Lev Menand on *The Fed Unbound: Central Banking in a Time of Crisis*

Lev Menand is an associate professor of law at Columbia University Law School and writes widely on legal issues surrounding the Federal Reserve. Lev rejoins Macro Musings to talk about his new book titled, *The Fed Unbound: Central Banking in a Time of Crisis.* Specifically, David and Lev discuss why the Fed can be considered unbound, the history of the Fed’s engagement with the shadow banking system, and Lev’s solutions for reform.

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 [email protected].

David Beckworth: Lev, welcome back to the show.

Lev Menand: It's great to be back.

Beckworth: Well, I was looking at our previous discussion, which was in May, 2020. It seems like an eternity ago, and that was back right in the heat of battle with the pandemic. In fact, we were running two shows a week and I was also doing these bonus segments. And you're one of the guests, the few guests that we did bonus segments with. And I went back and looked at that. And you know what we talked about, among other things? Can you remember?

Menand: I can't actually.

Beckworth: Okay. We talked about the important issue of gold in the basements of the New York Federal Reserve building. And you shared with me that there's a tour that you can go see, and I still haven't done that. So I need to get to the New York Fed and take that tour that you've you told me about. And of course, that gold was in the movie Die Hard, number two. Okay. Yeah. So great times. We had a great discussion. And more seriously though, during that previous conversation, we talked about your paper that was titled, *Unappropriated Dollars: The Fed’s Ad Hoc Lending Facilities and the Rules That Govern Them.* And we got into your categorization, your list of the facilities, the many facilities the Fed brought out to play during the pandemic.

Beckworth: And what I really liked about that, and we'll come back to that in a minute, but you had this nice delineation between liquidity facilities and credit facilities. And from that list, there's some big implications that flow out of that. But I'm glad to get you back on and talk about your new book. So you've been a busy man. I should mention to our listeners that you're now an associate professor. So congratulations on that as well, Lev. So you are just changing the world, writing books on the Fed, getting promotions, and now you're back on the podcast. So happy to have you on board.

Menand: Thank you.

Beckworth: Tell me about the motivation for the book. Why did you write it?

Menand: So I think there's a narrow motivation and a broader motivation. The narrow motivation you've already touched on, which was the pandemic panic, the, basically, financial crisis we experienced in the global dollar system in March and early April of 2020, which was addressed very rapidly and effectively by the Federal Reserve, and as a result, has faded from the public consciousness to the extent that it ever punctured the general public consciousness, given everything else that was going on in March and April, and that has gone on since then in this country and around the world. And I wanted to explain really what happened there. There was a crisis that had the potential to cause as much damage as the 2008 crisis and didn't, and it involved an even more aggressive government response, in many respects, than 2008. And that's a story, I think, that is one that should be of interest to a general audience.

There was a crisis that had the potential to cause as much damage as the 2008 crisis and didn't, and it involved an even more aggressive government response, in many respects, than 2008. And that's a story, I think, that is one that should be of interest to a general audience.

Menand: And the book is trying to draw on, for example, that paper we talked about last time and other work to describe what the Fed did and why in 2020, and what its effects were, both narrowly with respect to the financial system, and more generally what the political economy and distributional consequences and legal implications were of what the Fed did at the beginning of the pandemic. The broader motivation for the book is my sense that what happened in March, 2020 was not a one off. It was not the sort of thing that a central bank has to do whenever there's a pandemic. We can't just attribute it to this global health emergency and say, "Well, we won't have another global health emergency. We won't have another massive Federal Reserve response to a huge financial sector meltdown."

Menand: I think that we now live in a financial monetary system in an economy that is highly vulnerable to panics in the way that the economy was in the 19th century, for example, and that every time we have a business cycle downturn, we're likely to see at least some runs and panics depending on the frothiness of the boom time in the cycle and the effectiveness of regulators during that period. We may have an experience like 2020, where [inaudible] central bank support is sufficient to avoid a depression or a recession that is a product of financial system breakdown, or we might have a situation like 2008 or even 1932, 1933, where a financial system just shut down, means a massive economic dislocation. And I think that that arrangement, that circumstance that we find ourselves in on an ongoing basis is very problematic and is a pressing problem that needs public policy attention, and I wanted to call attention to that and suggest some solutions. I'm under no illusions that it will be easy to try to tackle this problem, especially outside of a depression style event. We're not going to be able to avoid such an event and avoid such a solution if we don't start talking about it and thinking about it now.

Beckworth: Yeah. I agree with you the issue of what I'll call the global dollar system or what you call the shadow banking system, but all these dollars around the world, in the US and around the world. Many of them are very runnable. This maturity transformation taking place on balance sheets of banks, financial firms around the world, it's definitely an unresolved issue. Some of us look at the glass half full, half empty, but for sure the potential’s there for future runs and it hasn't been resolved. So I'm looking forward to that part of the conversation in a little bit. Something you just mentioned though that really struck me is that maybe the public consciousness wasn't quite what it was for me and for you during the pandemic. They're focused on the disease, on the death, the dying. But for people like you and me, and I'm sure all the listeners of the podcast, wow, what a crazy time it was in terms of the Federal Reserve, its footprint, its intervention, the Treasury coordination with the Fed.

