David Andolfatto is a vice president for the St. Louis Federal Reserve Bank and has published widely in the field of monetary economics. David also blogs at MacroMania and is a returning guest to the podcast. He rejoins Macro Musings to talk about his thoughts on macro theory, plumbing issues, central bank digital currency, and more. Read the full episode transcript: Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected] David Beckworth: David, welcome back to the show. David Andolfatto: Thank you so much David. It's always a privilege to be here with you. Beckworth: Oh, it's always fun for me as well to chat with you. And you've been very helpful to me over the years, giving me
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David Andolfatto is a vice president for the St. Louis Federal Reserve Bank and has published widely in the field of monetary economics. David also blogs at MacroMania and is a returning guest to the podcast. He rejoins Macro Musings to talk about his thoughts on macro theory, plumbing issues, central bank digital currency, and more.
Read the full episode transcript:
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: David, welcome back to the show.
David Andolfatto: Thank you so much David. It's always a privilege to be here with you.
Beckworth: Oh, it's always fun for me as well to chat with you. And you've been very helpful to me over the years, giving me advice. And you've been on the show a few times. I believe this is your fourth appearance, if I'm counting correctly. So you're a regular here on Macro Musings. And I trust you have your nominal GDP targeting mug, is that right?
Andolfatto: I do, but I think I deserve another one at some point.
Beckworth: You and George Selgin keep asking for nominal GDP targeting mugs. I'll check with the bosses at Mercatus to see what we can do about that. Well, it's great to get you on. And I know you probably need to give your qualifier about what you're about to share with us. So I'll let you do that at this time.
Andolfatto: Well, absolutely. As always, the views that I'm going to express on your show are my own. They do not necessarily reflect the views of the St. Louis Fed or the Federal Reserve system. So it's just me, and direct all your anger and criticism to me, not the Fed. Thank you.
Beckworth: Well, I like you David, because you are willing to come on and have honest discussions about these issues that are important. Alright, David, I want to speak to some recent developments that you care about and that we all care about and discuss. And one of the ones that's really interesting that came out just recently in the April FOMC minutes was discussion of a standing repo facility. So let me read an excerpt from the minutes, and then I'll throw it over to you. But I found this very encouraging.
Beckworth: So, a discussion in the minutes starts with this: "The staff briefed participants on the Federal Reserve's experience with the daily repo operations with primary dealers that have been in place since September 2019, and the temporary Foreign and International Monetary, or FIMA, repo facility established in March last year. The briefing also reviewed considerations that could be relevant for policymakers' judgements regarding whether these arrangements should become permanent, standing facilities."
Beckworth: Now, skip on down a few paragraphs and then we hear, what did the participants say? What did the FOMC members, how did they respond to this report? And it's very encouraging from where I sit. It says, "In their discussion of considerations related to the establishment of a standing repo facility as part of the committee's overall approach to policy implementation and an ample reserve regime, a substantial majority of participants saw the potential benefits of an appropriately calibrated facility as outweighing the potential costs." And they go on to discussing the benefits and costs, but that's great news, as far as I'm concerned. I was eager to hear your response to that development.
Thoughts on Standing Repo Facility Developments
Andolfatto: Well, I agree completely. I thought it was very good news as well. I think that a number of minds have been changed, given recent developments in the little repo tantrum that we experienced, the events of March, for example, as well. The regime's framework, and for a variety of reasons, was not working quite the way a lot of people were expecting. And this standing repo facility, which, of course, Jane Ihrig and I, who's at the board, blogged back in 2019. We were trying to make a case for it. And it seems like people are coming on board with it. It's very gratifying to see, I think.
Beckworth: Yes. And as you mentioned in a previous show, when you first brought this up and we discussed it, you noted that other central banks have done this already, so the Fed wouldn't be the first central bank to do it. You also mentioned it would be a nice completion to what the Fed already has. So on the lower bound the Fed has the overnight reverse repo facility, right? So, kind of a floor. And, this would create a ceiling, if I understand your proposal correctly, is that right?
Andolfatto: It could obviously serve as a ceiling tool as well. The effects, or kind of the properties that this facility might afford are multifaceted, depending on the parameters of the facility. Jane and I argued, for example, among other things, it could be a way to promote the G-SIBs and the regulators to substitute treasury securities for their living will arrangements for example. And that might in turn permit the Fed to drain reserves with undue consequences.
Andolfatto: And that would be something that the Fed might want to do, consistent with its 2014 normalization principles and plants just this idea that we'd like to have a smaller footprint as we can. We want the minimally ample reserves, if you like. So, the other reason, as we pointed out, it could serve a complement interest rate control, avoid these events, like in March for example, where you've all of a sudden, perfectly nominally safe US treasuries, off the run treasuries are being discounted excessively. And it's kind of unnerving. It seems unnecessary. I know of no economic theory that suggests that the sudden evaporation of liquidity for nominally risk free securities is a good thing. So why not provide this safeguard to kind of mitigate or possibly eliminate those sharp spikes in money market rates?
It's kind of unnerving. It seems unnecessary. I know of no economic theory that suggests that the sudden evaporation of liquidity for nominally risk free securities is a good thing. So why not provide this safeguard to kind of mitigate or possibly eliminate those sharp spikes in money market rates?
Beckworth: Yeah, very interesting developments. And as you mentioned, I think you can say two broad areas where this would serve, it would provide interest rate control, on one hand. On the other hand, it would facilitate better use of bank balance sheets, in terms of how many reserves are holding versus treasuries. At least it would give them the flexibility, if they wanted to hold treasuries instead of reserves.
