David Andolfatto on Life at the Fed, Equity-Based Finance, and the Blockchain

David Andolfatto is a vice president of the St. Louis Federal Reserve Bank and a professor of economics at Simon Fraser University. He joins Macro Musings to discuss life at the St. Louis Fed, equity-based finance as a means of averting financial crises, and challenges in using monetary policy to drive nominal growth. Finally, David also clarifies some of the misconceptions surrounding Blockchain technology and explains what this technology may mean for Federal Reserve policy.

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: David, welcome to the show.

David Andolfatto: Hi, David. Thanks for having me. Before beginning, as I alerted you, I'm going to have to give a disclaimer. I would like everybody to know that the views that are put forth here, the opinions that I express are exclusively my own, and should be in no way or not necessarily the view shared by my colleagues here at the Federal Reserve Bank of St. Louis or anywhere in the Federal Reserve System.

Beckworth: All right. Well, thank you for that. Let's talk about how you got into macro first. So when did you first become aware that you wanted to be a macroeconomist?

Andolfatto: I guess the same way that, perhaps, a lot of people got interested in the subject. I had the great fortune of taking a course by a professor that made me think outside my regular box. He was presenting ideas. I remember it was a course in Canadian economic policy way back in the early '80s, in fact. He was describing or explaining things, interpreting things in ways that just were at complete odds with my preconceived worldview. I remember it was really a frustrating experience to have my preconceived notions destroyed at one time or another.

Beckworth: It would be same.

Andolfatto: It occurred to me, I like this. I want to be able to do this. What is this magic that this person has that he is able to organize his thinking so clearly and just demolish preconceived notions or to think clearly about issues in a different way. That's what really got me going with that one professor.

Beckworth: Now, how did you get into the Federal Reserve System? You were at Simon Fraser previously. Is that correct?

Andolfatto: Yeah, and prior to that, I was at the University of Waterloo in Ontario for much of the '90s. Moved back to Simon Fraser in Vancouver, which is my hometown. I got a call from...In 2008, Jim Bullard replaced William Poole as president. Jim hired Chris Waller, the research director here. Of course, we all knew each other from the academic conference circuit. Chris asked me if I'd like to come down, help out in this time of crisis.

Andolfatto: It was the right time, right in the middle of the financial crisis essentially. The Fed was right in the center of discussions. My research had pertained to monetary theory and policy. I thought it was a great opportunity to come down and just witness what was going on and contribute in any way I could to the formulation of policy.

Beckworth: At the St. Louis Fed, it has been historically known as a monetarist leaning institution, and that has been some time ago. How would you characterize it to date? There are some new monetarists here, like Steven Williamson. Would you characterize yourself as a new monetarist?

Andolfatto: I don't like labels like that myself.

Beckworth: OK. You do monetary research model of research as well as some other areas.

Andolfatto: Yeah, well sure. I would say that new monetarism refers to a set of tools. It's like a hammer, and yeah, I pick up the hammer once in a while, but it's not the only hammer I use. I use other tools as well. Steve does as well. How would I characterize it? In fact, the environment is quite eclectic and in fact, we do not have so many people in what you might call monetarist or monetary theory and policy. There's a lot of people in our research staff, studying international trade, development issues, labor market analysis, housing markets, etc. etc.

Andolfatto: The department's been fashioned more or less over like what any good academically oriented research department would look like. There's a wide range of views that are expressed, even by the same people. I don't think it's like the old days, the hard‑core monetarists. If you wanted to restrict it to just one label, I would say that a lot of general equilibrium new monetarist thinking in there for sure.

Beckworth: Well, in other words, you guys still take money seriously, if I can paraphrase. I mean, you...

Andolfatto: Well, I would say that, to take money seriously, you have to take the financial market frictions seriously. Steve Williamson has spent a career on writing down and thinking about financial markets, financial market frictions, things that could possibly go wrong. I've spent the bulk of my career also thinking about financial institutions, the financial frictions, monitory policies design, to know how they affect the financial markets, how they might be designed to mitigate financial crisis. Yeah, we take money, financial frictions seriously.

Beckworth: What is it like, on a day‑to‑day basis, as a Fed economist? I know it depends on the time. I've communicated with you before and you were really swamped up before an FOMC meeting.

Andolfatto: Yes.

Beckworth: But other times you're doing research and other times you're doing conferences. What is it like to work as an economist at the Federal Reserve?

Andolfatto: Well, I can't speak for all of the Federal Reserves. I think the experience might vary depending on where you are. I mean, New York might be different than St. Louis. It might be different from Dallas, for example. But here, in St. Louis, I mean when Jim came in, he really had in mind trying to develop a department, really a high‑caliber research division modeled after a high‑quality academic institution, with an obvious kind of policy bent to it. Even within our department, I think the experiences differ.

