Monday, June 29, 2020

Is fiat money to blame for the Iraq war, police brutality, and the war on drugs?

I often encounter memes claiming that fiat money is to blame for all sorts of government evils. Here is one example from Kraken bitcoin strategist spokesperson & bitcoin meme factory Pierre Rochard:

The rough idea behind this family of memes is that the Federal Reserve, the world's largest producer of "fiat" money (i.e. irredeemable banknotes), is responsible for financing all sorts of examples of government over-reach, say foreign invasions, police brutality, and the twin wars on terrorism and drugs. It does so by producing seigniorage, or profit, which it passes on to the state. Replace fiat-issuing central banks like the Fed with bitcoin or a gold standard, and seigniorage would cease to exist. With the government's purse strings having been cut, a relatively peaceful society would be the result.

This meme's premise is wrong. In practice, central bank seigniorage in both the U.S. and other developed nations is a very small part of overall  government revenues. And so even if fiat money were to be displaced, say by bitcoin or a gold standard, it wouldn't change the state's ability to fund the war on drugs and adventures in the Middle East.

Let's look at the U.S. Below are two charts showing how much income the Federal Reserve has contributed to the Federal government's overall receipts going back to 1950. (Beware. One chart relies on a regular axis, another a logarithmic axis. But they use the same data). The Fed's contribution has been steadily growing over time. In 2019, it sent about $53 billion to the Federal government.

You may be wondering how the Fed generated $53 billion in profit, or seigniorage, in 2019. Most of this income comes from issuing banknotes, or cash. For each $1 in banknotes that it issues to the public, the Fed holds an associated $1 of bonds in its vault. These bond have typically yielded 3-4% in interest. But the Fed only pays 0% interest to the owners of its banknotes. Which means that it gets to keep the entire 3-4% flow of bond interest for itself. It forwards this income to the Federal government at the end of the year.*

Seigniorage tends to grow over time. (But not always. Below I'll show how Sweden's seigniorage has been shrinking). The larger the quantity of banknotes that the public wants to own, the more interest-yielding bonds the Fed gets to hold, which means more seigniorage. In general, banknote demand increases with economic and population growth.

Interest rates are another big driver of seigniorage. If bond interest rates rise from 4% to 8%, the Fed earns more on the bonds it owns in its vault. Banknotes continue to yield 0% throughout, so the Fed keeps the entire windfall for itself (and ultimately for the Federal government).

By the way, a big driver of nominal interest rates is inflation. If inflation is expected to double, then bond owners will require twice the interest to compensate them for inflation risk. So inflation boosts seigniorage (because it boosts the interest rate that the Fed earns on the bonds in its vaults), and deflation hurts seigniorage (because it reduces interest rates). In the chart above, the one with the logarithmic axis, you can see how the Fed's seigniorage increased during the inflationary 1970s. It flatlined from the mid-1980s to the early early 2000s, which coincides with inflation subsiding.

US seigniorage is relatively small. In addition to enjoying revenues from the Federal Reserve, the U.S. Federal government also gets money from individual and corporate income taxes, social insurance and retirement receipts, excise taxes, duties, and more. Below I've charted the relative sizes of these contributions.

As you can see, the Fed's contribution (the grey line) is a rounding error.

Below is a chart showing what percentage of total government revenue is derived from the Fed.

In 2019 the Fed contributed just 1.5% of total U.S. Federal government receipts. This contribution has hovered between 1% to 3% over the last four decades. So the meme that fiat money abetted the Iraq War, the expansion of the police state, or the U.S.'s military industrial complex is mostly hyperbole.

What about other developed nations?

The Bank of Canada provided $1.2 billion in earnings to the Canadian Federal government in 2018. But the Federal government took in $313 billion in revenues that year, which means that the Bank contributed a tiny 0.4% fraction of total revenues. The reason for the big gap between the Bank of Canada's tiny 0.4% contribution and the Fed's 1.5% contribution is the global popularity of the US$100 bill. Canadian cash doesn't enjoy a big foreign market.

I mentioned Sweden earlier. Below is a chart of seigniorage earned by the Swedish central bank, the Riksbank.

Sweden is one of the only countries in the world where banknote ownership has been falling. This de-cashification is compounded by interest rates that have fallen close to 0%. Which means that the Riksbank's bond portfolio isn't earning as much as it used to. This combination has just decimated the Riksbank's seigniorage. In 2018 its seigniorage amounted to a paltry SEK 267 million (US$29 million). This is just 0.00003% of all Swedish central government receipts.

So in sum, central banks in places like the US, Canada, and Sweden are not a big source of government funding. If you want to stop governments from engaging in bad policies like the war on terror, the war on drugs, and foreign meddling, you've got to work within the system. Vote, send letters, go to protests. Sorry, but buying bitcoin or gold in the hope that it somehow defunds these activities by displacing the Fed is not a legitimate form of protest. It's a cop-out.

P.S. By the way, I am not saying that control of the nation's money supply hasn't been used to finance wars in the past. Obviously it has. Greenbacks helped pay for the Union's war against the Confederates. Henry VIII paid for his wars by dramatically reducing the supply of silver in the English coinage.

*The Fed enjoyed a big spike in seigniorage after the 2008 credit crisis. This is because it issued a bunch of deposits to bank (known as reserves) via quantitative easing. The Fed only had to pay 0.25% interest on these reserves, but the bonds that backed them were earning 2-3%. This QE-related income has declined as the Fed has unwound QE (since reversed) and long-term interest rates have declined.

Wednesday, June 24, 2020

Banks are slow to increase rates on savings accounts, but quick to reduce them

Chase Sunset & Vine, 2012. Painting by Alex Schaefer

Banks don't like to share higher interest rates with their customers.

Case in point: let's take a look at what happened as the Federal Reserve, the U.S.'s central bank, went through a long period of hiking interest rates from 2015 to 2019.

The Federal Reserve's first rate increase (from 0.25% to 0.5%) was in December 2015. It increased rates once more in 2016 and three times in 2017. But the interest rate on the average U.S. savings account and interest checking account didn't start to rise till spring 2018, two and a half years after the Fed's first rate hike (see chart a few paragraphs down).

If you're like me, you'd assume some sort of direct linkage between: 1) the interest rate that the Federal Reserve pays its customers (i.e. banks) and 2) the rate that these same banks pay their customers, you and me. Just like we have a checking account at a bank, banks maintain checking accounts at the Federal Reserve, the U.S.'s central bank. They earn interest on balances held in those accounts. This rate is known as the Fed's interest rate on reserves, or IOR. As the Fed increases the interest rate that it pays on these checking accounts, the banks earn more from the Fed. But for some reason the banks don't pass these earnings on to the public.

This lack of pass-through bothered me when I first tweeted about it over a year back. But I didn't take it too seriously, figuring it was due to some sort of institutional inertia. Banks are slow monolithic beasts. If they're slow to increase rates, at least they're slow to chop them, too, right? So on net, we customers aren't any worse off.
But are banks actually slow to reduce rates? Well, the results are in. The Fed began to cut rates in mid-2019. When Covid hit in March, the Fed rapidly ratcheted IOR down from 1.6% to 0.1%. Banks went from earning around $38 billion in interest on their checking accounts at the Fed (in fiscal year 2018) to almost nothing.

