Peter Stella on the Fed’s Off-Balance Sheet Transactions and Public Financing of the COVID-19 Crisis

Peter Stella is a former IMF official, where he led the Central Banking and Monetary and Foreign Exchange divisions, and he now hosts a webpage titled *Central Bank Archeology*. Peter is also a former guest of Macro Musings, and rejoins to talk about the COVID-19 crisis, central bank balance sheets, and more. David and Peter also discuss the dangers and challenges of the Fed’s off-balance sheet transactions, how the government should approach crisis financing, and who should be managing the country’s public debt.

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: Peter, welcome back to the show.

Peter Stella: Thank you, David. It's great to be back.

Beckworth: Glad to have you on. As I mentioned in the email when I invited you back on, you were highly demanded by listeners. Many people reached out to me and said, "We want Peter back on the show. We want to know more about the monetary plumbing." So, all those monetary plumbing fans out there, you know who you are, Peter is now back by demand. So, welcome back to the show.

Beckworth: Peter, we are in the midst of the COVID-19 crisis and a lot has been going on. I want to talk to you about it and how you view the financing of it. I know you're going to walk us through some historical perspective on this. Before we do that though, I want to zero in on the Fed's balance sheet because a lot of people have been asking about it. I just want to run some numbers by you, just to put things in perspective, add some context. As of today, it's May 29th, the Fed's balance sheet is about $7.1 trillion. It was about $4 trillion before this whole crisis started. So it's risen about $3 trillion, about a little over one and a half trillion in treasuries and some additional assets, GSEs, securities have bought, repos have been purchased, temporary purchases.

Beckworth: So, we're getting near the 33, 34% of GDP mark, and forecasts have the Fed's balance sheet getting as high as 40% possibly, maybe getting 9-10 trillion in size. Most of it has been, again, from the revived large scale asset purchases, GSEs. There hasn't been a whole lot on these credit facilities. They've actually been surprisingly small. But, the Fed's balance sheet has grown bigger. Now, compared to the ECB in Japan, it isn't that big, but many people are wondering about it. I want to just get into it with you today, should we worry about it? Should we worry about public financing of this crisis in general?

Beckworth: I wanted to get a few questions on the Fed's balance sheet and then we'll step back and move into the more general discussion about public finance. One of the interesting observations about this crisis is the use of the Federal Reserve. There's a critique that's been going around and one we've discussed on this show, and that is that Congress and Treasury are effectively using the Fed as an off balance sheet way to finance this crisis. So, the Fed again, when the original CARES Act was passed, the idea was Treasury would leverage up and use the Fed balance sheet to get an extra $10 trillion of funding out there.

Beckworth: We've had people on the show talk about how this isn't really well thought out, because the Fed is limited in what it can do. It can only lend, it can't do grants. It has to participate with counterparties that are solvent, all kinds of legal hurdles that don't make it a very effective way to do off-balance sheet transactions. But nonetheless, that is the case. We brought this up and I've had some feedback from listeners who say, "Well, so what Beckworth. We have a rich history of this, the GSEs, the Resolution Trust Corporation for the savings and loan crisis. We have a tradition in the US of going off-balance sheet when we want to fund something that might be pretty pricey."

Beckworth: So, I want to ask you, is there a danger of going off-balance sheet like this? You've worked with other central banks, you've seen it overseas, what are some of the challenges of taking this approach to financing big public expenditures?

The Public Financing Infrastructure of the Crisis

Stella: Now, coming back to your original question, if you're not concerned about this, you're not paying attention. But, I'm not particularly worried about it at this time. We're actually in a very fortunate position from some sense technologically, in terms of the modern payment systems we have that allow us to get money out to people very quickly, that we didn't have in the Depression or other times in the past. We also have a very well developed, I'm talking about the United States and Europe, UK, very well developed securities markets that can handle enormous amounts of issuance in relatively short periods of time. Which again historically speaking, was not frequently the case or often the case.

Stella: I've actually encouraged by some of the changes that I've perceived in the way policymakers are thinking about this crisis, in particular the ECB and the Fed. So, the technology, a lot of people are using historical analogies naturally, but we have much a more advanced technology now than we did even in the 1960s or '70s, in terms of the debt market and payment system. It's not just payment systems are pretty dull, right? Even more dull are accounting systems, but the advent of straight through accounting processes, which means when you take your $100 out of the ATM, your account is immediately debited, the bank makes an adjustment. The thousands of pages of forms that banks have to submit to regulators, to shareholders, they're automatically all adjusted in real time.

Stella: So, can you imagine if we had to send out 50 million checks to people today and they had to go and present ID and wait in line and cash them at a Federal Reserve bank to get cash, bank notes? I did a back of the envelope calculation for that, and it would take about 51 years, okay?

Beckworth: Wow.

Stella: I'm talking about Great Depression, you were doing paper-based accounting for all of these things. I don't even know if people had photo IDs then. I grew up in New Jersey, we didn't have a photo ID for your driver's license until I don't know when. So, we take for granted, and people are complaining, somebody got a check that they shouldn't have gotten a check, it's really remarkable. Yeah, mistakes will be made because we're moving very fast, but the technology has enabled us to do the accounting and all of these things, it's really remarkable. So, the technology, fundamental technology has really enabled us to address very fast moving prices in historically a very, very fast way, and the way people are thinking I think has changed even since 2016, in terms of the policymakers’ response. We have fantastic debt markets compared to the 1960s, '70s, '80s. So yes, I'm concerned, but there are some strengths that I think people are overlooking.