Andolfatto: I think a lot of our junior staff, they probably can't tell the difference of being with the Fed or being in a regular university department, apart from the fact that you obviously don't have to teach, although some may do at the local universities. They contribute in ways to our policy briefings. Everybody participates at some stage in the policy briefings. At a more senior level, where I'm at, I mean it's a typical there. You come in here, and like you said, there's all sorts of things to do. Sometimes, we're worried about recruiting. We have to recruit. Sometimes, we're preparing for FOMC, FOMC briefings. I coordinate the FOMC briefings here, a lot of the day is spent just organizing things, administrative.

Andolfatto: We also have an extensive visitor visiting the scholar program. We have visitors from all over the world that are visiting at various points in the times, sometimes my own co‑authors, so that's the time I spend to sit down with them and do some research. Jim gives regular policy discussion meetings. The whole division's invited for that, even the visiting scholars. We host those quite regularly. Then I serve on the FOMC Senior Council here. We meet pretty regularly to discuss issues relating to FOMC policymaking, so a lot of stuff. It's like there's never enough time. In other words, it's lot of fun and really interesting.

Beckworth: Now, you're one of the few Fed economists that blogs regularly solo. Now, there's some...The New York Fed has a blog that has multiple authors. Atlanta Fed's that way too. But you and Steve there at the St. Louis, but you each have your own blogs, you blog independently. Why do you think there's so few other Fed economists that do that? I mean, you guys seem to do it fairly well and regularly. What's your secret?

Andolfatto: Well, I think both Steve and I had started our blogs before we came to the Fed. I did so just shortly before, in 2008. Of course, I think there is a little bit of a tension there in having, especially, anybody at the Fed to blog individually. I think we are permitted to do so largely because Jim trusts us, and he doesn't want to muzzle us. He trusts that we'll be responsible and know that we discuss policies that will be sensitive and delicate as the case occurs.

Andolfatto: I think there's probably so few, because naturally it's a little risky, I think. I mean, you go out there and you say something, and that happens once in a while, it's kind of misconstrued. Suddenly, there is a little mini media storm about it, and it could be a little bit embarrassing for the parties involved. That's probably what accounts for why there are not so many individual bloggers at the Fed.

Andolfatto: Our secret here is, like I said, there's no secret. Jim is very open. He is very supportive. He values it and he understands that sometimes little slip‑up's going to occur, but the benefits far outweigh the cost. The benefits being, for example, when Steve and I blog, or discuss, or promote Jim's recent speeches, some of which are controversial in their own way, and it starts a blog discussion that sometimes can be very useful. Very useful to...some of the thoughts that are expressed can be brought to the table and aired in our council, for example.

Beckworth: Yeah. Definitely, you get a lot of real‑time recognition and discussion from blogging, from Twitter. I think it's definitely useful. I know Mark Thoma has said before, when he saw David Altig, who's Atlanta Fed now, he was previously at the Cleveland Fed. He had his blog up there, macroblog, and he took it with him down to the Atlanta Fed, and it changed the very nature of it.

Beckworth: Back at the Cleveland Fed, it was him...and very similar in spirit to what you guys are doing at the St. Louis Fed, and he went to the Atlanta Fed, it fundamentally changed. Mark would like to see more blogging, as all of us would, and people like you. It's need to have the few of you that we do, that we have this inside peek into what you guys are thinking, and just to hear your thoughts. You guys have original thoughts too, so it's been great to engage with you.

Beckworth: Let's move on to some actual topics. We talked just a minute ago about financial stability, which is an emphasis that you guys place heavily there. Recently, you've been responding to John Cochrane on your blog post. Let me lay out what John Cochrane has been making on his blog. He's been arguing for equity‑based financing for banks. He sees banks and bank runs coming from the liability side. He really stresses this that all the problems or most of the problems in banking panics arise from the liability side of a bank's balance sheet. It's not the asset side.

Beckworth: For our listeners, the liability side is the bank deposits, where like, you and me, Dave, when we go to the bank, put our money in there, those deposits are a liability for the bank. There are fixed‑value claims that we can get out on demand anytime, and this creates a potential problem if you all want to pull out the same time, if there is some kind of panic. During the 2008‑2009 crises, this wasn't an issue. We had FDIC insurance, no one was worried about that. But there was a run by institutional investors on wholesale banking or shadow banking. That's kind of what picked this interest again.

Beckworth: John Cochrane has come out and he...my understanding ‑‑ and correct me if I'm wrong ‑‑ is he wants to, more or less, eliminate run‑prone banking. He wants to eliminate any kind of short‑term debt, liabilities that banks would have, and turn to equity‑based banking entirely. Is that correct?

Andolfatto: Well, we have to be careful when we're speaking...I don't want to speak on behalf of John. I mean, I have read some of his blogs, and to be fair, I'm still trying to absorb all of the arguments. But that would be one characterization. Probably, a softer one would be that if it to the extent that banks are permitted to issue run‑prone or debt‑like liabilities that they would be fully backed with cash, for example, or treasury. But yeah, that's like the basic idea. He wants to eliminate...why don't we go with the extreme view and just eliminate demand deposit liabilities and use equity‑like liabilities.

