Lev Menand and Josh Younger on *Money and the Public Debt: Treasury Market Liquidity as a Legal Phenomenon*

Lev Menand is an associate professor of law at Columbia University and Josh Younger is a senior policy advisor at the Federal Reserve Bank of New York and a lecturer at Columbia Law School. Lev and Josh also recently co-authored a paper titled, *Money and the Public Debt: Treasury Market Liquidity as a Legal Phenomenon.* They are also returning guests to Macro Musings, and rejoin the podcast to talk about this paper and its implications for the Treasury market. Lev, Josh, and David also discuss the transition from bank to market financing, whether an increasing level of debt is leading to more instability, the impact of recent regulations on the primary dealer system, how to restore the balance between public debt and money creation, and a lot more.

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 and Josh, welcome back to the show.

Lev Menand: Thank you.

Josh Younger: Thanks for having us.

Beckworth: It's great to have you on. As I said, welcome back, which means both of you have been on before. In fact, I've had Lev on several times. Lev, I believe, introduced me to you, Josh, and then you came on the show. Of course, you guys are both legends of other podcasts as well, so this is nothing new to you. You're great to have on the show because as listeners know, I love to talk monetary plumbing, Treasury market issues. This is another great opportunity to do that. Before we get into all of that though, I hear, Josh, you have a disclaimer to offer us.

Younger: Yes, I actually still really enjoy the opportunity to say this, so I guess I'm pretty fresh at the Fed, but just that views are my own and don't necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System.

Beckworth: Okay, so let's jump into your paper. Again, the title of it is, *Money and the Public Debt: Treasury Market Liquidity as a Legal Phenomenon.* Really interesting paper, goes through the history of public debt and money creation interaction between the two. We'll work our way through the history, but before we do that, maybe give us a motivation and the history behind the paper. What brought you two together to write this piece of work?

The Motivation and History Behind *Money and the Public Debt*

Younger: I didn't come from a formal training in either economics or finance or anything like that. I was an astronomer, so I came to markets fairly fresh in 2009. My timing was interesting. One of the contrasts I always like to draw, at least these days, between financial markets and economics and in my old world of physics is, in physics, the rules are set and they're trying to figure out what they are. They're immutable. The laws of the universe are what they are, and let's just try to figure out how it works. In financial markets, especially in economics more generally, you can adjust the rules to choose certain outcomes. In a lot of ways, it's the reverse of a natural science education. You get to play with the machines. You try to get the outcome you want. What should the weight of a proton be? Let's figure out how to do that kind of thing. That makes you think about why we have the arrangement that we currently have.

Younger: I spent a long time writing sell-side research in interest rate markets and took a lot of things for granted; just the fact that repo is an essential component of plumbing, which we'll talk about, the role of dealers in the system. It was fun at one point to think about why we have this arrangement. I've written a previous paper with a colleague. My wife's a lawyer, so I know a lot of lawyers and a mutual friend of ours and I wrote a paper about bank capital during the 2020 experience and that implicated Treasury markets very directly. Doing the thing I usually do in academics is you get coffee with a lot of people, and Lev and I were introduced by a mutual acquaintance and have similar interests and, in particular, just trying to figure out why the current system came to be and what we can learn from that; in terms of embedded interest and also what part of that works well and what part of that doesn't work well, to really think critically about it.

Menand: I would just add that the 2020 experience, in particular, March 2020, is probably the root cause of this paper in a bunch of different senses, in the sense that it created a policy conversation, which this paper is meant to inform, that policy debate, because we saw such great dysfunction of the Treasury market, and policymakers from a range of agencies turn their attention to what went wrong in March 2020. Also, because 2020 led both Josh and I to produce work that brought us together. In particular, I wrote about the 2020 response by the Fed and the repo market. Josh and I connected over shared interests in the origins of the repo market and what the repo market really was built to do and built for. This paper answers those sets of questions along the way towards trying to inform current debates about Treasury market reform.

Beckworth: Lev, you've been on a few times before, and I see this as a continuation of some of those conversations we had. You had a wonderful paper, a law review paper on all of the facilities that were introduced in 2020, as you mentioned. I still quote this on many other podcasts, how you'd divide them up into liquidity facilities versus credit facilities, and your comments on that. Then you had a nice little book. I believe it's called The Fed Unbound. Is that the title? Yes, and that was a great summary of a lot of the conversations they were having. This paper in some ways, in my view, looks like an extension of that conversation. Then, of course, Josh has been on before talking about Treasury markets and interest rates. Great synergy here bringing the two of you together. Again, the paper is titled, *Money and the Public Debt: Treasury Market Liquidity As a Legal Phenomenon.*

Beckworth: It's published in the Columbia Business Law Review. We'll provide a link to it in the show notes. You can probably google it too and find it fairly easily. Now, I'll say this one thing about law review articles and then we'll move on, but this is over 100 pages. When I first saw it, I was like, "Oh, man, I got to read 100 pages." Then I realized, "Oh, half of that is footnotes." It was really about 50 pages maybe, but it was very interesting throughout. If you love history, you love finance, it's a great read. Don't let the length intimidate you. Both Josh and Lev are great writers. We want to get into this history because it's a fascinating history of understanding how federal debt and money creation have become interlinked. Before we do that, I want to maybe give the listeners just a preview or maybe an overview of the paper itself. What are the arguments you're making in the paper from a 30,000-foot perspective? Then we'll jump down to each of these periods and how it sheds light on that argument.

An Executive Summary of *Money and the Public Debt*

Younger: Maybe I can give it a shot first and Lev can jump in as well. *Money and the Public Debt* is chosen specifically because the idea of money in this context is somewhat fungible. The question is, where does the government borrow money? What does that even mean, conceptually, for a government to borrow money when the government is responsible for issuing the money and also borrowing that money? How does that arrangement work? We're really charting a really seismic shift in the way the government conceives of its own finances that happens in the post-war environment. Prior to the Second World War, most of that period, money and the public debt were very closely connected. We refer to that as monetary financing or fiscal dominance if you want to be a little more provocative. Generally speaking, the money supply and the public debt were very closely linked together through the banking system.

