Will Bateman is an associate professor and associate dean of research at the Australian National University College of Law. Will has recently authored a paper titled, *The Fiscal Fed,* which takes a close look at the Fed’s fiscal functions during the two World Wars, the Great Depression, the Cold War, the global financial crisis, and the COVID-19 pandemic. Will joins Macro Musings to talk about this paper, the origins and evolution of the Fed, the implications for policymakers, and a lot more.
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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: Will, welcome to the show.
Will Bateman: Thanks, David. It's really great to be here.
Beckworth: Will, it's great to have you on, and I discovered your paper on Twitter, now called X. I believe some of my common friends, probably your common friends, promoted the paper. I love the title, *The Fiscal Fed.* For some, it'll be very provocative, but I think what you do in the paper is a great exercise in dismantling an illusion of this independence of central banks. There's always going to be some underlying connection to fiscal policy.
Beckworth: You do a great job with the history, it's fascinating. I learned a lot of things about the facilities, the Fed's work, and how the Fed and Treasury were closely interacting for many years. We'll get to all of that in a bit, but tell us about this paper. You're over in Australia, and it's a great paper. Again, I encourage listeners to read it. We'll provide a link to it in the show notes. How did you get into the history of markets, of legal structure, in the US?
Bateman: Well, thanks, David. It is a bit odd for someone with my accent to be expounding in great detail and at great length on the history and contemporary practice of money and monetary authorities in the US. I consider myself a central banking scholar and a scholar of sovereign debt markets, and I study the ones that really matter. I study the monetary hegemons, they're called, the reserve currency issuers, which are, in one sense or another, the rule-makers for the globe, not just for the domestic economy.
Bateman: Of course, they're the Fed, the European Central Bank, the Bank of England, Bank of Japan, and, increasingly, the People's Bank of China. So, I've got papers out, and I continue to research and collaborate really closely with people and on all of those jurisdictions. The Fed is a natural target because it's the world's central bank, in some sense. But also, for someone who's really keen to understand all the intricacies of the Treasury and the central bank relationship, the Fed offers a unique opportunity.
Bateman: On the one hand, the literature is incredibly threadbare in the US in terms of exactly how the Fed operates as a government bank, not just a banker's bank, which is a point I make in the paper, but also the availability of transcripts in the Federal Open Market Committee deliberations is unparalleled. The degree of transparency, actually, in central bank deliberations, but also Treasury desk operations, is just a treasure trove for an academic and a scholar like me, so the Fed was a natural target for my interest.
Beckworth: Well, we'll provide a link to your web page and your other articles on central banks, but let's jump into this article. Maybe give us the executive summary before we jump into the specific sections of the paper.
An Executive Summary of *The Fiscal Fed*
Bateman: Yes, okay. Well, the executive summary, and this is, I must say, a really big paper, so I'll do my best with the summary, is that current scholarly and policy treatments of the Fed fail to acknowledge or systematize the really well-established fiscal supporting function of the US central bank or the US monetary authority. This means the conventional understandings of the Fed as predominantly a private market stabilizing institution are only partially correct.
Bateman: The paper examines the way that the US has used public monetary authority, whether it's through a central bank system like the Fed or through a statutory bank-chartered system like the national banking system, as a form of fiscal support throughout its history, essentially from foundation onwards, and focuses particularly on moments of crisis, the war funding for the First World War, the Great Depression, Reconstruction, World War II, Cold War financing, then the global financial crisis and COVID-19 pandemic.
Bateman: The paper looks very closely at ways, using internal Fed documents and a relatively granular examination of Treasury market operations, to show that monetized support for fiscal power at those particular points in history was really critical to state survival. The paper has this sort of descriptive component, but then it also attempts to relate that very long history of monetary-fiscal coordination to some very high-level ideas of central banking independence and the idea of the need to separate fiscal and monetary authorities to avoid inflation and inflation management.
Bateman: The paper is not an MMT paper. MMT people get very angry at me on Twitter. On some level, that's a badge of honor. On another, it's an indication that I'm not an MMT scholar. Obviously, the paper acknowledges that the fiscal support provided by the monetary authority, particularly in fiat currency regimes, has enormous risks, but it attempts to systematize and theorize the circumstances in which monetary support, ultimately debt monetization, has historically been important, significant, and has benefits that outweigh the costs.
Beckworth: Yes, your paper is very timely. I just want to briefly get into a few of the issues, and then we'll jump into specific historical episodes you go through. Just the timing, I think, is great because, right now, we're having a conversation about problems in the Treasury market, liquidity challenges. We saw some in 2008, 2020. There's potential strains now. A lot of discussions have been had recently over what we can do to improve functioning of the Treasury market.
Beckworth: I think there's this growing awareness that the Treasury market isn't this panacea of tranquility and soundness. There's a lot of work to be done, and more importantly, as it relates to your paper, that there is a connection between the Fed and the Treasury. I think your paper is timed greatly, and it's going to speak to some of these issues. Let's talk about the origins, the history of the Fed, relative to some other central banks because I think that illuminates a lot as well, how the origins and the evolution of the Fed may be two different things.
The Origins and the Evolution of the Fed
Bateman: In some sense, they are. The Fed, unlike almost every other central bank that you can find in the OECD, was not created to fund a war and was not created overtly to fund the US government. In fact, as the paper acknowledges, the war funding arrangements for the Civil War created, in many respects, the inelastic currency, which was a part, or a contributing factor, to the various financial panics at the end of the 19th century and beginning of the 20th century, which stimulated the Fed's establishment as a kind of private market stabilization tool. The Fed was obviously not established to do what we would consider to be broad-spectrum monetary policy today.