Beckworth: When I look back then myself, I think more of that story, less of the public health story. But clearly, a million people have died in the US, so it's clearly a big, important story too. But yeah, that's a good reminder, Lev, that not everyone else is thinking about this like we are, so it is good to have a book written. And I'll say it's a very accessible book too. It was fun to read. It's not too long. And you bring up some of these interesting stories. Okay. Let's get into it, and let's start with what we touched on last time, but I think it's useful here to recap, what did the Fed do that was so radical or so amazing in terms of its scope and scale that causes one to say the Fed is now unbound, as in the title of your book?

Why Could the Fed Be Considered “Unbound”?

Menand: Yeah. Great question. And I think there's a good segue from your last comment as well. Of course, for specialists and listeners of the podcast, March and April, 2020 is an extremely salient event, although even with respect to that audience, I have a goal in the book to correct what I think is a misunderstanding and a common misunderstanding about that period, which was that it was a dash for cash, as it has often said, that there was just a desire to have more dollar cash, when actually, I think that a lot of cash demand was actually about the destruction of private money substitutes. And so a run on the issuers manifests as a dash for cash, but it's not that the issuers of repos and Euro dollars want cash, it's that the holders of the repos and Euro dollars are running on them.

Menand: And so we'll get back to that. But I think that the story of March and April [2020] is largely, although maybe not entirely, about runs as opposed to some just sudden desire of people around the world to have cash. So what did the Fed do and why? Why would I say that it is sometimes unbound? The Fed, first and most importantly for, I think, a lot of the book and the listeners, it stopped a run in the shadow banking system. What does that mean? It stopped a run on financial institutions that do not have bank charters, US bank charters, but nonetheless issue liabilities that function like US dollar deposit accounts in various respects. They are cash equivalents. They are a form of private money substitute. And the people that hold them are interested in their money nature, their exchange ability at any time for actual government cash. So they're highly prone to run in bad situations.

I think that the story of March and April [2020] is largely, although maybe not entirely, about runs as opposed to some just sudden desire of people around the world to have cash.

Menand: And there are a variety of instruments that fit this description. Overnight repo is a form of deposit substitute in the wholesale markets. Euro dollars can literally be a US dollar deposit at a non-US financial institution, but it can also include other forms of overnight dollar liability. One to four day commercial paper. That's a lot like a deposit account or a time deposit. It's used for cash management purposes. It's rolled over in good times. It's withdrawn in bad times, highly runnable. Money market mutual funds of the prime variety that are fractionally reserved and that have credit risk assets. Now we have a stablecoin maybe we'll get back to, which is a new area, but wasn't significant in March of 2020. There are trillions of dollars of these instruments, and they're highly runnable.

Menand: They're uninsured. There's no deposit insurance. And so the Fed stepped in and used what I call ersatz discount windows to lend to support these issuers, to indicate that these issuers would be able to make good on their deposit alternative liabilities, because they could turn to the Fed. And I called these the liquidity facilities, and there's a whole range of them. We can get into more detail about them. But the way I like to conceptualize them is different ersatz discount windows, the Fed has set up on an ad hoc basis to support different types of non-bank financial institutions, shadow banks that are engaged in a deposit alternative business. And so for a bank, there's the discount window, which is a statutory facility, because the Fed, as I argue in the book, was set up to administer the banking system, limited purpose, and a presumption behind the Federal Reserve Act and Title 12 is basically that the vast majority of money created in the economy is by the government or by the chartered banks.

Menand: And so it's assumed, as it were, that the discount window is sufficient, but it's not when you have half the money in the shadow banking system. And so the first unbinding of the Fed, the first way in which it is unbound, it is expanding outside of its traditional role, is to support all of these shadow money markets. The second thing... And by the way, in this regard, the Fed is repeating its playbook, as I'm sure your listeners are aware, from 2008. And so this is the second time the Fed has done this. In some ways, it was on a greater scale this time. The runs were fiercer and the Fed had to turn to a non-lending a mechanism to really quell the panic.

Menand: It did trillions of market functioning purchases, which was not something really that it did in 2008. It tried to heal the shadow bank balance sheets by pushing up asset prices to strengthen their financial position, to quell the run. So there's a series of things that the Fed did with respect to the shadow banks. And then, in 2020, the Fed goes further in a bunch of ways. Congress passes a law, the CARES Act, that gives the Fed legal cover and a hard nudge from Congress to lend outside of the financial system and try to support other pieces of the economy that have not liquidity problem in the way that the shadow banks do. They're not money issuers. They're not issuing claims that function like cash equivalents and need that state support.

Menand: They are ordinary businesses. So you have the main street facility for, actually, basically the medium size businesses and nonprofits. They're not small businesses. These are pretty sizable entities. You get the municipal liquidity facility for state and local governments and municipal entities. You get the secondary market corporate credit facility, which goes out and buys $13.5 billion of corporate bonds issued by large corporations. These are very much outside of the traditional role of the Federal Reserve, and, I argue in the book, are a byproduct indirectly of the Fed's new role in having to repeatedly and aggressively use its balance to support the shadow banking system. So when you start seeing the Fed support AIG first in 2008, with over $100 billion committed and the Fed pumping hundreds of billions to foreign central banks, and then doing this again in March, there's just a political demand and need to now turn this balance sheet towards other purposes.