Younger: The predominant buyers of federal debt were banks. When banks buy securities, they issue deposits. Those deposits are new money. For a lot of that period, there was no central bank in the United States. Even if the central bank isn't buying securities, when commercial banks buy them, they are expanding the money supply to finance government expenditure. That really gets solidified after the Civil War and lasts essentially until the Second World War when the transition back to a peacetime economy requires more creative thinking, at least in the view of the policymakers at the time because post-war inflation is running rampant. The Fed feels like it's in a bit of a bind with respect to the connections between, and we'll talk about it, the pegged yield curve. Treasury needs to roll its large debt stock and the Fed needs to combat inflation.

Younger: The transition from bank financing of federal expenditures to private market, non-bank financing of federal expenditures, requires a lot of creative engineering. The repo contract or the repo arrangement is the predominant tool that they use, not only to involve themselves in markets but also to generate a new market of quasi-monies that ends up being a really significant driver of a lot of things that happened later. The story of the mid-part of the 20th century is often expedient solutions to very acute policy problems that then take on a life of their own. Repo markets are a great example of that. It's very successful in transitioning or weaning the market off of bank finance and money finance of federal debt. In doing so, it creates a whole other range of considerations that end up coming back, and in part, 2020 is a manifestation of that.

Menand: 2008 as well, of course.

Younger: Yes.

Beckworth: The big takeaway I got from the paper is that you're summarizing the history of a transformation that's been undergoing since, I guess, World War II. I try to think of it in two simple terms, bank financing versus market financing. There's been a big switch and a big movement towards market financing. Later, you talk about shadow dealers, shadow money creation as a part of that. Just as an overview, would you say this trend has been accelerating? Is it more linear? Have the two recent events, 2008, 2020, accelerated this transformation? Then also just briefly, was this transformation inevitable? I know that's a long question you could answer, but was this transformation something happening globally or was it driven by the actions we're going to talk about in the paper?

The Transition from Bank to Market Financing

Younger: Well, nothing's inevitable, in fairness. These are very concrete decisions. One of the things that I've enjoyed most about this work is looking back at when those decision points were and the options on the table. There were some very concrete moments in the '50s and '60s, in the '80s and the '90s and the 2000s, when there's kind of a fork in the road, so to speak. Like what [inaudible] said, you got to take it, but the question is which way you go. It wasn't inevitable in the sense that there were decision points that were critical and somewhat binary in a lot of respects. In terms of the progression of this transformation, I would think of the pre-2008 environment, the mid-2000s as the zenith of the primary dealer system. That's when, by a lot of different statistical measures, markets are most active. It's when they're most heavily reliant on independent dealers to intermediate the Treasury market.

Younger: The crisis in 2008 and subsequent reforms create a bit of a cognitive dissonance where dealing in Treasury securities is housed within banks; a big change, goes from outside of banks to inside banks over the course of 2008. Then those banks are regulated in a way that is inconsistent with the elasticity that the non-bank dealers showed in the pre-crisis environment, and so then there's lots of reasons why you'd want that. There's lots of reasons why you wouldn't, but the world today is caught between these two extremes. On the one hand, we want Treasuries to have money-like qualities. On the other, we want a safe and sound financial system. What combination of rules generates or optimizes around both goals is kind of the debate we're really having now. That's ultimately the question when we talk about Treasury market reform. Its best aligning policy with those two underlying goals.

Menand: Just to circle back to the inevitable, non-inevitable frame that you put on your question, somewhat just tempting for me to circle back to for a second. I'm mulling it over my head and I almost think it's unusually not inevitable. It's unusually contingent. It's unusually contingent because the current structure of Treasury markets actually took a great deal of effort by central bankers in particular to bring about. Central bankers later had to engage legislators in codifying bankruptcy remoteness. They had to coordinate internationally and they had to coordinate on Wall Street. There were a lot of barriers to doing this, including legal barriers, because the banking laws and the Federal Reserve Act itself are not set up for the type of Treasury market structure that is ultimately developed by the McChesney Martin Fed in the '50s and '60s. That's something they are building out against the grain of the New Deal banking laws. If anything, I would say it's sort of a surprise that we get this sort of Treasury market structure.

Menand: What you would have expected coming out of World War II is some type of bank-based Treasury financing strategy that resembles the Treasury financing strategy we had had for a century up until that point. This is sort of a surprise that we go a different direction towards a secondary market strategy and towards a strategy that was so non-bank-based based on the dealers. One would've had a hard time, I think, in the '40s, predicting what ultimately transpired.

Younger: It's interesting to think about, also, the system, in the legal construct, was not inconsistent with dealing Treasuries from the inside of banks. They were, in fact, carved out of Glass-Steagall. Glass-Steagall anticipates a world where banks will have to be the market makers in Treasury securities and makes an explicit carve-out for them. To Lev's point, there's a bit of a square peg and somewhat square-hole problem where it'll fit, but it does take some work. That work is the focus of the paper. What was that work? What was required to do so? That makes for an interesting story. Maybe the fact that it's interesting shows that it wasn't inevitable. Otherwise, it wouldn't be a very interesting story to tell.