Beckworth: Because those reserves do take up balance sheet space. And as we're seeing right now, with all the reserve creation going on, it's putting downward pressure on overnight markets. So it would be, I think, an added degree of freedom at a minimum, if we could get this. The minutes mention this, and I've had people on the show mention this as well, the Fed has tinkered in an ad hoc way, with a repo facility, as you mentioned just a minute ago as well, with the September repo crisis. It stepped in then. The FIMA facility as well. And I had some people tell me, "We don't need a standing repo facility because we already tried one, this kind of temporary ad hoc one. And there wasn't a lot of take up." But that's probably not the right way to look at it, right? How would you respond to that comment?
Andolfatto: Part of it depends on how one defines a standing facility. Obviously, the New York desk stands ready to intervene on a discretionary basis, and as the situation may dictate. And indeed, they did so during the little repo tantrum. But the point is, they did so without lag. And, I mean, it only took a matter of hours, perhaps, to respond. But still, I've spoken to traders on the street there that say they weren't sure of how the Fed exactly was going to respond. I mean, they were making educated guesses. And on the grand scheme of things, perhaps this is not hugely important. But it's really an unforced error. I mean, with a standing facility, among other things, the terms of trade would be posted, and participants would understand ex ante, before the fact, that this facility was available.
Andolfatto: And indeed, if the facility was working properly, I would argue, and if the interest rates, the terms of trade were calibrated properly, that one would probably expect very little take up, because investors, traders would actually view the facility more as an outside option that would govern the terms of trade that they would discover through their private trades. So, the take up of the facility is not a proper metric to judge its success. It's really due to, if we eliminate these events where money market rates suddenly spike for no good reason, I think that's the metric for success. Much in the same way the Fed was actually founded in 1913, primarily. One of the main reasons was to smooth out these types of money market rate fluctuations, to provide an elastic currency to kind of eliminate, or at least mitigate, the seasonal fluctuation in money market rates. Which, there's no good theoretical reason for interest rates to fluctuate in that manner. It really was more symptomatic of an underdeveloped, kind of over the counter, decentralized market. And the Fed basically set up a facility, the discount window, to accommodate that need. And it worked pretty well, I would say. So same thing with the repo facility.
If the facility was working properly, I would argue, and if the interest rates, the terms of trade were calibrated properly, that one would probably expect very little take up, because investors, traders would actually view the facility more as an outside option that would govern the terms of trade that they would discover through their private trades. So, the take up of the facility is not a proper metric to judge its success.
Beckworth: Yeah. So your point is, a permanent facility would create different expectations ex ante than one that is temporary, ad hoc, bring it online when the crisis hits. And I think the whole point of the take up critique is that, well, if there wasn't much of a take up then you know it would be working, right? I mean, if they don't need to go to the Fed, it would suggest, at least, that things are better. If you're not having the big blowout, and markets aren't melting down, and therefore you don't need to tap the standing repo facility, then maybe your facility is doing what it's supposed to do. So, how we interpret the evidence, I guess, depends on how you identify the problem, which is always an issue. Okay. So standing repo facility, great news. I think both you and I are happy about it. I know George Selgin's happy about it as well. He actually took your proposal and suggested expanding it to have more counterparties, more broad class of assets.
Beckworth: So, all kinds of creative ways you could go with this, but at a bare minimum, just get this basic model that you and Jane Ihrig had suggested out there, and hopefully prevent the repo event of September 2019, that we had as well as the March treasury meltdown. Okay, so that's the first recent development I wanted to cover with you. We've done that. Let's go and talk about the Fed's new framework, the average inflation targeting framework. And as listeners of this show will know, I am generally supportive of it. I'm happy to see it. I like it because it now allows the Fed to do makeup policy, and I prefer a nominal GDP level target or a nominal income level target. But I still see this as a step in the right direction. And we were having a conversation on Twitter, a great place to hang out with people like David Andolfatto and others, and you provided a little bit of a pushback.
Beckworth: What I was doing is, I was kind of pushing back myself on all the inflation hawks out there, the naysayers. I was like, "Look, put aside the pandemic concerns, base effects, applied bottlenecks. Even if we didn't have those, the Fed's new framework would require some temporarily higher than nominal inflation, above two percent, this makeup period. We would expect to see that if this new framework is working. So don't freak out." And then if anything, I argued it's a version of price level targeting, therefore we might have greater price stability over the long run. But you pushed back with a good critique to my enthusiasm, so share it with the audience.
David’s Critique of the Fed’s New Framework
Andolfatto: You know, first of all, I think, actually, David, you and I are basically more or less on the same page here, really. I mean, fundamentally. And I have to reflect on what exactly my concerns are. I mean, part of it is just the way the issue is framed and marketed, communicating the policy. You know, my whole perspective is, if I think back about what the rationale was to establish an independent central bank and what motivated the initial inflation targeting regimes, inflation targeting was initially motivated as a ceiling. An independent central bank is there to fight inflation, to keep a lid on inflation. I mean, the idea that we'd have low inflation never even crossed people's minds. I mean, [the] central bank is there to keep a lid on inflation. And the inflation target, early on, was, I think, even though they set a target, it's very much in the spirit of providing a ceiling tool.
I think back about what the rationale was to establish an independent central bank and what motivated the initial inflation targeting regimes, inflation targeting was initially motivated as a ceiling. An independent central bank is there to fight inflation, to keep a lid on inflation. I mean, the idea that we'd have low inflation never even crossed people's minds. I mean, [the] central bank is there to keep a lid on inflation.