Menand: This has given rise to a new politics around the Fed, because the Fed wasn't designed to engage in this ad hoc discretionary credit allocation, nor was it really designed with a sense that it would engage in the large scale shadow bank back stopping, although there's much more of a statutory hook and function and purpose there. And so you have an institutional ecosystem really that was set up for one set of purposes that is now being put to a lot of uses that are quite a bit different, and it's put in a variety of strains on the institution, and I think leading to suboptimal policy. So even though in the moment, the Fed's responses were critical to helping keep the economy from imploding, the Fed is not the best mechanism to rely on in those circumstances, and we would be much better off if, in my view, we had alternative ways of stabilizing the economy, and also we didn't have an inherently unstable financial system that required so much state sector support in such huge numbers on such a regular basis.

The Fed wasn't designed to engage in this ad hoc discretionary credit allocation, nor was it really designed with a sense that it would engage in the large scale shadow bank back stopping...And so you have an institutional ecosystem really that was set up for one set of purposes that is now being put to a lot of uses that are quite a bit different, and it's put in a variety of strains on the institution, and I think leading to suboptimal policy.

Beckworth: Wow. So much there, Lev, to unpack. So let's do it. Let's give it a shot. So just to recap that list you mentioned, there's the liquidity facilities that the Fed brought into play in 2020, and those are to support the shadow banking system, which, as you mentioned, has its own issues and challenges, and it's still a problem. We'll come back. But then on top of that, it started doing credit policy. The problem I have, and I think you have with it as well, is that credit policy, what we mean by that is it's picking winners and losers, but it really hasn't been delegated that authority. That's something that Congress is supposed to do. And if Congress wants to officially delegate it and do it appropriately, now of course they might argue some of that was delegated in the CARES act, but there's still some legacy issues that come with that. So we have both shadow banking issues, we got credit issues and maybe the Fed, in fact, I would agree that the Fed is not the place to be doing credit policy. And I'm sympathetic to the idea that you bring up in the book about a national investment authority, some other body that takes on that role and leaves the Fed to itself.

Beckworth: You bring up in your book, there's legal issues, a whole host of issues, but let's maybe step back and go to the first piece of that. And as the shadow banking system, you argue in your book that a key reason, as you see it, for this, this unbounding, this growth, this increased reliance upon the Fed is its engagement with the shadow banking system. So maybe walk us through the history because you talk about it. How did we get to this place? Even before 2008, you share some important points in history where the Fed kind of opens the floodgates that later become the shadow banking flow of issues into the Fed.

The History of the Fed’s Engagement With the Shadow Banking System

Menand: Yeah, I think that's a great question and a great place to turn next. One of the arguments that I make in the book, although it's not the focus of the book and it is something that I'm working on in other projects is trying to account for the emergence of the shadow banking system in the first place. And I do think that the Fed is an important part of that story, an underappreciated part of that story. And so today we just sort of take the global dollar system for granted and see the Fed as basically stuck between a rock and a hard place. When the global dollar system gets into trouble, there are runs on the non-bank pieces of the system and the Fed can either stretch its statutory authorities, and commit huge amounts of balance sheet to stopping those runs. Or it can just basically fail in its section 2A mandate, which is monetary expansion, consistent with full capacity utilization over the long run. You're not going to get that.

Menand: In fact, you're going to get an acute recession or depression if you let the shadow banking system fail. That's very much exactly the lesson of the 1930s. So, this is how the Fed looks, but incidentally, the Fed was instrumental in actually building the system. So at least at one point, really believed that this system would be good. And what I argue in the book is that the origins are happening a surprisingly long time ago. The global dollar system did not emerge overnight, a shadow banking system of the scope and scale that we saw in 2008, that was beyond the ability of the banking system to support, that required state support and that sunk the economy, took really 40, 50 years to build. And an active role was played by government officials.

Menand: One official in particular was significant. That's William McChesney Martin, who was chairman of the Federal Reserve Board for, I believe 19 years starting in 1951. And he's famous for the punch bowl metaphor. Which is sort of ordinary monetary policy dictum. But I think he also ought to be famous for basically inventing the modern repo market and inventing the modern eurodollar market. So in the 1950s, it was William McChesney Martin who thought that securities dealers who were barred from the banking business by Glass-Steagall and the New Deal legal framework for money and banking, that they ought to have access to overnight loans at the New York Federal Reserve Bank, just like banks, so that they could compete with banks in the government securities market, which was the one part of the securities market that banks were permitted to operate in under the Glass-Steagall regime.

Menand: So there's this competition between banks and non-bank dealers in the government securities market. And Martin says, "The dealers are very upset." The banks out-compete them, of course, because they have access to the discount window. And Martin says, "We'll create repo loans. We'll do repo loans with the dealers." And by the way, the dealers at this time were also doing repo loans with big corporations who had deposits. And so they were competing with the banks by undercutting their deposit business with big corporations by offering those corporations repos, overnight repos instead of deposits. And they were now undercutting the banks because the Fed was [inaudible] it by actually supplying the same overnight liquidity. And this is important because otherwise the dealers would have to get their funding from the banks, which is how the system was designed to work. And so Martin wants to basically unwind this New Deal framework that puts the banks in the prime position.