Beckworth: Fair point. As the title of your paper makes clear and you make clear throughout the paper, this is about a legal phenomenon. It was choices, policy decisions made, legislation that moved this in this direction towards more secondary market financing. One more summary before we move into the actual periods. Where we are today is where we are relying more and more on shadow dealers, shadow bank, shadow money creation, to be this intermediary. Because as you note in the paper, the balance-sheet capacity or elasticity, I think, is the term you use, for the primary dealers is flatlined due to all the Basel III regulations and things coming out of 2008, Dodd-Frank and such. In order to intermediate, we're looking elsewhere. We're looking beyond the regulatory perimeter. That's the concern about financial instability that, if you go there, then they're not well backed up. The Fed has to step in more when there are crises with them. That's the direction we're going and that's part of this big issue, right? The one thing, though, I would add to that would be just the amount of debt we're creating. Isn't that also part of the story? Just that we have created large peacetime deficits and it looks like we'll continue to do that. It's both not having enough balance sheet capacity as well as a growing supply of debt.

Liquidity, Shadow Dealers, and Money Creation

Younger: I think it's important to take a real big step back and say, "What do we mean by liquidity?" because this is a term that gets thrown around a lot. It's very poorly defined. It means a lot of different things, depending on the context. When we talk about Treasury market liquidity, at least when I talk about it, I mean, I have a bond and I would like money instead of this bond. I want that to be an easy thing to do. I want to be able to "sell the bond." The selling of the bond is really the exchange of a security for cash, in the absence of cash, something that's very close to cash, and cash is always par. It doesn't fluctuate in value. It's very short maturity in the sense that I can demand convertibility into some high-powered form of money. How does an intermediation process produce that liquidity in the sense that I can exchange large quantities of securities for large volumes of cash without disrupting the market?

Younger: It can do one of two things. It can redistribute money that's in the system very efficiently. There's somebody who has cash and wants a security. I have a security. I want cash. Put them together, not a problem. That requires the two to somehow meet and that's what dealers are supposed to do. That's making markets. The second thing is you have to produce new money. If there's no idle cash in the system to meet the demand of someone willing to sell the security, then balance sheets have to "expand."

Younger: An expanded bank balance sheet is the production of new money. That can be commercial bank money. It can be central bank money. Either way, it's new money supply that is exchanged for the security. In a world where there's "two-way flow," meaning that there's always sellers to buyers, then the system just needs to be efficient in binding those two parties. In a one-sided event like 2020, that's where elasticity is really important because you have more sellers than buyers. That's sort of a silly thing to say because prices are going down because there's more sellers than buyers. That's a world where you do need elasticity in the form that we're describing. That's the critical piece. How do you create a system that can deliver new money as needed to meet this demand without significant cost in normal times and without significant disruption in stress times.

Menand: I think it's really worth emphasizing this point. This is, I think, the core insight of the paper, that Treasury market liquidity, the highly liquid market in US government debt, is actually a function of monetary system design. It requires a monetary system that can rapidly expand the money supply to support the monetary intensiveness of Treasury trading. When, suddenly, people want to convert a lot of Treasury securities into cash, you actually need to expand the supply of money to facilitate that. You can think about the debates running up to the Federal Reserve Act involving crops and the harvest cycle in the fall. It's a bit more tangible and concrete for people. We used to have a very transactionally-intensive economy during harvest season and so you needed to expand the money supply. There needed to be literally more money in circulation to support all of the transactions that had to take place using money during that time.

Menand: Then there were other parts of the year when we needed less money. It's the same thing with the Treasury market. If, suddenly, everybody wants to switch their Treasuries to cash, somebody has to provide more cash to the system. That can be the central bank directly. The central bank ultimately did perform that role in 2020 and performed that role in the 1940s. But it can also be, and this is a second piece of our core point, it can also be central bank-backed money issuers, either commercial banks, which are the congressionally chartered, core monetary institution of the modern US economy, or it can be alternatives to commercial banks. That's what the primary dealer system is. It's a Fed-constructed alternative component of the monetary system designed specially to support the monetary needs of Treasury traders, people who own Treasuries who sometimes need to sell them and want to have that cash liquidity for their positions.

Menand: What we're charting is a change in the composition and structure of the monetary system where we have a primary dealer-dominated framework from the 1950s through 2008 to a mutated, less functional, less stable, and, for a variety of reasons, potentially more problematic structure that still involves the dealers but now also involves what we've called shadow dealers, so hedge funds that are funding themselves in the repo market but don't have the same sorts of relationships with the central bank as well as a variety of other players, including high-frequency traders. It's that market structure, which is somewhat less designed than the primary dealer system, which was intentionally built. This new system was developed after 2008. It's that system that has had a series of tough moments. Part of what we can understand is why it's having these tough moments when we understand that it is just less capable of providing that elasticity than the earlier systems, monetary elasticity.

Beckworth: I like the way you mentioned it in the paper, that this new mutated system, as you called it, you used the phrase, "Quickly, somewhat chaotically, unheralded, and largely undesigned." That's a pretty damning indictment.

Menand: That's a great turn of phrase by Josh there.

Beckworth: Oh, that was Josh. Great wording there, Josh. I'm completely sympathetic to that. Thank you for clarifying the whole liquidity point and how this is related to monetary creation, but let me just push back a little bit. Do you think the primary dealer system worked in part… Again, I'm not far from perfect and there are issues we're going to talk about, but it worked in part because, usually, at least up until 2008, the government would tend to run countercyclical budget deficits. It wouldn't accumulate vast amounts of debt. There were always deficits during war times, and then peacetimes, generally smaller deficits. We go post-2008, and now we're having sustained large budget deficits. No matter what system you have in place, there's going to be more demands on it, more taxing. Again, I agree, this is a mutated system, but isn't there any added pressure from the fact that… The CBO projects a 200% debt-to-GDP ratio in a few decades. Right now, we're around 100. Is there any role for that in making this system more unstable than it already is?

Is Increasing Debt Creating More Instability?