Beckworth: That is an interesting observation about technology. So, is it the case then that even if policymakers during the Great Depression had figured out the perfect policy, it still would have taken time to implement it that we don't have to deal with today? So, maybe to some extent they were destined to some challenges, some hardships back then because they didn't have what we have. That's a pretty profound thought.

Stella: Yeah. People talk about helicopter money, right?

Beckworth: Yeah.

Stella: Let's think about what that literally is, and why it's was such a good analogy. You're literally dropping money out, physical cash out of helicopters. Nobody has to sign for it, register it, have a bank account. You just grab it, put it in your pocket. The nice thing about this, the government doesn't know who got it, so they can tax it away from you, and that's important. If you want people to say, "Oh, this is an increase in my wealth, I'm going to spend it," it's important that they know, "Hey, I'm not going to have to pay taxes on this."

Stella: I think the policymakers have realized this and they're saying, "Hey, you won't be taxed on your stimulus check and so forth, and so on."  But, when you think about that literally, and I don't know if I mentioned this in the previous show, but I was in Instanbul once, maybe 15 years ago, around the St. Sophia Mosque and the Blue Mosque. It's a big square. All of a sudden, I saw a helicopter coming low and hovering over this big open space. All of a sudden, things started falling out of the helicopter and I thought, "What is going on?" People were scrambling and grabbing them. They were blue jeans. They were designer jeans that were being dropped out of the helicopter as a publicity stunt. They were getting caught in trees and people were fighting each other and grabbing them out of trees.

Stella: So, it was real chaos. The mayor of Istanbul in the newspaper the next day said he really wasn't happy about this. But when you think about it, we take for granted in a theoretical model, oh, yeah, we just take a derivative or something, and everybody gets his money. It just doesn't work that way. Even in a helicopter drop, it's chaos, it would be chaos. In the Great Depression, how would you have done it? How would you have done it? In the United States, every month we send out about 60 million Social Security payments. This is a lot of money and it's happening every month automatically through the system, and all the records are being kept. Records that you were paid or not paid. So, we're really at a much stronger point. I'm not saying you want to give money away, but-

Beckworth: Yeah, I know it is profound.

Stella: ... You absolutely can't do it today. Think about, I don't know how old you are, but my father was born in 1919. So, you're just thinking, well how in the world would they do something like what they're doing now? There was no unemployment insurance, no deposit insurance, no old age and disability Insurance, what we call social security.

Beckworth: No record keeping to know who to send it to at that time.

Stella: No. People didn't have ID cards. One of my mother's uncles was a master plumber, and there was like a physical... Well actually, her father was, my grandfather was a master plumber. I guess there was some certificate or like paper based certificate that said Joseph O'Brien. In New York City at that time, there might have been a thousand Joseph O'Brien's, right? So, the story my mother used to tell was, somehow he lent his plumber's license to somebody, maybe a relative O'Brien, and he never got it back. That was a big deal, right? So, we just take it for granted that we can do these things and people complain, "Oh, why did it take a week to... Come on."

Beckworth: Right, right.

Stella: We just like you said, even if we said we want to give this money away, how do we do it? There was a very interesting, I don't want to go too long on this, but, during the Roosevelt administration, there was an issue called the Veterans Bonus. So in 1924, US World War One veterans were given a bonus depending on how long they served in the military during the First World War. In 1924, this was granted by congress but it was payable in 1945. In the midst of the Great Depression, there was a lot of political pressure to pay the bonus early. So, I believe people had received in 1924, a paper certificate which said what their service was and what they're entitled to, in 1945 20 years later. So, the idea was, it seemed pretty simple and I would think super politically popular, let's just pay the veterans their bonus now with print money, and give it to the veterans in 1935, instead of making them wait until 1945.

Stella: The interesting thing that might surprise some people is, Roosevelt was dead set against this. He vetoed the legislation, even though he knew it was going to be overridden, and it was overridden. His argument for not doing it... I mean, the argument for doing it was, "Well, this was one thing where we could kind of get the money out the door in a couple of months to a list of people who you might say sort of deserved it." But, Roosevelt said something like, "Well, we want to send the money to the needy. Just because someone wore a uniform doesn't mean they're needy." It's a remarkable political statement, because I can't think it was very popular to say something like that.

Beckworth: Right, right.

Stella: But, it comes back to this question of, how do you identify who the needy people are in 1934, 1935, and keep the accounts and track of, "Did I give this Joseph O'Brien 10 stimulus checks or not?"

Beckworth: That's interesting, and it's something we have talked about on the show before that, it has been difficult, at least from our modern perspective, to get payments to people because, we literally don't have the infrastructure in place. The IRS, it's tax season, people are working from home, we don't have a Small Business Administration that's really scaled to size to do the PPP effectively. But yet, it's much, much better than what they would have had in 1929, 1930, because they didn't have any of the infrastructure back then. They didn't have any of those new deal agencies, the byproduct of legislation, Social Security, for example, which would have been name names of people. So, that is an interesting thought.