Menand: Now there are variety of reasons Martin wants to do this. Surely one of them has to be his experience, personal biography as a former dealer himself and former head of the New York Stock Exchange. And so he has sort of a certain vision of the dealer's role that he is now vindicating in his position as basically chief bank regulator at the Federal Reserve Board. The second thing that Martin does is facilitate the development of the modern eurodollar market. So eurodollars are these overseas dollar deposits and that market begins as a very, very small activity. The first eurodollars are supposedly issued by a bank called Eurobank, which is a Paris bank, wholly owned by the Soviet Union. And the Soviet Union did not want to have its dollar deposits at Citibank in New York because they would be subject to US legal process, exactly the sort of legal process that we're now seeing US can extend to European entities as well using secondary sanctions, but this was before secondary sanctions, financial sanctions were a major tool of US policy. I'm not even sure if they were used at that point ever, or conceptualized.

Menand: The word eurodollar had nothing to do with the currency euro, which of course didn't exist at the time or even the continent Europe, it was Eurobank. And when Eurobank sent wires in dollars, they got to be called by people in the business, “oh, eurodollars. Euro dollars are coming through.” And now we use that term widely to refer to any dollar denominated deposits that are issued by a non US bank, a bank overseas. And that whole idea is outside the scheme of the banking laws, the conception of the banking laws.

Menand: And so at first it's just this small business of Russia, China trying to avoid process. And then it starts to expand when London banks start to get involved and see this as an arbitrage opportunity. An arbitrage on the whole US regulatory regime for banking, which at the time includes regulation Q, FDIC insurance, all this stuff that makes it expensive to do the banking business in New York. For example, if you could set up a bank that wasn't subject to all of those tools in London that had basically a dollar banking business and made dollar denominated loans on the left hand side, and it had dollar denominated deposits on the right hand side, you could afford to pay much more interest. You wouldn't have to comply with regulation Q and you could attract a lot of dollars from a variety of places from petro states who would rather hold them in a London bank, earning more interest than in a New York bank complying with regulation Q, and even from the US itself.

Menand: And so, okay. So how does the Fed fit into the emergence of this market? You're going to be worried about your balances of dollars and as non US banks, if you're the depositor, because you're a general claimant on the bank on this foreign financial institution, they don't have deposit insurance and they don't have access to the Fed’s discount window. And so there was a limit to how big this market could grow because people were wary of it. And the critical move was to have the Federal Reserve bless this market and agree to back stop it. And so Martin starting in 1962, stretches the Fed's legal authority to set up swap lines with other top central banks in which it starts to lend to those central banks, not just to support the function of the Bretton Woods system, but also to provide dollars to those central banks so that they can all lend just in the way that happened in 2008 to banks that are doing the dollar business in their jurisdiction.

Menand: And this all comes above surface in 1974. Now this is post Martin when there's actually a crisis of this system, a run on the eurodollar and the proto repo market, which brings down Franklin National Bank, which is an actual bank, but it was engaged in these shadow bank business models and they run. And this is where Herstatt risk comes from. That's also caught up in all of this, there's a run on the whole system. And the way the run is quelled is a BIS communique in the early fall in which the Fed and the other central banks put out basically the first original “whatever it takes” statement where they say, "We will make currencies available to each other in whatever amount is necessary to ensure that institutions can make good on their foreign currency liabilities." And once that piece is in place, these markets are able to grow quite a bit.

Beckworth: Yeah, it's a very interesting story. And I hadn't realized that the 1974 event was so pivotal in maybe catalyzing what had been set up and put into place there and just to step back… So we have the Fed, we have William McChesney Martin, he's the key person here. So maybe we could say, to take his little illustration, the punch bowl, maybe instead of putti ng the punch bowl away, he's putting another punch bowl out at a different party, the repo and eurodollar party. He has multiple punch bowls he's keeping his eye on at the time, and so, and maybe some punch bowls are spiked more than others, but nonetheless he's made punch bowls abound.

Beckworth: Okay. So with that said, though, again, you have the shadow banking system, here's the history, you've mentioned repos. You mentioned the eurodollar. In the book you also mentioned the emergence of the money market funds in the 1970s. And I just want to add one little detail to that story. That emerges in the 1970s, as you note for retail, people like you and me. And as you note in the book, that's because of regulation Q, we couldn't earn a high enough interest rate on our bank account to keep up with inflation. And I guess the government didn't want banks to lose customers to lose business. But what I hadn't learned, and I read recently is that the government also restricted the size of the dollar amount of treasuries a retail person could buy. So I think it was a thousand dollars or more. So it was difficult for an average person to hedge themselves against inflation by buying treasuries.

Beckworth: And so money market funds were a solution for the retail person. Their checking accounts were losing value with high inflation. So again, just connecting all the dots here. Had the Fed kept inflation in check, or had we not had that inflation, it would've been interesting to see what would've happened to money market funds. Would they have been as prominent or as popular as they are now? So we have repo, we've got eurodollars, money market funds, you mentioned commercial paper and then stablecoins. Are those the big categories? Am I leaving any out?

Menand: No, those are the big categories. Let me just say on money funds, I think you're exactly right. And we didn't get to that one, or I didn't get to that one. Incidentally, that was a type of non-deposit deposit that the Fed was against. So the Fed supported the repo market, the eurodollar market, and they actively tried to prevent [inaudible]

Beckworth: Well, that's interesting.

