The Fed Sets The Scene for a U.S. Digital Currency
By lending widely to businesses, states and cities, the U.S. Federal Reserve has fundamentally altered the role of the central bank and paved the way to issue its own digital currency.
Toby Sellecker was shaking slightly with excitement, but he was hoping that the woman behind the exotic car rental counter wouldn’t notice.
“Are we all done here hun?”
The woman whose name tag said “Barbara,” didn’t even bother looking up from her soap opera while Sellecker nervously filled in the paperwork to rent the 2017 Ford GT that was sitting in the driveway of the exotic car rental lot in the outskirts of Las Vegas.
Eyes still glued on her daytime soap opera and chewing a piece of gum that she probably first started on during the Reagan administration, Barbara (or “Barb” as her friends called her) nonchalantly asked,
“So will that be partial or comprehensive insurance?”
“Are you sure? It’s a lot more expensive y’know?”
“Yes, I’m positive. And just to confirm, this covers all damage to the car?”
“Even if I take it down to Speedway?”
“You could take it to the moon hun, just sign here.”
And by the time the claims assessor was done with the Ford GT that Sellecker had rented, the total damage to the car was in the region of US$400,000, almost the entire price of the car brand new.
But because Sellecker had opted for comprehensive insurance and because the insurance company would pay out to the exotic car rental company, neither the rental company nor Sellecker cared that the car eventually wound up in a crumpled heap at the back of a junkyard along the Las Vegas freeway.
A victimless crime?
Because when the Selleckers and the exotic car rental companies of the world heap the cost of risky behavior onto someone else, society as a whole pays a higher price.
Too many Selleckers and auto insurance premiums skyrocket for everyone.
Too many exotic car companies who don’t check on their clients and the cost of insuring a rental car soars.
Since When Did A Hazard Become Moral?
Also known as “moral hazard,” the situation arises whenever individuals take on more risk because someone else pays for the consequences of that risk.
During the 2008 financial crisis, then U.S. Treasury Secretary Henry Paulson worried that by bailing out the Wall Street banks, he would be creating a “moral hazard” because by backstopping the risky behavior that the investment banks had undertaken, they would essentially be incentivized to pile on more risk, with tax payers footing the bill at the end of the day.
Fast forward over a decade later and such concerns of “moral hazard” seem quaint, even outdated.
As the world battles the coronavirus pandemic and an economic downturn that the International Monetary Fund says could rival the Great Depression, the Federal Reserve is in the process of redefining central banking.
In an effort to insulate the U.S. economy from the vagaries of the coronavirus pandemic, the Fed has lent widely to businesses, states and cities — breaking a century-old taboo about deciding who gets money from the central bank in a crisis, on what terms, and what risks it bears in terms of getting the money back.
But it’s not as if the Fed has a choice.
Channeling his inner Churchill, Federal Reserve Chairman Jerome Powell said in a speech this month,
“None of us has the luxury of choosing our challenge. Fate and history provide them for us.”
“Our job is to meet the tests we are presented.”
To be sure, the Fed’s intervention has been broad, deep, and most importantly, timely.
Thanks to Powell’s reassurance that the Fed is “not going to run out of ammunition,” the S&P500 has only shed 11% for this entire year, despite staring down the chasm of what could potentially be the worst economic recession since the Great Depression.
And after cutting interest rates to near zero in mid-March, the Fed bolstered those moves by introducing a torrent of bond-buying programs, acting in effect as a buyer of last resort.
To say that these actions creates “moral hazard” is not incorrect, but it also misses the point.
Unprecedented Times Call For Unprecedented Institutions
These are unprecedented times and Powell no doubt wants to prevent the United States and the rest of the world, from plunging into another Great Depression because of the Fed’s failure or reluctance to act.
But not everyone agrees with the Fed’s approach and some money managers argue that the chips should lie where they fall.
In a letter to shareholders this month, Howard Marks, director of investment fund Oaktree Capital Management wrote,
“Capitalism without bankruptcy is like Catholicism without hell.”
“Markets work best when participants have a healthy fear of loss. The fact that something can have negative, unintended consequences, doesn’t mean it’s a mistake.”
Yet these are not normal market conditions and it was a strict adherence to free market capitalism that has been widely attributed to the length and depth of the Great Depression.
Powell himself, quite distinct from his role as a bureaucrat, defined the government’s task from a moral standpoint, saying in his speech,
“People are undertaking these sacrifices for the common good.”
“We need to make them whole to the extent we have the ability.”
To be fair, the Fed’s intervention this time was not as a result of corporate greed that threatened the stability of the entire financial system.
Because the world is essentially on “hold” due to the coronavirus pandemic, governments need to step in and prop up businesses they would otherwise be left to their own devices.
By committing to buy up huge tranches of U.S. bonds, the Fed is also allowing the government to cheaply finance its debt, which is soaring at the moment, as the U.S. Treasury Department sends checks directly to households and spends more on unemployment insurance.
But while the Fed is now acting effectively as an extension of the Treasury Department, it is not naturally suited to this role.
Reforming The Federal Reserve
The way the Fed influences monetary policy is through its ability to create money, crediting banks with funds that they can lend and setting interest rates.