Beckworth: Let's give some examples for our listeners. Some of our listeners understand it, some may not. But this is similar in spirit to the cost for higher capital requirements. Right? This is how do banks fund their loans and their other investment activities.

Andolfatto: Correct.

Beckworth: What we're talking about is the traditional way of borrowing short term either from depositors or from the money market. What he is advocating is moving away from that and moving more towards equity. How would a bank actually fund itself with equity? What would be the concrete steps it would take?

Moving from Debt to Equity Funding in the Banking System

Andolfatto: Yeah. I mean, I like to step back a second, and can I ask the question, what is a bank and how is it distinguished from, say, other financial institutions, like insurance companies or pension funds? I like to view financial intermediaries as asset transformers. If you think about it, this is important because a lot of the interventions and policies we're talking about either pertain to the asset side of the balance sheet or the liability side of the balance sheet of these institutions. But what these institutions essentially do?

Andolfatto: One view is, if you take a look at the asset side of pension funds, of insurance companies and of chartered banks, to a rough approximation, they kind of look the same. They have assets. They have loans. They've cash reserves. They have securities, government securities. Banks originate mortgage loans and stuff like that, but they basically have interest‑bearing assets on the asset side of the balance sheet.

Andolfatto: What distinguishes these intermediaries is how they structure the liability side of their balance sheet. A pension fund is in the business of structuring a time‑dependent liabilities. Right? People get to cash out when they retire, and that's kind of a time‑dependent, time‑contingent event.

Andolfatto: Insurance companies issue structured products that are redeemable in the event of an accident, or a fire, or car crash, or whatever. To make redemption at an insurance company, you have to go out and fill out claim. It's often a cumbersome and time‑consuming process, but this is what an insurance company does.

Andolfatto: It takes deposits in the form of premiums. It uses these resources to load up on the asset side of its balance sheet. It will purchase income‑generating assets, and it would use this income to finance operating expenditure, pay‑out claims, etc. Banks are...they're, qualitatively, doing something similar in the sense that the structured product that the banks are offering are these demand deposit liabilities. That is to say, they structure their liability such that the deposit holder has the option to redeem the bank liability on demand for cash at a specified exchange rate, which is usually at par.

Andolfatto: The big question is, is why do people find this type of a structured product useful or in demand? There's theories out there for explaining why this type of structured product, the demand deposit liability, supported by fractional reserve banking, is desirable in some circumstances. I could give you names of papers, in case the listeners are interested to go look. The famous 1983 Diamond‑Dybvig model.

Andolfatto: This is the type of theory that could simultaneously explain why this particular structured product is valued by individuals, and by society, and why at the same time it might make the financial system prone to bank runs. I think that a lot of what John writes, and I've seen a blog post where John actually makes reference to the Diamond‑Dybvig model, and says, "The Diamond‑Dybvig model is an example of what happened during the financial crisis." The issuance of short‑term debt to finance longer‑term illiquid assets, and then you had this run. As you said, these institutional investors.

Andolfatto: John actually appeals to the Diamond‑Dybvig theory as formalizing the notion of why these types of structures are unstable, or subject, or at least fragile, which is to say that they could remain stable for prolonged periods of time, but some event happens that suddenly causes the structure to collapse. I blogged, I said that's right. That's good, that you appeal to that theory, to highlight this point that this type of financial structure is potentially fragile, but I would like to point out the same theory also points out the benefits of the structure. There are some benefits to this structure, and so it's not entirely clear to me why the benefit side is ignored, and the costs side is emphasized.

Andolfatto: That was the gist of my blog post, was trying to promote a discussion as to what would lead people to conclude that restricting banks to finance their assets solely with equity, or capital, which is the word that they use, why that would eliminate bank runs in the targeted sector, but what would be the cost of the system? I was trying to promote a discussion along those lines.

Beckworth: To be clear, this benefit, there's this trade‑off. There's this cost of the potential bank run, but the benefit is, correct me if I'm wrong here. The benefit I think you're saying is, the public has this desire for a stable medium of exchange, for some asset that they can quickly turn into purchasing power. This structure is one that produces it. Is that the benefit we're talking about?

Andolfatto: That's part of it. There's two things here, and here I'll speak in the context of the model, the Diamond‑Dybvig model. The issue here is that some assets are illiquid. They're perfectly safe, they're interest generating assets, but they're illiquid. The bank is essentially an intermediary that transforms illiquid assets into liquid liabilities.

Andolfatto: If you take a look at history, and ask yourself, "What was the property of all the most successful monies," you'll see that most successful monies that have ever circulated are debt instruments. What is the reason for that? Debt, especially safe debt, provides people. The fact that you can go to the bank, and make a withdrawal from the ATM, you know you can just go and withdraw a dollar from your account, and it's going to be a dollar. That's what it means to be given the right to withdraw money at par, on demand.