Menand: Potentially, in the sense that if there's more debt outstanding in private market hands, that means that there's a greater amount that might be sold all at once. It's the volume of selling that tests the system. If there's a huge volume of selling, you need monetary elasticity to match that volume of selling. If there's a lot more debt, but the holders are content to hold it to maturity and have no interest in its convertibility to cash and never sell it, then it's not a monetarily intensive shift. What happened in March 2020 wasn't that we had way more debt than we had in March 2016. It's that the people who held it wanted to sell it all at once and you needed to have elasticity to absorb those sales in the system. That's the real concern that policymakers have to focus on. That’s the variable to keep an eye on, is how much selling do we anticipate possibly occurring, and is the market structured in a way to absorb those sales?

Younger: For some context, this will be a good transition to the earlier history. What we did in the paper is we said, "Go back to the major events of the past 200 years," so the Civil War, First World War, Second World War, great financial crisis, and COVID, and say, "How much debt was issued?" Let's try to put it all on equal footing by adjusting it to roughly 2019 GDP terms. If you size it to the 2019 economy, how much would it "cost" or how much debt was issued on a net basis to fund each of these, let's call them "expenditures"? The Civil War was about $14 trillion. The First World War was about $11 trillion by this measure. World War II is $44 trillion in three years. The great financial crisis is pretty close. What actually happened was about $11 trillion in debt issuance and then COVID is about $6 trillion. Go back to World War II. Of the 44, the Fed buys 4 on an adjusted basis. The rest is mostly absorbed by the banking system. To Lev's point, the question is, are these sellers of the debt or are they holders of the debt?

Younger: Because, the old bank-driven system was able to create enormous quantities of debt without a ton of market disruption and without a massive footprint for the central bank in a lot of cases. Even during World War II, we remember the pegged yield curve, but we forget that the Fed wasn't the biggest buyer of that debt at the time. The question is how stable the holders are. That's where the post-2000 arrangement gets worrisome, because when you start accumulating large quantities of Treasury securities held in a format that's very similar to what a market maker would do but held by non-dealers, this is the shadow-dealer system we're referring to, they're much more fragile because they're much more sensitive to small fluctuations in the value of those holdings. They ultimately are not in this business. They are not market makers. They are not dealers. They are in it for profit. When that profit is threatened, they're going to be very aware of the risk they're running. When all of that gets risk-managed down at the same time, you get the 2020 episode.

Beckworth: In other words, we've had much larger moments where we quickly ran up the debt than we did in the COVID experience. We were able to handle it better than we have recently. That's the quick answer to my question. It's not so much the debt. It's the system itself and whether it can handle it.

Younger: Yes, and then the question is, what are the side effects? Obviously, war produces inflation and so that's the balancing act that we have to think about.

Beckworth: Yes, right. Those are important issues, but your paper is focused on the system itself, the financial system. Let's jump into the history. For the sake of time, let's move into the period where this entanglement really begins to take hold, and that's the Civil War period, the National Banking Act. Maybe walk us through the history of that and what it tells us about this issue.

The Civil War Period and the National Banking Act

Menand: The thing to keep in mind is that the federal government has three core strategies for dealing with a mismatch between its revenues and its expenditures. It can increase taxes, it can borrow existing money, or it can print new money. There are obviously other things that the federal government can do, but we don't think of those as core strategies. It can seize goods, in kind. States can do that. States have other strategies, but these are the three administratively efficient core strategies. We generally think of the US government only using the first two that, that third strategy of printing money is generally not thought to be on the table. In the Civil War, it's very much on the table. In fact, in 1862, you get the Legal Tender Act. Congress has tried borrowing and put the entire state-based banking system into suspension. They can no longer redeem. The gold is drained from the vaults of the state banks. There's been an attempt at borrowing and the federal government shifts to printing money, that third strategy.

Menand: Then the next year, in 1863, in a pretty monumental act of state building, Congress creates the national banking system that we still rely on today and, more or less, moves away from direct money printing. Now, there's this conception that shifting to the national banking system means that we've now separated monetary and fiscal, that we're not relying at all on strategy three. We're just going to borrow. But, if you look at the design of the national banking system, it's actually still entangled, because what happens is rather than print the money directly like the Legal Tender Act, 1862, under the national banking system, the federal government is essentially chartering investor-owned banks to print the money and requiring them to use that money to buy Treasury securities. In effect, the national banking system is lending to the government by printing money. It's a hybrid 2-3 strategy where it looks like you're not printing money. It's no longer a direct issue of the US Treasury, but it's pretty much still an indirect issue of the US government.

Menand: There's some very important political economy reasons why Congress pursues this strategy, but part of the point of the paper is to show that the federal government is supporting its fiscal needs through a combination of two and three that in monetary system design, we are building in support for the spending of the federal government. We do not have a full fiscal monetary separation. In an important sense, under the national banking system and ever since 1863, the federal government has used its ability to structure the monetary system to support federal finance.

Beckworth: Josh, do you want to add anything to that?

Younger: No, I think that it's conscription. We have a military and we have a civilian population, but when there's conscription, those two things are entangled. The national banking system is conscripted into funding the government through a variety of incentives, and not explicitly, but it really is the only option on the table because direct money issue was a problem. The Confederacy had enormous inflation issues well beyond what the Union had in part because of the funding strategy they relied on, which was much more aggressive in direct money issue. The national banking system basically serves its purpose for quite a while. There are issues along the way, but after the war, it largely remains as designed and is able to facilitate most of the commerce that the country needs to do. There's a bunch of issues around panics and financial instability. That's where the Federal Reserve ultimately comes from, it is an attempt to resolve that, but it's not on the scale of war finance. As Lev was mentioning earlier, it's about farmers and their need for physical currency.

Younger: Actually, the Treasury used to box up paper notes in anticipation of the harvest season because people needed small denomination bills to sell their crops. This is largely manageable, and even through the panic of 1907, there's a legislative response. The Aldrich-Vreeland Act creates capacity to do emergency currencies, so they relaxed these rules a little bit. They say, under an emergency, you can issue money not backed by Treasury securities, so they start pulling back a bit, but ultimately, the banking system is core to federal finance until, really, the First World War, which is when everything changes.