Stella: Right. You recall the notion in 2008 of shovel ready infrastructure projects. If anybody's ever done an infrastructure projects or been involved with one, or even a home remodeling, there's no such thing as a shovel ready infrastructure project. These things take years to plan and design and bid, and so on and so forth. So, if you believe this crisis is a three month of a four month or five month crisis, that's not an option. It's really not an option. You need to get the money out fast. We have the capacity to do it.

So, if you believe this crisis is a three month of a four month or five month crisis, that's not an option. It's really not an option. You need to get the money out fast. We have the capacity to do it.

Stella: Let me also touch on this point about the Small Business Association, a Small Business Administration. People might have realized this, but I was aware very early on in the beginning of March, that this worldwide, this provision of assistance was going to be done through the banking system. It's impossible. I don't think anyone would argue that the Small Business Administration should have the staffing to administer a program like this. When you... I'm kind of a practical person. I've been around the world, I've seen things that other people haven't seen, and the model looks very clean. But Chile, when they imposed capital controls, which could have been a very good policy, basically they had to set up, devote an entire floor of the central bank and hire people to administer the capital controls. I mean, it's a huge, huge task.

Stella: So, I think people realized very early on in the US and Europe, that since the banks are not the problem this time, I hope, we hope, they're going to be part of the solution. We are going to work through the banks. In other words, unfortunately, if you don't have a relationship, you're a small business you don't have a relationship with a bank, it's unfortunate. That's the only way to get the money now, right?

Beckworth: Yeah.

Stella: The Small Business Administration can't hire 100,000, bank loan officers and assess collateral and all these things. So, you had to work through the banking system, I think, just from this mundane administrative reason. Of course, much better if you have your direct deposit information with the IRS, and if you need to get a check. But all of these things, we're working, we have to work through the financial system. That's why in a way, I'm not trying to sound like an apologist, but if you're in a real hurry, and you're the Treasury, you're saying, "Look, there's no way I could administer this in the relevant time period. I don't really even want to set up the infrastructure to administer this, because I'm hoping in six months time, I'm never going to have to do this again."

Stella: You just can't find the experienced people on the street anyway, to do it. So, you're going to work through the banks. Well, why not work through the Fed, which is working with banks in an indirect way?

Beckworth: That's a nice segue back to my question about using the Fed kind of in an off balance sheet way. I mean, that point there makes a good case for doing so, that the Fed has at least relative to Treasury and other government agencies, has a better apparatus set in place. But in general, should we be taking this approach? I mean again, it's a rich tradition in the US, the GSEs, Fannie and Freddie are off balance sheet, the savings and loan crisis was handled off balance sheet. So I mean, I guess there's maybe a long term question there versus the immediate one. Maybe these are two distinct issues, but what are your thoughts based on your work overseas and what you've seen?

The Fed's Off-Balance Sheet Approach

Stella: So let me say, I don't want this to be misinterpreted. There will be smoke and mirrors. There will be. There always will. What do I mean by that? We'll be arguing 10, well maybe not me, but other people will be arguing 10, 15, 20, 30 years from now, what really happened? What really happened, trying to sort out these accounting issues of what balance sheet was it on and what was the real cost of this and so forth and so on. The Fed, let me be critical here, in its defense of what it did in 2008, frequently claimed, "Well, we made money on all of this, so it doesn't matter."

Stella: Now, I started my career in the IMF in the Fiscal Affairs Department, and I wrote a lot about, let me quote Mark Twain, "There are lies, damned lies, and statistics." A lot about statistical manipulations of central bank balance sheets, government balance sheets, arguing that they should be both, you can't ignore one without looking at the other and so forth and so on. So believe me I know, I know almost anything is possible. It's not that I theoretically know it's possible, I've seen things that you would think are impossible, but I've seen them, they've been done and they've been published. It's not any different in this crisis.

Stella: So, let me come down to the economic aspect of this. The right way to have measured what the Fed did in 2008, 2009 with the Maiden Lane LLCs and so forth and so on, was to look at the risk adjusted return to the investment. Just because you wound up making money, still doesn't mean it was in expected value terms, not a subsidy, or you weren't potentially losing money, that it wasn't a quasi-fiscal expenditure. So, it's very difficult to properly sort out what is really going on in real time, in terms of, what is the risk adjusted capital at risk if you will.

Stella: So, coming down to a very practical question, it's common for treasuries to provide capital indemnity to public institutions, to the central banks. The question is, what's the right amount? What's the right amount? Is it completely open ended? We see that in the UK, but we tend not to usually see that. In the US Congressional Budget Office, since about the Reagan administration, I think it started around 1980, has been required to do fiscal scoring of all kinds of exposures to new credit programs. So, if you're asking me whatever the Treasury has I think paid in 45 or $50 billion to support some of these debt programs, are you telling me that was done in some super actuarially sound way? Probably, it's in a world where nobody knows what the numbers are. So, I'm trying to draw this distinction here between lies, damned lies, and statistics.

Stella: We're operating with statistics, forecasts that the variance in their reliability is so high you could justify almost anything. From saying, "Oh, we don't need to contribute. We don't have to pay any insurance premium to the Fed for this”, or “we should be guaranteeing the full amount." I think you could probably find some projection that would justify anything from one end to the other and anything in between. So, it's certainly from my standpoint of transparency and fiscal accountability and governance, it's not the right way to run things. But in a crisis, this is inevitable. Things are moving in real time, it's inevitable that this is very murky and obscure.