Andolfatto: John's view of replacing that type of contract, which is run‑prone, with equity‑based banking, is that guarantee is not there. It would be more, if I understand him correctly, and I should emphasize that caveat. It would be more like putting your money in a money market mutual fund with a floating net asset value procedure that the purchasing power of your bank money could potentially fluctuate by the end of the day.

Beckworth: Let me read a quote you had, I really liked in your post. Again, this hopefully fleshes out what we're talking about. You say, "What Cochrane advocates is the replacement of our present ATMs with a one‑armed bandit, spitting out random returns whenever we want to redeem our bank equity shares for cash." You have a picture of someone at a casino, pulling the lever of a slot machine. That paints the picture. What you're saying is, the stable medium of exchange is gone. That property's gone. It fluctuates.

Andolfatto: A lot of this also depends on how the asset side of the bank is structured, right? If the asset side of the bank, John would claim that's not such a big deal, quantitatively, because the asset size of the banks are safe. That's true, to the extent that, if the asset side of the bank was just cash, or it's in Treasuries, it's not perfectly safe, but John's downplaying the riskiness of the asset side.

Andolfatto: My claim would be, I don't know. I think that there would be this move on the part of banks to load up on higher yielding "safe assets," to generate higher profits, to lower the cost of the depositors. Depositors would be attracted to that business model, because you'd be able to earn a higher interest on your deposit account, or you'd have to pay lower fees, the same thing. Especially over prolonged periods of financial market tranquility, like the great moderation, for example. People tend to become complacent, and so they will naturally be attracted to banks who are going to produce this product. I think I've lost my train of thought here, David.

Beckworth: Let me pick up right here. In his defense, one point he brings out, I think it's a fair one. Today, it would be easier to do something like he proposes, because of technology. In fact, you can see it. If you have money in a stock mutual fund, you can quickly pull it out.

Beckworth: There may be some barriers, but his argument is, if you held an ETF, or a mutual fund of some kind, the technology is available where you can just take your card, which would be linked to that, and you could swipe it. Yes, you would have to be aware of the balances, but look at your app. How much? Typically, it might be stable, may not change a lot, but you can look on your phone. "OK, I've got so much in my account, I'm going to use it to pay for my groceries today." That's his argument, that technology has got us to the point where we can use these equity‑based financing forms of banking.

Andolfatto: I think he's partially right there. My issue is, again, I don't think this question can be answered independently of how the bank is actually structuring the asset side of its portfolio. Let's suppose the bank structures its asset side perfectly safe, so it's holding just Treasuries and cash.

Andolfatto: Then, I don't really care what it does on the liability side. You've basically got a form of 100 percent reserve banking, and whether the liabilities are shares, or equity, or capital, or debt is almost irrelevant. Yeah, the development of these markets, it would be very easy to just use your bank money in this case, to make purchases. That's fine.

Andolfatto: My question would be, what's to stop these banks from loading up on slightly riskier assets, or assets that are perceived to be safe, and usually are safe over extended periods of time, but in a crisis, they could become suddenly illiquid. If you've got equity banking, in equity banking, it's true that it's run‑prone in the sense that, let's suppose it's all equity. The bank would be spared having to undertake fire sale of its assets to meet its obligations. I think that part is absolutely correct, what John is saying. What would happen is that you, as a deposit holder, you have shares in this bank, you would suffer a huge haircut on your deposits.

Andolfatto: The point is that everybody is sharing. That's what it means to have a share in the bank, that everybody would be sharing in the loss. There would be no need for a disorderly disposal of the bank's assets to meet these pressing obligations. I think that's a vision that John has. The pushback I have is, it's not that I disagree with him, by the way. It's more in the spirit of promoting a discussion.

Beckworth: Sure, sure.

Andolfatto: We have theories out there of why corporations structure their liabilities in particular ways. What are some of the issues that are raised when you have equity financed over debt‑financed? There's all sorts of theories out there that I would like to be brought on the table to discuss.

Andolfatto: If you have equity‑based banking, just like anything, one of the nice properties of debt is that you really don't have to pay too much attention to it. If you're a senior debt claimant to a firm, you don't have to pay too much attention to what's going on at the firm, because you know that if there's enough of a capital buffer, it's going to be the equity holders that are going to take the bland of any kind of bad behavior, or some sort of shock to the balance sheet.

Andolfatto: That's precisely the property that makes debt an attractive monetary instrument. If we were to force banks to use, just go to equity‑based banking, there must be some cost to this, otherwise I would argue that the institution, we would've seen that it would've been quite prevalent on its own. The question is, why don't we see it?

Beckworth: Banking would've evolved differently. There's some latent inherent demand for these very run‑prone assets. Typically, they're safe. Typically, they're not going to be run on, but there's just some demand. People want certainty. It depends on the person, the stage of their life, how risk‑averse they are, but there's always going to be some appetite for them.