Bateman: It was built to do something like lender of last resort, something like security market smoothing in the face of monetary scarcity at the end of the 19th century, start of the 20th century. That's very different to the Bank of England, to the Bundesbank or the original Riksbank, to the Bank of Amsterdam. A lot of the old European central banks were created very forthrightly to fund the government. The Fed was not deliberately designed to do that. However, it did begin, it did start to do that. It began to follow the playbook very quickly, and the paper expands upon that in exhausting detail.
Beckworth: It's a fascinating history. For those who love the history of central banking, it's fun to go back and think about it. For example, the central bank of France was founded by Napoleon. What a great story that is, there's a Napoleon movie coming out here pretty soon. For those of us who watch the movie, we'll be looking for any references to the central bank of France in it. But, the Bank of England was tied to the war being fought between William III against Louis XIV of France. There's lots of rich history tied to the creation of these institutions. As you note, the Fed was created more to create elastic currency and financial stability. Maybe, let's go back just a little bit more to the founding of the nation. I think some of this tension, confusion, or even the illusion of separation can be tied to our founding because Alexander Hamilton really did not want to finance government debt with money creation. That was the original intention.
Beckworth: Then as you outline in the paper, reality hits up against the wartime needs, and then we have the First Bank, the Second Bank of the United States, and then probably the biggest manifestation then is the Civil War and the National Banking Act. Let me make a case here that even though the Fed is not directly the creation of a war, it's indirectly a creation of the war. I'm going to make the link between the Civil War and the Fed, which you just touched on, and that is, the Civil War led to the creation of the national banking system, which created a captive market for the government debt. That same system also created the financial instability you just referenced, right, which then led to the creation of the Fed. So, you can trace a line from the Civil War all the way to the creation of the Fed. Now, of course, there's a lot of detours and other things happening along the way. So, maybe a counterfactual would be, would the Fed have been created had there been a different system at the Civil War? Who knows?
Bateman: Well, who knows? The fascinating thing is that right from the Second Bank of the United States, 1816 to 1836, you have the Supreme Court of the United States justifying the existence of a central banking system as a fiscal necessity. McCulloch v. Maryland, an 1819 decision, which ultimately underpins the constitutional validity in the US of the Federal Reserve, which was a case about the constitutional validity in the exemption from state taxation of the Second Bank of the United States, the ultimate legal foundation for that is as an essential and necessary part of the fiscal apparatus of government. Now, there's enormous problems with reading terms like "fiscal" and "monetary" back 200 years because they blur and they shift together, but what was clear is that the Second and the First Bank of the United States operated on a relatively similar basis as the Bank of England. Not identical, but similar conceptually at the time, which was to provide a kind of credit intermediation at scale for the national government.
Bateman: Those banks lent a lot of money to the US Treasury and they also discounted bills and advanced cash out to the private market. There is this much deeper history, quite poorly understood. The records are lost, so if you try and do a very deep dive into the First and Second Bank, you're going to come up against burnt and moldy and ultimately lost financial records, which doesn't help things, but there is this longer history all the way back.
Bateman: Of course, as you quite rightly said, the critical point for the history of the Fed is 1863-1864, the Civil War, because that's when you do get this first massive wartime financing drive, which is built quite clearly on continental and American precedence of using a competitive group of financiers to lend money to the government with an interest rate, sort of spread harvesting, if you like. They lend money to the government for an interest rate.
Bateman: The government gives them the authority to issue a government-backed currency, the National Bank notes, which don't carry an interest rate. The national bank send those notes out into circulation, lend money to the government, and collect the spread between the two. That was an incredibly successful war-financing measure and ultimately less inflationary than raw money printing, which was tried at the same time, but we all know how the greenbacks ended.
Beckworth: So much fascinating history there. I wanted to spend time on two more things, and then we'll move forward to more recent history. Number one, the Second Bank of the United States, I think, probably a lot of listeners know about the Bank War that President Andrew Jackson… he brought to bear on that Second Bank. Nicholas Biddle was the president. He was viewed as an elite, out of touch, East Coaster, and Andrew Jackson is the people's man, populist.
Beckworth: What's fascinating… I think when I look at that, I see that original strand from the founding of the nations, worried about money being excessively created and funding government. Come to the present, you still see some of that. We saw some of that after 2008, Ron Paul with “end the Fed.” Then even today, and this may just be campaign rhetoric, but GOP presidential candidate Vivek Ramaswamy talked about-- he would make the Fed an election issue, which has echoes of the 1832 election and Andrew Jackson making the Second Bank an election issue.
Beckworth: I think you see this unique flavor or culture of American politics running through our history with the central bank and Treasury connection. One other interesting observation, you mentioned the period between the end of the Second Bank and the Civil War, and you note in your paper, that's the independent Treasury period. If I remember correctly, and correct me if I'm wrong, wasn't the Treasury doing, effectively, open market operations from time to time? Effectively, the central bank and the Treasury were one institution.
Bateman: Indeed. Yes, indeed. It's very, very hard to run any kind of sovereign state without something like open market operations at some point. It's a point I make later on in the paper, the demands for sovereigns, for finance, and the supply and demand dynamics in sovereign debt markets can get so lumpy and so volatile that if you don't have a monetary authority doing something like open market operations, you very quickly run up against sovereign defaults, and sovereigns don't like to default.