So, it's certainly from my standpoint of transparency and fiscal accountability and governance, it's not the right way to run things. But in a crisis, this is inevitable. Things are moving in real time, it's inevitable that this is very murky and obscure.

Stella: By the way, whether the Fed makes money or loses money in the end, again, it really has nothing to do with whether it was a good idea or not, in my mind, but, it really depends on the risk adjusted return.

Beckworth: So in a crisis, don't let perfect be the enemy of good. Maybe using the Fed is all we could do given our institutional capabilities in the US.

Stella: Right. We can talk about the budget process and all that.

Beckworth: I mean, just being pragmatic about it. Again, I think there are ways to address some of these problems before the next crisis so that in a bind, if we do rely on the Fed, we do it in a more thoughtful way.

Beckworth: Peter, let's move on to a broader issue here. We've been talking about central bank balance sheets, but let's step back and look at just the general public finance view of a crisis like this. So, in real time, this is huge. We think there's a huge collapse in the economy, all indicators point to that, lots of uncertainty, we're trying to throw everything we can at this given the political constraints. What is your view of how we should approach a crisis like this?

How Should the Government Approach Crisis Financing 

Stella: It might sound irresponsible, but basically you spend now and figure out how to finance it later. In looking for historical parallels, I'm reminded of the First World War. Now, why? First of all, it was a true surprise. World War Two, the Nazis, it was pretty clear something was happening. World War I, assassination in Sarajevo, maybe there's going to be a small difficulty between Austria-Hungary and Serbia. It wound up being absolutely global, at least European catastrophe. At the time, people thought, "Well yeah, this war will involve major combatants, but it's going to be over in a few months. It'll be over by the end of the year, maybe even over long enough to get the harvest in." So, I'm talking about assassination in late May or June. We think, "Okay, it will be over. It will be over in no time."

It might sound irresponsible, but basically you spend now and figure out how to finance it later.

Stella: So, there's a very interesting thing that immediately happened and that is, all the major European belligerence sent agents to the Americas, their equivalent of ventilators and medical equipment, and that was horses and mules. So, the military technology that at that time meant we would need a lot of horses and mules to conduct this war. We were on the gold standard. So basically, agents were sent out to the US West, Canada, Argentina, with cash, cash pay, "We need to get these horses and mules before the Germans do or the Belgians do." So basically, countries were running down their foreign exchange reserves, people were selling horses and mules knowing they had the buyers over a barrel so they were demanding cash payment.

Stella: Now that was okay if you think the war was going to last three or four months. A lot of the belligerents inconsistently, of course, we're thinking, "Well, reparations from the loser are going to pay our expenses. We're going to win and the loser is going to have to pay us off. So, we're not really worried about that."

Stella: The war continues. Of course, countries requisitioned horses from their own population, paid for those too. Just a number, the UK alone sourced over 600,000 horses and mules from North America during the First World War. So, time moves on and the war's carrying on. So, the UK Government says, "Well, we're running out of reserves. This is a little bit dangerous." So what they did was, they got together, the large investment houses in the UK and said, "You know, we would like your high grade foreign corporate bonds, railroad bonds, equities, and we'll give you UK government bonds and exchange."

Stella: So, it was basically agreed. The UK Government got all this denominated, foreign exchange claims, packed them up, sent them by boat let's say to Wall Street, and used those as collateral to borrow from JP Morgan or sold them, sold them in the New York Stock Exchange or sold them in the US foreign market. Argentina was in the same spot. Argentina was a real solid country back then.

Stella: Basically, that was the second round, kind of, I wouldn't say force, but let's say coerced debt exchange. We didn't have a well-developed debt market in any of these countries. So, this was the solution. Time goes on and the UK government needs more money, and everybody has surrendered their foreign exchange claims. They're running out of gold. So, they have to issue, let's call it a war bond. Here's where very interesting cases of smoke and mirrors comes up. In those days, again, all the bonds were paper-based. You were selling them by subscription, not by auction. So, subscription means the government sets the coupon and the maturity, let's say 4%, and then you come in and buy as much as you want whenever you want. So, you subscribe to them.

Stella: Now, if the government sets the interest rate too high, everybody subscribes. If they're paid too much, if they set it too low, people are done with the bond subscribing. They don't get them. Remember, this is not a time where you could raise taxes anyway. Probably most countries didn't even have an income tax, and taxes take time. So basically, you had this subscription going on, and typically what would happen, if the government needed the money and the private sector didn't come in and subscribe, the central bank would basically take a big chunk.

Stella: So what happened in the UK is very interesting, is that subscriptions, the interest rate was a bit too low. Of course, you're borrowing at a time where you're in distress now. If you had done this at the beginning, maybe people would have let you, but now you're in distress, you're having trouble. The war has not been won in three months. So basically, the Bank of England was faced with buying about three fourths of the offered amount. Everyone said, "Well, the optics of this would look really bad, because people would know, "Hey, wait a minute, I bought those bonds, but nobody else is buying them. I must be a fool. They're only being bought by the central bank, Bank of England."

Stella: So, the bank decided to subscribe to let's say, formally subscribe to let's say 30%. Then, essentially what they did was, they had the Chief Cashier of the Bank of England, subscribe to an enormous amount of bonds as a private person.

Beckworth: Wow.

