Author: Aaron Wistar
The $21-trillion market in U.S. government securities is the “deepest and most liquid fixed-income market in the world.” Except, of course, when it isn’t. As last year’s historic meltdown in the Treasury market demonstrated, the status of Treasury securities as the ultimate safe, liquid asset—to which investors will predictably flee in times of uncertainty, war, panic, or pandemic—is not a given. The liquidity of the world’s most liquid market depends, in the last instance, on the Federal Reserve’s guarantee.
More than a year later, the reverberations of the March 2020 panic in the Treasury market are still being felt. At the end of July, the Federal Reserve announced that it would establish two facilities to ensure market breakdowns like that of March 2020 (or October 2019) never happen again: a domestic standing repo facility (SRF) and a repo facility for foreign and international monetary authorities (FIMA). Combined, these facilities will serve as a permanent liquidity backstop for the U.S. government securities market. By giving major institutional investors—both foreign and domestic—the right to post their Treasury securities as collateral in repurchase agreements with the Fed, they reassure market participants that the U.S. public debt will always be immediately convertible to cash without significant capital loss, even in periods of extreme market turbulence. The very existence of such a guarantee should bolster private liquidity provision, making the actual usage of the facilities largely superfluous. As a recent report from the G30 Working Group on Treasury Market Liquidity explains, private dealers and other financial firms need to be confident in their ability to finance their government security portfolios with repo credit if they are to reliably make markets. At the end of the day, “complete confidence can come only from direct access to liquidity from the Federal Reserve, which has essentially unlimited capacity to provide funding.” This is what the SRF and the FIMA repo facility offer: complete confidence that the spigot will never turn off.
The goal of these new standing facilities is to enhance the moneyness of U.S. Government securities. At the most basic level, the March 2020 dysfunction was about the non-identity of Treasuries and cash. The crisis occurred when money market funds, hedge funds, and foreign central banks all attempted to liquidate Treasury holdings at once to meet a surge of actual or expected cash demands. Each expected that their Treasury holdings would be a reliable store of value that could be converted to cash as needed. But when private dealers proved unable or unwilling to absorb the flood of selling on their own balance sheets, markets seized up. Ultimately, the Federal Reserve had to step in as a dealer of last resort, purchasing $1.5 trillion worth of government securities in March and April 2020 to restore market confidence that Treasuries were still as good as dollars.
The sheer quantity of bond purchases necessary to stabilize the Treasury market in early 2020 (along with the ongoing QE purchases thereafter) led to a common complaint in the financial sector that the “the church-and-state separation” between fiscal and monetary policy had broken down. The hallowed institution of central bank independence was crumbling as the Fed experimented with “debt monetization”—“printing money” to finance government deficits, rather than allowing the forces of supply and demand in the bond market to keep deficits in check.
What this (possibly disingenuous) line of criticism glosses over, however, is the fact that the debt was already monetized well before the crisis, whether it was on the Fed’s balance sheet or not. Indeed, one reason it was so crucial for the Fed to perform the equivalence of Treasuries and cash in March 2020 is that Treasury securities of all maturities have functioned for decades as a kind of money in the shadow banking system. Much as commercial banks operate by issuing short-term deposit liabilities against long-term assets, shadow banks today finance Treasury holdings by posting them as collateral in short-term repurchase agreements. Because of this, even long-term Treasury bonds have effectively become a money market instrument, a form of shadow money that circulates among financial institutions. So when the Fed rescued the government securities market, it was not simply bailing out the fiscal state. Rather, it was stabilizing the architecture of the shadow banking sector—a sector which cannot function without an implicit (now explicit) guarantee that Treasury bonds will remain convertible to short-term cash in repo markets.
Today, as Federal Reserve purchases of Treasury securities continue to the tune of $80 billion per month, the Fed faces ongoing criticism in the financial press for “topping up the punch bowl” when the party is in full swing. In response, the central bank has announced its intention to start reducing purchases later this year. The new repo facilities ensure, however, that the government securities market will not suffer once the Fed begins to taper. As Zoltan Poszar astutely points out, it seems they were introduced precisely at this moment to insulate the government securities market from the potentially disruptive effects of the Fed’s wind down. The Fed, in effect, is “foaming the runway” for an exit from pandemic monetary policy—replacing “funded QE” (permanent reserve creation though outright purchases) with “financed QE” (temporary reserve creation through repo). Another way of looking at this is to say that the Fed is hoping it can expand its contingent assets and liabilities as a substitute for actual balance sheet expansion. If banks and other financial firms are confident that their Treasuries can be converted to money on demand—at a cost that is well below their yield—they’ll be happy to hold more Treasuries and less cash. This will help prevent bond prices from collapsing as QE winds down (or if the Fed once again decides to shrink its portfolio in pursuit of “policy normalization”). A shrinking balance sheet will appease right-wing critics, while an expanding shadow balance sheet will shield the financial sector from price volatility and liquidity risk.