So did banks take three or four years to pass lower Fed interest rates rates on to their customers? Nope. In just a month or two, the banks obliterated all the interest rate gains that customers wit savings account had enjoyed since 2018:

No, banks aren't lethargic beasts that are universally slow to change interest rates enjoyed by savers. They seem to have a strategy of increasing rates slowly, and then reducing them rapidly. Assholes.

Note that the savings rate I am using is from the Federal Deposit Insurance Corporation's website. FDIC takes the simple average of rates paid by all insured depository institutions and branches for which data are available.

By the way, this data probably doesn't represent the experience of the minority of financial sticklers who make an effort to locate high-interest rate savings accounts at online-only banks. JP Morgan's Goldman Sachs's Marcus currently offers 1.03%, much higher than the 0.10% that the Fed pays to Goldman JP Morgan. Ally offers 1.10%. But the average savings account holder doesn't bank at these institutions. They stick to Bank of America or Wells Fargo, which both offer a measly 0.01%.

This asymmetry isn't a new phenomenon. In "Sticky Deposits", Federal Reserve economists John Driscoll & Ruth Judson found that rates are "downwards-flexible and upwards-sticky."

More specifically, the authors used proprietary data from 1997 to 2007 to show that interest rates on bank accounts and other retail deposits adjust about twice as frequently during periods of falling Fed interest rates as they do in rising ones. They estimate that this sluggish pass-through from rising Fed rates to customer rates costs American consumers around $100 billion per year!

My favorite chart from Driscoll & Judson is below:

Source: Judson & Driscoll

At left, we see the number of weeks it takes for banks to decrease the rate on interest checking accounts in response to a cut in the Fed's interest rate. At right we see the converse, how long it takes increase rates in response to higher Fed rates. Decreases tend to happen quickly (the purple bars in the left chart congregate closer to zero weeks) whereas increases are slow (the purple bars in the right chart congregate close to 100 weeks). More specifically, during Fed easing cycles, checking deposit rates are updated on average every 22 weeks, but during tightening cycles it takes an average of 50 weeks.

So what explains this asymmetry? A lack of competition perhaps? If I had to guess, I'd say low financial education and dearth of customer attention. Banks can afford to be assholes because most customers either don't understand what is happening, or don't notice.

If the banks are taking advantage of their customers' ignorance and inattention to the tune of $100 billion per year, should something be done?

One option would be to provide a government savings option that 'corrects' for this asymmetry. Like digital savings bonds. Or maybe a government prepaid debit card with a built-in savings account. These cards would offer an interest rate that is linked to the Federal Reserve's interest rate, but only available to those below a certain income ceiling.

Or what about setting statutory minimum interest rates on savings accounts? In Brazil, for instance, banks are obligated to link the rate they pay on savings accounts to the central bank's interest rate:

Or maybe it starts with education. As part of its new financial literacy drive, Ontario will teach children how to identify Canadian coins and bills and compare their values in Grade 1, saving and spending from Grade 4, how to budget starting in Grade 5, and financial planning starting in Grade 6. If the result is a more savvy population, banks may face more pressure to pass on higher interest rates.

Or maybe nothing. In which case one hopes that over time the combination of better financial technology, branchless banking, and competition from Silicon Valley will eventually result in better pass-through and more symmetry in interest rates.

Friday, June 5, 2020

Want to open an account at the central bank? I'll pass, thanks

The only type of central bank-issued money that we hoi polloi can own are banknotes. But over the last few years, researchers at central banks have been increasingly toying with the idea of issuing digital money for public consumption. I count 380,000 search results on Google for the term "central bank digital currency," up from zero just a few years ago.

There are two types of proposed central bank digital currencies, or CBDCs. The first, Fedcoin, is implemented on a blockchain. I wrote about it here. But the odds of Fedcoin happening are minuscule. This post will be about the second type.

The second is a basic bank account, sort of like PayPal except run by a central bank like the Federal Reserve (or the European Central Bank or the Bank of England.) Just like you go to PayPal's website to register for an account, you'd head over to the Fed's website to open an account. A Fed version of PayPal would let you pay your friends, accept donations and business income, and buy stuff at stores. Except you'd be using Fed money, not PayPal money.

I'm not philosophically or ideologically opposed to the idea of a Fed PayPal. If the Fed (or any other central bank) wants to get into providing payments services to regular folks, fine. The same goes for Walmart. If it wants to start providing retail bank accounts, great. Ditto for Facebook. I think Libra is an admirable project. Oh, and I also want more co-operative banks and credit unions. What about community currencies? By all means, let's get more alternative systems like Ithaca Hours and the Bristol Pound up and running. And while were at it, commercial banks, credit unions, and municipalities should be allowed to issue banknotes. Heck, why not a Nike banknote?

In short, the more payments options people have, the better. (My one caveat: If a central bank is going to introduce a central bank version of PayPal, it should be obligated to recover its costs. FedPal shouldn't have an advantage over regular PayPal, the Michigan First Credit Union, or a commercial bank like Wells Fargo.*)

All that being said, I'm not terribly optimistic about the prospects for a central bank version of PayPal.

With paper money, central banks already have an incredibly popular product. Banknotes are anonymous. People can use them for activities that might be frowned on, and this is a pretty big market. Bills have another nice property; they are ungated. Anyone can accept a dollar without needing to open an account. This accessibility has made paper dollars, which can move fluidly across borders, wildly popular in nations with poorly functioning banking and monetary systems. Most importantly, central banks have a monopoly on the business of issuing cash. So they don't have to worry about competition.

But the success of central banks' cash line of business won't translate into success for a central bank version of PayPal. Given the current state of anti-money laundering regulations, we probably wouldn't be able to open a Fed PayPal account anonymously. Furthermore, it's unlikely that the Fed, or any other central bank for that matter, would open up eligibility to non-citizens living in foreign countries.

So forget about catering to the huge market of anonymity seekers and foreigners who would love to hold a U.S. dollar account directly at the Fed. FedPal would probably be a US-only product. (Likewise, the Riksbank's e-krona would be a Sweden-only product).

But this is a crowded field. Whereas cash is a government-run monopoly, thousands of competitors offer digital payments accounts. Can the central bank differentiate itself from a slew of other digital account options? I'm skeptical.

1. Features?

You've gotta keep in mind that CBDC is a brainchild of macroeconomic theoreticians, not product designers. Macroeconomists don't have any expertise in designing retail banking products. And so I'm not terribly bullish on the Fed or the Bank of England coming up with new features that would differentiate a central bank account from any other payments accounts.

2. Safety?

Not really. In the U.S. (as in most developed countries), bank accounts and prepaid debit cards are already insured up to $250,000. For most regular folks, dollars held at the Fed won't be any safer than those held in banks.

3. Fees?

The Fed might try to offer a low-fee option, perhaps to the unbanked or the underbanked. But in the U.S., this is getting to be a crowded field. Chime, Varo, Ally, and Simple offer no-monthly fee accounts. There are plenty of no-fee prepaid debit cards out there, too. Just last week, I spotlighted the PODERcard, which is marketed to unbanked immigrants.