Beckworth: There was this entanglement created by the national banking system, and Josh, you alluded to some of the financial instability issues it created. I think it's well-known for having these central clearing cities, which made it susceptible to runs. Overall, it met the need, which is the core of this paper, of the fiscal financing need in terms of providing a ready market. One observation about that system, though, is that, eventually, the government began to run down its debt. It tried to bring the debt back down and that, in turn, meant that these banks couldn't create as much money. This whole period is known for a very strong deflationary downward trend in the price level. Overall, it met the needs of the government. Let's go to the Federal Reserve, its creation in 1913, which you alluded to also was in part due to the financial crisis during that postbellum period. What changes happen with the Federal Reserve?

The Impacts of the Federal Reserve Act

Younger: The Fed initially doesn't see itself as particularly relevant to the government securities market. They're authorized to buy government securities, but the Real Bills Doctrine, which was pretty critical to their self-conception at the time, is that money should be created around commercial activities and real goods. One of their first acts is actually around the agricultural finance demands. They start incentivizing the production of agricultural paper, which is secured by physical crops. They don't really see themselves as in the federal finance business. As you mentioned, it's pretty straightforward to do that because the federal debt is fairly small. They're trying to provide monetary elasticity that's not tied to federal finance, but that's tied to real economic activity that's occurring entirely separate from government expenditure. They don't really have very long to exist in that world because, within a few years, the US is involved in the First World War.

Younger: There's just enormous need for funding expenditure because war is extremely expensive. The US hasn't really had that kind of demand on the federal government since the Civil War. There have been obviously incidents along the way, but expenses on the scale of the US involvement in the First World War have basically never been attempted. This is where McAdoo, the Treasury secretary, is faced with a choice. He can repeat what he perceives to be the mistakes of the Civil War era or he can find another way. One of the ironies of the story we tell is that the First World War is the birthplace of the repo market, but it is a very different approach to war finance than the Second World War that came after and the Civil War that came before. It's very focused on the redistribution of existing money. McAdoo, he's a somewhat flamboyant writer, so in his autobiography, he says, “we need to basically create a popular crusade to harness passions and the Civil War was a mistake because they relied on financiers and we really wanted the people to finance the war.”

Younger: Behind the scenes, the Fed and the Treasury, which are still very intertwined at the time, there's not really a concept of central bank independence, are trying to figure out ways to put their thumb on the scale in favor of federal finance. Sometimes it's a heavier thumb than others, but it becomes very clear, even at the very beginning, that pure redistribution of existing money is not going to satisfy the needs of the military during the First World War.

Menand: So, what you get are changes to the Federal Reserve Act. The Federal Reserve was just set up at the end of 1913. By 1916, fundamental changes have been made in order to facilitate, basically, monetary support for federal finance. Then you get lending by the Federal Reserve banks to the banks against Treasury collateral at preferential rates and bank lending to individuals to the private sector at preferential rates to hold liberty bonds. There's this complex system of support to facilitate end users investing in US government debt. McAdoo is very focused on rallying patriotic sentiment to generate demand for Treasury securities. But even still, the McAdoo administration is relying on banks and central banks to provide support.

Younger: He directs a lot of that pressure at the banks themselves. So, there were four major Liberty Loan campaigns during the war and a couple of Victory Loans afterwards. In between, there's this need for bridging the gap. They used to issue certificates of indebtedness. There's a certain format for government borrowing, but the expectation made very clear by McAdoo in somewhat colorful letters to every bank president in the United States is, we expect you to buy, in some cases a quota, he issues. And then some banks don't make the quota, so he writes another letter, very publicly released. It's basically some version of, "It's a nice little bank there. It'd be a shame if anything were to happen to it." Just very, very thinly veiled pressure-

Beckworth: Moral-suasion.

Younger: Yes, we'll call it moral persuasion. That's the bank finance part. What's interesting about this whole episode is what later becomes quite useful is repo contracts, which we'll talk about shortly. Repo contracts are initially a short-term fix for a tax law that didn't anticipate its impact on borrowing between banks and the Federal Reserve. There's a revenue act in 1917 that imposes a tax on the promissory notes of banks. That tax is found to apply to notes that are used for, in borrowing from the Federal Reserve. It basically renders discount window borrowing uneconomic for most of the banks in the United States.

Younger: So, they need to find a way to continue supporting bank finance through this… they call it borrow and buy. This is where an individual would buy a bond with borrowed money. They say borrow and buy until it hurts. That's an example of the pressure put on people. That's still new money. They're borrowing from the bank and the bank's borrowing from the Fed. They need to keep the pipe open. The spice must flow, so to speak. So they use repo contracts, which are considered a purchase and a sale rather than a loan as a way to avoid this tax. It's initially a very idiosyncratic thing. There was a repo market prior to the war, but it was really just used as a short-term fix because it took Congress a little while to do their work and they were expecting the law to be changed within a few months. In the meantime, we'll just do repos. This is an example of that tactical approach to policy goals that has a very long shadow. The origins of repo in particular are very obscure in that sense.

Menand: It's a legal arbitrage from day one. There's a tax that makes a 15-day loan from a Federal Reserve bank to a member bank, against Treasury collateral, uneconomic, and to get around the tax, the Federal Reserve Bank buys the Treasury security from the member bank at an artificial preset price with an agreement 15 days later to reverse that transaction. They structure something that is a secure loan in the form of two purchases in sales and say, "Now the tax isn't owing because there is no loan here, there's just a series of market transactions." This is the birth of repo, is tax avoidance. Now, this tax avoidance comes with the blessing of the Treasury Department, which administers the tax code because nobody wanted this tax to affect the relationship between banks and member banks. But, while the law is being fixed, this solution is developed and then it turns it out to facilitate a lot of other lending arrangements that are not clearly within the ambit of the Federal Reserve Act or the banking laws.