Bateman: So, yes, in the independent Treasury period, you see something like market smoothing operations through asset purchases, debt repurchases. I query whether or not they're fully analogous to what we see today. Although Friedman and Schwartz, of course, in A Monetary History of the United States, that incredible tome, that provides a really good analysis of Treasury open market operations immediately before the Fed's creation, sort of 1909, 1912. If listeners are keen to dive back into the monetarist history, that's the place to do it.
Beckworth: Okay, so fascinating. Well, let's move forward in history and in your paper. Let's talk about the early creation of the Fed. We already touched on it. It was created more for the elasticity of the currency, but not long after it's created, we have World War I. Start walking us through the history, World War I, Great Depression, World War II. What's happening there that makes that linkage transparent and clear?
The Early 20th Century Fed: World Wars and the Great Depression
Bateman: Well, this was the period when The Fiscal Fed is birthed. The part of the paper is called “The Birth, Growth, and Hibernation of The Fiscal Fed.” The Fed is created in 1913-14. By 1917, World War I is happening. And that’s… I think it's April 1917, is the first direct line of credit from the Fed to the Treasury. $50 million of sovereign debt bought by-- I think it's the Federal Reserve Bank of New York, but I don't have the paper in front of me, and the money is used by the Treasury secretary to buy the Danish West Indies, which then become the US Virgin Islands. This initial injection of Fed credit actually adds to the total sovereign territory of the United States during wartime. The agreement to purchase the US Virgin Islands from Denmark was secured just before the Fed credit was injected. It seems from my analysis of the balance sheets, that was necessary to complete the purchase on time.
Bateman: So, there was an issue of default interest having to be paid to Denmark if the purchase wasn't completed. The credit provided was highly concessionary. It was about 100 bps below market rates, then prevailing in the secondary market for US sovereign debt, and there was great protest from the governors of the Federal Reserve and also the Federal Reserve Bank of New York's subscribers on the basis that this was essentially coercive credit being provided, and there was a formal protest made on that ground. This is, I think, an extraordinary episode. It shows your point, David, that there is still this link with war financing, because as soon as conditions become sufficiently grave, the fiscal-monetary boundary dissolves. All of a sudden, even the Fed, which wasn't created as the Bank of England was and the Bank of France was, even it becomes a tool of the Treasury.
Beckworth: Yes, so fascinating, again, to think through those experiences. You also discussed the liberty bond purchases or, I guess, indirect financing through the Fed?
Bateman: Which is, in many ways, the far more economically momentous example of fiscal backstopping by the Fed. About four or five months after the U.S. Virgin Islands get bought, the liberty bond drive commences; of course, the largest sovereign debt drive in United States history by many orders of magnitude. The Fed is a critical part of the infrastructure of the liberty bond financing, particularly their success. A program is run by the Treasury and the Fed and the big banks in New York called the borrow-to-buy or borrow-and-buy program. The basis of it is that the Fed will offer you short-term and medium-term credit at a discount to the prevailing price or the prevailing yields for liberty bonds in the primary market. The Fed very consciously at the Treasury, not the Treasury direction but with the cooperation of the Treasury, sets its terms of borrowing to a concessional level in order to inject as much demand as possible through the major banks in New York.
Bateman: But also, actually, it's not just New York banks at this point, it’s also banks across the United States, into the Treasury coffers for the liberty bond purchases. For people who are particularly into the details of this, you could borrow from the Fed at 3%, and you could buy a Treasury bond paying a 3.5% coupon and collect the spread. You could discount your 3.5% Treasury bond once you had it at your reserve bank at 3.5%. Essentially, your cost of monetizing your debt as a debtholder was completely neutral, and you had a positive incentive provided by the Fed to subscribe to Treasury debt in the first place. The quotes are in the paper. The Treasury, Fed, politicians, financiers are unanimously of the view that they couldn't have completed the liberty bond drives without this ongoing concessional credit from the Fed. Hence, the reason why they were walking around saying, "Borrow from the Fed, buy from the Treasury."
Beckworth: Right, so the Fed's indirectly supporting this liberty bond drive.
Bateman: They are indirectly supporting it but intentionally. This isn't as though there's a monetary policy lever set, the optimal discount rate, or the optimal advance rate for financial market conditions in Chicago or New York is 3%. No, the yields and sovereign debt was set by congressional legislation. The Treasury and the Fed governors get together and they say, "Okay, the coupon rate is set at 3.5%. What do we need to offer in terms of the cost of our credit to induce people to buy Treasury bonds?" It's that subtly different point. It is indirect, yes, it is, but it's also intentional federal support.
Beckworth: How important was this effort during this time in creating the US dollar as the main reserve currency of the world? Because historians say, it's during World War I, maybe after World War I, that the UK and the British pound goes to the side and the dollar emerges. I think Barry Eichengreen has argued, the Treasury bill market becomes real important also. Is this part of the story going on during this time?
Bateman: Yes, that's a great point. I defer to Barry Eichengreen on all matters concerning the internationalization of the US dollar. So, yes, this is a part of that story, basically because the deep and liquid markets in US risk-free securities, government securities, couldn't have been created or at least perhaps, counterfactually, they could have been. Historically, factually, they couldn't have been created without this central bank support. The best work on this, it's not quite as eye-catching as Barry Eichengreen's work, is Kenneth Garbade's work, an exceptional book called Birth of a Market, the history of the US Treasury's market.
Bateman: Then another book of his is called After the Accord, which are almost transaction-level, historical analysis of Treasury debt issues, if you like, the development of the primary dealer system and the role the Fed played in developing both the primary dealer system and the deep and liquid markets in treasuries. Of course, Kenneth was a Fed Reserve Bank of New York research economist for about 25, 30 years, so he's in a good position to be a deep authority. Perhaps, he does have a different accent to me and a very deep authority on these questions.