Stella: Presumably, this was financed by a loan from the bank to this senior officer, so that when they published the statistics in the newspaper saying, "Oh, you know the bond, the subscription is going along very, very well. The private sector uptake has been whatever." But behind the curtain, this was absolutely smoke and mirrors, right? So, I'm giving you an example, pretty replicable. Let's say Treasury and in a crisis, things like that happen. Now, the story doesn't end there. There's a very interesting next stage because, of course that bond wasn't enough, so they had to introduce another bond. Let's call it the Second War Bond. Because they realized the interest rate in the First War Bond was too low, they were going to offer a much higher coupon, let's say 5% instead of 3%.

Stella: There was a bit of an uproar because the people who had bought the coupon at 3%, were going to take the big capital loss, right? Saying, "Oh, we were patriotic and we bought the bond. Now, the next bond is 5%." So, the Treasury decided to give the original bond holders the option to convert into the new bond, at par. So, it unexpectedly gave them the option to transform their 3% bond into a 5% bond with no cost. Now, the Economist Magazine and people were outraged. "This is crazy. Why would you give these people who they lent you in good faith at this rate, and now you're just giving them money? Giving them this? This is crazy. This is terrible."

Stella: On the one hand you could say, "Yeah, that makes sense." But, if you take a look at it from the games theory point of view, and you say, if this is churning from a onetime game into a repeated game, in other words, you have to keep going back to the market maybe again and again, and again, maybe it's not such a bad idea for the purposes of selling this bond, to just say, "Hey, you know you guys, we're going to give this option because we want to be known as a reliable partner so to speak, in financing." This has a parallel interestingly enough, when we come back to this central bank independence question. We all know about the Treasury Accord in 1951, where the Fed had been-

Beckworth: Yep.

Stella: ... [inaudible] interest rates, keeping Treasury bond rates up, fixed. Well, there's something very interesting, and I don't think this is widely known. But, there's a footnote in one of, I can bring these papers that alerted me to this, I can bring in Garber’s paper. the Treasury actually offered the same exact step up to holders of bonds at the time when the Treasury issued the first bond that had, let's say the higher coupon. Basically there was an offer, an exchange offer by the Treasury, right after the accord, to the existing holders of the Treasury bonds to swap them into the higher new coupon bonds at par. So, this idea isn't-

Beckworth: It's been done in the United States.

Stella: It's been done in the United States, it's been done in the UK. You might say, "Oh, this is outrageous," but if this is a repeated game, maybe this makes sense. Again, when we come back to what I was talking about at the beginning, the US Treasury now, and other countries, have a very regular and predictable strategy. That's what it's called. We don't take advantage of the markets for short term gain, because this is a repeated game. The Treasury's issuing debt this week, next week, the week after, not just in the US, basically all of these countries. So, there's this notion of a symbiotic relationship going on.

Stella: These markets have proven to be very, very successful in terms of funding expenditure over the long-term. You're talking about decades, but they come in awfully handy at times like this. So, if I could say, if the government had been perceived as having screwed the patriotic bond holders at the First World War, when Second World War rolls around, maybe you would have an even bigger problem. So, the financial markets are much more deep and fluid than they were before. I think again, coming back to our strengths today is that, because of regular and predictable, because many countries, even in emerging markets who absolutely couldn't have an issuing of bonds to finance their COVID-19 expenditures, they didn't have to issue money. They can issue bonds now because of the work they've done in the last 20 years.

Stella: I saw Israel issued 100 year bond recently. They were in basically hyperinflation in the 1980s. So, I think that's a strength that should be tapped now, in terms of the financing. So coming back to the original statement is, I can't tell you how much money to spend. I can't tell you where to spend it, but I know it needs to be spent now. We know enough about this crisis. Later is not working.

I can't tell you how much money to spend. I can't tell you where to spend it, but I know it needs to be spent now. We know enough about this crisis. Later is not working.

Beckworth: Spend now and worry about the financing arrangements later. That's your point?

Stella: Yeah. No, it's Congress or the parliaments should decide how much to spend and where to spend it. I think in terms of the financing aspect, we're in a really much, much stronger position than we were in the Depression, and even in the 1960s and '70s in terms of technology and the debt markets. If there's one big picture point I would make here is, the idea of financing with helicopter money, however you perceive that term, let's call it central bank money, which is floating rate debt, it's floating rate government debt, where you're adjusting the interest rate every day potentially right now, versus issuing long-term debt, which the US Treasury is issuing 10 year TIPS, which is an inflation index security, 10 years at a minus 47% basis points annual yield.

Stella: That means the US Treasury, I'm talking about last week, last week or two weeks ago. So you've locked in, and the Treasury just locked in a negative real yield for 10 years. US Treasury issued last week a 30 year bond at 1.32%. 30 years. So, if you think inflation might average 1.5 or 2% over the next 30 years, again, negative real yield. We care about the real yield. We don't care about the nominal, the real yield for 30 years. Why in the world would you want to finance... Why would you trade that for issuing central bank money, which is paying a floating rate? It just doesn't make any sense.

Beckworth: It goes back to what you mentioned earlier.

Stella: Given the technology we have now, this isn't the Great Depression where we had to basically hand out physical bank notes.

Beckworth: Well, going back to what you mentioned earlier though, maybe it's just expediency right now that the Fed is effectively financing a lot of this deficit. So, the Fed is buying up a lot of the debt this year. Just to be clear, what you're saying about the floating rate financing, you're talking about bank reserves, right?

Stella: Right.