The public sector is already active in this field, too. The Federal government already offers a no-fee prepaid debit card, the Direct Express card, to over 60 million Americans who receive Federal benefits. And state governments often provide no-fee debit cards for tax refunds, unemployment, and other state benefits. It's hard to see what a CBDC can bring to the table.

4. Higher interest rates?

Might a CBDC be able to offer higher interest rates than the competition? A few commentators have suggested that a Fed version of PayPal offer regular Americans the same interest rate that the Fed pays large banks that keep accounts at the Fed. Banks maintain accounts at the Fed so that they can make interbank payments and meet reserve requirements.

In the chart below, the Fed pays banks the blue line, interest rate on reserves. This rate has historically been far higher than the two red lines in the chart: the average rate that banks pay customers on a checking or savings account. (For its part, PayPal pays its customers 0%).

Were the Fed to pay FedPal account holders the blue line, i.e. the same interest rate it pays banks, this would effectively convert a FedPal account into an incredibly high-yield checking account. No doubt it would become a wildly popular product.

But serving millions of retail customers is a lot more expensive than serving a couple of hundred banks. Think customer help lines, fraud prevention, advertising, paper check processing, ATM network fees, and more. As I stipulated at the outset, FedPal shouldn't be allowed to operate at a loss. This would be unfair to the thousands of community banks, credit unions, fintechs, and commercial banks that are trying their hardest to provide payment services to the public.

To recover its costs of serving a retail customer base, the Fed would have no choice but reduce the interest rate it offers. How low would it go? As a monopoly, the Fed is unused to the rigors of competition. I wouldn't expect it to be able to run a tight enough ship that it could afford to pay customers an especially high interest rate.

5. Speed?

Nope. With the introduction of Zelle, it's possible for Americans to make free instant payments, 24/7. Many other nations (like Sweden) also have real-time payments. We've got it here in Canada, too.


So central bank version of PayPal would be just another middling bank account. Sure, roll it out. But don't expect it to change the world. 

Funny enough, central bank macroeconomists are worried about the opposite: that CBDC could change everything. In the papers they write on the topic, macroeconomists fret that any CBDC they introduce will be so attractive that consumers will rapidly desert their regular bank and open an account at the central bank. This would cause the whole banking system to implode.Without a stable base of deposits, banks would be unable do any lending.

In my view, the real threat is the opposite. Given the institutional constraints I listed above, a central bank version of PayPal is destined to be a middling payments product. But it gets worse. Because central bankers are so worried about the macroeconomic effects that a FedPal will have on the economy, they will inevitably underdesign these accounts, turning a middling product into a crappy one. Adoption will never occur, and so FedPal will be wound down. This failure will go on to undermine the reputations of central banks.

The lesson is, either do a stellar job designing these things... or don't do it at all.

* If the U.S. government is going to get more actively involved in offering low cost payments services to the public, there's a better way to get there than starting up a new CBDC-based system from scratch. Just offer government-sponsored prepaid debit cards. 
The neat thing is, it already does this. Millions of Americans who receive Federal benefit payments like social security already use the Direct Express card, a no-fee debit card issued by the government in partnership with Comerica. And to help disburse coronavirus relief payments, the government recently issued millions of EIP card, a no-fee prepaid debit card in partnership with Metabank. As I suggested here, why not make these cards better by letting card owners send/receive real-time payments via Zelle, attaching a savings account to the card, and giving users the in-app option of buying Treasury savings bonds.

In a recent article for the Sound Money Project, I suggested that the IRS start issuing debit cards too.

Saturday, May 30, 2020

How the Bank of Canada's balance sheet went from $118 billion to $440 billion in eight weeks

Ever since the coronavirus hit, the Bank of Canada's balance sheet has been exploding. In late February its assets measured just $118 billion. Eight weeks later the Bank of Canada has $440 billion in assets. That's a $320 billion jump!

To put this in context, I've charted out the Bank of Canada's assets going back to when it was founded in 1935. (Note: to make the distant past comparable to the present, the axis uses logarithmic scaling.)

The rate of increase in Bank of Canada assets far exceeds the 2008 credit crisis, the 1970s inflation, or World War II. Some Canadians may be wondering what is going on here. This blog post will offer a quick explanation. I will resist editorializing (you can poke me in the comments section for more colour) and limit myself to the facts.

We can break the $320 billion jump in assets into three components:

1) repos, or repurchase agreements
2) open market purchases of Federal government bonds
3) purchases of Treasury bills at government auctions.

Let's start with repos, or repurchase operations. Luckily, I don't have to go into much detail on this. A few weeks back Brian Romanchuk had a nice summary of the Bank of Canada's repos, which have been responsible for $185 billion of the $320 billion jump.

With a repo, the Bank of Canada temporarily purchases securities from primary dealers, and the dealers get dollars. This repo counts as one of the Bank of Canada's assets. Some time passes and the transaction is unwound. The Bank gets its dollars back while the dealers get their securities returned. The asset disappears from the Bank of Canada's balance sheet.

The idea behind repos is to provide temporary liquidity to banks and other financial institutions while protecting the Bank of Canada's financial health by taking in a suitable amount of collateral. If the repo counterparty fails, at least the Bank of Canada can seize the collateral that was left on deposit. This is the same principle that pawn shops use. The reasons for providing liquidity to banks and other financial institutions is complex, but it goes back to the lender of last resort function of centralized banking. This is a role that central banks and clearinghouses inherited back in the 1800s.

How temporary are repos? And what sort of collateral does the Bank of Canada accept? In normal times, repos are often  unwound the very next day. The Bank also offers "term repos". These typically have a duration of 1 or 3-months. The list of repo collateral during normal times is fairly limited. The Bank of Canada will only accept Federal or provincial debt. That's the safest of the safe.

But in emergencies, the Bank of Canada is allowed to extend the time span of its repos to as long as it wants. It can also expand its list of accepted collateral to include riskier stuff. Which is what it did in March 2020 as it gradually widened the types of securities it would accept to include all of the following:

Source: Bank of Canada

That's a lot of security types! (The list is much larger if you click through the above link to securities eligible for the standing liquidity facility, see here. Nope, equities are not accepted as collateral.)

As for the temporary nature of these repos, many now extend as far as two years into the future. See screenshot below:

Source: Bank of Canada

(Note that the Bank of Canada has a very specific procedure for moving from "regular" purchases to "emergency" purchases. Part of this was implemented due to its initial reaction in 2007 to the emerging credit crisis. It accidentally began to accept some types of repo collateral that were specifically prohibited by the Bank of Canada Act. The legislative changes implemented in 2008 remedied some of the problems highlighted by this episode and codified the process for going to emergency status. Yours truly was involved in this, click through the above link.)

Anyways, we've dealt with the $185 billion in repos. Now let's get into the second component of the big $320 billion jump: open market purchases of long-term government bonds, or what the Bank of Canada refers to as the Government of Canada Bond Purchase Program (GBPP). This accounts for another $50 billion or so in new assets.