Andolfatto: Let me take a middle ground. I think that one way to phrase it is, we know that debt, demandable debt in particular, has a role to play, in some circumstances. We can debate whether it be circumstances of change over time, with technology, or whatever, but there is a role for debt, even in the hypothetical world without a government.

Andolfatto: On the other hand, you could make the argument, as some have, like Ed Mahdi, and Hal White, and I think John, as well, would make this argument that there are a number of distortions in the economy. Distortions that favor debt over others forms of financing, and that even if we admit that the demandable debt product has a socially valuable role to play, nevertheless, these other distortions make banks become over‑levered.

Andolfatto: They make too much use of these types of products, and over‑expose themselves, and the system, to this form of financial fragility. We don't have to necessarily argue for the elimination of the product, but we could lobby for interventions that would compel banks to hold more capital, and to hold safer assets on their balance sheet.

Beckworth: I also think, just from a practical perspective, it would be tough to completely eliminate it.

Andolfatto: Absolutely.

Beckworth: There'll always be some firm in the shadows, on the margins, who would say, "Hey, I'll provide this stable medium of exchange." Let's talk quickly, before we move on to our next topic. Let's talk about some of the asset side solutions. You already alluded to some of them earlier, and I think we see some movement toward this, for better or for worse, but providing direct access for an average person, or maybe for all firms to things like Treasury Direct.

Beckworth: You gave this as an example, turning the Treasury Direct system into a payment system, so that you and I as individuals can purchase treasuries. Why not be able to turn that into something more? Along those lines, maybe I need to be careful here, since I'm talking to a Fed official. The reverse repo facility that was introduced last year, I believe it was last year.

Beckworth: It effectively opened up for financial firms that didn't have access to interest on the reserves, the same type of access to the Fed's balance sheet. Now, some of the big banks and shadow banking system that weren't able to go in and get interest in reserves, are able to get access to those assets, as well.

Beckworth: It's providing access to these safe assets that weren't available previously. When this happened, there was this talk about a creeping nationalization of financial intermediation. In the limit, why not let everyone just have their own Federal Reserve account? Now that's extreme, may never happen, but do you see that as moving in that direction? I wonder if John's proposal would take us down that path.

Asset Side Solutions: Possibility of Fed Bank Accounts for the Public

Andolfatto: Yeah, I've actually heard John as a proponent of that view. I don't want to speak in terms of the Fed, per se, but just speak about central banks in general, opening up their balance sheet to the public. Not necessarily, one model would have. Let's back up a second again.

Andolfatto: You take a look at the existing structure, the institutional structure of the financial system, or anything, for that matter, it evolves slowly over time, and it's largely a by‑product of what existed technologically in the pre‑Internet days. At one time, it may have made sense to have being structured in this manner, to have the central bank be the bank that charters banks, and to have the chartered banks service the retail customer.

Andolfatto: These days, it's trivial to go on to the Internet and open up an account. Now, I think that indeed, as you mentioned, and I was surprised to learn myself, just a little while ago, the Treasury does, in fact, do this. It does permit individuals to open up accounts directly with the Treasury.

Andolfatto: The thought was, "If a Treasury can do it, why can't a central bank do it as well?" I think that for a number of reasons, you might not see this happen in some jurisdictions. You might see, for example, in the United States, I know that there is just the nature of Americans, I think, is to seek private sector solutions to issues whenever it's possible.

Andolfatto: Only when it can be demonstrated that there is a pressing need for a government intervention, only then that the intervention would be considered. For example, the founding of the Fed itself. The attitude in some countries like the United States, we should let the charter banks handle the payment system, by and large, with the central bank just playing a supporting role.

Andolfatto: I think in other countries might be more amenable to the idea of opening up the central bank's balance sheet to the public. One model would be just as a utility account. It could be a very low interest, or zero interest, or possibly even negative interest rate utility account, where not only individuals, but firms, also individuals operating the cash management at large corporations could go and park 500.

Andolfatto: If they need to go and park $500 million overnight some place, they want a safe place to do it, they can go to a conventional chartered bank, because of course deposit insurance only covers a trivial fraction of that. These individuals are compelled to go out into the shadow banking sector. This is exactly where they're going to park $500 million against some safe collateral in the overnight repo.

Andolfatto: Why not give them the option of parking the money directly at the Fed? You could imagine the private banks continuing to offer higher service accounts. It's not like you go out and you steal all their business. The banks would be free to go out and compete, to offer higher service accounts, and you see the system coexisting, but with this option provided by a central bank.

Beckworth: Implicitly, this framework exists in panics already, doesn't it? I mean, when there is a big financial crisis like 2008, 2009, at the end of the day, money market mutual funds were backed up by the government. What this system would be, would be cutting to the chase, having direct access without having all these implicit backups, and maybe some of the distortions that it creates. It's definitely an interesting thought experiment, and it would be interesting to see where this goes over the next few decades.

Andolfatto: You will eliminate all the counterparty risk.