Beckworth: So, this was the birth of repo, but as you know, in your paper, through 1951, still, the main monetary instrument were deposits and reserves, still through the primary market. Walk us through what happens in 1951. I guess you got to talk about World War II to really, maybe get you there, but what's the big transformation in that time?

The Big Transformation in 1951

Younger: The Second World War is even more… we talked about before, you're basically trying to raise $40 trillion worth of debt, in modern terms, over the course of three or four years. It's basically impossible to do that with a redistribution of existing money. So, the Fed basically commits to a pegged yield curve. This is yield curve control and they set a price. There's not a lot of evidence as to how that price was even really determined other than that's kind of where things were when they decided to do it, but 2.5% for long bonds and five-eighths of a percent, I think it was at the front end, like a peg, a completely determined yield curve where the Fed says, basically what the DOJ does now, they do fixed price operations. They say, "We'll always buy 2.5%." The irony of that is it actually ends up that they're net sellers of long-term debt in the end because everyone kind of moves out of the curve. It's economically efficient to do so; part of the reason why their balance sheet doesn't expand as much as you would otherwise expect.

Younger: By the end of the war, there's a lot of focus… Initially, when the war is over, in an interesting echo of what's happened over the past few years, the initial concerns are much more around employment and economic growth, maintaining economic growth in the post-war economy, and there's relatively little concern about inflation. Part of the reason for that is there's still price controls, but Truman ends up vetoing the extension of the Office of Price Administration, partly because he wants a stronger measure, not a weaker one, but the price controls are all lifted at once, and inflation runs rampant. There's some oscillation in that, but by the early '50s, especially with the Korean War outbreak, there's a lot of concern that the Fed's hands are tied too tightly. They can't address the price level in the way that they want because they're still committed to buy Treasuries at a fixed price.

Younger: They have to, to some extent, relax that control, but the long end is still at 2.5%. Treasury, on the other hand, loves being able to raise funds at a very specific rate. That's presumably below what you would expect if inflation is running at 10%. 1951 is when this all comes to a head. There's this frantic back and forth, basically, between the Treasury and the Federal Reserve. It culminates in what's generally just called the accord. It's the Treasury-Federal Reserve Accord. In it, it's pretty vague public commitment to maintain orderly markets on hand, but also to free the market from Federal Reserve control, subject to the fiscal needs of the Federal Government. Basically, the message is, "We are going to wean the market off of explicit Fed support," but they don't really say how. To some extent, I think they're not entirely sure how they want to do it. There's a lot of debate internally because once this announcement is made, there's a lot of internal studies that are made as to what the right approach should be, what should the Fed be committed to doing because, presumably, they're not going to just let the market go on Tuesday and not come back.

Younger: And so, in that debate, repo is raised as a potentially useful tool because what they need to do is get dealers to do what the Fed used to do, which is buy what you're selling and sell what you're buying. The way you do that is you make dealing a profitable business, and that means they need to provide funding to dealers at a rate that's consistent with them being a profitable going concern. They want dealing to be good business. If dealing is good business, there'll be more dealers, they'll do more dealing, more market making, more market stabilization. In an ideal state of the world, this is all symbiotic, so they start offering repo at rates that facilitate dealers doing their job in a way that maintains profitability so that they're more willing to do this at scale. That's what, ultimately, they need. They need dealers that can rise to the occasion of a market that's grown by 40 trillion in modern equivalence when they've otherwise been entirely on the sidelines, for the most part, over the past ten years.

Beckworth: Now, Fed Chairman William McChesney Martin, he was a key person in this story. Is that right?

Younger: Yes. He is the Treasury representative in negotiating the accord. He's tasked with representing the Treasury in the accord negotiation process, and he's ultimately brought in by the president to take over. He's a committed inflation fighter. He's very focused on price stability, and in his initial remarks, when he takes the oath, he talks about inflation being a greater threat than the enemies beyond our shores, I think, is how he put it, which is interesting because a few days earlier, they sentenced the Rosenbergs to death. This is very much in the middle of the Red Scare, and he's saying inflation is as bad as the communists. That willingness to make a public commitment to it is really important. It means that he's very committed to what he perceives to be the free market. He thinks that market prices that are determined by supply and demand, and especially in support of non-bank holdings of Treasuries, because he really blames the inflation on bank money supply expansion that's mostly related to the buying of Treasury securities.

Younger: He says, "If we can get non-banks to buy these things, then we're going to have a lot more success in maintaining stable prices." The question then becomes how to do that, and so dealers are… primary dealers, I'm not sure if they're called primary dealers at that point, but it's a distribution mechanism, because the banks have an existing relationship along a lot of dimensions with the Fed and the Treasury, and if you want to get non-banks to buy them, there's a lot more of them. They're scattered. You want to try to get international demand, so what you need is a distribution mechanism, and dealers are presumed to provide that for the market.

Menand: I just know that Martin himself was a former dealer and he was a former head of the New York Stock Exchange. This is a capital markets man come to the banking system and come to the very pinnacle of the banking system, and he recreates that system to really adjust, in a significant way, the role that capital markets and that dealers, in particular, play. The primary dealer system, the repo market are all developed and deepened under his leadership, and he runs the Federal Reserve Board for nearly two decades in the '50s and '60s, so he's a really pivotal figure. In addition to being a major hawk on monetary policy questions, he has a big role to play in banking and monetary system design.

Beckworth: That is interesting. He was very committed to inflation, as Josh was saying, but he also was pivotal… and we talked about this last time, Lev, when you were on the show, in helping foster and grow the repo market to what it became during this time. That takes us up to 2008. We touched on this already. The primary dealer system struggles, there's a run on it, it's not well-designed in terms of safety backup. Then we have a bunch of legislation that comes out of the great financial crisis. The pinnacle is Basel III. So, maybe summarize for us what this legislation, these new regulations, have done to the primary dealer system and why it has fostered the spread of other forms of financing for government debt.