Beckworth: Bank reserves and rates can change instantaneously, I know that it could change within the day. It's all up to the Federal reserve. So, your point is that could go up and we actually hope it would go up, because that means recovery is under way, we'd have higher rates versus locking in a long-term yield. So here's the pushback I've gotten on that point, because we've discussed this on the show before. So, here's the challenge. Could the Treasury finance its deficits without the Fed’s support? In other words, yes, the Treasury goes out and issues 30 year bonds, one and a quarter percent, but some of that's being bought up indirectly at least by the Fed, and in their large scale asset purchases.

Beckworth: So, could the Treasury finance it? If the answer is no, then ultimately, it's still going to be financed short term, right? The reserves are funding the purchase in the markets of these long-term treasuries. On the other hand, if there's still this big, safe asset shortage out there, people around the world are craving treasuries, and the Treasury could finance without reliance from the Fed without support from the Fed, then, I think the case could be made for that. So, does this really hinge upon how much financing comes from the bond market versus the Fed?

Treasury Financing: Bond Markets vs. the Fed

Stella: Let's talk about the timing again, just in terms of the mechanics. At the end of the day on Wednesday, the US Treasury had $1.3 trillion in its account at the New York Fed. That's the most shocking number on the Fed's balance sheet. Prior to this, prior to 2008, as I'm sure you know David, the Treasury managed its cash pretty carefully. It aimed to hold a balance of $5 billion at the New York Fed on average. If you look at the numbers for 2006, 2007, it held 5 billion on a daily basis. So, this number of 1.3 trillion is absolutely shocking. This is an example of one of these numbers that, what does it mean?

Beckworth: Right, it's so big.

Stella: It's not interpretable, right? Presuming the Treasury is going to spend that money very fast. But, why do I mention that? Let's just go through the mechanics. Suppose that Treasury stopped issuing debt and kept spending, it would by its own spending, create a trillion dollars in bank reserves. It would send a check to my children. They all got their stimulus checks. Send another check, they would deposit them, it would go into their bank account, that bank would have reserves at Fed. So, the Treasury would be in some sense printing money. So, that's nothing. That's just arithmetic. That's the mechanics of it. So your question is, how does the Treasury refill its bank accounts?

Beckworth: Yeah.

Stella: My answer, I'm putting this in simple terms and I tend to think of the simple terms. But, basically you would wake up the next week, the Treasury would wake up, and the banking system and wake up and say, "Gee, our excess reserves have gone up by $1 trillion. We're getting 10 basis points from the Fed. Hey, US Treasury is offering Treasury bills that at 50 basis, or more like 30 basis points. So, let me gobble them up. I mean, why not? Why not? I don't think the Fed is going to raise the interest rate on reserves anytime soon." I'm talking now as a bank. Well, why not?

Stella: So, I've run into this problem in many countries with debt managers all over the world. Because, whenever I tell them, "Oh, just issue another like trillion dollars of debt," and they're thinking in the old way like, "Well, how can we do that? The market isn't there for that." I say, "No. Yeah, the market is there for that because you just put a trillion dollars into the system and took it out." So, I think really what we want to do... Let me come back to that. In any crisis, every crisis, coming back to that First World War crisis, you finance by creating money in the short run, in some way. You liquidate your liquid assets, then you create money.

Stella: Then over time, as in the UK system, they stumbled upon, over time, what's the best way actually to issue bonds, not just an emergency, but over time? Believe me, I've seen this in dozens of countries. They have gone through financial crisis, and invariably let me just give you in a nutshell, the typical financial crisis is also a fiscal crisis. The central bank lends to banks, takes collateral, that's trash. Whether they call it trash on day 1, or it takes them 10 years to say this actually is trash, they take trash. So, they're basically creating money to support the banking system or to support the government. They're taking collateral, which is worth nothing.

Stella: We get back to this policy and insolvency problem. We've created all this money, the exchange rate starts depreciating because people want to convert that money into foreign exchange. If it's a real asset, you get inflation. So the central bank, let's say we're starting in a world where they have no domestic debt, where it's in Latin America or Asian countries in the 1980s. So what happens? The central bank says, "Well, we have to do something." So, they issue their own debt. But, they're issuing it in a crisis and they've never issued debt before. So, they issue really expensive debt in a very unprofessional ad hoc way.

Stella: But then, what you see as time passes, you get out of the crisis 10 years, 20 years later, and you look at what Brazil, Mexico, Chile, Peru, Israel, other countries, Thailand, have done. They've done a fantastic job of developing domestic debt markets.

Stella: So, if you look at the central balance sheets of those countries now, and you look at the consolidated balance sheets, they're financing themselves with domestic currency and local debt, plus foreign debt. But, they're not financing themselves with money. So, that's why I want to point people to, let's look at how countries who've navigated this in the past, what are those debt managers doing? They're not saying, "Oh, please central bank, issue a lot of money." No, no, no. They're issuing long-term bonds. They're to issue more obviously, but keeping within some sort of strategy. Over time, and I'm… sorry, this is taking me a long-

Beckworth: No, this is good, this is good.

Stella: …the original point. But at the beginning, yes, the central bank will just like the Bank of England did, it will buy a ton of the government debt. So, it will at the beginning finance with, let's call it money creation. No doubt about that. I've seen this, there's no problem. The Fed set interest rates as well in 2008, 2009 and other central banks have done it. The Swiss National Bank did this, the European Central Bank did this, right? Not everybody did this. Canada did not do this. Other countries survived the crisis without doing it. But, if you do it for a short period of time, I have absolutely no problem with it.