Menand: ... and failed. And I agree it, when it emerged, it was very much a sort of populist reform to the system in contradistinction to repo and eurodollars, which were opposed by populous members of Congress and were seen as undermining the New Deal. And I also agree. And then now of course, that changed in the post inflationary period. Money funds became an institutional product, but initially it was very much about what you refer to, and I think you are very much right to identify inflation as playing a significant role in damaging, perhaps it's the death now, in some sense of the New Deal banking system, because that system wasn't set up well to deal with that type of inflation or the type of interest rates that Fed ultimately imposed. And it caused a lot of stuff to fritz out.

I think you are very much right to identify inflation as playing a significant role in damaging, perhaps it's the death now, in some sense of the New Deal banking system, because that system wasn't set up well to deal with that type of inflation or the type of interest rates that Fed ultimately imposed.

Menand: Regulation Q wasn't well administered. And I do think the hypothetical where we didn't have the inflation of the '70s as a very interesting hypothetical, and I would need to think more about how it plays out, although I'm not sure we could have avoided the inflation of the '70s just through better monetary policy, because there were a lot of supply side shocks like we're seeing now. And there's little that the monetary authority can do about a supply side shock and a supply side shock can still be very disruptive to an administrative regime like reg Q as is what happened in the '70s.

Beckworth: Yeah. So that's interesting to frame the development of what I'll call wholesale shadow banking, repo, and eurodollars. The Fed was all for that, but when it came to retail shadow banking, the Fed’s like, “no, no. Hands off.” Which is interesting because if you look today, recently at the Fed's white paper on central bank digital currency, you see the same kind of theme running through that. Right?

Menand: Absolutely.

Beckworth: They're pretty jazzed up about wholesale CBDCs, but retail, which I know you and Morgan are big fans of, they say, “no, no, no. Hands off.”

Menand: That's right. Same thing with stablecoins, right. So insofar as stablecoins are really a retail shadow money product, there are not a lot of fans in the central bank or in much of the regulatory community. And it's viewed quite a bit differently, even when functionally it's similar from wholesale shadow money and instruments. And there obviously there are explanations for this.

Beckworth: Sure, sure.

Menand: …that we could get into.

Beckworth: Let's get into it in a minute. I want to just go back again, we're spending a lot of time on this, but it's important because it's a key part of your book, but shadow banking or the global dollar system. So one of the big issues I think you're making in your book is this: the Fed was designed for the traditional banking system, the commercial banking system, that was the set of financial firms that had access to the Fed's balance sheet. And it was geared towards that. But now it's increasingly servicing the shadow banking system, which is much larger, especially if you think globally, it's definitely much larger. So what the shadow banking system means is that the Fed's balance sheet is at least implicitly backstopping something much, much larger than just the traditional banking system.

Beckworth: And I think that's kind of a point you're trying to make in this book is that it may not be on the books, but it's there. And we've seen in 2008, we saw in 2020 it's implicitly there. And you do make this point in your book that as a result, people are more willing to engage in shadow banking and grow the global dollar system. So we even see evidence of this as other research that shows during panics overseas, people actually issue more dollar liabilities. It's a safer, lower costing liability than their domestic currency. And you get this global dollar cycle that's also been brought up from literature that can create problems for emerging markets in other countries overseas. So look, there's a lot of challenges involved with this and we'll get to the legal ones in a minute. But before we step away from shadow banking, Lev, can you say anything positive about it? We've been making this kind of case that it creates problems, it's not ideal, but is there a glass half full argument to be made for this?

The Glass Half Full Argument for Shadow Banking

Menand: Yes, I'm glad that you asked that question and gave me an opportunity to offer, I think, some of the logic that was behind it. So of course I think the cost greatly outweighs the benefits, but let me try to outline some of the benefits, or the benefits as they were perceived by the people who helped develop the system, because as I'm sort of arguing here, it is very much constructed, it's not just a market phenomenon, the market came up with this solution. Policymakers are integral, and what do they think they're doing? They think they're creating deep and liquid capital markets, and that capital markets will be a more efficient way to allocate capital in the economy than bank lending. And they think that the New Deal system is ill served... ill served in the national or international economy.

Menand: One of the key features of the US banking system, going back to the decline of the second bank of the United States in the 1830s, is extreme diffusion. This is a political choice, nobody thinks it's more efficient to have thousands of banks. It's an inefficiency that is embraced for its legitimating effects and also for the sort of economy that it facilitates, a more local regional economy, where credit is allocated by banks to businesses in those regions. You don't have big national champions, and as a result, it's much harder to have the banking system support large national businesses, and in particular international businesses.

Menand: And so US conglomerates, business conglomerates turn to capital markets to borrow because you have a very diffused banking system, the banks are ill sized to support very large businesses. And the shadow banking system, the more their cost of funding is supported by the central bank, and the more it is money financed, essentially, the lower it will be. And so you can have a deep and liquid capital market, that's basically money financed, which is contrary to the scheme of Glass-Steagall. Of course, they're trying to deprive capital markets of this sort of low cost of funding that comes from money financing balance sheets.

Menand: And so Martin is trying to reintroduce that, and he does it initially in government securities. And so the idea is, well, the government has an interest in cheaper government securities so surely having that be more money financed on the dealer side is good. And this is a very successful project. So we get deeper and more liquid capital markets from allowing them to be essentially money financed and state-backed in the sense that the central bank is backing the money financing. This just lowers the cost of capital for all the dealer firms and allows them to become much, much bigger and allows them to do a lot more market making and make all sorts of trading much more cheap. And so you get these capital markets that support the development of large businesses, and then you get, especially post-1971 and post-1974, the emergence of large banks that operate internationally, and the global dollar system, which sort of replaces Bretton Woods, which is again, an explicit policy goal during this time is to support the creation of that system.