As a central bank, the Fed avoids “moral hazard” by leaving the decisions as to who these loans go out to, at what interest rate and on what payment terms, to the commercial banks.
But ever since the 2008 financial crisis, the Fed has developed the infrastructure, to intervene in a timely manner to shore up markets, and this is precisely what the Treasury Department is taking advantage of at this critical juncture.
In 2008, the Fed bailed out Bear Stearns, a troubled investment bank, by agreeing to provide a US$25 billion loan, collateralized by unencumbered assets from Bear Stearns.
But when the Fed drew the line at Bear Stearns and refused to step in to rescue another investment bank, Lehman Brothers, confidence in the credit markets evaporated overnight.
Recalls one trader from that time,
“Essentially what the Fed was saying was that we’re all on our own. There is no backstop, at which time who can you trust? Whose books can you rely on?”
Since then, the Fed has experienced awkward moments, managing the assets of Bear Stearns, including foreclosing on a shopping mall in Oklahoma City, owning loans on Hilton hotel properties in Puerto Rico and Hawaii and selling off a portfolio of debt on Red Roof Inn hotels following its bankruptcy.
Considering that a central bank is often criticized as being ill-equipped to act as a direct lender, the Fed has proved that it has some experience in managing loans directly to firms.
More importantly, the Fed made money on the loans that it made during the 2008 financial crisis and has now gained over a decade of experience in dealing with assets other than Treasuries.
And that experience is likely to grow only deeper during this current crisis as the Fed’s corporate debt backstops have been extended to include companies whose credit rating has recently been downgraded to junk status, as a result of the coronavirus pandemic.
Add to that that the Fed will also buy exchange traded funds that invest in junk bonds and provide financing to investors in business-loan funds known as collateralized loan obligations and the Fed has evidently shed its role as strictly a central bank, but as a direct lender of last resort.
That’s not even accounting for the Fed’s US$600 billion Main Street Lending Program that will see the central bank lend directly to small and midsize businesses, offering loans for up to four years, through the banking sector.
The raft of measures taken by the Fed has fundamentally altered its role as a central bank and potentially creates the ideal environment to support the Fed’s own central bank issued digital currency.
Got A Bank? Might As Well Coin Some Digital Dollars
Before the coronavirus pandemic and the raft of stimulus and bailout packages issued by the Fed, one argument against a Fed issued digital currency was that depositors would now have a direct relationship with the central bank, a role that it was supposedly ill-suited for.
The other issue was that the Fed was not well-placed to decide who should receive loans, the size of such loans, their tenure and the terms, all arguments against a Fed-issued digital currency.
But our current time has proved more than ever that the Federal Reserve should seriously consider issuing its own digital dollar.
The Fed has proved that it can and will act as a lender of last resort, even directly to businesses in times of crisis.
Considering the chaos in the issuance of stimulus checks, digital wallets, maintained with the Fed could have ensured near instantaneous deposit of digital dollars — at a time when for millions of Americans, the difference between receiving a stimulus check today or in a few weeks, could determine whether or not they have a home or end up homeless.
But a Fed digital currency could do a whole lot more than just facilitate stimulus checks, it could also provide a bank account to the unbanked, allow small businesses to accept payments in forms other than cash, and create an entirely untapped digital economy.
And the benefits of a Fed-issued digital currency don’t just stop there.
Because depositors will have a direct relationship with the central bank, it allows a far wider range of policy options.
Instead of relying on commercial banks to trickle down loans, the Fed, which has acquired some new skills over the past decade, can do so itself.
A digital dollar can also be used to increase aggregate demand directly — the Fed can put dollars directly into the hands of one of the largest drivers of the global economy, the American people.
Not to mention that the financial system as a whole could be made safer.
By allowing individuals, private sector companies and non-bank financial institutions to settle directly in central bank money, as opposed to bank deposits, there is less liquidity concentration and credit risk in payment systems.
Credit markets are also less likely to seize up because the Fed’s steady hand is always there, this would reduce the short term rate spikes witnessed late last year as overnight liquidity dried up.
As the lender of last resort, the Fed can intervene even more directly to prevent liquidity logjams during periods of crisis while reducing the systemic importance and influence of large banks.
And direct deposits with the Fed also reduce the need for deposit insurance.
Because digital wallets themselves become a payment system, a digital dollar could make it much easier for small businesses to accept digital payments directly, especially those that are currently unable, or unwilling to pay the fees associated with accepting credit cards.
More importantly though, a digital dollar with the Fed acting almost as an international clearing house, could help to remove some of the friction inherent in global trade flows.
Trade settlement is particularly clunky, still relying very much on paper documents and archaic methodologies more akin to the age of sail then the age of communication.
A digital dollar issued directly by the Fed could be placed in different escrow accounts and settlement which would otherwise take days or weeks, could be done in a matter of hours and even minutes.
To be sure, a digital dollar will not make physical cash go away — it is not intended as a replacement, but as an option.
The same way that the rise of digital music has led to a resurgence in the appreciation of the aural qualities of vinyl records, the rise of a digital dollar would still leave many hankering for the physical comfort of cotton cash.
But the coronavirus pandemic provides a unique opportunity for the Federal Reserve to lean in to the potential of a digital dollar and the ability of a digital dollar to further entrench the greenback as the center of the global financial system.