Whereas a repo is temporary, an outright purchase is permanent. Some commentators have described the purchases that the GBPP is doing as "quantitative easing". But the Bank of Canada has been reticent to call it that. When it first announced the GBPP, it said that the goal was to "help address strains in the Government of Canada debt market and enhance the effectiveness of all other actions taken so far."

This is a non-standard reason. Large scale asset purchases are normally described by central bankers as an alternative tool for stimulating aggregate demand. Usually central banks use interest rate cuts to get spending going. But when interest rates are near 0% they may switch to large scale asset purchases. (The most famous of these episodes were the Federal Reserve's QE1, QE2, and QE3). But the Bank of Canada seems to be saying that its large scale purchases are meant to fix "strains" in the market for buying and selling government bonds, not to stoke the broader economy. 

Together, the GBPP and repos account for $235 billion of the $320 billion jump.

Let's deal with the last component. Another $65 or so billion in new Bank of Canada assets is comprised of purchases of government Treasury bills (T-bills). A T-bill is a short term government debt instrument, usually no more than one year. This is interesting, because here the Bank of Canada can do something a lot of central banks can't.

Most central banks can only buy up government debt in the secondary market. That is, they can only purchase government bonds or T-bills that other investors have already purchased at government auctions. The Bank of Canada doesn't face this limit. It can buy as much government bonds and T-bills as it wants in the primary market (i.e. at government securities auctions).

Since the coronavirus crisis began, the Federal government under Justin Trudeau has revved up the amount of Treasury bills that it is issuing. As the chart below illustrates, in the last two Treasury bill auctions (which now occur weekly instead of every two weeks) it has raised $35 billion each.

For its part, the Bank of Canada bought up a massive $14 billion at each of these auctions. That's 40% of the total auction. In times past, the Bank of Canada typically only bought up around 15-20% of each auction. This 15-20% allotment was typically enough to replace the T-bills that the Bank already owned and were maturing.

By moving up to a 40% allotment at each Treasury bill auction, the Bank of Canada's rate of purchases far exceeds the rate at which its existing portfolio of T-bills matures. And that's why we're seeing a huge jump in the Bank of Canada's T-bill holdings.

(So who cares whether the Bank of Canada buys government bonds/T-bills directly at government securities auctions instead of in the secondary market, as it is doing with the GBPP?  It's complicated, but part of this controversy has to do with potential threats to the independence of the central bank. But as I said at the outset, I'm resisting editorializing.)

These three components get us to $300 billion. The last $25 billion is due to other programs. I will list them below and perhaps another blogger can take these up, or I will do so in the comments section or in another blog post:

+$5 billion in Canada Mortgage Bonds
+$5 billion in purchases via the Provincial Money Market Purchase Program (PMMP)
+$1 billion in Provincial bonds
+$8 billion in bankers' acceptances via the Bankers' Acceptance Purchase Facility (BAPF)
+$2 billion in commercial paper
+$1 billion in advances

And that, folks, is how the Bank of Canada's assets grew to $440 billion in just two months.

Tuesday, May 19, 2020

One country, two monetary systems

I often write about odd monetary phenomena on this blog. Here's a new contender, Yemen's dual banknote system.

Yemen uses the Yemeni rial as a unit of account. As one of the poorest countries in the world, Yemen still relies mostly on banknotes to make transactions, which are issued by the Central Bank of Yemen, or CBY.

One of the convenient features of banknotes is their fungibility. This means that one banknote is perfectly interchangeable with another. For a few months now, something strange has happened to Yemen's banknotes. Old rials and new rials have ceased to be fungible. Any rial note that was printed prior to 2016 is now worth around 10% more than newer rial notes.

More generally, the entire Yemeni monetary system has split on the basis of banknote age. From a Western perspective, it would be as if every single U.S. banknote issued with a Steve Mnuchin signature on it, the current Treasury Secretary, were worth 10% less than bills signed five years ago by his predecessor Jack Lew.

Conflicts are always complicated. What follows is a short but drastically simplified explanation of how Yemen's banknote problem began.


In 2014, the northwestern part of Yemen was taken over by rebel Houthis. They also managed to capture the capital, Sana'a. Meanwhile, an internationally-recognized government occupies the south, the port city of Aden being its capital. Very few people live in eastern Yemen.

Source: Aljazeera

The Central Bank of Yemen has always been located in the capital, Sana'a. It tried to be a neutral party between the two warring sides. This sounds like it must have been a very awkward role to play.

For instance, before the war started the central bank was responsible for paying government salaries, including the army. When the war kicked off some soldiers supported the rebels in the north while others joined the internationally-recognized government in the south. According to Mansour Rageh & coauthors, this meant that the central bank was simultaneously paying the salaries of both sides of the conflict. That's touchy.

This balancing act eventually broke down in 2016 when the internationally-recognized government forced the central bank to move to Aden. Rageh et al explain how this happened. In short, the government convinced the international community to block the Sana'a branch's access to foreign reserves. It also prevented the branch from getting new banknotes printed.
So by late 2016 we've got two different branches of the central bank, one controlled by the rebels and the other by the internationally-recognized government. The latter controls most monetary functions.

With the stage set, we can now start to get into the meat of why old rial notes are worth more than new ones. After the Aden branch of the CBY had established itself in 2016, one of the first things it did was order a bunch of new banknotes to be printed up by Russian note printer Goznak. These arrived in Aden in early 2017. They looked like this:

Source: Banknote News

You can see that there are some differences between the new 1000 rial note and the old one, pictured below:

Source: Banknote News

The rebels were not happy with the new notes. It's easy to guess why. Fresh money could be used to pay government fighters, not rebel fighters. This "blood money" would then cheekily flow north via trade. Since anyone who holds a banknote is by definition funding the government that issues it with a no-interest loan, the rebel north was financing its own enemies. (The technical term for this sort of financing is seigniorage).

In 2017, the rebels began to limit the ability of northern civilians to use the newly issued banknotes. This mostly affected banks and other large businesses in the northern Yemen, which were now required to avoid dealing in the new notes. Anthony Biswell of the Sana'a Center for Strategic Studies has a much weightier explanation of this transition. Do read his article if you want to learn more about this topic.

Anyways, on December 18, 2019 the rial spat crescendoed into a full out ban. The rebel government announced that everyone in the north had thirty days to turn over new notes at any of 300 agents located across the region. In return they would get an equivalent amount of old banknotes, if available, up to 100,000 rials per person. That's around US$170.

Anything above this 100,000 rial limit would have to be converted into a digital rials. These would be supplied by one of three privately provided electronic wallets. Unfortunately, Yemen has almost no digital payments infrastructure, so these balances wouldn't be of much use.

Thanks to the December 2019 ban, the price of old and new rial banknotes has completely diverged. Below is a chart from the World Bank.

Source: World Bank

We can surmise why a big gap has developed between the two types of notes. The stock of old pre-2016 banknotes is fixed. It can't grow. But the supply of new banknotes is not fixed. The Aden branch of the CBY can get Goznik to print as many notes as it wants. So the rare rials, the old ones, are worth more.