The Impact of New Regulations on the Primary Dealer System

Younger: I should say just quickly, going back to the '50s and '60s, the Fed never does much repo. It's a fallacy to say that they were the market or they were providing financing directly, but they backstopped it. What we've always found is that when central banks are involved in a market, that gives investors confidence to participate. Most of the repo market's growth is driven by corporates who are cash-rich and would rather not earn zero on their deposits. This is a deposit substitute. This is where the quasi-money idea comes in, which is it has a lot of features of money, but it's not really money, but it's close enough, and it pays you, so I'd rather do that. The 2008 experience is related in the sense that the thing that makes repo money-like is the presence of collateral and short maturities. And in 2008, because the repo market expanded to include all kinds of mortgage-backed securities and other dead instruments, the quality of the collateral came into question, which will be a sharp contrast that comes later.

Younger: So, that's a run on the bank in the sense that their assets are bad and the liabilities are demandable. So, if you're worried that the assets of a bank are bad, then you're going to go run first because the last guy in line gets no money. The same is true in the repo market in 2008. The message from that is, one, we want more things happening inside of the bank regulatory perimeter. That's where Goldman Sachs becomes a bank holding company. That's where Morgan Stanley becomes a bank holding company. We as a society, I guess, is the message. I was an astronomer at the time, so I can't really speak to that. Those are colliding galaxies, so there's some similarity between the explosions. But, the view is, or at least seems to be, that let's get these things inside of banks that gives you access to a lot of support, and also, you're within the regulatory perimeter. Then the question is, how do you fix that regulatory architecture to avoid the same problems? There's a lot of different ways that that's done, but the one that's most relevant to this conversation is leverage constraints.

Younger: The message of leverage constraints is, if we're to learn one thing from the 2008 subprime crisis, you could argue that the thing you learn is that sometimes the stuff you thought was high quality was not so high quality, which is a somewhat banal thing to say now because obviously, people can make mistakes, but that they can do it at systemic level and in ways that are destabilizing, is really important, so leverage ratios are a backstop, intended as such, which is to say, we have this risk-weighted capital requirement that relies on an assessment of the risk embedded in an asset to size the amount of capital, loss-absorbing capacity that you need to support that asset.

Younger: Let's just say the whole bank has to have 5%, just in case; at least 5%, maybe more, relative to total assets. You can totally see the logic of that. What it does is, it caps the size of the banking system at a certain level of capital. You can also see the logic of that, especially in a world that had just gotten a too-big-to-fail experience. Within the structure of the bank itself, especially when that bank is holding a dealer now, the dealer is subject to all of these rules, and if you have a size constraint, the thing you want to do the least of is things that require a lot of leverage to be profitable. So, the Treasury desks in the pre-crisis era were running 20, 30, 40 times leverage because they didn't charge much for their transactions. That's liquidity. You want to do things at scale at low cost. To make something that's highly liquid still profitable, or at least to meet shareholder expectations of profitability, you need more leverage. So, high leverage, low margin activity, like Treasury dealing and repo dealing, are severely disadvantaged in that system, to the extent that leverage is binding.

Younger: The question then becomes, do I care about my leverage exposure or not? This is where I think it's really important to think about how you would run an actual business under those circumstances, which is leverage may or may not be binding today, but it might be binding tomorrow. At a minimum, I need a set of business processes that allow me to target a certain level of leverage. So, you get these size constraints percolating all throughout the institution because if you want to get a bunch of cats to stay in their lanes, which maybe I shouldn't call traders cats, but it's hard to be precise about exactly, if you're the buyer to the sellers and the seller to the buyers, how much balance sheet you use tomorrow is hard to say, so you put some pretty rigid guardrails in to say, "You shall not grow past such size, and if you got a good reason to get bigger, Treasury desk, give me a call."

Younger: And that's totally reasonable, again, but introduces a lot of frictions. And so, in the post-2008, post-Dodd-Frank world, Treasury dealing within banks doesn't grow very quickly, whereas the market is growing quite quickly. This is where shadow dealers come in and it's a little bit of like the Jeff Goldblum, "Life finds a way," situation where there's a need to warehouse securities that have been sold and don't yet have a buyer, and there is a need to connect buyers and sellers more efficiently to minimize the extent to which that is true. So when we talk about shadow dealing, we think of the functions of a dealer, which is matching trades and warehousing inventory, split up by market incentives between two sets of non-bank, non-dealer counterparties. One is the high-frequency traders who do a really good job of finding buyers and sellers, and they go home in a lot of cases with no inventory.

Younger: The second is the inventory management because that's never going to be perfect. That inventory management is increasingly taken over, whether they knew it or not, by relative value hedge funds, who were putting on market neutral, meaning not exposed to the level of rates, but very small price discrepancies between individual securities, and those price signals have incentivized the growth of a very large position, that, one, reflects the price signal element of these inefficiencies on the dealer side, meaning if dealers aren't going to buy sales from the market, then they're going to cheapen them up, and then that's going to get bought by somebody else, then they'll probably want that on a relative value basis.

Younger: The other is this relationship management component, which is, "use it or lose it" balance sheet. If balance sheet is a scarce commodity, and the repo desk has $100 worth of balance sheet on any given day, they're going to go to their clients and say, "Look, I told you I'd do up to $20, but you only used half of that this quarter, so I have got to give it to somebody else." That process creates an incentive to use balance sheet or lose balance sheet access. And so when we talk about Treasury futures basis trades, that is a way to do precisely what I just described. That's a way to hold a highly leveraged position that is not terribly exposed to significant moves in the market. That was a very common placeholder in the 2017 to 2019 era when the Treasury market was growing quite rapidly, but dealer intermediation capacity wasn't.