Andolfatto: What we witnessed is the Great Recession, of course, was that inflation in the United States and other jurisdictions, began to undershoot, began to be very low. Now, not very low. I mean, on average the United States undershot by about 50 basis points, say, since the time that the inflation target was officially adopted in 2012. 50 basis points, I recall vice chair Stan Fischer saying, "Now, come on, we don't even measure inflation accurately enough to kind of know whether this is significantly different than target. So let's just call it a victory." But instead this idea, I guess there's just this fear, there's this perception that the Fed, that these overly hawkish overtones coming from the Fed in a post-crisis era kind of contributed to the slow recovery of that period, and also at the same time, the low inflation. And that we wanted a different framework, and that sort of mistake would not be repeated.
Andolfatto: My own interpretation is that, as a slow recovery, that period had more to do with the fiscal drag. And that the Fed was actually not near this... At the zero lower bound was really kind of more or less, it didn't have that many tools to generate the inflation that many people wanted, in any case. My own view is, listen, now, I mean, we've adopted this average inflation targeting regime with the expressed intent of increasing the inflation rate. And to most people, inflation is the cost of living, their... One thing that the Fed learned at the Fed Listens events was that a lot of people were concerned and didn't understand why the Fed wanted to make their cost of living rise more rapidly. It's kind of a tough... We're doing it because in the long run we believe that this will anchor the long run inflation around 2%, and that this is going to be beneficial to us all in the long run, rather than letting inflation expectations drift down to 1% or 0%. We believe. And it's a tough sell. I think it's a tough sell.
Andolfatto: So my own view was, listen, we should have an alternative strategy would have just been for the Fed to basically declare victory and to promote the needed fiscal response, and that inflation would have come back naturally and there's very little the Fed could have done in any case. I mean, it could have done a little bit of course, but when you're at the zero lower bound, what are you going to do? I mean, it's basically the fiscal policy that has to step in and inflation would have come back, and so it would have been much better, I think from a communication point of view to say, listen, the Fed's not going to get in the way of any inflationary pressure generated by a fiscal response to help people out, and then indeed, the Fed is willing to tolerate inflation even higher than target for a while as a make-up strategy.
Andolfatto: It's suddenly different than promoting inflation. It's kind of a notion that we'll tolerate it as a by-product of an adequate or a good policy rather than actually promoting price level increases. So as you have pointed out and I agree with you, it would have been much better for the Fed, I think to frame this in the context of promoting nominal income growth, which is I think where you're coming from, and I agree with that, and it's basically doing the same thing. Sometimes prices and wages don't always move at the same pace.
Beckworth: Yeah, no, I agree with that and I guess where I'm coming from is, look, let's take the win. It's a small win, but it's a step in the right direction, and even your boss, I shared this video with you on Twitter. President Jim Bullard said this is in the class of models that's getting us closer to something like nominal GDP level targeting. So yeah, I completely agree with you. The easiest way to sell a make-up policy is not to say, “hey, we're from the Federal Reserve and we're here to help you by making your cost of living go up.” That's nuts. I completely agree. That's nuts. What you could say is, “well, we're here from the Federal Reserve and we're here to stabilize and restore the cells that you lost if you're a firm…
Beckworth: Or if you're a household, we're going to restore your income to where it was pre-pandemic or before the recession hits.” That's a much easier, palatable thing to swallow, and then you say, look, by the way, in the process of getting your incomes back to where they should have been, there might be a little bit extra inflation that comes with it, but I agree. That's definitely the way to sell it, but again, I'm taking this as a win in that sense that this is a first step in that direction and let me run something by you, David, I ran by George Selgin in a previous podcast, and that is the way the Fed is doing this is effectively very, very similar to a nominal income target in the following sense. So Rich Clarida, vice chair, mentioned this in two speeches, one late last year and one earlier this year, that this is really a form of temporary price level targeting.
Beckworth: He compared it to Bernanke’s proposal for temporary price level targeting. If you look at Bernanke’s proposal, he says look, we want to have this make-up policy when we're at the zero lower bound, big demand shock. So we want to get away from that, but once we get away from that, we want to go back to a more regular type inflation target where we see through supply shocks, where we see through temporary inflation ups and downs, and I'm like, man, what does that sound like? That sounds like nominal income targeting, nominal GDP targeting. I mean, so if this is what it takes to get us there and the world's a better place, I'm all for it, but at some point, I do think it is important to get the messaging right. So, for all the Fed officials listening right now on the show, I implore you take that next step. Be brave, take the next step and go all the way in, but I know politically, it's easy for me to say this, sitting behind a microphone here in a studio, but I know you got to crawl before you walk, walk before you run, and that's maybe where we're going with this.
Andolfatto: Well, there's also the interesting question to what to do when a nominal income growth is high. In that case, I guess it's kind of strange. You might want the Fed then to revert to its cost of living framing. Now, you don't want the Fed to be saying we're here to kind of reduce your nominal income growth. We're here now to restrain the cost of living from rising too rapidly.
There's also the interesting question to what to do when a nominal income growth is high. In that case, I guess it's kind of strange. You might want the Fed then to revert to its cost of living framing. Now, you don't want the Fed to be saying we're here to kind of reduce your nominal income growth. We're here now to restrain the cost of living from rising too rapidly.