Who benefits from this arrangement? To be sure, the global reputation of the U.S. dollar is probably enhanced by maintaining the appearance (however misleading) that the private sector, and not the Fed, is the ultimate wellspring of demand for Treasury debt. And most mainstream economists would likely point out that depth and liquidity of the government securities is a boon for the U.S. taxpayer, as the high liquidity premium on Treasuries makes for lower financing costs. Still, once you read a bit of Modern Monetary Theory, these arguments start to ring hollow. Yes, there is a liquidity premium on Treasury bonds. But there is much higher liquidity premium on actual cash. If fiscal deficits were monetized directly, say with a trillion-dollar coin, the idea of liquidity premia marginally reducing yields becomes moot.
Much more directly than it benefits “the taxpayer,” guaranteed liquidity in government security markets benefits finance capital, and—to risk redundancy—the very, very wealthy. In the 2010s, the top 1% of U.S. households owned 55% of the domestic household share of public debt. The domestic corporate share of public debt, for its part, has long been dominated by the financial sector, which has held roughly 97% since the 1980s. Older generations might still have an image of lower- and middle-income Americans stashing savings bonds in filing cabinets or safe-deposit boxes. But today, the humble and relatively egalitarian savings bond accounts for an ever-diminishing fraction of the public debt. The lion’s share is in the form of marketable securities, traded among Wall Street firms and high net worth individuals. (This is all documented in Sandy Brian Hager’s excellent book on the subject).
The growing foreign demand for marketable Treasuries is equally an expression of growing inequality. As Matthew Klein and Michael Pettis argue in Trade Wars Are Class Wars, Countries like China accumulate large holdings of U.S. debt as a consequence of a “high savings,” export- and investment-centered model of development that is based on regressive transfers of income from workers and pensioners to major corporations and the state. What’s more, a substantial portion of foreign demand for Treasuries is not really “foreign” at all—it comes from U.S. Corporations and wealthy individuals stashing funds in tax havens. (Ever wonder why the Cayman Islands holds more Treasury debt than India?)
Perhaps there is another way. For the past 70 years, since the Treasury-Federal Reserve Accord of 1951, the institution of central bank independence in the United States has been defined by the Federal Reserve’s informal mandate to “minimize the monetization of the public debt.” Today, the new standing repo facilities make clear that the Fed is more committed than ever to keeping the debt monetized—not necessarily to provide cheap financing to the Treasury, but rather to maintain private sector financial stability. So, what if, instead of keeping monetization behind the scenes for the purpose of backstopping shadow banks and financial elites, the Fed publicly embraced debt monetization and channeled it to a broader public purpose?
One idea is mandating that the Fed provide accessible, interest-bearing checking accounts (“FedAccounts”) for the general public. This would involve a huge expansion of Federal Reserve liabilities as it opened new checking accounts for millions of Americans, and correspondingly huge purchases of Treasury securities. Aside from eliminating banking deserts, streamlining the payments system, and putting predatory check cashing services out of business, one benefit of the FedAccounts proposal is that it would displace the engine of private debt monetization that propels much of the shadow banking sector. Consider government money market funds (MMFs), for example. This is a $4 trillion sector whose sole purpose is to convert U.S. Treasuries (and Treasury repo) into cash equivalents. Why should private firms be allowed to profit from this activity when the Fed is already guaranteeing the moneyness of Treasuries? What service do they provide? FedAccounts would displace these funds by offering to pay all depositors the same rate of interest that the Fed currently pays to commercial banks—known as the interest-on-reserves, or IOR, rate. At 0.15%, the current IOR rate is significantly higher than the 0.01% average return on government MMFs over the past year. What’s more, where MMFs issue cash equivalents (technically equity shares whose value is stabilized at $1), FedAccounts would offer fully guaranteed government money. Essentially, they would cut out the middleman, delivering higher yields directly to consumers.
More ambitiously, the Federal Reserve could leverage its debt monetization powers to fuel a green transition. The legal scholar Saule Omarova has proposed the creation of a National Investment Authority—a kind of public asset manager whose sole purpose would be directing investment capital toward green development. Omarova suggests that the Fed could support the liquidity of debt issued by the NIA in the same way that it currently supports the liquidity of Treasury and Agency securities. Building on Omarova’s proposal, we could imagine the Fed promoting widespread participation in such a National Investment Authority by marketing investment accounts to consumers that offered higher yields than FedAccounts but had more time restrictions or penalties for withdrawals. To incentivize participation, these public investment accounts could be made risk-free—guaranteed against nominal loss—much as the possibility of redemption guarantees holders of savings bonds against nominal capital loss today.
These are just a few of the more developed and (with a bit of political imagination) eminently attainable reform programs. But the main thing I want to elicit here is a sense of possibility. There is no law mandating that the Treasury and Federal Reserve coordinate to provide interest-bearing, high-denomination money for the shadow banking sector. Nor, as Nathan Tankus points out, is there any necessary financing purpose to the Treasury issuing a range of maturities paying different interest rates. Issuing and stabilizing Treasury bonds is subsidizing private finance. The clearer we can make that, the better we can demand that the Fed subsidize the things that really matter.