Stella: What I have a problem with is this notion of permanent monetary finance, the notion of helicopter money as a permanent solution. I think if you push that question back on those who advocate permanent monetary finance, they said we should have more. Okay, more than what please? More than what? So, the Fed has had permanent monetary finance for the last 75 years, but the amount has been constrained. What am I talking about? Well, if you look at the physical Federal Reserve notes outstanding in the US economy from 1957 to 2007, well, they've grown.

What I have a problem with is this notion of permanent monetary finance, the notion of helicopter money as a permanent solution.

Beckworth: Right.

Stella: Well, look on the other side of the balance sheet, Treasury securities, that's monetary finance. I think 50 years is a pretty long time. So, I consider that permanent. Well, why is that not a problem? It's not a problem because people wanted those bank notes.

Beckworth: Yeah, real money demand has grown with the economy.

Stella: Money demand has grown. My point is, if you're talking about helicopter money or permanent monetary finance, I think you must be saying that the proportion of US government finance that is accounted for by money, should grow from where it was in 2007, and I've done the calculation just so that you know. I looked at the total growth in US public debt from 1957 to 2007. I subtract the amount that the Fed bought over those 50 years. I add in the increase in central bank money, which is reserves plus bank notes over that time period.

Stella: So, 16% of US consolidated financing has been monetary finance. To be honest, it's a higher number than I thought it would be. It's 16%. So, I don't see any problem with us thinking, "Oh well, that proportion can continue forever over time." The only problem with that is, I think it's a very antiquated notion because, we come back to the technology question. I don't see a big demand for fiscal bank notes growing in the next 53 years. I know for sure that actually the demand for bank reserves from 1957 to 2007 fell in nominal terms, fell in NOMINAL terms.

Stella: So, I don't see a future for that personally, even if it were a good idea. Even if you thought it was cheap, I just don't see it saying, "Oh, that should go up from 16%." I don't know that the helicopter money people ever say it should go from 16% to 25% or whatever, but I think that's the way you have to look at it. So, the way I'm looking at it is saying, "Gee, I think there's a pretty strong demand for more government debt. If we're putting our eggs in one basket, it shouldn't be in the money basket. If we're talking about permanent reliance on something, we should be putting our money in the government debt basket."

Stella: Again, the way to properly develop that basket or not squeezed the golden goose too much, is to keep selling debt, not to make some sudden swerve of this idea, "Oh, helicopter money." I mean, the more I think about it, the more it seems to be exactly the wrong way to approach it, again, in the long run.

Beckworth: In a crisis maybe.

Stella: It is absolutely going to happen. We're going to see the Fed's balance sheet grow, absolutely no question, trillions more. But, when we're talking about thinking through the implications for the long run financing this, the debt markets are… and I'm encouraged by this, because the Treasury is continuing to issue debt, issuing the TIPS, issuing 30 year bonds. You look at the interest rates they're getting, I think it's great. I'm sure if you talk to the debt managers in Peru or Mexico, they're saying, "Yeah okay, we need to raise this money fast, and this is more than the market can absorb right now. So yes, central bank can help us out." But, I'm absolutely sure over time they'll want to do what they've been doing in the last couple of decades, and that's basically develop the domestic debt market even more.

Beckworth: Just to summarize, and if I've understood you correctly, what you're saying is, we've got to have the right time horizon when thinking through this process. So, the scenarios that I propose to you is really thinking short term. So short term, the Fed is buying up a lot of Treasury debt, but your point is, ultimately, it's going to be a temporary injection and therefore how we finance it over the long run... At some point, this huge increase might be reversed or refinanced in a different way. At that point, you refinance it with government debt locking in these low rates. Is that fair?

Stella: Absolutely. I want to clarify something for all the listeners, some of whom know this, but I think it's very important. If you look at the Treasury, it's a one page statement, the results of each auction. You look down and you'll see a line that says SOMA on there, which stands for the System Of Market Account, which is a weird, weird word for what the Fed is buying at the auction. You'll see it is on a separate line. So, it's what we would call an add on. So, the rates that I'm talking about are not literally being suppressed because the Fed is in there bidding at really low interest rates. The rates that we're seeing is the market bidding versus what the Treasury is offering. Now, how central banks typically do their buying at auction is, when they do buy at auction, some central banks are prohibited from buying other than from the market. But in many countries, there's ability for the central bank to roll over its maturity treasuries at the auction in a noncompetitive way.

Stella: So basically, and I believe that is still what is going on. In other words, what the Fed is buying right now is actually the reinvestment of maturing treasuries. It can be 30% of the amount that the Treasury has auctioned to the market. I'm not saying it's a small number, but, it's not directly influencing the market rates. So, that's why I'm confident. David, I don't know if you think our listeners have understood that point, but it's basically saying, the Fed calls up the Treasury two days before the auction and says, "You know, I've got 10 trillion of treasury securities maturing this week. So, I'm going to want so many of your three month bills and so many of your seven years and so on." The Treasury just makes a note of that and says, "Okay yeah. After the auction, we're going to give you that."

Beckworth: No. I think that-

Stella: So, when you look at so to speak, the demand curve at the Treasury auction, the Fed is not there. The Fed is what we call-

Beckworth: Right.