Beckworth: You absolutely would, exactly. Let's move on to another topic that you've written extensively about, and something I've been grappling with a lot lately. This is thinking about, what really drives the power behind macro policy? By macroeconomic policy, I mean fiscal policy, monetary policy.

Beckworth: When it's really able to generate nominal demand growth, and whether that affects real GDP or not, we'll hold that to the side, but if you really wanted government to generate what they call aggregate demand, what I would prefer to call nominal demand growth, you've stressed that it's important to look at the consolidated balance sheet of the government.

Beckworth: In other words, we've got to look at both the Treasury's balance sheet and the Federal Reserve's balance sheet. Otherwise, if we keep our eyes just on the Fed's balance sheet, we might be frustrated. You did a post called, "This Dirty Little Secret." You can expand on that point, and share with us why it's important to look at this consolidated balance sheet of the government.

The Importance of the Consolidated Balance Sheet View of Government

Andolfatto: I think that, first of all, that's important because logically, it's true, right? If you write down, in all of our economic models, you write down a monetary authority, a government sector, and there's this link. These two institutions are linked through a consolidated balance sheet. It's just inevitable that the link is there. The dirty little secret is something I took from Eric Leeper's paper. When we speak of monetary policy, as we're prone to do, we often don't speak of monetary policy is interacting in any way, or conditioning the statements we make on the stance of fiscal policy.

Andolfatto: The dirty little secret is that, every time we speak of monetary policy, and every time we make a claim about the effects of monetary policy, here or there, in the back we're making an implicit assumption, a dirty little secret that the fiscal authority is behaving in a particular way, usually in a way that passively accommodates the goals of the monetary authority. Why is it important to keep this in mind is because, you ask what if the central bank wants to create a nominal GDP growth, or create higher prices? Just suppose, for whatever reason, is it even feasible for it to do it? The answer to that question depends critically on what sort of powers, or fiscal support the central bank has at its disposal.

Andolfatto: People look at Zimbabwe, for example, or Venezuela, they go, "Oh, look at those central banks have no trouble raising the inflation rate. Why does the Fed have so much trouble? Why does the ECB have so much trouble?" To understand that what appears to be a conundrum, you have to understand what's happening on the fiscal side.

Andolfatto: In Zimbabwe, as far as I could tell, the fiscal and monetary authority were one and the same thing. We know how to create hyperinflation. You just print a bunch of money, and then distribute it very rapidly to the population. It's exactly that act, the distributing money to the population, that in most jurisdictions, that is an act of fiscal policy that the central bank has no control over how that money is actually injected into the economy.

Andolfatto: Central banks, like the Bank of Canada, or the Fed, for example. The Fed is restricted in how it can inject money into the economy. It cannot just helicopter drop money into the economy. It has to expand its balance sheet, it has to print. The money that it injects has to take the place of assets, as in the large scale asset program.

Andolfatto: We print a lot of money, sure. We inject a lot of money into the economy, sure, but at the same time, we're withdrawing an equivalent amount of safe assets from the economy. This type of asset swap, it's not immediately clear what the effects on even nominal variables is, of rearranging nominal claims in the economy in this manner.

Andolfatto: John Cochrane has alluded to just re‑labeling the color of the money from blue money to green money. Interest‑bearing Fed liabilities are pretty close substitutes to short‑term Treasuries. What would you expect to happen if you were to just replace these treasuries with interest‑bearing Fed notes?

Andolfatto: It's not immediately clear, and so I think that's why I think it's important, when we're having these discussions about the effect of monetary policy, we should make an effort. We, you, me, everybody should make a greater effort to always alert people to the assumptions we're making about how fiscal policy is assumed to react when we're talking about a particular monetary policy intervention.

Beckworth: I think another way of saying this, and this, for me, has been eye‑opening, to be honest, is that fiscal solvency ultimately matters to what happens to inflation. This is an example. This is, again, an extreme example, but let's just assume that the Fed became insolvent, and there was a hole in the Fed's balance sheet.

Beckworth: Let's say some of its mortgage‑backed securities a few years ago, let's say they lost value, and so they had more liabilities, more monetary base outstanding, more reserves outstanding than had assets to pull it in. What that would potentially do is, make the public concerned. Maybe the loss in money picks up.

Beckworth: What we would expect to happen in a situation like that is that the Treasury would bail out the central bank, or the Federal Reserve. The Treasury would say, "Hey, don't worry, Federal Reserve. You've got a hole in your balance sheet. It could be inflationary, but what we'll do is we'll give you some more treasuries. Just take those treasuries, close the hole, you can pull up the monetary base."

Beckworth: That just moves the question back one step, right? Then we ask the question, is the Treasury solvent enough? Is it going to be able to handle that increased debt? If I take that example, I'm implicitly drawing upon that same reasoning every day, that the Fed's balance sheet is always implicitly backed up by the promise of the Treasury to bail it out, should it arise. It's a joint effort. Is the Fed going to be solvent? Is the Treasury going to be solvent? Then we've got to step back, I think another level, and ask this question. What ultimately is driving the considerations that shape this consolidated balance sheet? That's where I think we get to the question of, what does the body politic expect? What does Congress expect?