Beckworth: No, he is a great author. I guess you could say his books are the equivalent for the Treasury market history of what the monetary history of Friedman and Schwartz are for the monetary history in terms of, with all due respect, dry, tedious but thorough reporting of what actually happens.
Bateman: It's the challenge for all authors in this field, is to write about this material in a way that doesn't make people go to sleep because it's fascinating, but in order to get to the meat of it, you have to dig through a lot of dry material.
Beckworth: Well, you do, you succeed. Again, I encourage listeners to read the paper. It's a fascinating discussion. Again, just to summarize the importance, World War I does two things we can summarize. One, it knocks the UK down and the sterling as the reserve currency of the world, but it also builds up and tells the world, "There's this new market that you want to get into," but it wouldn't have happened absent the war. Well, I guess some other counterfactuals, you said, could possibly emerge, but the history we see is that it took this catalyst, World War I, to make the dollar the reserve currency of the world for multiple reasons. Okay, let's move forward to the Great Depression. Let's talk about several things that happened there. You note that there's initial QE during this time, I think relatively small QE, but there's a QE. There's also direct financing. Walk us through what's happening.
Bateman: This is a critical period. From 1932 to 1936-37, so much about the institutional practices, the bedrock of the way the Fed and the Treasury continue to view their relationship, are laid down. It starts with, of course, the banking crisis, the Reconstruction Finance Corporation, and the election of FDR. I don't think on this channel, I need to explain that there was a banking crisis in 1932. There was a banking crisis in 1932, right?
Bateman: The pre-FDR solution to the banking crisis was about recapitalization of banks, reliquification of financial asset classes that were used in the wholesale money market, and the government backstop in that process was supposedly the Reconstruction Finance Corporation, which was designed to essentially inject liquidity by buying dodgy assets or buying asset inventories from these distressed banks, which are going out of business at a rate of, what is it, 30 a week or something at one point in 1932.
Bateman: It's established by legislation, reconstruction finance, debt security. It's initially financed by a fiscal injection, but there isn't a lot of money in the Treasury in the '30s. Then the Fed begins buying US Treasury securities, so the Treasury has funds to inject into the Reconstruction Finance Corporation, which I guess is a little bit like a bank rescue or a financial rescue, special-purpose vehicle at that point. FDR gets elected, and there's the demonetization of gold, there's the banking holiday, and there's this sort of hard reset on the financial system in the United States. Concurrently with that occurring, the Fed begins unlimited QE. The QE is sometimes explained as quite small. The Treasury asset purchases in some of the literature in the 1930s is explained as quite small compared to what happened in 2008 and 2020.
Bateman: Query to whether that's so, what matters to market participants is that they're unlimited. What matters is that there's an unlimited guarantee. Dealers will always have a downstream buyer of securities they buy at primary market from the Treasury. What you see coming out of the Federal Open Market Committee in 1932-33 are these unlimited guarantees by the Fed to stand behind the US Treasury market. The amount of securities purchased may be lower, but the promise, which is, again, what matters whether you're a rational expectations theorist or just a bond trader, that's what matters, is there. Essentially, this QE program is understood as one of the stabilizing factors, along with gold demonetization, along with the FDIC, along with the bank holiday process that actually prevents the nationwide collapse of the financial system. And then, that's, if you like, the Minsky cycle QE in 1932-33.
Bateman: Then what happens is the Reconstruction Finance Corporation under FDR becomes a New Deal financing vehicle. This is explained at much greater depth in the paper. I know I'm not the first person to write about this, but I may be the first legal wonk to write about this. So, all the legislative authorities are there. The way that the Reconstruction Finance Corporation ended up being indirectly funded by the Fed is detailed in the paper.
Bateman: Of course, that financing vehicle is used by the government for pensions, military expenditure, housing purchases, infrastructure funding. So many of the first and second New Deal and then post-war state development measures are ultimately funded by the Reconstruction Finance Corporation, which is indirectly funded by the Fed. That form of QE has both-- or fiscal support, if you like, has the financial market rescue component, which is very well-detailed in Friedman and Schwartz. Then there is this later developmental state backstopping function occurring with LSAPs from 1933 right through to 1947.
Beckworth: There's both direct purchases of treasuries as well as financing supporting the Reconstruction Finance Corporation. The Fed is actively involved there. On the '32-33 QE experience, if we can call it that. I'm sure back then, they didn't call it QE.
Bateman: No, they definitely didn't call it that.
Beckworth: I referenced it being relatively small, and I guess, just to be clear, I think your point is well-taken. The message it sends, it's a signal. I dare say, it's another reason why the world begins to trust the Treasury market, right? You have the World War I story we talked about. Now, here's the Great Depression. The Fed again is signaling, "You can trust this market." I think that's an important point.
Beckworth: I guess my point was relative to the subsequent inflows of gold that led to a huge increase in the monetary base… If you look at the monetary base, so the Fed buys up these treasuries on the asset side, the liability side of its balance sheet, you see the monetary base grow. You can see a spike. Clearly, there's a spike there. It comes back down eventually, but what you see is when the gold flows come in from people freaking out about Hitler in Europe.
Beckworth: I just recently learned also that Joseph Stalin started mining lots of gold. Between the two of them, large amounts of gold flowed into the US, which then supported a monetary expansion, which in turn helped support recovery along with all the other things that you mentioned. I was referencing more like a size on the graph, which is really a trivial point. I think your point is a more important one. Is this the signal it sent?