I'd expect Gresham's law to kick in, too. Gresham's law says that if a government stipulates that two payment instruments are to circulate at the same rate, but one is worth fundamentally more than the other, then the "bad" one drives out the "good". More specifically, the undervalued money will be hoarded (or exported), leaving only the overvalued one in circulation.

In Aden's case this is likely to translate into "bad" rials (the post-2016 ones) driving "good" rials (the pre-2016 notes) out of circulation. Since the Aden government treats both old and new banknotes as interchangeable, but old ones are worth more, the old ones will all be exported to the north.


Where might all this lead? With the Sana'a branch having declared war on new notes, the Aden branch may do the opposite and try to hurt the old ones. This would involve orphaning all of its pre-2016 banknotes. That is to say, the Aden branch will demonetize them; cease accepting old notes as its liability or obligation.

But even if they were to be demonetized, orphaned rials would still circulate.

The topic of "orphaned" currency has popped up before on this blog. The Somalian central bank ceased to exist in 1991. Yet even though the Somali shilling now lacked a central bank sponsor, they continued to be used in Somalia as a medium of exchange, as recounted by Will Luther here.

A new Somali central bank has stated that it will re-adopt these old shillings and replace them with new currency. To date, this hasn't happened.

Along these same lines, even though Saddam Hussein disowned Iraqi dinars that had been printed in Switzerland, these so-called "Swiss Dinars" continued to circulate in northern Iraq. After Saddam was deposed by the Americans in 2003, the new central bank re-adopted all of the orphaned Swiss dinars.

If the Aden government is going to disown old Yemeni rials, I wouldn't expect them to remain orphaned for long. The Sana'a branch of the Central Bank of Yemen would quickly adopt them as their own obligation. At which point Yemen's unofficial two-currency system would become official. The Sana'a branch might even try to get its own version of the rial printed up. If so, it would have to rely on printers other than Goznak.


Yemenis already face so many difficulties. The sudden emergence of a dual-currency regime only compounds their plight. Prices are a language. We become fluent in this language as we engage in our commercial habits of buying, selling, and appraising. The sudden rial split forces Yemenis to start "speaking" in two different price arrays (three if the U.S. dollar is included). It's terribly inconvenient.

There are also costs to renegotiating rial-denominated debts. If one Yemeni owes the other, are they to pay in old rials or new ones? Debtors will always prefer the debased currency, new rials, but creditors will ask for the stronger one, old rials. Somehow a decision will have to be made.

Finally, a dual currency regime means that Yemenis will be forced to convert from one type of currency to another to make payments. That means incurring fees, hassles, and waiting time.

In the west, we take fungibility for granted. To achieve monetary standardization, a big investment in technology and coordination is required. The fact that a dollar is worth the same in Los Angeles as it is in New York, or Vancouver as it is in Halifax, is worth celebrating.

P.S. Yemen's old rials are really old. See image below. Dilapidated banknotes are a major problem. They make trade harder and allow for easier counterfeiting.

Monday, May 11, 2020

Why Fedcoin

Six years ago I wrote a blog post about Fedcoin. Fedcoin is a type of central bank digital currency, or CBDC. (I called it Fedcoin at the time, but it could be any central bank that issues it, not just the Federal Reserve.)

So why Fedcoin?

The rough idea was that it might make sense for the Federal Reserve to create a digital version of the banknotes it issues. To do so it would use a blockchain, much like the blockchains that power Ethereum or Bitcoin. Anonymous users all over the world could download Fedcoin software and run it on their computers. In the same way that anyone can use a U.S. banknote (or bitcoin), anyone could get some Fedcoins and spend them.

Why a blockchain?

Public blockchains have many well-known problems. Because they are decentralized, they rely on work-intensive methods to process transactions. This reduces the throughput they can achieve. Transactions start to lag and they system becomes unusable.

To avoid these capacity issues, people generally advocate an alternative approach to CBDC. If a central bank is going to issue digital money that regular folks can hold, best to do so by providing a basic bank account. Sort of like PayPal, except run by the Fed. It would be faster and more efficient. 

Fedcoin has some benefits that Fed PayPal doesn't, though.

Like I said earlier, Fedcoin would replicate many of the features of a banknote. The banknote system already operates in a decentralized manner. This means that it is fairly robust. If the Fed is hit by a computer virus and has to close down for two weeks, the banknote system will continue to function just fine. That's because we banknote users—individuals, businesses, banks—operate large parts of the cash system, independently of the Fed.

Fedcoin would be similarly decentralized, thanks to its blockchain. And so hopefully it would still function when disasters, hacks, and invasions knock the Fed out of action. At least, more so than a PayPal account hosted on Fed servers.

More controversially, if the U.S. is going to create a digital currency, should it should be an anonymous one?

PayPal-like accounts at the Fed aren't anonymous. I mean, the Fed could allow people to sign up anonymously. Sort of like how egold, the anonymous PayPal that operated in the 2000s, allowed pseudonymous usage. But account holders would never really know what the Fed was doing behind the scenes. Might it be tracing everyone's account activity such that it could build an accurate portrait of each user?

No, if it wants to provide anonymous payments, then the Fed probably needs to give people a means of verifying that its technology is actually doing the job.

With Fedcoin, everyone could download and run the software, poke and prod it, audit it etc. This would allow the public to confirm that no one was operating behind the curtains. What you see is what you get. Sort of like how a $100 banknote is obviously anonymous. Just pull it apart. No surveillance technology. Just cotton, ink, and a security ribbon. I doubt the Fed could provide that sort of transparency with a Fed version of PayPal.

A fully anonymous digital dollar would have some good properties. It would protect us from surveillance by governments and corporations. In a recent article for Coin Center, Matthew Green and Peter Van Valkenburgh explore how this might work.

But anonymity is no panacea.

An anonymous Fedcoin would be the perfect medium for fraudsters and extortionists. Granny extortion schemes are a big business right now. (Head over to Kitboga to see how they work). These boiler-room operations, many of which are run from India, rely on awkward payments methods like Western Union or Walmart gift cards to get granny's money.

But imagine how easy things would be for an extortionist if they could get granny to convert her $100,000 portfolio of savings bonds into sleek & anonymous Fedcoins, and then send them instantly to India.

Or take ransomware. Criminals plant a virus on a corporation's servers and then demand a ransom to free their files. Ransomware operators—most of whom operate from Russia—rely entirely on bitcoin for payment, which is illiquid, volatile, and traceable. But imagine if the criminal could get paid in anonymous digital dollars. That would make the ransom process much easier.

So as you can see, anonymity is messy. It helps good people to avoid harm. But it helps bad people evade good rules.

One way to tidy up this mess might be an anonymity tax. (In my last paper for R3, I explored this idea. And in a previous blog post, I talked about an anonymity tax on banknotes). Briefly, the Fedcoin system would be designed so that anyone can get as much anonymous money as they want, and use it however they like. But they'd have to pay for this privilege. One technique for setting a tax is to charge an hourly fee, or a negative interest rate, on anonymous balances. Another option, which I get from Ilan Benshalom, is to implement a withdrawal fee, say 5%, on anonymous Fedcoins.