Beckworth: I do think this is where central banks play an important and indifferent role than Treasury. They're the institutions that brought in, communicated, popularized inflation targeting. Inflation targeting actually starts in New Zealand, Great Britain, Canada, spreads to the rest of the world.

Beckworth: We're doing it in the US. I think we were doing it implicitly for a long time before 2012, but we're doing it. My thinking has come to the point where, I think we've gotten so good at inflation targeting in advanced economies, that's what the public expects. That ultimately is shaping what's going to happen to this consolidated balance sheet going forward. Does that sound reasonable?

Inflation Expectations and the Consolidated Balance Sheet

Andolfatto: It does. What is interesting is, I actually have a blog post on this as well. It's related to an old literature, actually. Not old, 1970s, that Tom Sargent and Neil Wallace used to talk about, the struggles between the monetary and fiscal authority, and how these two separate agencies don't always necessarily coordinate with each other. There's different forces driving, and at times, one might be dominant over the other. I think that one interpretation is, central banks have been very, especially in the US with Volcker, and other places with inflation targeting, have been successful in bringing inflation down.

Andolfatto: If you can understand this is a struggle between the monetary authority that once lower inflation, and the fiscal authority that wants to continue to deficit finance, and a strong and determined central banker like Volcker can make it very, very punishing to a fiscal authority to embark on deficit finance by raising interest rates, and contributing to a bit of recession which is politically costly.

Andolfatto: You can see how a central bank can win a struggle, if it's sufficiently determined, against a non‑cooperative fiscal authority to bring inflation down to target. Over time, if you imagine the tension a fiscal authority wants to inflate more, and the monetary authority wants to keep inflation in check. Over time, the central bank develops a reputation for maintaining a nice inflation target around two percent, because it's always trying to keep a ceiling on this inflation rate. In the present environment, it's interesting, because in fact, the inflation rate is actually falling below the target.

Andolfatto: Certainly, we can't say that the government's not printing debt, because it definitely is, but obviously what's got to be true, especially in the context of the US, and other jurisdictions that produce safe assets is that their worldwide demand for the US Treasury is just going through the roof. Despite the increase in the supply of this Treasury debt, the yield's going to show us that the demand has been out‑stripping the supply. There's this huge shortage of safe assets, and one of the market mechanisms to increase the real supply of these assets is disinflation.

Andolfatto: One interpretation is this worldwide demand, growth in the demand for this safe US Treasury debt, and the fact that in Congress, there's resistance against increasing the supply any further, but the effect of this is disinflationary. The question is, what would you expect a central bank to do that wanted to raise the inflation rate in this environment?

Andolfatto: The central banks develop a reputation, and all of the force of their inflation targeting has come from bringing inflation down, and preventing it from going higher. Here, we have natural market forces, in conjunction with behavior of the Treasury, that is keeping the inflation rate below target. The question is, what is the central bank supposed to do, in this type of environment, to raise the inflation rate back to target? Again, this comes back to the issue of whether a central bank needs fiscal support to reach a particular target.

Beckworth: My answer would be it would need a new political consensus by the public. You're right, there is this safe asset demand. We've both written about it. You've got a nice paper on it, from the "Journal of Monetary Economics." In theory, the consolidated balance sheet of the US government could offset that increased demand by supplying more.

Beckworth: To me, the question is, why hasn't it done that? I go back, again, to this incredible commitment that we've built up, the public now expects of low inflation. That is what we have to change. I've read some of Leeper's work, and one of the struggles I find, when I read his work, it's not easy to adjust fiscal policy. There's lags, you have to get commitment. I think that's where it's important that rules come in. You either have to have a higher inflation target that everyone buys into. That, again, is a tough sell to the public. As you know, I'm an advocate of nominal GDP level targeting.

Beckworth: Whether it's nominal GDP level targeting, or price level targeting, if there was a buy‑in to something like that, that would require a commitment by the public, by the consolidated balance sheet, by government, to keep it. Again, getting from here to there, I understand is very difficult, because you would have to break this, what I view as an inflation targeting straitjacket. We've been so good at inflation targeting, the public now expects it, and any deviation from it is heresy. We've worked ourselves into a corner, so reading stuff that you've written, Cochrane has written, it really has made me think more broadly about, yes, money still matters.

Beckworth: Let me step back a minute, and stress this point, and you've said this, too. The quantity theory, in a sense, still holds here. It's just a question of what ultimately is driving it. What's driving velocity, what's driving the big monetary aggregates. It's a broader way to think about monetary theory. It's not just the Fed, it's the consolidated balance sheet. David, you have also written on blockchain technology, cryptocurrency, so why don't you tell our listeners, why is this an important topic, number one. Number two, what does it mean for Fed policy?

Blockchain Tech and Its Implications for Fed Policy

Andolfatto: Yeah. Wow. Have you got another hour?