Bateman: Look, it's useful to remember that in 1931-32, the gold standard collapses in its country of origin. Of course, across the Atlantic, the gold is demonetized in a day during this incredible fiscal crisis when there's threats to mutiny in the Navy because Navy servicemen aren't getting their pensions or their salaries paid. And the gold standard suddenly disappears in its country of origin. The psychological shock to markets was extraordinary.
Bateman: I suppose one of FDR's geniuses was that gold was largely demonetized in '33 in the US, but there was enough sophisticated financial stabilization that despite the Wall Street crash and despite the Great Depression, markets continued to function in some reasonable sense through the 1930s. For the high-value investor community, that sends a very important signal. It's also worth mentioning in the paper that this idea of disorderly markets is first set out as a kind of reaction function within the Fed in the 1930s. Of course, this is under Eccles. Eccles would be considered a deeply heterodox economic thinker today, but also, potentially, a deeply heterodox financial market actor. But even today, at the beginning of the COVID crisis throughout the financial crisis, during the examples of QE that I referenced in the paper in the '70s and the '50s, the Fed says, "Look, we are reacting to disorderly Treasury markets. We have historical precedents that when there's disorderly Treasury markets, we'll step in to stabilize them."
Bateman: That idea of what a disorderly market is— and there's enormous dispute within the Fed about whether you can have a disorderly market, if supply and demand moves sufficiently out of whack, that treasuries are very cheap or very expensive on any particular day… such is life. That's the market. Of course, the Fed will move in to control prices and control yields. And in 1936, the Federal Open Market Committee set out a series of criteria about when they think markets will be disorderly and what they'll do when money and Treasury markets become disorderly. That essential criterion hinges on the idea of stabilizing the Treasury's revenue and also the importance of consulting with the Treasury.
Bateman: If I can just quote it, “it's the duty of the reserve system to determine at any point of weakness in the Treasury market, whether it is sufficiently disorderly to justify intervention. At times of disturbing weakness, when intervention is justified, it appears desirable to consult with the Treasury, indicating the intention of the committee to operate in the market and its willingness, A) to make all necessary purchases, this is of Treasury bonds itself, to operate 50/50 with the Treasury or to keep out of the market entirely in case of the Treasury expressing a desire to make all purchases itself in order to employ funds, which may be on hand for investment.”
Bateman: What's so interesting about the 1930s is also there's this commitment within the Fed to do things which would be considered in the European Union, for example, illegal, under their separation of fiscal and monetary rules. Also, this idea of what a disorderly market looks like continued to be important today but was set at a time when the Fed saw its duty as supporting stability in sovereign debt markets, which I think is a really important thing, which is still a part of internal Fed discussions, it's clear, but is lost in the external policy analysis.
Beckworth: Something else that happens during this period, and you bring it up, is the Treasury gets this security drawing authority. I believe it starts in 1942. I actually became aware of this back in 2019. George Selgin wrote a blog post where he talked about this. This apparently had to be renewed every few years and it continued all the way up to 1981. A legacy of this period is that the Fed and the Treasury could directly connect and the Fed could finance the Treasury directly up until 1981, which is mind-blowing. Walk us through that facility. Was there limits on how much the Fed could finance or conditions surrounding it?
Breaking Down the Security Drawing Authority
Bateman: It is. It's such an interesting point. Of course, completely normal in many central banking systems to have direct overdraft facilities between the central bank and the Treasury, but it was an emergency measure in the United States, and it was subject to various quantitative limits, so five billion during most of World War II and then it sat at that level through most of the post-war period. This was a direct credit facility between the Fed and the Treasury. Of course, five billion is a very large figure from 1942 until 1981. It's not trivial. It's trivial today. And critically, these were entirely bilateral overdraft facilities. It wasn't as though the Fed was given permission to bid Treasury auctions. It already had that facility. These were entirely bilateral credit transactions between the fiscal and the monetary authority. I've actually got a graph, I've gone through all of the annual reports of the Treasury and the Fed following Kenneth Garbade's excellent work on this.
Bateman: And there's a graph… for people who want to see it, there's a graph in the paper that actually outlines the points in time and the years when this facility was used, and it relates them to major fiscal receipts. Because if you compare these direct credit facilities to GDP or to gross debt or net debt, eventually they start to look ridiculous. But, when you compare them to excise duties, when you compare them to corporations' tax or certain kinds of individual income tax, all of a sudden you realize that the Fed, through these direct credit facilities, was providing material financial accommodation, at least on the liquidity front, to the Treasury through most of what's called the golden years of capitalism, and then, of course, significantly more in the stagflation years leading up to the Volcker shock.
Beckworth: Yes. It's neat to see this facility, if you want to call it… what do you call it? Do you call it a facility or just a credit…?
Bateman: Yes. Let's call it a facility. Technically it's just a statutory authority to make direct loans, but let's call it a facility. Yes, I think, legally, it was structured as buying and selling of certificates of indebtedness as opposed to an overdraft facility.
Beckworth: In terms of today's language, [it is] a facility, but I think maybe one way to think about it would be the equivalent, today, of allowing the Treasury to run a negative balance on its TGA account at the Fed, which would be one way to get around, for example, a debt ceiling or something like if it were still legal. It's just so fascinating and George Selgin brings it up as a potential solution to something like 2019. Again, maybe you put some caps on it. I would hope if it ever is enacted by Congress, it would be some mechanism to… some small percentage of GDP or inflation adjustments over time, it would grow. I remember during this period when George was talking about this, someone from Canada emailed me and mentioned they already do this in Canada. Maybe they do it in Australia as well, but a small portion of the public debt can be bought by the central bank.