By taxing anonymity, the tax revenues from Fedcoin usage might be used by the government to offset the negative effects of payments anonymity. For instance, it could be used to bolster the budgets of fraud departments at the FBI, or to compensate victims of ransomware.

But even this remedy is messy.

An anonymity tax puts regular people and criminals into the same bucket. That hardly seems fair. And it subtly ostracizes licit users of anonymous Fedcoin. We want anonymous payments to be a regular good, not something icky or tainted.

That's where I'll leave it. Sorry, no neatly wrapped and bowed conclusion. With anonymity, there are never clean options. Just kludges. Hopefully some are less kludgy than others.

Thursday, April 23, 2020

The best investment in the world

I've blogged about strange trades before. There's Kyle Bass's bet on 5-cent coins. The great Japanese gold trade of 1859. And the epic bull market in shares of the Swiss National Bank, Switzerland's central bank.

This post is about the best investment in the world. I won't leave you hanging. It's the U.S. "Series EE" savings bond.

The coronavirus pandemic has led to a huge collapse in U.S. interest rates. As of April 21, the 30-year U.S. government bond rate was at 1.17%, down from 2.33% at the beginning of the year. The 20-year rate was at 0.98%, down from 2.19%.

But there's one corner of the U.S. government debt market where a a juicy 3.5% interest rate is still to be had: grandpa's savings bond. Snap it up quick, because it may not last.

Savings bonds have been around since 1935, when Franklin D. Roosevelt came up with the idea of getting regular folks to help fund new Depression-era programs. Savings bonds have always had low face values; investors don't need much money to get started. Each savings bond is part of a series, and each series has different features. This post is about one of those, the EE series.

1935 advertisement for US Savings Bonds

On the face of it, the Series EE savings bond seems like an awful investment.

The government pays EE savings bond investors a paltry interest rate of 0.1% a year. Instead of getting interest payments in hand as you would a regular bond, the Series EE payments gets re-added to the bond every month. So no regular flows of income over time--you've got to wait years to get any return. (In bond-speak, it's a zero-coupon bond). To make matters even worse, the bond is non-marketable, meaning that it can't be resold. Once you own it, you're stuck with it.

But there's a odd feature that turns this bond from dud into stud. Here it is:

What this fine-print says is that the government guarantees that the Series EE will double in value in 20 years.

If you do the math, this works out to an incredible 3.5% yield. As I pointed out earlier, the regular 20-year government bond only yields 0.98%. So anyone who buys an EE savings bond is making over three times the market rate! It's not often you get a gift like this. Check out the chart below:

There are some catches. To earn this 3.5% return, you have to hold the thing for twenty years. No backing out! This sort of commitment isn't for everyone. Who might these terms appeal to? If you're 30 or 40 and planning to retire by holding a government bond ETF for 20 to 30 years anyways, you might want to switch into savings bonds. Or, if you're a grandparent or parent and want to gift a baby some funds for college, an EE savings bond is a great option. (They can earn interest tax-free for  education purposes.)

The other catch? The limit is $10,000 per year per social insurance number. So unlike most fancy arbitrage trades, this isn't meant for all of you fat cats out there. It's for regular Americans. Which is why I like it.

(I suppose a hedge fund manager could rig up system that evades these rules. This would involve gifting $10,000 to hundreds of straw men, using their identities to invest in savings bonds and harvest the 3.5% rate. But this seems like it might not be worth the cost.)

Hurry up. You have till April 30, 2020 to buy the current crop of  EE savings bonds. There's a chance that after April 30 the U.S. government will reduce the 3.5% interest rate on subsequent versions of the EE bond. The government would do so by replacing the guarantee to double the bond's value after 20-years with a 25-year, or 30-year, guarantee.

It's made this change to the doubling period before. Up until 2003, the government guaranteed that an EE bond would double in 17 years. But that year it changed the terms so that subsequent issues would require 20 years to double. (It doesn't make changes retroactively. So if you already own a bond, you needn't worry).

Given such a sweet deal, you'd think that EE savings bonds would be flying off the shelves. Not so. Below is a chart of showing the dollar value of EE bonds issued going back to 1999.

In March 2020, the U.S. government issued just $5.2 million in Series EE savings bonds. That's hardly anything! Back in 1998, it was issuing a cool half a billion dollars worth of EEs each month. (The big drop in 2011 is when the government stopped printing paper savings bonds. Conveniently, they could be bought at the post office. The government now only issues them in electronic format.)

The chart below shows the total quantity of EE savings bonds outstanding. Given the slow rate of issuance (and quick rate of redemption), the total quantity of EEs in existence clocks in at $80 billion and falling, far below its $130 billion peak.

The tiny trickle of new EE bonds being issued could be good news for today's investor. It might mean that an alteration to the crazy high interest rates (i.e. the 20-year doubling period)  is not on the government's radar screen. So if you buy $10,000 before April 30, you could be able to reload and get another $10,000 next year.

Why is no one interested in buying EE Savings bonds?

I'm only speculating here, but I feel that the population's general understanding of bonds is on the decline. Today's bond investor buys government bonds packaged up in the form of an exchange traded fund, or ETF. These are available on the stock market. Not so in the old days. People had to purchase bonds individually through their broker. And this process encouraged them to be somewhat attuned to the principals of a bond. Or they had to open an account at Treasury Direct, the government's investor portal, and make the purchase themselves. That's a very hands-on way to invest in bonds, and obliges people to learn about bond fundamentals. Or they could buy a paper savings bond at the post office, a route that has been closed.

Bond ETFs provide a relatively hands-off way to buy and sell government bonds. No need to understand how a bond actually works. And so today's investor has mostly forgotten what a savings bonds is. "It's that strange thing grandpa buys." Or "RobinHood doesn't offer it."

Compounding matters is the fact the the EE's magic 20-year doubling number (which is what gives it its kick) is buried under a miserable advertised interest rate of just 0.1%. You've got to be one of those folks who enjoys combing through the fine print to catch it.

So if you're already a committed government bond holder, consider making the switch to Series EE savings bonds, folks!

Sunday, April 19, 2020

Stephen Poloz needs to be honest with Canadians about negative interest rates

To soften the blow of the COVID-19 pandemic, the Bank of Canada is running what it sees as an expansionary, or loose, monetary policy. I think an expansionary policy makes a lot of sense.

The problem is this. The Bank of Canada has several tools it can use to loosen. Some are better than others. But it has stopped trying to use its best tool.

What is its best tool? Well, there are three ways that the Bank of Canada can loosen monetary policy.

Say interest rates are at 4%. Stephen Poloz, the Governor of the Bank of Canada, can either...

1) Cut the interest rate, say to 3.75%
2) Keep rates at 4% but do $20 billion or so in quantitative easing. This is just a fancy term for buying up assets like government bonds.
3) Keep rates at 4%, but promise to maintain them at 4% for extra-long. This is known as forward guidance.

Let me explain the third, forward guidance, because it's complicated. Basically, Poloz says that he will keep the Bank of Canada's interest rate at 4%, but promises to maintain it at that level for longer than would otherwise be warranted. The intuition here is that by committing to keep interest rates extra loose in the future, he can loosen monetary policy now.