Beckworth: So here's my response to that, David. First off, just empirically, that has rarely been a problem. I mean, 1970s, yes, but there are bigger, I think, problems going on in the 1970s, but I think it's just not a practical problem, number one. Number two, I mean, I think you can do it without outright contractions. You can slow the rate of increase and then finally, and this is where maybe people would have quibbled with what I'm about to say, expectation management. I mean, part of doing a level target is the idea that the market itself, the public itself will do a lot of the heavy lifting, right? If you know the Fed is going to tighten if things go too fast or it's going to expand, do make-up policy if you go too low, the hope is that gets baked into public expectations and the public does the heavy lifting. So let's put this in terms of money since you and I both like to think in terms of money here. The velocity of money would adjust appropriately if this becomes a credible level target of sorts.
Andolfatto: Those are all fair points, but as a central banker, you know that I'm trained to think about how to behave in various contingencies, independent of what the probability of those are of occurring. So we should be prepared to craft our narrative either way when we're above or below. That's all I'm saying, even if it's like you say it’s not-
Beckworth: No, that's fair. That's fair. And you're right. It may come. Even if it's a rare event, it may still happen so that's absolutely fair. Okay. So we've covered recent developments, standing repo facility, great news. We've discussed where we are with this new framework. The other recent development I want to talk about before we move on to some less timely ideas is the fact that the Fed came out yesterday and made this announcement. Chair Powell came out and made the announcement that they will be releasing a report this summer on a central bank digital currency, and I know this is something near and dear to your heart and I wanted just to read one excerpt from that statement, something that they stressed here and Jay Powell stressed in his brief announcement.
Beckworth: Here, it says, "As the Federal Reserve explores the potential benefits and risks of CBDC,” it's the acronym for central bank digital currencies, “the key focus is on whether and how a CBDC could improve on an already safe, effective dynamic and efficient US domestic payment system and its ability to serve the needs of households and businesses.” And this is Jay Powell speaking now. "We think it's important that any potential CBDC could serve as a complement to and not a replacement of cash." He's coming in and at least I interpreted as saying, look, we're not here to rock the system, rock the boat. We're here to add an extra tool in a way to compliment what we already have, but I would just love to hear your thoughts on this since you've done a lot of work on central bank digital currency yourself.
The Fed and Central Bank Digital Currency
Andolfatto: Yeah. And indeed, I just have a recent piece out associated with the recent conference that Cato hosted on discussing these issues. Yeah, my own view is I'm pretty agnostic here. I mean, I don't think it's going to be critical to have a CBDC, and when we speak of a CBDC, of course there are a variety of design proposals ranging from direct accounts with the Fed or full reserve accounts that are intermediated by through the banking sector, so-called synthetic version. I've kind of toyed or promoted the idea that others have of a central bank digital currency as a basic public option, just a place where just a no-frills bank account, no fees, no minimum balance, costless transactions.
Andolfatto: We can go on the interstate highways for free and travel and stuff, and it promotes commerce and just enhances the basic living standard for everybody, just accesses there, and that the banks themselves could continue with their more Cadillac accounts with many more services. They're not going to necessarily be disintermediated here. People are likely to have both CBDC accounts and retain their bank accounts and retain their relationships with their bankers, and so as a basic public option, there's no need for deposit insurance, for example.
Andolfatto: And I harken back to the US postal savings system, in fact, that was implemented around, I can't remember now exact date, around 1907, maybe around that or maybe just after the panic of 1907. By the accounts that I read at the time, postal savings was actually an attractive type of arrangement for a great number of people. This was pre-Fed and pre-deposit insurance, and so you had these small accounts that were fully insured that post offices were great because there's a post office in every town and the system worked fairly good for the constituents it was serving, and at its peak, it had something like, I don't know, maybe 10% of the deposit base in the country, but that model was basically killed by FDR when he introduced federal deposit insurance in 1933.
Andolfatto: So their competitive advantage there faded and the system kind of withered away in the 1960s, but now today with the internet, why not have direct access to the electronic component of the Fed's balance sheet? Everybody in the world has direct access to the paper component of the Fed's balance sheet. It's called the US dollar, the currency, and indeed it's like one of the most successful of our exports judging by the way these hundred dollar bills are circulating around the world. So we seem to have no problem in letting anyone in the world have permissionless access to the Fed's balance sheet as long as it's in paper form. Well, what's so special about paper? Why not extend the same privilege to the electronic component and just cut out the middleman because at the end of the day, when you're talking about payments, although there's a lot of things you have to worry about…
Why not have direct access to the electronic component of the Fed's balance sheet? Everybody in the world has direct access to the paper component of the Fed's balance sheet. It's called the US dollar, the currency, and indeed it's like one of the most successful of our exports judging by the way these hundred dollar bills are circulating around the world.
Andolfatto: Security, security of communications, managing the database. At the most fundamental level, making payments is all about just debiting and crediting accounts on a ledger. I mean, this is not rocket science. So why not just have a central ledger where everybody's connected and can make debit and credits to their accounts basically for free, for free, basically because I mean, as a basic public option, I think it makes this for the same reason we don't charge people for walking along the sidewalk… it would promote economic activity. It would eliminate the high interchange fees that small businesses rightly complain about. It may do something to promote financial inclusion, although I don't think that's necessarily the root problem there, and so for a variety of reasons, myself and others have kind of promoted the idea.
Beckworth: Well, let me ask exactly what is a central bank digital currency because there's different versions of it, but what I have in mind, and I'm sure our thoughtful listeners out there already know what this is, but some may not, but when I think of a central bank digital currency that compliments what we already have in terms of cash or at least the equivalent of cash, as you mentioned, it would be something I had on my cell phone or my Apple watch, and I come up to you and I like your golf clubs. I want to buy them from you. So I say, “Hey David, here's a couple hundred dollars,” and I just transfer it from my phone to your phone. I mean, how would it work in practice as you see it?