Bateman: Yes, that's right. It's actually really common. I've got a paper called, *The Law of Monetary Finance* in the Oxford Journal of Legal Studies where I look at the UK, the US, and the Eurozone, but also the Bank of Japan and the Bank of Canada just quickly in terms of these kinds of overdraft facilities. I mean, the Bank of England has always had one. It's called the Ways and Means Advance and the Treasury has had that sort of overdraft facility in the UK forever.
Bateman: At various points, it's activated to essentially stop defaults in the short-term government debt market, because there have been various points where there is just no money coming in and a lot of money going out, particularly in 2008-'09 and without these kinds of overdraft facilities, particularly when the market mechanism breaks down, when the dealer system starts to come under enormous stress, is just necessary for the effective operation of the system. I think that's the 2019 George Selgin analogy right there.
Beckworth: Yes. Once again, the US is unique here. Going back to the history of following that rich tradition where we're, I guess, leery of bad behavior emerging, fears of inflation… once again, it's manifesting itself. One other thing from this period, Great Depression, World War II period: yield curve control. This leads us up to the Fed Accord. You're from Australia. The Reserve Bank of Australia did a form of yield curve control not too long ago, so you know it firsthand. Walk us through that. What did we learn from that experience?
Learning from the Yield Curve Control Experience
Bateman: This is, of course, the large-scale asset purchase program that happens during the Second World War and after the Second World War. In many ways, it, operationally, is very similar to the financial crisis and COVID-19 QE programs. The only difference is the communications strategy. Those programs are not explained as yield curve control. They're not explained as capping yields in sovereign debt markets. They're explained as aggregate demand stimulus programs that operate through a number of channels.
Bateman: Operationally, very difficult to see a difference between… obviously, there was no Fannie Mae, Freddie Mac in 1940, 1942, but there was an enormous supply at the Treasury desk and very little, very patchy demand from the financial sector. The paper just steps through… I mean there's other very good histories on this, but what the paper tries to do is step through both the short and the long end of the Treasury curve programs that were run to supply the US war effort with funds. It goes through a very deep analysis of the transcripts of the FOMC, where the Treasury is often in the room and explaining, "If you don't cap yields at a particular level, then we won't have purchases to buy our bonds." That's a negative for the war effort. Of course, this led to all these enormous distortions in the Treasury market and it led to excessive speculative arbitrage in the fixed-income market and the bond trading market. And so, there were all these, if you like, negative consequences of capping yields during World War II and immediately after it.
Bateman: What's interesting from the paper's perspective is that, and this is contrary to a number of economic histories on it, there's at least two reasons why the Fed and the Treasury explain these programs, the yield control programs, and one is demand management. The other one is inducement of fiscal support, debt monetization. The other one is, look, we're doing a version of what we did in World War I to ensure that Treasury markets remain deep and liquid and that there's guaranteed purchases of Treasury debt and guaranteed funding for the US Treasury during these moments of crisis. There's also a broader macroeconomic objective of a stimulus in a wartime economy. I think that what I've tried to do in the paper is really bring out both of those two objectives, which are often there, but then not in the participant's own language. Of course, this leads to the worries about debt monetization, inflation, economic underperformance that leads to the 1951 Accord.
Beckworth: Alright, let's move forward for the sake of time to the '50s and the '70s. You note an experience in 1958, I believe in 1971, where there's interaction going on. Walk us through those experiences.
QE in the Cold War
Bateman: These are QE, I call it QE in the golden years of capitalism. It could also be QE in the Cold War. 1958 and 1970 are really striking moments. '58 is when Eisenhower sends troops, US troops, to Lebanon. 1970 is Nixon sending troops to Cambodia and then the Kent State shootings. Both of those announcements, those wartime measures, coincide with big Treasury refinancing operations. They coincide with a really significant balance sheet, significant refinancings. In both '58 and '70, there's just no bids.
Bateman: The Treasury at this point goes out to market and says, "Here's our offering circular for X amount of refinancing debt." If they don't get the debt, it's a default, and there's very few private bids. It's a full-on sovereign debt crisis. In both '58 and '70, there are, again, these unlimited promises by the Fed, implemented in transactions, to purchase unlimited amounts of US Treasury debt on the secondary market to prevent the refinancing's failure. There's also, in both of them, significant drawings on these direct credit lines. The Fed actually says, "Look, we can directly lend some money, but we'll also stimulate secondary market demand by doing a lot of secondary market purchases to make sure that these refinancings don't fail." Now, this is important because both of these events occur many years after the accord, which is often understood to be this very sharp moment in US economic history of separating the Treasury and the Fed, the fiscal and the monetary institutions.
Bateman: But if you look at the terminology of the accord, it's actually quite gentle, quite dovish in terms of what it requires. It's occupied a much sterner place in people's minds as the years have gone on. But the wording of the accord is that, quote, “the Treasury and the Federal Reserve have reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose to assure the successful financing of the government's requirements, and at the same time to minimize monetization of the public debt.” So, the accord is not Article 123 of the European Treaties that require this absolute severance of these two institutions, and absolute prohibition on monetary financing. It's actually quite accommodative, and the episodes in '58 and '70 are examples when the Fed essentially did targeted QE to support the Treasury to prevent failed refinancings, and a failed refinancing is, of course, the first step on its sovereign default, and will probably, almost probably, consistent with the terminology and the intention of the accord.