Stella: So, I'm pretty optimistic and I'm thinking, if the market is voluntarily sanguine enough to lend you 30 years at these rates, I say, go for it. If you start running into resistance, you back off, but talking with the market. This is not-

Beckworth: No, this is good. This really in my mind has clarified the issue. Because, I was thinking just in terms of the short term crisis, but ultimately from a consolidated balance sheet view and time-wise, the government can refinance how it does its operations after the crisis, and we can finance with long-term debt. So, that's a great point.

Stella: There was one thing I did want to say that I think maybe I've been avoiding in some sense the whole time, and this is your off balance sheet question. I've been talking mostly about the relations between the Fed and the Treasury and this kind of thing. It's very, very important to accept that, when the Fed is taking claims on the private sector, it is acquiring an asset and it is paying for that with reserves. If we consider that from a consolidated basis, which I think we should, as equivalent to a US Treasury debt, we're not capturing that in the statistics, okay?

Beckworth: Okay.

Stella: We count Fed reserves as part of US Treasury debt. That comes back a little bit, I think you mentioned at the beginning. When central banks issue debt, I saw this many times, going back in the 1980s, analysts would have a big kind of crimp in their brain, "Do we count the central bank's debt as part of public debt or not?" I think if you look at it properly, the answer is obviously yes. When you have the US Treasury buying mortgage backed securities in 2008, it was financing by issuing debt. It was under a program whose name escapes me at the moment, but Congress approved that program.

Beckworth: This is the Supplemental Financing Program?

Stella: No, this was under the Bush administration.

Beckworth: Oh, Bush administration, okay.

Stella: The titles of these laws are always politically nice, like supporting the US homeowner or something. But actually, what the Treasury was doing was buying agency debt, and mortgage backed security debt before the big crisis in 2008. But, this was under a law. Congress had to approve it. The Treasury secretary was under an obligation to report to Congress about using the money. There was a limit on it set in the law. You couldn't go out and buy as much as you wanted. Of course, the debt that Treasury was issuing was subject to the debt limit.

Stella: Now, the really bizarre thing if you put these two programs side by side is, then come to the end of 2008, or beginning of 2009, the Fed starts buying mortgage backed securities and agency debt. There's no law saying the Fed should do this. There's no real requirement that the Fed should report to the Treasury minute by minute on what it's doing. Eventually, Congress made the Fed do this, but not at the beginning. Absolutely, there was no limit on how much the Fed could buy. There was no limit on the amount of reserves the Fed could create. In other words, no subject to the law that governed.

Stella: To make it even more ironic, at the beginning, the Fed was actually absorbing the reserves that it was creating to buy mortgage backed securities, by selling treasuries to the market. But, when you think about it, this is exactly what the US Treasury was doing. Exactly. Selling treasuries to the market to finance the purchase disasters. So, all that activity, that was on budget under law subject to congressional approval, subject to the debt limit. When the Treasury does it, it was not approved by Congress, not subject to the appropriation process, the debt being issued wasn't subject to any kind of limit. Let's face it, that makes no sense in the end. So, this is... Dodd-Frank tried to limit what the Fed could do there, but you would need something more dramatic to really keep this very clear.

Stella: In other words, I'm not... When you do the consolidation of money creation by the Fed buying treasuries, this becomes an issue of debt management, how you do financing. I don't want anyone to think that I'm implying that's the same when the Fed is doing all these other things. That's really what we should be worried about in the long run. We don't have a good record on that, I'm speaking of the United States here, in that in 2009, the Fed and the Treasury issued a joint statement about how they should be doing their respective roles.

When you do the consolidation of money creation by the Fed buying treasuries, this becomes an issue of debt management, how you do financing. I don't want anyone to think that I'm implying that's the same when the Fed is doing all these other things. That's really what we should be worried about in the long run. We don't have a good record on that.

Stella: It's a one pager, the penultimate bullet point says the following. "When budgetary circumstances permit, the US Treasury will take the Maiden Lane facilities off the balance sheet of the Fed." That was the right thing to say, it's absolutely the right thing to do, but you know what? Never happens. That wasn't a big amount of money. The proper way, in other words going forward in my scenario is, "Okay Fed, you created these LLCs and da, da, da. You had to do it. But at some point, the Treasury buys them from you, takes it onto the Treasury balance sheet," which has happened in other countries. It's happened in Sweden, happens in the UK, other countries. The US said it, didn't do it-

Beckworth: This is the... Sorry.

Stella: That's coming back to this. It's a repeat game.

Beckworth: Yeah. This is also the-

Stella: There'll be another crisis and-

Beckworth: Yeah.

Stella: ... Hey, it's really important I think, that you do the right thing. Not immediately, at the right time. You do the right thing at the right time. Next time, people are going to remember. Maybe not too many people remember what I just told you, and maybe it wasn't good for me to remind people of that, but it's a fact. A lot of countries have promised to recapitalize their central bank, they haven't done it.

Beckworth: This was a big part of our discussion in the last podcast. So, I encourage listeners to check it out, where we spend a lot of time talking about who should be managing the public debt of the US. Should it be the US Treasury or the Fed. This really helps us see that the importance of the Treasury taking that responsibility. Well with that, our time is up. Our guest today has been Peter Stella. Peter, thank you so much for coming on the show.

Stella: Thank you David.

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