being the main friction where he goes, really what matters a lot is nominal debt rigidities. You can't quickly renegotiate your mortgage. Those are the things that really matter and have huge consequences. We saw that in 2008 and as you mentioned, in the great depression. It's just that our models haven't incorporated that friction as much as maybe they should have.

Fernandez-Villaverde: So in that sense I have been playing with a colleague of mine, Guillermo Ordonez at Penn for five years on a paper that we have not finished and we should finish one day. And over there we argue that renegotiating contracts is costly. And in addition to it, you don't want to be the first that renegotiates the contract. So imagine that your bank has a mortgage to you and with your neighbor. So you don't want to be the first that renegotiates the mortgage with the bank because then who knows. Maybe the bank will offer a better deal to the second person or the other way around.

Beckworth: Interesting.

Fernandez-Villaverde: And inflation is a way to renegotiate all nominal contracts in the economy at the same time. So think of having to go through the mess. Imagine that it will be better if we get out of this crisis and it will be better if all debts and all nominal contracts get reduced. Get a 5% haircut. Very difficult. Even if yes, because we are going to make a small army of lawyers rich. If that happens, we get a 5% inflation that is unexpected. Well that's a 5% haircut, right? We don't need more lawyers. We do it in a second. And that's a little bit intuition of what is in my paper, in my second paper with my coauthors.

Inflation is a way to renegotiate all nominal contracts in the economy at the same time. So think of having to go through the mess. Imagine that it will be better if we get out of this crisis and it will be better if all debts and all nominal contracts get reduced.

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Beckworth: Yeah. And that again speaks to the benefit of having counter cyclical inflation. It serves a very useful purpose. And I'm glad to hear that you're working on this too because you're a pretty well-known modeler. So you can get the momentum going, Jesus. That would be great. So we have a few minutes left. I just want to touch base with your thoughts on Europe. You're from Spain, you've written about the Eurozone, you care about it immensely. You have family there. So any more thoughts on what's happening in Europe in response to the COVID-19 crisis?

The Impact of COVID-19 in the Eurozone

Fernandez-Villaverde: Yes. So the situation right now is pretty bad. I'm not going to put it in any other way. I think we were very unlucky because the country that got hit the first, and to a very large extent the most, is Italy. Italy was the weakest link in the Eurozone and a lot of people had made that point because in comparison with Spain they had not really put their house in order in the sense that if you look at the Spain in 2019, in fact already by 2016, 2017, wages and prices and real estate values were back in order. Okay. So it was painful. It was difficult. And we had way more unemployment than we should have had under a better policy, but we purged, if I can say it in that sense, the problems from the system. Italy had not done that. So precisely in the country that you have the weakest link is the country where now the rich regions, which is Lombardy, Veneto, and the rest of the north, are particularly hit by the epidemic.

Fernandez-Villaverde: And in addition to it I think there is a feeling within Italy that they have not been helped enough by the rest of Europe. So you are on one hand a country that is already in a very weakened position with a tremendous financial and economic crisis. And very, very much unhappiness about the reactions of Europeans about this. Either the European Union is way more proactive in trying to share risk in the right way or this cannot continue. Something is going to blow up sooner or later. On the other hand I also understand a little bit the argument of the Germans because they are going to tell countries like Spain or Italy that we had relatively eight good years between 2012, 2015, and early 2020 and we did very little to prepare ourselves for the future.

Either the European Union is way more proactive in trying to share risk in the right way or this cannot continue. Something is going to blow up sooner or later.

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Fernandez-Villaverde: I gave a very large public talk in Spain in May, 2019 and I was going in some detail about how our fiscal situation was really very, very weak. And I said we are going to have a crisis. I promise you we are going to have a crisis. I just don't know where this crisis is going to come from. And when that crisis comes, we are really, really, really going to be close to the limit of what we can borrow. And that's sadly what we are now.

Fernandez-Villaverde: So the Germans and the Dutch are a little bit reluctant to lend to us. On the other hand, I think this is a perfect example of a situation where they should lend to us. To us I mean Spain and Italy because this is not really our fault in the sense that it's not that we created this virus ourselves. So this is going to generate huge amounts of unhappiness in the European Union and I really hope the European leaders will be able to find a path forward. On that dimension I'm actually relatively pessimistic. I hope that in one year when we talk again I can report a better news, but right now I really see a conundrum. I don't really see an easy way out of this situation.

Beckworth: So could this crisis be the straw that breaks the camel's back in terms of the Eurozone? So many people thought that the Eurozone crisis would break up the Eurozone. At least Greece might leave. That never happened, which is remarkable. Shows the commitment of three Europeans to this project. But maybe we're getting close to a tipping point.

This is going to generate huge amounts of unhappiness in the European Union and I really hope the European leaders will be able to find a path forward. On that dimension I'm actually relatively pessimistic. I hope that in one year when we talk again I can report a better news, but right now I really see a conundrum. I don't really see an easy way out of this situation.

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Fernandez-Villaverde: In Italy, I think so. Something that was not sufficiently appreciated by American or let me say more general, English speaking commentators, is that in countries such as Greece and as Spain being part of the Euro and the European Union was a commitment never to go back to the dictatorships we have in the 1970s. And I say that during the financial crisis, and some people, very famous prominent figures of this profession never believe me. But I told them look, you talk to the generation of my parents. They grew in a dictatorship and they are more than willing to eat grass if necessary never to go back to a dictatorship. That means that if you need to be in the Euro and you are going to eat white steamed rice for a year you have to eat white steamed rice. Now Italy is different because Italy’s dictatorship ended, in parts of the country, 1943. And in the north, 1945.

Fernandez-Villaverde: So idea of a dictatorship and Euro as the solution to your dictatorship is not that valid anymore. And then a lot of people may be tempted to say maybe we can go alone. Look at the British. They are going alone and it's okay. They are not collapsing. And that's what really, really worries me. So if I were going to give you probabilities, I will give a 35% probability to Italians doing something really nasty at the end of this crisis unless the European Union offers some type of [inaudible] of debt as the cause of the crisis.

Beckworth: Well that would be bad news for the rest of us too because if that happened then it'd be just an intense financial crisis globally on top of everything else that we're going through right now. So let's hope it doesn't come to that. Let's hope the leadership steps up to the plate in the Eurozone and delivers.

Fernandez-Villaverde: Well, hopefully. Yes.

Beckworth: Okay. With that, our time is up. Our guest today has been Jesus Villaverde-Fernandez. Thank you so much for coming on the show.

Fernandez-Villaverde: Okay. Thank you. Was a lot of fun to be back.

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