The Plumbing and Practice of a Central Bank Digital Currency
Andolfatto: Well, I think what you're getting at is the distinction between what the people make between account-based money and token-based money. So account-based money is the type of money that you and I are familiar with in our bank accounts. I mean, they're registered accounts. You have to identify yourself to open an account. I have to provide an address and that account is identified with you, and what you're doing is you're sending your bank an instruction to debit your account and credit the account of somebody else. So, in that way, these electronic digits move from account to account, or if you like digital wallet to digital wallet within the banking system.
Andolfatto: The other type of money that we make some use of is a token-based money and this comes predominantly in the form of physical cash or sometimes coin. Cash is a bearer instrument. It's a token, a permissionless bearer instrument where ownership is defined by possession and nobody really is there to intermediate when I debit my pocket of a dollar and credit your pocket. So, there's this idea of, to what extent can we replicate this bearer property digitally without the aid of a third party, or perhaps with the aid of a third party, I guess, and to me, this looks like is an anonymous Swiss bank account where you have numbered accounts.
Andolfatto: And so, you're debiting account number 202 and crediting account number 204, and you don't have [any] idea who these people are. Anonymous Swiss bank accounts have been around for a long time and certain laws have arisen to discourage the practice. So it seems strange for me to think about why we would not want to think about embedding that property in a central bank digital currency when we've gone through so much effort to kind of discourage the practice of creating and facilitating the use of bearer instruments.
Beckworth: Let me make the case for bearer instruments. So you mentioned earlier how the hundred dollars bill is our biggest export overseas. Now I know some of that goes to illicit activity, drug lords and the like, but it's also used by states that aren't functional. Zimbabwe use the dollar, an unofficial dollarization took place there, or people even in the US, people who might be here illegally and they don't want to be caught. I mean, it serves a useful function to have that kind of anonymous token based money and it actually encourages good behavior as opposed to going to loan sharks or something else. So I can still see a place for something like a central bank digital currency that's token based. It still could serve parts of the population that need it beyond just the bad guys.
Andolfatto: I guess that's right. I mean, and indeed, they do, these people do have access to physical currency for that purpose. The question is how to reconcile this product with the anti-money laundering laws and the KYC, Know Your Customer laws. I mean, how do we know we're not promoting also terrorist organizations in funding their activities that they're ultimately going to come and really hurt us. It's really a delicate cost benefit analysis to make. In the context of the foreign countries you just mentioned, I don't see any reason why a registered product, just let them open up an account, a government account, which actually foreign governments do do this at the New York Fed. Okay, there's the considerations you raised. I think theoretically they're there, but as a society, we're going to have to make a cost benefit analysis here. And who knows, I mean, there may be designs. We can't discount the possibility of clever design properties that would permit small denomination, token based money in a manner that doesn't facilitate the bad activities. So, we should keep an open mind there.
As a society, we're going to have to make a cost benefit analysis here. And who knows, I mean, there may be designs. We can't discount the possibility of clever design properties that would permit small denomination, token based money in a manner that doesn't facilitate the bad activities. So, we should keep an open mind there.
Beckworth: So, David, let me make the case again for why some token based money would be appropriate. I mentioned already the people who maybe lower income levels, maybe they're here illegally, or maybe people overseas in Zimbabwe don't trust their state. But on top of that, there's a civil libertarian in me that says, "I don't want Uncle Sam to know everything I'm doing, everything I'm buying." And I'll go even one step further on this argument. I've got to be very careful here. I'm on a ledge. I could fall down really far.
Beckworth: And that is, sometimes you don't want to follow the state. Sometimes maybe they have regulations that are onerous, that maybe are created by vested interests. Sometimes there might be reasons to pay things under the table because the regulations, it's a bad law. So on the margin, it keeps government honest. So I guess I'm laying my cards on the table there, if we do this, I would like to see at least some version of a token central bank digital currency. And maybe you could also have the Fed account version that you've suggested.
Andolfatto: I mean, so I've thought of those arguments as well, and I think I've been leaning to the extent that there's a demand for the product that you just described, that indeed this might be the role that something like a DAI might play. Ethereum is experimenting with offering its own type of stablecoin, for example. So in other words, if there is a need along that dimension, it's not immediately clear to me that it's the Fed that should be fulfilling that need. Perhaps the private sector is the place to look to fulfill that particular niche.
Beckworth: That's a good point though.
Andolfatto: Because why would you want the Fed involved? You're talking about this constituency that doesn't want to connected to the Fed, so let the private sector handle that.
Beckworth: Yeah, that's fair. And I had George Selgin on the show recently and we were talking about this very thing, because the Fed opened up comments for granting access to fintechs, to its balance sheet. So fintechs, in theory, could get Fed Master accounts and what are the rules and regulations? So yeah, what you just said, let a fintech provide that token based approach and they could be the ones connected to the payment system via the Fed. All right. So do you see a future then for stablecoins in our world then possibly?
A Future for Stablecoins
Andolfatto: Yeah. I mean, we're still very early on in the development of these structures and I am still not entirely sure what it is they're offering in terms of a gain for society. Now, there may be something there to the extent that the structures, the protocols are able to facilitate record keeping more efficiently, more securely just as a technological standpoint. I mean, I think this is a net gain and there's probably a role for these stablecoins to fill in the missing gaps in the payment system, right? Despite the immense gains that have been made over the 20 or 30 years we know that the plumbing is still not in a state that we're fully satisfied with if you just think about the state of correspondent banking, for example.