Menand: And an important part of that is that banks all over the world can maintain a dollar deposit business that is sort of ultimately backed up by the US central bank. And this facilitates the use of the dollar in international trade, including trade between third countries that don't involve the US. This facilitates just sort of dollar dominance in a whole range of respects because the alternative system would require anybody that wants to hold dollar deposits to hold them at a US bank, and that would mean a lot of countries would try to form different systems, because we would've cut out all of their financial institutions from the game, as it were, of the global dollar system. So they're cut into the game through the eurodollar market.

Menand: And so there's a sort of international globalized economy that's being facilitated through the creation of these shadow banking entities. And it's important to remember when this was all being built up, a lot more of the new deal restrictions were still in place on what banks could do. And so banks were very restricted in their activities. Those were all subsequently rolled back in part because banks are now competing with the shadow banking system that could do all this other stuff. And so now we think, "Oh, well, banks can do a lot stuff. They operate in a lot places." But banks were much more restricted when this all got going and so loosening up... Monetary liberalization, broadly speaking, was the goal here and was very much achieved.

Beckworth: So let me share with you a few other arguments one could make for the benefits of shadow banking. So on one side of the ledger, we got the cost, which you've outlined very well in your book, but let me put something on the positive side there on the ledger. Start off with this, it increased seigniorage flows to the US economy. Now some of that goes to private sector, so financial firms have lower costs on the dollar. The exorbitant privilege story, the US government has lower financing costs, but as well as the private financial systems, anything in US dollars, and maybe even some foreign banks overseas here are taking advantage of the eurodollar system, so that'd be one.

Beckworth: A second story you could make is that globalization, it's not perfect, but it has elevated a billion people out of poverty, globally, right? And it helped to have a global medium of exchange. It helped to have dollars to help facilitate trade. Now, maybe you could have had a system without the dollars, but it certainly made it happen. And we know that dollars were a key part of globalization, getting goods back and forth. And again, far from a perfect story, but you think of all the people who have been lifted out of poverty, maybe that's an argument, maybe it's not, for shadow banking.

Beckworth: And finally, how do we know the alternative isn't worse? And by that I mean the following: I had Ricardo Reis on the show and he was talking about this issue and he cited another paper that had been done that kind of modeled, what would it look like if you had a bunch of regional-like currency areas? So let's say the Chinese yuan was dominant in one part of the world, the dollar in one part and the Euro in another. And what this paper showed is you could actually have greater runs. One system might have a crash and everyone runs out of one system into another system, and then in the future could be from one system to another system. So there could be even more instability. So am I making too strong a case here for the benefits, or do you see any merit in those stories?

Menand: Well, I think that you are blending together the benefits of an international currency system and a single international money with international shadow banking in dollars. They are related in that the system we have involves a huge amount of international shadow banking in dollars, which by the way, is different from domestic shadow banking, which we also have, which can't be justified on these grounds really.

Beckworth: Fair.

Menand: It's not clear that were the US to crack down as it were on international shadow banking and dollars, the dollar would no longer be able to serve as a reserve currency, for example. I suspect it would continue to serve as a reserve currency, because the main reasons have nothing to do with the ability of foreign commercial banks to issue dollar deposits. It has to do everything with the need of foreign governments with large savings to put those savings in a stable investment with a positive return that can be easily liquidated, and the US has the deepest, most liquid capital markets for reasons that aren't just shadow banking. And it issues a lot of debt.

Menand: And China still has a trillion dollars of Treasury securities, not because Deutsche Bank and Japanese financial companies are able to issue deposits denominated in dollars or because there's an international dollar market, but because there's nowhere else to go. You could try to put your savings in euros, but you would have to worry about the euro collapsing. And other than that, there just aren't a lot of "safe assets", as economists like to call them, to go into. The dollar has an advantage as a reserve currency that is unrelated in many ways to this system. Now the dollar's use in trade finance and trade invoicing, I think is connected in part, as I was suggesting earlier. There's an extent to which countries would be resistant to this system and the dollar's dominance if they were sort of cut out of the business side of it. So you mentioned the seigniorage, I don't think really the seigniorage goes to the US government. Obviously, they benefit from the treasuries demand, but I would not attribute that to the global dollar system as a banking matter.

Menand: And on the creation of dollars overseas, that's undermining a US banking franchise and its profitability, which is actually subject to US tax, and creating basically seigniorage for dollar creation overseas that the US doesn't get any piece of and can't tax. And in that way, foreign jurisdictions are basically cut in on the value of this system. If you cut them out, what would happen? It's hard to say, because I agree with you that having a single international currency is very beneficial for global trade and for all the countries involved probably, and those benefits would still be there as a counterweight to countries trying to switch to a multipolar monetary system, which would be inefficient and not serve interests, especially not in the near term... The reason why people transact in dollars in international trade, is it is just cheaper to do the transactions that way and to finance them that way. And it will continue to be cheaper, even if I think there was a crackdown on the eurodollar market, although I do agree with you that that is implicated there, that those are connected.

Having a single international currency is very beneficial for global trade and for all the countries involved probably, and those benefits would still be there as a counterweight to countries trying to switch to a multipolar monetary system, which would be inefficient and not serve interests, especially not in the near term.

