November 19, 2020
Saule T. Omarova, Cornell Law School
The COVID pandemic gave a renewed sense of urgency to the idea of offering every American household and business a free digital-dollar deposit account at the Federal Reserve (the Fed), the country’s central bank. In its currently popular form, the proposal to create such FedAccounts was advanced in 2018 by Morgan Ricks, John Crawford, and Lev Menand. FedAccounts as a “money-and-payments safety net” for the unbanked or under-banked Americans, their proposal effectively reframed the traditionally technocratic debate on central bank digital currency (CBDC) in terms of financial inclusion and democratic access to financial services.
Yet, despite its growing appeal, the FedAccounts proposal offers only one half of the solution to the problem of democratizing finance. Most importantly, the FedAccounts discussion focuses almost entirely on the liability side of the Fed’s balance sheet, while giving the asset-side issues at best a cursory nod. The full consequences of the proposed expansion of the central bank’s liabilities, however, cannot be fully understood without explaining how that would affect the composition of its assets. Massive inflows of deposit money would create both new pressures on, and new opportunities for, the Fed to channel resources to productive use in the nation’s economy. By not addressing, or even acknowledging, these potentially game-changing implications of FedAccounts for system-wide credit allocation, the current debate overlooks the full transformative potential of this reform. It also precludes a deeper discussion of how FedAccounts could affect the structure and operation of the U.S. financial system. Glossing over these consequences obscures potentially significant policy choices involved in the process.
My new working paper seeks to shift the debate by confronting these fundamental questions. The paper advocates a comprehensive reform of the structure and systemic function of the Fed’s balance sheet as the basis for redesigning the core architecture of modern finance. It offers a blueprint for transforming the Fed’s balance sheet into what it calls the People’s Ledger: the ultimate public platform for generating, modulating, and allocating sovereign credit and money in a democratic economy.
On the liability side, the paper envisions the ultimate “end-state” whereby FedAccounts fully replace—rather than compete with—private bank deposits. Explicitly making this assumption helps to illuminate and explore the full range of new monetary policy options enabled by the compositional change in the Fed’s liabilities. It also reveals the extent to which familiar arguments against the issuance of FedAccounts (or other forms of CBDC) reflect the underlying fear of the corresponding growth of the Fed’s assets. In wider discussions, the idea of central banks as large-scale investors in financial assets triggers warnings about governments “crowding out” private investment or “picking winners and losers” in ostensibly private markets.[1] Experts emphasize the difficulty of defining technical parameters for central banks’ expanded portfolios and the riskiness of “a potentially larger central bank footprint” in the financial system. Unsurprisingly, the prospect of wholesale migration of deposits from private banks onto the Fed’s books takes these long-standing concerns to a whole new level.
But this very same prospect also offers a unique opportunity to rethink the composition of the Fed’s asset portfolio—with a view to augmenting the Fed’s structural capacity to channel credit into the real economy. Traditionally, the bulk of the Fed’s assets comprise federal government debt and various securities purchased pursuant to crisis-containment and market-stabilization operations.[2] It is widely taken for granted that any recalibration of the Fed’s portfolio, necessitated by CBDC/FedAccounts issuances, would continue to involve the same “traditional” asset categories. That, in turn, leads to a seemingly insurmountable problem: What if there are not enough government bonds, or high-quality corporate bonds, to meet the central banks’ growing demand?[3] Would the Fed have to start buying corporate stock?
Not necessarily. A better—and, in the long run, more practical—solution to this problem is to design new asset classes, specifically to offset the dramatic increase in the Fed’s deposit liabilities. Under the proposal laid out in my paper, three asset categories would constitute the core of the Fed’s newly restructured and expanded portfolio.
First, a considerable portion of the Fed’s assets would be channeled into redesigned “discount window” loans to specially licensed lending institutions.[4] Affordably priced and fully collateralized by high-quality assets, these New Discount Window (NDW) loans would effectively replace deposit funding for banks and enable a broad range of non-bank credit institutions to access this reliably “patient” capital. The NDW facility’s role as the principal source of funding for private credit markets would, in turn, amplify the impact of the Fed’s collateral eligibility policies on the economy-wide credit allocation. Thus, the Fed could explicitly preference certain types of loans (such as loans to small and medium-size non-financial firms and minority-owned businesses, student loans, etc.) and exclude others (such as margin loans, private equity bridge loans, etc.). It could also make carefully targeted adjustments to its collateral requirements for the purpose of temporarily increasing or decreasing the amount of private credit flowing into particular segments of the economy, in response to specific structural bottlenecks or other inefficiencies in credit allocation across various sectors or firm types.
Second, the Fed would invest in securities issued by existing and newly-created public instrumentalities for the purposes of financing large-scale public infrastructure projects. One such new public instrumentality is the National Investment Authority (NIA), a development-finance institution proposed elsewhere. As proposed, the NIA would act directly in financial markets as a lender, guarantor, securitizer, and venture capitalist with a broad mandate to mobilize, amplify, and direct public and private capital to where it’s needed most. Accordingly, by purchasing NIA-issued bonds, the Fed would be investing in the long-term development of the nation’s economic capacity. In effect, it would be offsetting the dramatic increase in its own liabilities by dramatically augmenting the flow of credit into the coordinated nationwide construction of public infrastructure that enables and facilitates structurally balanced, socially inclusive and sustainable economic growth.
Finally, the third principal asset category on the Fed’s newly redesigned balance sheet would consist of a diversified portfolio of trading assets maintained for the specific purpose of financial market-stabilization. The Fed would use this newly established portfolio to conduct regular purchases and sales of a broad range of securities and other tradable financial assets with an explicit view to modulating volatile swings in certain systemically important prices. A straightforward extension of the Fed’s current “open markets operations,” used strictly as the means of interest rate management, this new form of strategic market trading would serve as a flexible and direct tool of preventing systemically destabilizing booms and busts in financial markets.[5]
In sum, these three new investment choices would empower the Fed to channel greater quantities of credit to productive uses in the real economy more directly and effectively than it can hope to do today. On a more fundamental level, the proposed comprehensive restructuring of both sides of the Fed’s balance sheet—the nation’s core economic ledger—would democratize not only access to financial services but the very process of generation and allocation of financial resources. This deep shift, in turn, would directly and profoundly change the structure and operation of the banking industry, “shadow banking,” and capital markets.[6] As the paper shows, it would eliminate key structural incentives for excessive financial speculation, reduce systemic complexity, and ultimately restore the socially efficient public-private balance in today’s finance. It would change how the financial system works—and what it does for all of us.
The full draft of the paper is available here.
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[1] See, e.g., Stephen G. Cecchetti & Kermit L. Schoenholtz, The Fed Goes to War: Part 3, (Apr.12, 2020), https://www.moneyandbanking.com/commentary/tag/Market+maker+of+last+resort.
[2] As discussed in the paper, the COVID crisis has significantly expanded the range of instruments eligible for the Fed’s emergency asset purchases. See also, Lev Menand, Unappropriated Dollars: The Fed’s Ad Hoc Lending Facilities and the Rules that Govern Them (May 2020), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3602740.
[3] See, e.g., Bank of England, Discussion Paper: Central Bank Digital Currency: Opportunities, Challenges, and Design 37-38 (Mar. 2020).
[4] On the Fed’s current discount window program, see https://www.federalreserve.gov/regreform/discount-window.htm.
[5] See Robert C Hockett & Saule T. Omarova, Public Actors in Private Markets: Toward a Developmental Finance State, 93 Wash. U. L. Rev. 103, 141-44 (2015).
[6] The paper offers a detailed analysis of these structural implications.
[7] Testing testing