Beckworth: So, the Fed Accord of 1951, to some extent, its understanding has been overstated in terms of what was actually accomplished, maybe some norms were set up, but what you illustrate is that 1958, 1971 shows how quickly those norms can be broken. If push comes to shove, if there's a potential of a sovereign market meltdown, then the Fed will step in. I think that's a useful reminder, we'll come back to this in a few minutes, that if we go into war, and there seems to be a lot of war right now, sadly going on around the world, if the US is forced into conflict, we may come up against this reality again, this illusion that somehow the Fed can just do its own thing on an island, is that an illusion? It's a product of what is happening around it. Let's use that to segue into the period in your paper that you call the anti-fiscal Fed. I like this, because the time period you mentioned for it is 1981 to 2007. As a macroeconomist, I have another term for that period, the Great Moderation. I think there's some important overlaps between those two terms.
The Anti-Fiscal Fed Period
Bateman: Absolutely. Of course, Volcker didn't just shock the general economy, he shocked the Treasury market too. The gigantic increase in interest rates to try and milk this persistent inflation or squeeze this persistent inflation out of the economy in the early '80s, that had an impact on Treasury borrowing costs, a huge impact on Treasury borrowing costs, I think intentional. Volcker did several things to sever the accommodative passages between the Fed and the Treasury. One was to not renew or not support the renewal of these direct credit lines that we've talked a little bit about, so they disappear at the same time Volcker assumes control of the Fed.
Bateman: And of course, this gigantic spike in borrowing costs at the Fed and in the general economy also impacted the Treasury. So what I call the anti-fiscal Fed is also driven by a series of economic scholars very familiar to people. Buchanan, Sargent, Kagan, Wallace, these titans of the new classical tradition, did some really incredible work on the relationship between central bank support of the Treasury and price stability, looking particularly at post-war examples of Europe hyperinflations.
Bateman: And there are these major papers, which I look at in my paper, which were clearly influential on someone like Volcker and influential on the institutional practice of the Fed to step back from, in that pure central bank independence fashion, a supporting role with the Treasury. That's why it's called the anti-fiscal Fed just because it's when, what David's been calling this illusion, that the Fed sits on an island and thinks about the general economy completely separately to any considerations occurring at the Treasury desk, or the Treasury's sovereign desk, and executes a price stability, monetary stability mandate.
Bateman: This is obviously impacted by the general accommodation of trade conditions, external demand for US dollars throughout the 1990s, and these are Great Moderation conditions, which mean that the Treasury can step back from a large welfare-distributing function without there being catastrophic social impacts. Also, when it needs deficit funds, it will usually be able to find them in foreign purchases.
Beckworth: One thing about the Great Moderation period is that I will confess, I, too, was under the illusions, so to speak. To be clear, I do think there is a role for central banks. They've been given this mandate, the idea being, they're going to be less susceptible to political winds and more independent, but there is a reality behind that. The way I like to think about it is to think it's fiscal policy setting the guardrails on a road, and the Fed's driving the economy on that road and has some leeway between the guardrails.
Beckworth: But where those guardrails are really shapes how wide or how open that road is. You just can't get away from that. Sometimes we forget we're on a smooth road, we forget the guardrails are there, but we get some rough patches, we hit those guardrails, we know they're there, and I think that's one way for me, at least, to think about the Great Moderation. It was easy to forget those guardrails were there and become complacent. I think that's the emergence of a lot of interest and a lot of work on monetary policy. I will mention, my colleague at Mercatus, a visiting fellow, Eric Leeper, has done a lot of work on this. We'll have him on the show soon to talk about more of the work he's going to do, too. Well, let's segue from that to the more recent periods, QE periods. What have we learned from that as it relates to the argument you're making in the paper?
The Significance of More Recent QE Periods
Bateman: This is, in many ways, the guts of the paper in terms of the major new contribution. What I did with QE was a really extensive review of the deliberations of the Federal Open Market Committee from mid-2008, as late as I could possibly get them, because the transcripts are released on a delay. You find a lot of really fascinating things when you start to look at how the FOMC explained to each other, and ultimately justified the decision internally, to commence QE, and what the objectives of QE were. Of course, the large-scale asset purchase programs are extremely complex and had multiple instruments and multiple objectives and multiple timeframes. Let's just call them QE for the podcast, it’s more fun for everybody.
Bateman: When they were launched, they weren't really explained as doing anything in particular. So when QE externally began or when the asset purchases began, they were just announced to the public as things that were happening. It wasn't until three or four years after that they were on the run. Of course, economists, market participants, academics, policymakers, politicians had ideas about why they were happening, but the Fed didn't really offer a particularly clear rationale or analysis for why, or what asset purchases were designed to achieve, other than very vague things like market stabilization or stabilizing conditions or implementing monetary policy to the zero lower bound. Yes, that's all true, but eventually, they were explained as a kind of aggregate demand stimulus operating through either the portfolio rebalancing channel or the liquidity channel, the bank lending channel, the wealth effect channel.
Bateman: But, it was always, look, what we're trying to do with QE is provide stimulus when we've hit zero or near zero interest rates in short-term money markets. We're going to do that by buying assets, which will reduce yields on assets and change the relative prices and returns of different assets in financial markets, and push people towards investment in corporate equity or away from fixed income and into productive economic enterprises. What you find when you dig into the deliberations of the FOMC is that there was also just an element of fiscal backstopping here. Part of the public explanation was, "Look, we are not doing debt monetization. We're not doing anything fiscal. We're not doing fiscal support when we do quantitative easing." It's a very different reality inside the FOMC from 2008 onwards. QE is debated and explained as a form of debt monetization by people who are both in favor of QE and opposed to QE and also people who are in favor of debt monetization and opposed to debt monetization.