Andolfatto: So, to the extent that these stablecoins are there and can plug these gaps, they might be providing something good. More likely what they're doing though is promoting the incumbents to move, the incumbents and their regulators to respond to this threat, which again is a net gain for all of us. So it could be that the role of these stablecoins is that it's just promoting regulatory changes, because it's not immediately clear what say a stablecoin like the Diem, for example, that is sponsored by Facebook, is going to provide.
I think this is a net gain and there's probably a role for these stablecoins to fill in the missing gaps in the payment system, right? Despite the immense gains that have been made over the 20 or 30 years we know that the plumbing is still not in a state that we're fully satisfied with if you just think about the state of correspondent banking, for example. So, to the extent that these stablecoins are there and can plug these gaps, they might be providing something good.
Andolfatto: Is the demand for this product going to come essentially from some form of regulatory arbitrage? In which case, you might question the social value of a Diem. And the answer might be to reformulate the regulations that are prohibiting the domestic incumbent money services businesses from competing on an even keel with the Diem. So if it's regulatory arbitrage, and I don't know to what extent it is, I think there's some of that, then regulators are going to want to keep an eye on this. But on the other hand, to the extent that it's really this new technology, blockchain based or whatever that offers a more efficient structure, then it's potentially going to be something that could really take off, especially in the case of a Diem, because Facebook has a global network of over two billion people.
Andolfatto: And it's presently selling that as opposed to the Libra Project, which it’s coming back and saying, "Listen, we want to promote this U.S. dollar." Basically, they're promoting themselves as a money fund, a government money fund. And it all sounds really good, but, of course, there's nothing to say that they're going to be committed to remain a government money fund. They might take on different types of securities on their balance sheet. They're going to move to a fractional reserve banking system. Should they be regulated as a foreign currency? Should they be regulated as a security? These are questions. And then what happens if maybe one day they release themselves from the dollar peg and then we have a world with six billion users of Diem and what does this do to U.S. monetary sovereignty, for example? So these are questions. I don't know what the answers are to these questions, but I think these are the questions that are very much on the minds of policymakers and regulators.
Beckworth: So funny you bring up Libra because I recently interviewed Mark Carney for the show, and we talked about his famous 2019 speech at Jackson Hole, where he called for a synthetic hegemonic currency. And everyone remembers that part, and he really stressed this to me, because that's just the tail end big idea that flows out of all the logical steps he made prior to that. And the points he made prior to that is, look, we have this dollar dominant global system, which means emerging markets, other countries really get thrown around when the dollar swings in value or the Fed tightens or eases.
Beckworth: And it's not a very stable system financially. It definitely benefits the U.S. in terms of seigniorage flows and being able to finance deficits at rates that are lower than otherwise would be the case. But he suggested this as a way to provide an alternative to the dollar. It would, he argued, stabilize it. So, you present a scenario here where Facebook's money market fund, it's global, it's big. And then it separates itself from the dollar. It becomes a currency unto itself. Well, who knows, maybe it could serve a stabilizing purpose in the world. Now, from the U.S. perspective I would worry, but from maybe a global perspective, it might serve some good.
Andolfatto: Maybe. But on the other hand, how comfortable would we be with knowing that our global money supply is under control of unelected-
Beckworth: Mark Zuckerberg.
Andolfatto: It's not immediately clear that-
Beckworth: Fair enough. Yeah, fair enough, fair enough. Alright, David, that's been fun discussing these recent developments, the standing repo facility, the developments in the average inflation targeting framework and the future of central bank digital currency. Those are things that we are keeping a close watch on. But let's step back and look at some other topics that I think, they're timely but framed from a broader perspective and a rich history in economic theory. I want to start first with one that's tied to the conversation we're having today about overheating. Is the fiscal relief too big?
Beckworth: Some prominent policymakers like Larry Summers and Olivier Blanchard are worried that we have applied too much fiscal stimulus to the economy. And I bring this up because you've written some great posts on your blog, and you've written articles too, academic articles, about the idea of fiscal dominance. And you had a post recently about some unpleasant monetarist arithmetic. So I want to begin just with this question here and then you can run with it any way you want, but how are monetary policy and fiscal policy linked, even in normal times? So it's maybe easier to see it today, but even pre-pandemic, how are they linked and what does it mean for us today?
The Linkage Between Monetary and Fiscal Policy
Andolfatto: Yeah, so it just follows from in the consolidated government budget constraint. I mean, I don't know if that means anything to your listeners, but just roughly, if we think of a central bank as determining interest rates, the general level of interest rates, this is going to affect the yields on U.S. Treasury securities. It's going to affect the interest rate that the Treasury pays on the securities it issues. And then there's the question of financing the interest expense of the debt. So, I mean, right away, we see that monetary policy, interest rate policy, can directly affect the interest expense of the government debt and therefore have implications for fiscal policy. I mean, monetary policy can also affect the fiscal situation through other mechanisms, through creating recessions or whatever. But there's a direct link right there for you, the interest expense.
Andolfatto: And then there's a question well, I mean, how is the fiscal authority going to finance this interest expense? I mean, there's a variety of ways, hypothetically. I mean, it could, for example, embark on an austerity regime. For example, they might want to raise taxes or cut spending to re-divert resources to pay the interest on the debt. That might be one way to do it. And that's typically how we think of a "responsible fiscal policy" that wants to manage its long run state of its circulating debt to stabilize it, that it might want to adjust its primary surplus to make sure that the GDP ratio doesn't go wherever. But alternatively it could be that the fiscal authority chooses not to make these types of adjustments for a variety of reasons, and if that's the case, then the Treasury is just basically going to be forced to finance the deficit by issuing Treasury securities at a faster pace.