Beckworth: I'll give you ten minutes.

Andolfatto: When you hear blockchain...This is a good place to plug my blog again, David, because I do go into greater details here on my blog for listeners who are interested. When you hear blockchain, what it is? You know what? It's something that should be familiar to you. I've blogged about this. It's a database. It's a virtual data base that's recorded and maintained on a public ledger, a distributed ledger of computers.

Andolfatto: Why it should be familiar with you? Because I argue that this is, by and large, kind of the way that a lot of economic exchange has taken place throughout history, and even today in small groups, small communities. If you think about it, if you think about interacting with your friends, or your colleagues, or your family, I mean we exchange favors for each other, but there's no monitory exchange happening when you do a favor for a friends that's subsequently reciprocated.

Andolfatto: This is a way actually, as far as I can tell, economic exchange existed in primitive societies, and there was not money, per se. Basically, what happened is everybody in the group would basically just look after each other. They'd exchange favor. They go and work. They consume and produce, etc. But all of the actions were recorded in kind of a distributed network of brains, right, and the communications were done through just verbally.

Beckworth: Interesting.

Andolfatto: The database would just be updated over time. Oh, David Beckworth, he has taken an hour out of his valuable life to record a podcast here for the benefit of society. Let's reward David in some manner down in the future by buying him a nice latte, or something like that.

Andolfatto: The blockchain is really just an electronic version of what's existed throughout history. It's just an electronic database that exists on some of sort of local or public...It could be a public ledger like Bitcoin that's updated by some communal consensus algorithm.

Beckworth: David, the blockchain is like a public record that is accessible to everyone at any time, because of the Internet it's accessible, so you don't need a third party. Typically, if you and I have a transaction, there's a third party, a bank involved, but what you're suggesting here is that this will be recorded on a public ledger electronically?

Andolfatto: I should clear here. There's no such thing as "the" blockchain, the blockchain is just an idea. The broad conceptual idea of a blockchain is some sort of distributed ledger that's recorded and updated by some sort of communal consensus algorithm. I think it's the way we put it. There are extreme forms of this. One is the very famous Bitcoin blockchain. That blockchain, which is a database, exists as a public ledger. It's open to absolutely anybody. Now, with gigabytes and size I don't know I'll deal with it but I mean it's there.

Andolfatto: The accounting books, I guess, on this ledger is not updated by any trusted third party like a bank or something like that. There's actually some sort of algorithm, a computer algorithm, that permits inputs from the community to collect this information, to update it, and to keep it secure.

Andolfatto: In the Bitcoin world, this communal effort is undertaken by the so called Bitcoin miners. What they really are just volunteer bookkeepers ‑‑ well, volunteer, they get paid for their services of course. There are other versions of the blockchain that might exist on a closed ledger but within an organization, for example, and that the communal updating occurs within a subset of trusted nodes in the system. The basic idea of the blockchain is that you're replacing a single bookkeeper with more of a communal effort that makes the system hopefully more robust.

Beckworth: What does this mean for Fed policy?

Andolfatto: One way to ask the question is what are the implications of blockchain technology for central bank, the way central banks conduct their interventions and how they might think about other aspects of policy, like their lending of last resort facilities. I've also blogged about this.

Andolfatto: This blockchain technology, as it has manifested itself, say with the Bitcoin protocol, what this has effectively done is introduce a foreign currency that's available to everybody in the world. It's a foreign currency that's essentially fixed in supply, it's a foreign currency that potentially is going to have a very low inflation rate, even possibly deflationary, and it's accessible to anybody with a phone and who has access to the Internet.

Andolfatto: Then, one way to think about how might this impact, say, the conduct of central banks around the world is...if you just think about Bitcoin as a foreign currency, it's a very handy currency substitute. You could see how potentially down the road this could affect the ability of central banks to create hyperinflationary regimes because people will just substitute into the competing currency.

Andolfatto: In terms of what impact it could have on other jurisdictions, like here in the United States, that remains to be seen. There's a lot of people who are hopeful and are claiming that this new technology will in some ways make the banking sector more efficient, that among other things it will permit the natural trades to occur much more efficiently, much more rapidly.

Andolfatto: To the extent that that's true, we know that a lot of safe collateral is actually tied up in the financial sector because of the delay in settling these financial trades though oftentimes firms have to post collateral as security against counterparty risk. That's in part where a large fraction of the demand for safe assets is coming from.

Andolfatto: To the extent that this new blockchain technology could improve the efficiency of the financial sector in terms of clearing and settling trade that might actually potentially release a huge block of safe assets into the economy. Of course that's something that would have an effect on the interest rate structure in the economy and obviously will be something that central banks would be thinking about or be worried about.

Beckworth: Very interesting.

Andolfatto: I could go on but I'll probably stop here.

Beckworth: No, that's fascinating. Our guest today has been David Andolfatto. David, thank you for being on the show.

Andolfatto: It's been my pleasure. Thank you, David.