Bateman: But in terms of the net empirical effect of QE, the people that were authorizing it and doing it, including the Fed research staff, said to the FOMC and explained to the FOMC, "Look, we're doing this. The effect of this will be that the Treasury has an accommodation which is very similar to the accommodations we provided in the 1930s, 1940s, 1950s, and 1970s." And so, the paper tries to present that in the Fed policymakers' own words. So, it goes through the major research memoranda, which are presented to policymakers on the FOMC, which detail very clearly and explain the different mechanisms through which QE will provide budgetary movement to the US government and ultimately budgetary support to the government. It also goes through the debates and the fears that some FOMC members have that debt monetization will deprive the Fed of its independence or that it will cause inflation to skyrocket and the people responding to those concerns, ultimately those people won the day saying, "We don't mind, it's a positive to me that QE is a form of debt monetization or fiscal support because it will help fiscal policy be effective at a time when fiscal policy must be effective."
Beckworth: So you're saying that there was some acknowledgment within the Federal Reserve that they were doing debt monetization, even if outside the Fed, they tried to distance themselves from that notion for political reasons.
Bateman: Absolutely, and that comes through incredibly clearly. I'm not a conspiracy theorist, and there's a lot of conspiracy theory work out there on what the Fed thinks. All that I've done is draw the major parts out of the deliberations in the FOMC. A fun quote is, and this is from a 2009 meeting from a Fed policymaker, “monetizing the debt to me is not a negative under the current situation, because it's helping fiscal policy be effective, provided we can do it in the context of not having rising inflation expectations and not having concerns about our independence.” This is a very profoundly crystal clear acknowledgment of what QE was then going to do, but there's many more. There's many more from 2009 right through to 2015, '16, that the effect and part of the intention of QE is to provide the type of fiscal support the Fed provided to the Treasury at earlier points in its history.
Beckworth: Okay, well we are running low on time, but I do want to give you the opportunity to maybe leave us with the big policy implications, or prescriptions if you have any, or what you would want a policymaker who's listening to the podcast… what are the takeaways you want them to go with from the show?
Outlining the Implications for Policymakers
Bateman: Yes, thanks, David. So, what the paper shows, what it attempts to do, is provide, if you like, a historical laboratory of times when the central banks provide fiscal support to the Treasury and it's been critical to, let's call it state survival, but also just the effective governance of the United States. As we discussed at the beginning, that sort of ramifies out globally. I present what I call a theory of sovereign financing gaps, which are these sort of inbuilt weaknesses, if you like, or inbuilt volatilities in the sovereign debt system. I developed this theory with a colleague of mine named Jens van 't Klooster, so I must give Jens a big shout-out here because he's been critical to developing these ideas.
Bateman: The idea of a sovereign financing gap is that governments, unlike private economic agents, are required to act and required to spend money to act in an effective way when crises arrive, whether the crisis is… we detail them, whether it's war, cyclical financial crises, social crises like the COVID-19 pandemic, or let's imagine environmental or future military investment requirements. Sovereigns will be required to act to ensure the survival of the body politic in ways which… and often private capital can't respond. Private capital has a lot of trouble responding when there's very high wartime taxation rates or when they're being attacked by war or when everybody has to sit at home because there's lockdown orders.
Bateman: When social crises reach particular points, the private credit system just breaks down on its own terms, and when those points of crisis are reached, it becomes legitimate for central banks to provide monetary accommodation and fiscal support directly to the Treasury, and directly, it might be through a secondary market system or it might be directly through these bilateral credit facilities that we've been discussing. But that point about legitimacy is really important, because most of the thinking around central bank independence is that it is definitionally never a good thing for the central bank to deliberately provide fiscal support to the Treasury.
Bateman: This is the basis, if you like, of central bank independence from the early 1980s. The course of history shows us something very different. It shows us that if that prescription were followed, if that illusion were never pierced or never revisited, what you get is an absence of inability to finance the Second World War, the inability to finance the economic rescue packages which followed the financial crisis or the Great Depression, and an inability to finance the public works and developmental state programs which led to reconstruction and the second New Deal.
Bateman: So, the challenge for scholars and policymakers is to be transparent and systematic about when they choose to make that kind of intervention, and just treating fiscal support by a central bank or debt monetization as a taboo, something that you can never speak of, and you never write in your textbooks, and you never teach your students about, is the wrong way to think about this program, this topic generally, but also public institutions in general.
Beckworth: Well, there is so much more to your paper. Again, we encourage listeners to go check out the paper. Will, before we go, you mentioned to me earlier, this paper may be turned into a book, a much longer book. This will be the short version if you do read it now. So, mention that briefly to us.
Bateman: Thanks, David. So, David was teasing me about the length of US law review articles and he's quite right. This was originally designed to be a law review article, which is sort of in the realm of 25,000 words, but the paper now is almost 45,000 words and it's currently under review as a book manuscript with Chicago University Press. If anybody's listening and they're in the US, I'll be visiting faculty presenting this paper at Harvard, Cornell, Georgetown, and Illinois in late November. So, it'll be on the websites and hopefully I can see some interested listeners in the audience.
Beckworth: Okay, with that, our time is up. Our guest today has been Will Bateman. His paper is *The Fiscal Fed.* Will, thank you so much for joining us today.
Bateman: Thank you so much, David. It's been a pleasure.
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