Beckworth: Okay, well let's move to the proposals you have in the book, and unfortunately, for the sake of time, we won't be able to go through all the other interesting points you raised in the book. And I'll mention one, the legality, the legitimacy of these developments of the Fed becoming “unbound,” it is a big deal. And I share similar concerns to you, the Fed's doing too much, it's going to jeopardize what it should be focused on, its mandate. But I'll let the listeners go to the book, read the book, that section. For the time we have left, let's walk through your proposals to fix this. Where do you start?

How to Fix the Shadow Banking Problem

Menand: So I've got two sets of proposals. One set has to do with the shadow banking problem, which I think leaves our economy vulnerable to runs and panics, which are destabilizing in the worst case, and in the best case, lead to a Fed unbound, where the Fed has to engage in a lot of support for private financial activity on an ad hoc basis, outside of a statutory framework that would constrain that discretion and the resulting political pressure for the Fed to get involved in other forms of credit allocation and support to the economy, which overloads the institution and creates a clutch, and clutches aren't effective ways to carry out policy. And so even if you wanted to have government entities performing all the functions that the Fed is now performing, you'd be better off having multiple entities.

Menand: So how do we solve that whole collection of problems? Regulate the shadow banking system. And so the thing about the banking system is because it's subject to ex ante regulation and supervision, in addition to the ex post backstop, you don't use the ex post backstop very much. You don't see the Fed, creating hundreds of billions of dollars and lending them through the discount window to support the banking system, because the banking system doesn't experience the runs. It doesn't force the Fed into using its balance sheet in that way. It's a system that has carrots and sticks, it's a balance system, right? And in order for it to remain a viable system, the banking system, you have to regulate the shadow banking system the same way.

Menand: So it's just a basic principle of financial regulation. We fail to apply it to banking, we apply it everywhere else. Insurance, if you do something that looks like insurance, even if you call it something else, if functionally the contractual arrangement is an insurance arrangement, then you have to follow the insurance regulations. And if you don't, that's illegal. Securities, this is perhaps the example that's most salient for listeners, if you create something that looks like a security and walks like a security and talks like a security, you've got to follow the securities laws. It doesn't matter what you call it, we're not formalistic about it. We don't have shadow security markets where people create things that operate like securities but are called something different, and therefore aren't regulated by the SEC.

Menand: We have this with banking, right? We don't functionally enforce the definition of a deposit issuance is what banks are doing that is subjecting them to the legal regime that was created for banks. And if people are doing something similar, they need to follow the same rules. And there are a variety of ways you can rationalize this system, but basically we need to have... Banks have a monopoly on banking, and then the regulations that apply to banks apply to everybody who's doing banking. And so that means that there are a variety of shadow banks that need to either have a bank charter or [inaudible] out there funding, stop money funding themselves. And Morgan Ricks has a statue of proposal for how you might do this. And I think that it would be a wise approach. There are other alternative mechanisms, but it's just fundamentally unsustainable to have a bank regulatory system that only applies to some of the entities that are doing banking.

If you create something that looks like a security and walks like a security and talks like a security, you've got to follow the securities laws. It doesn't matter what you call it, we're not formalistic about it.

Beckworth: So Lev, I can see that happening in the US. I mean, it seems like a feasible way to implement this reform. But how do you deal with the global side of the equation? You have all these eurodollars, you have stablecoins that can emerge overseas, how do you get an orchestrated effort to address it elsewhere?

Dealing With the Global Side of the Equation

Menand: Yeah, fantastic questions. So this is where the Basel Committee comes in, and this is where the sanctions tool comes in. So the whole eurodollar system depends upon two things. One, it depends upon dollar clearing in New York. And so the US could simply deny dollar clearing in New York to any foreign financial institution that is issuing dollar denominated deposits without a license from the United States. So my guess is the way to go about this would be to create basically a foreign bank license for any foreign bank that's in the eurodollar business right now. So you would allow these institutions to continue in the business if they applied for and receive a license. And then they would be subject to US regulations. Even if they're entirely operating overseas, if they are issuing dollar deposits or deposit-like instruments, they would be subject to regulatory supervision like a US bank.

Menand: And if you didn't follow that regime, you'd be denied dollar clearing. Which means you couldn't hold dollar deposits at a US based bank. And if you were a foreign bank, issuing dollar denominated deposits and you yourself couldn't hold dollar deposits on your asset side at a US based bank, you couldn't do it. It wouldn't work. You'd be cut off in the system. So the US can cut off any bank from the dollar system through the same tools that it uses for secondary sanctions. And so any non-compliant institution could basically be put on the list, the sanctioned entity list. And that would be the end of their ability to conduct a meaningful dollar business.

Menand: The other tool is obviously the swap lines themselves. So the Fed could have an agreement in place with every country that in order to be eligible for a swap line, you have to have all your financial institutions who are issuing dollar denominated debt comply with whatever US bank regulatory regime that would be established for that. And if they didn't, they couldn't get swap lines. If the swap lines were cut off as a tool, again, it's hard to imagine that the marketplace would continue to have confidence in holding money claims entities that we knew ex ante would be denied a swap line, that the central banks in that jurisdiction would be denied a swap line.