I like to think about forward guidance in terms of raising children. Say that I want to modify the behaviour of my three-year old kid. To do so I might reward him with an M&M. Unfortunately I don't have any M&Ms on me. So I promise to give him an extra M&M after the next trip to the grocery store. Hopefully this "guidance" about future M&Ms is enough to get him to do what I want, now.  

So which of these three is the Bank of Canada's best tool?

The Bank of Canada's actual behaviour over the last few decades hints at what tool it considers to be the most useful. In 99% of the cases, it has chosen to loosen policy by dropping interest rates, not by embarking on quantitative easing or forward guidance. It usually does so in 0.25% increments, but when the economic shock is large, it'll resort to large interest rate cuts. For instance, after 9/11 it chose a 0.5% reduction.

What about the current episode? The Bank of Canada describes the coronavirus fallout as "unprecedented". In its recent monthly monetary policy report, the Bank says that the severity of the current shocks has inspired it to roll out a "bold policy response."

But if the Bank's policy response is so bold, why has it stopped using its favorite monetary policy tool? Having reduced interest rates to 0.25%, the Bank of Canada says it won't drop them anymore. According to Poloz, interest rates now sit at Canada's "effective lower bound." The implication of his  phrasing is that not even a force of nature could move rates below 0.25%.

But that's simply not true. The Bank of Canada's favorite tool isn't stuck at a lower bound. It would be pretty easy to implement another four interest rate cuts. This would take the Bank of Canada's interest rate from 0.25% to 0%, then to -0.25%, -0.5%, and -0.75%.

Don't take it from me. In this 2015 Bank of Canada working paper, researchers Jonathan Witmer and Jing Yang estimate that the Canadian effective lower bound is likely between -0.25% and -0.75%, with a midpoint estimate of -0.5%. Canada would hardly be unique if it went into negative interest rate territory. Other countries have tried negative rates, including Switzerland, Sweden, Denmark, and the European Union. 

There's a good chance we'll need it. If we look at previous recessions, we generally got about 4% in interest rate cuts. During the 2001 tech meltdown, the Bank cut from 5.75% to 2%. In 2008 it went from 4.5% to 0.25%. But in our current recession, we've gone from 1.75% to 0.25%. So all the Bank of Canada wants to give us in 2020 is a paltry 1.5%. What a gyp.

What about the Bank's other options for easing? In the last week of March, the Bank of Canada announced a quantitative easing program of $5 billion per week. But by the Bank of Canada's own demonstrated preferences, quantitative easing can't be a great tool—in previous easing periods, the Bank of Canada didn't bother with it.

The problem is that quantitative easing doesn't do much. It sounds big and hefty. But in actuality, big purchases of government bonds are a bit like trying to move a jet plane with a fan. They're certainly no substitute for another rate cut.

As for forward guidance, the Bank of Canada hasn't announced it yet. But any parent knows that a promise of future M&Ms just isn't good as M&Ms in the present. Kids are skeptical of promises, and for good reason.

Stephen Poloz has described negative rates as "not sensible". Here's what is not sensible. We are currently in the midst of the fastest slowdowns in Canadian history, and the Bank of Canada staidly refuses to even consider the possibility of using its favorite and most effective instrument; interest rate cuts. I'm not saying that another rate cut is warranted. But Poloz should at least unshackle his best tool.

P.S. I've been down this rabbit-hole before.

In that post, I speculate why Canadian policy makers seem loath to consider further rate cuts into negative territory.

Look, Canadian regulators have always had a close working relationship with the big banks. This certainly had its benefits. But here we are seeing one of its drawbacks. Canada's big banks are conservative and afraid of change. They probably don't want to incur the frictional costs associated with transitioning to a negative rate environment. And they have probably voiced their concerns to the Bank of Canada. And so the Bank is supporting the banks by declaring the effective lower bound to be at 0.25%. This decision comes at the expense of all Canadian citizens. We all benefit from the ongoing usage of the Bank of Canada's strongest tool: variations in the rate of interest. QE and forward guidance are poor fill-ins.

P.P.S. I just stumbled on Luke Kawa's series of tweets from a few weeks back on the topic of the Bank of Canada's effective lower bound. He captures my thoughts too.

Monday, April 6, 2020

Cash and COVID-19

"I work at a bank and some lady tried to microwave her money to clean it........ 🤦🏼" from Twitter

I've written a series of posts and tweets over the last month about cash and COVID-19.

The first set of posts has to do with the idea of banknote contamination.

Banknote contamination

In my research for BullionStar, I found that the odds of a banknote being contaminated by a virus depends to some degree on the type of banknote. Traditional paper banknotes like the U.S. dollar are probably a lot safer than plastic ones, since they have porous surfaces that are less welcoming to viruses. Polymer and coated banknotes, like what we have here in Canada, are non-porous and thus much more conducive to both virus survival and transferal to fingers.

Funny enough, one of my references for the article was an old presentation by the Federal Bank of New York's Gerald Stagg, an MD responsible for administering the FRBNY's staff compensation and comprehensive benefits programs. Appropriately enough, the doctor had a sideline interest in banknote cleanliness!

Presentation by FRBNY's Gerald Stagg on currency health concers (PDF)

I suspect when all of this is over, central banks will have to conduct more intensive research on banknotes and pathogens. That way they can provide a prompt and standardized response come the next pandemic. Because right now they are all over the board. Hungary's central bank quarantined banknotes and heated them up to 170 degrees Celsius. Meanwhile the Bank of Canada advised Canadians not to panic, just wash your hands. This divergence hurts the credibility of both central bank's responses.

In a recent report on COVID-19 and cash, Raphael Auer and the folks at the BIS provide the following illustration showing how central bank have reacted through February and March:

Source: BIS's Covid-19, cash, and the future of payments (PDF)

My next post, this time for AIER's Sound Money Project, focused on the sudden changes to our shopping and payments habits that the coronavirus has brought about. At my local grocery I can no longer pay with cash, and when I go in (after waiting in a long line to ensure social distancing) they issue me plastic gloves. I found that during the Plague pandemics that swept through England and elsewhere in the 1600s, Brits were just as quick to modify their trading practices.

To help cope with the possibility that coins and marketplaces might help spread the plague,  so-called "vinegar stones" or "plague stones" were setup in out-of-the-way places. Villagers could go to these stones to conduct trade in a self-distancing manner with wary country-folk. The coins were put in a vinegar-filled bowl carved into the stone. It was believed that vinegar could counter the poisonous vapour that was believed (erronesouly) to spread the plague.

Plague stone at Eyam, Derbyshire

The main conclusion from my two posts was simple: if you're going to handle banknotes, don't touch your face. Wash your hands immediately after. And while you're at it, wash your hands after handling your debit or credit card, too.

Cash demand in a pandemic

The next series of posts and tweets dealt with the impact of the virus on the demand for cash. In an article for AIER, I showed that the demand for U.S. banknotes exhibited the largest week-to-week change since the year-2000 changeover in December 1999. Charted out, it looks like this:

Let's not panic, though. This doesn't constitute a bank run. As I pointed out in the article, the total stock of U.S. dollar banknotes may have jumped by $70 billion in March. But that's nothing compared to the $15 trillion or so in checking and savings deposits in existence, not to mention trillions more overseas.