Younger: And so, to preserve access to balance sheet, hedge funds were basically told to do something, and this was the thing that was the most effective way to do it. The problem with that is when you do a trade, expecting not to make money, then you have very little tolerance for losing money. And so, it looks a lot like a bank deposit because it's supposed to be stable value. It's supposed to be accessible if you need it, but ultimately something you can put on and forget about, and so when that is challenged in 2020, there's very little tolerance for that downside.

Beckworth: So, to summarize, the balance sheet capacity or elasticity of the primary dealers is dramatically changed after 2008 due to changes in regulation, Dodd-Frank, as well as new regulations rolled out from Basel through Basel III, and in turn, other intermediaries pick it up. You mentioned high-frequency traders, hedge funds. Then that leads us to 2020 when they ran on the Treasuries much like a deposit, much like money. Now we're at the point where, how do we prevent that from happening again?

Younger: It's going back to the first thing we discussed, which is that liquidity is… that elasticity is new "money". In this case, the new "money" is not bank deposits or central bank liabilities, it's repo because these are repo-funded positions. Repo's providing a quasi-money alternative to the money that the banking system is not able to produce under those circumstances. That's why it's a shadow form of dealing. It's not really happening within the banking system. It's happening outside the banking system. It's not bank money, but it's treated as money-like.

Beckworth: What are the proposals for fixing this? What are the proposals for restoring, maybe, saner balance between the public debt and money creation?

How to Restore the Balance Between Public Debt and Money Creation

Menand: What you need at the core of any attempt to reconstitute pre-2008 levels of liquidity is monetary elasticity somewhere in the system. You could say that we have monetary elasticity at the Federal Reserve, and so we are content with the Federal Reserve playing the role of large-scale market functioning purchases during periods of monetary intensiveness in Treasury markets. Lots of sellers come, want cash, there's a strain on the monetary system, and then the Federal Reserve addresses it by purchasing large amounts of Treasury securities. You see that this happens in March of 2020. By the end of the month, the System Open Market Account is making 50 billion-plus purchases per day. They're just providing the elasticity directly. That is an option, and if that's the sort of plan for how to deal with periods of monetary intensiveness in the Treasury market, then policymakers should presumably anticipate that this is going to happen and signal and organize and structure it so that it's not ad hoc. So far, I don't think that's the direction that policymakers have gravitated towards or want to go towards.

Menand: If you look at the remarks of policymakers following March 2020, it's, "How can we avoid having to make this direct intervention again?" Then you're looking at a whole suite of reforms that do one of two things. The first thing is, just reduce the monetary intensiveness of Treasury market liquidity during stress periods. This is things like all-to-all clearing. You just want to make it so that you need less monetary elasticity to facilitate the selling, and we see a lot of these technical solutions to try to bring down the monetary demand. The other thing you can do is bring up the monetary supply, but not through direct central bank provisioning, and that could be through changing the sorts of legal constraints on money suppliers, and there are two big money suppliers in this market, the commercial banks and the dealers, or it could be through other regulatory solutions.

Menand: And so one thing that has always struck me as a more appealing path, if we're going to go down the path of trying… not to have the central bank do this directly, then I think a more appealing path is to structure the provisioning through the banking system and through the commercial bank subsidiary of banks in particular, but this would require a bunch of legal re-engineering because commercial banks don't play a large role in this market anymore. It's shifted to the dealers and shifted to the shadow dealers. If you want to shift it back to commercial banks, you have to think about how to regulate commercial bank balance sheet as it is deployed for the Treasury market. That could involve changes to something called Regulation W or changes to the supplementary leverage ratio. Now, I'm just speaking for myself and not for Josh and certainly not for the Federal Reserve or the Federal Reserve System, but I think that the banking system is the best place to house the monetary elasticity that the Treasury market needs if we're not going to have that elasticity come out of the central bank directly.

Beckworth: Where do you see this conversation going? Do you think these discussions for improving the Treasury market, are they going to get any traction? You mentioned that the Fed officials aren't excited about doing more systematic asset purchases, but I know, for example, Darrell Duffie suggested that, at Jackson Hole, in his paper recently, the Fed should be more systematic in doing that. Jeremy Stein came back and argued no, he argued for more of these other suggestions that you brought up. Where do you see all of this headed?

Menand: I don't have a crystal ball, so I can't quite predict where we're going to end up, but I would venture the following prediction, that some changes will be made in the coming years, and I hope that before there is another breakdown in the market, which is a possibility if we don't see changes… The reason why I'm willing to predict that there will be changes is that there is a lot of attention on this problem right now. You mentioned the Darrell Duffie speech at Jackson Hole. I think that officials at a lot of agencies in Washington are focused on this, and this is the sort of issue where a lot of interests are aligned. It's not in the national interest, or in the interest of Wall Street, or in the interest of foreign holders of Treasuries, or in the interest of the banking system, or in the interest of the Treasury Department, to have a government debt market structure that is fragile in the way that ours proved to be in March of 2020.

Menand: Sometimes you don't have policy progress in Washington because powerful interests are at loggerheads. Health insurers want one thing, pharma wants another thing, AARP wants something else, and all of these interests are trying to battle out how they're going to split the pie, and hopefully, someone's out there looking after the public interest. But, there are these groups with very concentrated interests and they disagree. Here, there are definitely solutions that benefit certain groups more than others, but you look at the picture and you see Treasury market functioning and you see Treasury market non-functioning, and it's really hard to point out who's really benefiting from Treasury market non-functioning. That makes me think that we're going to see some changes.

Beckworth: Well, with that, our time is up. Our guests today have been Lev Menand and Josh Younger, and their paper is titled, *Money and the Public Debt: Treasury Market Liquidity as a Legal Phenomenon.* Be sure to check out the paper. Josh and Lev, thank you for coming back on the program.

Younger: Thanks for having me.

Menand: Thank you for having me. Thank you so much.

Photo by Saul Loeb via Getty Images