Andolfatto: And then the question is, well, what is the ability, the willingness and ability of the private sector to absorb these Treasuries at this faster pace? And what role does the Fed play in accommodating such Treasury issuance? And I find that for the Fed to achieve its mandates of… and the third mandate, by the way, that people don't talk about is, to keep a lid on long run interest rates. So, there's kind of an interest rate ceiling here so the Fed might be just compelled to essentially monetize these securities. And in that sense, the fiscal authority has gained control over the inflation rate.
Beckworth: So, David, let me ask the question this way, because I've had this conversation with people and I've gotten some heightened debates on Twitter about this, but many people will claim the Fed's liabilities are not backed by anything. Back in the day, the gold standard, you could literally take a Federal Reserve note and get gold or maybe even silver, if you go far enough back. Same thing with some Treasury bills, you might be able to get something in exchange. The greenbacks, which were Treasury bills, eventually were redeemable in gold after 1879.
Beckworth: But today, if you ask, well, what is this $100 bill, what is it backed by? And people say, "Oh, it's backed by nothing." And I disagree with that. I think even though there's not an explicit backing, implicitly, there is a backing. It's the future real resources the government's willing to collect via taxes, via whatever means it has to in order to make sure that this stock of outstanding government debt, money, bonds is not too much. When I say too much I mean so much that it leads to too high inflation. In other words, our dollars are implicitly backed by a commitment to future tax policy, tax actions, and if they're not, we begin to worry and inflation begins to take off automatically. So is it fair to say that there's this implicit backing? I guess the condition would be, given we want price stability and we're getting it, is there an implicit backing to future tax policy?
Implicitly Backing Future Tax Policy
Andolfatto: Yeah, I think that's the right way to think about it, especially given your conditioning statement. I mean, I think the way, in the lingo, in the literature we describe what you just explained as a Ricardian fiscal issue. The basic idea is that we can count on the fiscal authority, Congress basically, to adjust its tax and spend actions over the course of time in a manner that's going to ensure that there’s not an excess issuance of this Treasury paper that's ultimately going to lead to high inflation or excessively high inflation. So in that sense, to the extent that we can count on Congress to ultimately take the actions to restrain paper issuance, there is a backing, like the one that you described.
We can count on the fiscal authority, Congress basically, to adjust its tax and spend actions over the course of time in a manner that's going to ensure that there’s not an excess issuance of this Treasury paper that's ultimately going to lead to high inflation or excessively high inflation. So in that sense, to the extent that we can count on Congress to ultimately take the actions to restrain paper issuance, there is a backing, like the one that you described.
Andolfatto: But on the other hand, there's the so-called non-Ricardian regime, in a non-Ricardian regime where the fiscal authority is not so concerned about adjusting its tax spend in response to the potentially inflationary pressure, then what you'll likely to get, at least theoretically, is a higher price level. One way or the other, I mean you're going to have to… The real value of this then has to accommodate itself to the demand for the counter parties to actually be willing to hold it, on what terms? Somebody is going to be holding these Treasuries, without question. The Treasury's never going to default realistically,
Andolfatto: That doesn't mean that the Treasury and the Congress doesn't govern the terms on which these Treasury securities are hailed around the world, the terms, what inflation rate, what price level, what interest rate, and these are the things that could adjust. And so if you're interested in price level control, inflation rate control, yeah, it's exactly what you said. We can think of, in that case, we're insisting, we're hoping that our representatives in Congress are going to manage the budget in a way that keeps inflation anchored in the long run.
Beckworth: Alright, so, let me phrase this in a more technical manner. So what we're talking about here is the intertemporal government budget constraint. So we're looking at the resources the government has in the future discounted in present value terms, and if we look at that, so I mentioned tax and spend policy, and that's what we've been talking about, but there is one other term in that equation. We say the government's going to have to increase taxes, cut spending if we want to keep prices stable today. But another part of that is seigniorage, but I would call it more generally the network effect of your currency. So the dollar, as we've already discussed, is widely used around the world and that in itself creates some value for U.S. denominated debt, government liabilities. So you've got both of those things I think are important.
Beckworth: In the case of the U.S., I think that seigniorage part, that network effect part, is really important. Many countries, it's not, but I think it is here in this place. And I often wonder if many of the people who get worked up about inflation and have been since, I don't know, the past two decades and it hasn't materialized. And even now, it's remarkable. We've had a run-up in public debt and we still don't see signs of really high runaway inflation. We see a little bit of higher inflation this year, but we don't see the kind of runaway inflation one might think would be there with the run-up in public debt. People could look at this run-up on public debt and say, "Look, I don't see how we're going to adjust our future taxes and spending." But I wonder if what they're missing is this seigniorage network effect part, if that explains why, despite what we've seen, we're not going to have massively high inflation. What are your thoughts?
The Missing Seigniorage Network Effect
Andolfatto: Yeah, definitely, I think this is probably the one thing… My interpretation of what people, economists, have basically missed the last 10, 15 years in terms of the predictions of hyperinflation is that they look at the supply side. They see the money supply exploding. They see the supply of Treasuries exploding. And in the back of their minds, perhaps based on historical observations, they have in mind this stable demand for money or stable demand for Treasuries. And so, of course, if you increase the supply of money or Treasuries against a stable demand, you're going to have the usual textbook effects. But, of course, economic theory doesn't say that the demand for this stuff is stable. In fact, economic theory says we should accommodate for the possibility that the demand for this product might actually also grow over time. And indeed I can provide tons of anecdotal evidence of how there's been secular growth in the demand for U.S. Treasuries over time, both as collateral and shadow banking systems as safe stores of value for emerging economies, more added demand, regulatory demand out of Dodd-Frank and Basel. You could go on and on. And now indeed with the stablecoins.