There are all sorts of ways to visualize the quantity of banknotes in circulation. I came up with what I think is a more intuitive approach below:

Here's what the Canadian data looks like:

And the Australian data:

Some degree of cash restocking makes sense in an emergency like the one we are living through. In fact, a number of governments advise citizens to hold cash as part of their emergency preparedness guidelines.

The US Department of Homeland Security advises Americans to always have a kit that includes cash and travelers checks. The Canadian government's Family Emergency Plan template suggests that Canadians keep "some cash in smaller bills, such as $10 bills and change for payphones". And Sweden's emergency guidelines also advise that Swede's keep small bills on hand.

Sweden's emergency preparedness guidelines (PDF)

Saturday, March 28, 2020

Alphabet soup

It's that time of the economic cycle. Financial writers are flocking to the phrase alphabet soup again. This was a phrase we all adopted in 2008 to describe the hodge podge of credit facilities created by the Federal Reserve to deal with the credit crisis. Twelve years later, alphabet soup applies just as well to the Fed's response to the coronavirus crisis.

As in 2008 the Fed is currently trying to get funding into as many nooks & crannies of the credit system as it can. The easiest way to do this would be for the central bank to create a slew of new deposits and either lend them directly to corporations (and other counterparties like municipalities) or buy up already-issued corporate bonds and other debt instruments.

But things aren't that easy. The Fed's money is taking a somewhat tortuous route into credit markets.

Like 2008, the Fed has reacted to the crisis by incorporating a bunch of special purpose vehicles, or SPVs. An SPV is a subsidiary or corporation that is legally distinct from the Fed, but controlled by it. The Fed has then been lending fresh money to the SPV. And then the SPV on-lends this money to corporations, or buys up their bonds and other debt instruments.

To illustrate, take the Fed's newly unveiled Primary Market Corporate Credit Facility (PMCCF). The Fed is using this facility to lend to an SPV, this SPV in turn purchasing bonds directly from corporate issuers, like Walmart. The hope is that by providing Walmart with direct access to Fed credit, the retailer will be better able to maintain business operations during the pandemic.

Why doesn't the Fed just directly purchase Walmart bonds?

About all the Federal Reserve can legally buy are Treasury bills and other safe government securities. The Federal Reserve Act prohibits the central bank from purchasing Walmart bonds or any other type of corporate debt.

But a Fed-created SPV isn't really subject to the same set of rules as the Fed, right? If it is legally remote enough from the Fed, an SPV can "lawfully" buy all the Walmart bonds that the Fed can't, no? That's basically the strategy that the Fed took in 2008, and it is taking it again.

But that SPV still needs to be funded. Luckily for the Fed, Section 13(3) of the Federal Reserve Act allows it to exercise broad lending powers in an emergency. So the Fed invokes 13(3), lends funds to the SPV, and then has the SPV buy Walmart debt. Voila, the Fed has purchased Walmart bonds without actually buying Walmart bonds. All the legal i's have been dotted, the t's crossed.

The SPV structure isn't just a legal hack. It also allows the Fed to protect itself.

Each of the five or six SPVs that have been created over the last two weeks is backed up by the U.S. government. This means that if the SPV's loans or bond portfolio falls in value, the central bank needn't worry. The Federal government will promise to make it whole.

Take the aforementioned Primary Market Corporate Credit Facility, or PMCCF. The Treasury has currently invested $10 billion in the SPV to which the PMCCF will lend. So if the Fed buys $10 billion in Walmart bonds via the SPV, and Walmart goes bankrupt and its bonds become worthless, the Fed still gets $10 billion back. It's the Treasury that loses its investment, not the Fed. The SPV structure is a tidy way to formalize the Treasury's support.

To get more context about this protection, let's compare the PMCCF to another facility created by the Fed, the Primary Dealer Credit Facility, or PDCF. The goal of the PDCF is to get funds to primary dealers, large financial institutions that make markets in all sorts of assets including the all-important US government securities market.

To create the PDCF, the Fed has also invoked Section 13(3) of the Federal Reserve Act. The Fed's interactions with primary dealers are limited by law to buying and selling government-issued assets. The central bank can't lend to dealers, certainly not on the basis of exotic sorts of collateral. But the emergency powers embedded in Section 13(3) allow the Fed it to open a broad lending channel to primary dealers.

Unlike the rest of the alphabet soup of facilities that invoke Section 13(3), the Primary Dealer Credit Facility is not set up as an SPV, nor does it enjoy $10 billion in protection from the U.S. Treasury. I have it on good authority that the Fed doesn't believe that a firewall is necessary. A strict process is already in place to vet primary dealers. Furthermore, the Fed has an ongoing relationship with dealers because they mediate all central bank purchases and sales of government securities.

But the Fed knows very little about the counterparties that it will lend to under the other facilities it has created, like the PMCCF. To make up for this extra risk, it wants to get some protection from the Treasury should those counterparties fail.

And in a nutshell, that's why the Fed has taken such a circuitous route to get funds into the credit system.

The bigger picture is that you've got a very old set of laws embodied in the Federal Reserve Act. Many of these rules were designed back in 1913 when America was still mostly a farming economy. Debts were almost always short-term back then, usually in the form of a bill of exchange, a debt instrument that doesn't really exist anymore. Heck, a whole section of the Act is about discounting "agricultural paper". That section probably hasn't been invoked in fifty years.

Meanwhile, a massively complex financial system has evolved over the last century. All sorts of new exotic credit instruments have emerged, say like asset-backed commercial paper. Farming, once a dominant sector, now accounts for a tiny part of the US economy. In a modern crisis like the one we are in, Federal officials believe that they need to be able to deal in these new types of securities. And reach new industries. Because the Act is mostly designed for a previous era, Fed lawyers have had to drill a strange new path to the credit markets via Section 13(3), SPVs, and Treasury support.   

I'm going to leave off now. Readers will obviously have a lot of unanswered questions.  

Should the Fed be lending such a massive amount of money to such a wide variety of borrowers? (I don't have a good answer).
Why is the Money Market Mutual Fund Liquidity Facility called the MMLF and not the MMMFLF? (Nathan Tankus deals with this and much more in his two part overview of what the Fed has done up till now).
Aren't the Treasury backstops a waste of ammo? (George Selgin has a good explanation about why they exist, and I am inclined to agree with him. They're not a gimmick.)
Aren't the SMCCF and PMCCF unprecedented? (Yes, they are. These facilities fund SPVs that either lend directly to corporations or buy corporate bonds in secondary markets. The Fed never went this far in 2008). Are they a good idea? (In a recent blog post, Stephen Cecchetti  & Kermit Schoenholtz argue that they aren't.)
Shouldn't the Fed limit its support to buying bonds in the secondary market rather than lending directly to corporations? (Narayana Kocherlakota says no. He is opposed to the PMCCF, but likes the SMCCF. George Selgin and I don't see much difference between the SMCCF and PMCCF.)