Menand: And all this could be worked out in a sort of [inaudible], and there would be reciprocity, where foreign countries would be permitted to engage in a dollar banking business only if they followed US banking regulations and comply with this scheme. And similarly, euro-yen, the creation of yen outside of Japan, US would agree that if any US banks are issuing yen denominated deposits in the United States, that Japanese financial regulators…that activity would be subject to Japanese bank regulation. So it'd be reciprocity between the various systems. Now, obviously the US is the big player here because the creation of foreign currency by international financial institutions, it's predominantly done in dollars. I guess the second biggest is euros. So the European authorities would get to apply their regulatory framework. And that's how I sort of envision it being put together. But the US surely has all of the sort of sticks that it needs to enforce this. There's a lack of will. Because there's a desire not to proceed in this direction, but the power is there.

Beckworth: Well, speak to your other proposal, because you are well known for Fed accounts and that's part of the story, right?

The Fed Accounts Part of the Story

Menand: Yeah. So my other proposals have to do with the tendency to over rely on the Federal Reserve as a macroeconomic stabilization agent. And so even if we fix the shadow banking problem, that's going to reverse a lot of the pathologies in the current system. But we could still do better when it comes to macroeconomic management. Where for years we've relied largely on the Fed to handle both inflation and booms and recessions and busts. And it has relatively limited tools for that.

My other proposals have to do with the tendency to over rely on the Federal Reserve as a macroeconomic stabilization agent. And so even if we fix the shadow banking problem, that's going to reverse a lot of the pathologies in the current system. But we could still do better when it comes to macroeconomic management.

Menand: So the Fed was created to manage the money supply. It's a limited purpose mission of monetary expansion, consistent with long run, maximum growth. And you can get inflationary episodes that don't have anything to do with an oversupply of money. And right now we look to the Fed to crack down on that inflation. And you can get recessionary episodes like we just had where loosening up the constraints on bank money creation, by bringing the federal funds all the way to zero, is insufficient to stimulate the economy. And that's what caused quantitative easing to be relied on, for example. I find quantitative easing to be a second best at best macroeconomic tool. And in a zero lower bound situation, we could do some much more effective policy that didn't rely on the monetary authority using its balance sheet in ways that were unexpected and unanticipated.

Menand: And so I propose for example, more automatic stabilizers. So Claudia Sahm has a proposal where basically you have direct checks distributed as a sort of stimulus in a downturn, in a mechanical way. It wouldn't be like a discretionary thing. It would be like unemployment insurance. So you'd have more mechanical fiscal support for the economy in a downturn. And you'd have more automatic fiscal tightening for the economy in a boom period like right now. And we're struggling to impose the fiscal tightening that you might want to see right now. But if more of it was automated, that would be better. Or if we created another institution with discretion for managing something like this, managing fiscal tightening and loosening. That would just ease the burden on the Fed and allow the Fed to do its main job more effectively, would de-kludge the Fed.

Menand: I also think the government should be engaged in more industrial policy, more planning for alleviating supply insufficiencies in certain key areas, food, energy. There's just been a lack of state capacity and state thinking on a lot of these issues, which has left the US with unpredicted deficiencies in various areas that are now creating a lot of problems. And the Fed can't do anything about that, and yet we're still looking to the Fed to just basically shrink the economy down to the necessary size. So my second set of proposals are just, we need to look beyond the Fed and be more creative in how to manage the business cycle that doesn't just rely on money management as a cure all, because it can't cure all. And when you over rely on it, you have perverse, I think, unintended side effects.

We're struggling to impose the fiscal tightening that you might want to see right now. But if more of it was automated, that would be better. Or if we created another institution with discretion for managing something like this, managing fiscal tightening and loosening. That would just ease the burden on the Fed and allow the Fed to do its main job more effectively.

Beckworth: Okay, well, let's end on this point. So your book is about the Fed unbound, and you believe it's primarily becoming unbound because of the growth of the shadow banking system and the Fed's involvement with it. So there are a host of other problems or concerns people have with the Fed currently, you touched on them on your book. The growing reach of the Fed, using the Fed to do more and more work that Congress should do. Also, some people are debating the structure of the Fed. Is it outdated? Should we reform the regional banks, the Board of Governors? I worry about the Fed's balance sheet size. There's a lot of things you could get into at the Fed that are issues, but do you think if you fix this part of the Fed, this particularly what you view as big issue, that many of these other issues wouldn't be so pronounced? Are we so worked up about these other issues in part because the Fed is getting so engaged, being so active as it relates to the shadow banking system?

Menand: So surely there will be some issues about the Fed that will remain. For example, fights about access to master accounts by state depository institutions. That is a battle that won't be solved by fixing shadow banking. But a lot of the politicization of the Fed and the overburdening of the Fed and the overloading of the Fed would be improved if the Fed was able to return to a more limited purpose of administering the banking system, a function that it is well equipped to perform. It could be better equipped, that's what I'm saying. There could be other fights about improving that that that will continue. The CBDC debate, the master account debate. But the sort of Fed with a huge balance sheet that's pressed on to be the only alternative in macro emergencies and to be credit allocator, and to pick winners, even within the shadow banking system, all of those problems I think would recede and in a way that would improve policy outcomes across the board.

Beckworth: Okay. With that, our time is up. Our guest today's been Lev Menand and then Lev's book is titled, *The Fed Unbound: Central Banking in a Time of Crisis.* Check it out. Lev thank you for coming back on the show.

Menand: Thank you so much for having me.

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