Andolfatto: These stablecoins now are just screaming for U.S. Treasuries. The inflationary consequences, the interest rate consequences of this massive supply of U.S. Treasuries has to be juxtaposed against what we believe might be happening on the demand side. This is how, in fact, I interpret our recent low inflation episode is that I believe that it's largely a byproduct of this increased global demand for the product. But that's not to say that the inflation isn't going to happen, because maybe especially the way this administration is going, who knows? Maybe over time. When people don't see inflation despite very high deficits and debt levels, people become complacent. They think the economic theory is failed. Why should we listen to these people? And I say, "Fine, fine. Just cut taxes to zero." I mean, clearly there's no need for taxes here. I mean, just cut taxes to zero, keep on…
The inflationary consequences, the interest rate consequences of this massive supply of U.S. Treasuries has to be juxtaposed against what we believe might be happening on the demand side. This is how, in fact, I interpret our recent low inflation episode is that I believe that it's largely a byproduct of this increased global demand for the product. But that's not to say that the inflation isn't going to happen.
Andolfatto: And one or two things is going to happen. I mean, either we're going to have the greatest free lunch of all time, which I'd be very happy with, or you're going to see inflation. And my one personal view is I think we're going to see the inflation at some point, because just as a natural… we don't know what the global capacity is to accommodate the supply of Treasuries that are being pumped out. We don't know where that is. We don't know if the sustainable debt-to-GDP ratio is 100% or 200%. In fact, I have a paper coming out with Jim Bullard and a couple of other coauthors. We argue that the sustainable debt-to-GDP ratio might be much, much higher. But the point is, if we don't know where that limit is, I don't see any mechanism in place that prevents us from getting there, especially in the present political climate.
Andolfatto: And in the meantime, we get to finance all sorts spending with relatively low inflation and relatively low interest rates. And let's cross our fingers and hope that the spending is allocated to socially useful activities, infrastructure, for example, payments to people who need it, education, internet access, et cetera. And let's see how Congress responds if we do see excessive inflationary pressure.
Beckworth: Now, that's a great point. So even if there is this extra fiscal space due to network effects, seigniorage due to maybe even belief that the U.S. government will get its house in order in terms of spending tax policy. It can still create complacency, which could eventually lead to an outcome of high inflation. So we don't want to take it for granted. That's interesting. Your paper you mentioned, I'm looking forward to seeing it, that you and Jim Bullard suggest a really high number. It brings to mind a paper by Gauti Eggertsson and one of his grad students where he did something similar. Maybe a different framework, but he did a paper based on a conversation he had with Ben Bernanke when he was a grad student at Princeton and Ben Bernanke said, it’s kind of your free lunch scenario, "Look, at the end of the day, if monetary policy doesn't matter then the Fed could buy up the entire planet and there'd be no inflation."
Beckworth: So Gauti said, "Let's actually put this to a model and see how big the Fed's balance sheet would have to get before this happens." And if I remember correctly, and I may be off, I think they came up with a number like 400% debt to GDP. I mean, some really large number. And his point was, you couldn't even get there because there'd be supply constraints on the amount of debt, there'd be political constraints. So his argument is the number's really big, and particularly in the case of the U.S., and there'd be all other kinds of constraints that would prevent us from even getting to that point. So the takeaway I got from his paper is inflation is unlikely. Let me circle back though to this point you were making about viewing the debt problem from a demand side, not just a supply side. So you're right, many people that we know look at just the supply side, the growth of debt, without considering the demand for it maybe also growing.
Beckworth: And it's a good explanation for why inflation hasn't taken off, but let me go even further than that and take a stronger stand. It may explain why growth wasn't very robust over the past decade, and here's why. If indeed this demand for U.S. government liabilities is akin to a broad form of money demand, we know when you get excess real money demand scenarios, it's a drag on real growth. And consequently, if we have an excess demand for real government liabilities across the world, it could be creating drag on the U.S. economy. So that is an interesting scenario to consider, that maybe we would have had greater growth had there been more debt. Now I'll confess, it makes me uncomfortable to go down this path. Maybe we should have had a sovereign wealth fund to address this instead of just lots and lots of spending. I think there's other issues that come along with spending. I won't go into all of them now, but I'm curious to hear your thoughts on that question about whether the excess demand for U.S. government liabilities could have affected the real side of the economy.
Effects of Excess Liability Demands on the Economy
Andolfatto: Yeah. Well, theoretically, I mean, that's right on. I mean, we know to the extent that, say, money, let's just think of money, if we think of money as facilitating trade and we think of recessionary episodes as excess demands for money, excess precautionary demand for money and people diverting their wealth… it may very well be the case that the monetary/fiscal authority could have actually promoted more real economic activity by accommodating the demand over that period of time. So I'm certainly sympathetic to that. And I actually believe that's kind of true. I mean, I think that what we could argue about is the quantitative significance of that drag. That's not immediately clear. There might be more fundamental factors at work that are inhibiting growth opportunity and stuff like that. So, while I acknowledge that the effect is there, for sure, theoretically, it might even be there in reality, the question is quantitatively, what role did it play vis-a-vis other factors? I'm not so clear about that.
Beckworth: Well, with that, our time is up. Our guest today has been David Andolfatto. David, thank you so much for coming on the show to share your views.
Andolfatto: My pleasure, David. Thank you very much for the opportunity.
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