How Fed CBDCs could limit modern monetary theory’s impact
By David Tassone
In today’s world of high inflation and multi-trillion-dollar budget deficit, many believe the U.S. government has spent too much to bring the economy out of the COVID-19 recession.
While today’s inflation is properly attributed to the cost-push inflation caused by supply chain disruptions from the pandemic, some economists and politicians believe the government should continue to exert its financial resources to further expand the economy. Modern Monetary Theory (MMT) has become more conventional in today’s political environment; however, the Federal Reserve’s continuous quantitative easing tactics combined with the potential introduction of a central bank digital currency (CBDC) may counteract some MMT notions before becoming mainstream.
Modern Monetary Theory, the newest economic theory credited to Warren Mosler in the 1990s and popularized by economist Stephanie Kelton in the 2010s, argues that government expenditure is not constrained by tax revenue for fiat currency issuing countries. In Kelton’s book, The Deficit Myth, she posits that politicians have incorrectly created a narrative that the government balance sheet emulates that of a private household.
Borrowing to supplement
To maintain financial stability, a household must earn a paycheck before they are able to spend money. Taxes are the US government’s revenue stream, with 50% of this income coming from individual income taxes. Any deficit between revenue and expenditure must be supplemented with borrowing in the form of US Treasuries, increasing the budget deficit.
As such, these politicians believe a government must tax and borrow before spending (T(ABS) model). MMT contradicts this notion and says that fiat-issuing currency countries first spend their currency and then tax and borrow afterwards (S(TAB) model). This sequence change dramatically shifts the focus from a government needing taxes to spend to using tax policy to tame inflation.
The most important actor in the current financial system is the Federal Reserve. The Fed serves as the bank of the government and has several policy tools available to them to stimulate and tighten the economy during periods of economic contraction and expansion. The most common tool is open market operations, which is the “purchas[ing] and s[elling] of securities in the open market.”
Other not as commonly used tools are the discount window, discount rate, reserve requirements, and interest on reserve balances. In times of economic distress, the Fed can also implement unconventional monetary policy, most commonly quantitative easing, which is the buying of long-term treasuries to maintain lower long-term treasury yields.
During the Great Recession of 2008-09, Congress enacted the American Recovery and Reinvestment Act of 2009, which provided $968 billion to help bring the U.S. out of this recession. While Kelton argued that the lack of inflation and low unemployment rate the subsequent decade were proof the economy could have handled additional stimulus, she focuses more on the impact of U.S. fiscal policy rather than failing to account for the monetary policy implications of quantitative easing the Federal Reserve released into the market during that decade. By emphasizing fiscal rather than monetary policy, she is de-emphasizing the role the Fed played throughout this time.
In the aftermath of the Great Recession, the Federal Reserve went to unprecedented lengths to stimulate the economy. To start, they lowered the Fed Funds rate from 5.25% in September 2007 to near 0% by December 2008. Quantitative easing 1 (QE1) started in March of 2009 and the Fed purchased “$200 billion in agency debt, $1.25 trillion in mortgage-backed securities, and $300 billion in long-term Treasury debt ” to lower long-term yields.
QE2 began when business output and employment remained below targets with the “purchase [of] $600 billion of long-term Treasuries at $75 billion per month…conclud[ing] in June 2011.” Economic activity continued to expand, but not at the pace the Fed required, so they began QE3 in September of 2012 with “monthly purchases of $40 billion in mortgage-backed securities…and a plan to increase long-maturity Treasury securities holdings at $45 billion per month.”
All these monetary policy measures brought the U.S. economy beyond pre-recession levels but provided an economic drug in which the market experienced withdrawals once quantitative tightening began. This economic stimulation allowed the markets to perform at higher capacities than before; however, they created a moral hazard where consumers forgot what a truly free market looks like without this government backstop. This, combined with the COVID-19 pandemic, led to QE4 in March 2020.
While Kelton argues that the MMT and QE are not one in the same, emergency measures like quantitative easing is the MMT S(TAB) model in action, albeit in an emergency response. Federal Reserve chairman, Ben Bernanke, described this phenomenon when describing how the government pays its bills: “It’s not taxpayer money. We simply use the computer to market up the size of the account.”
Kelton furthers this, saying that the “federal government is already paying all its bills using nothing more than a keyboard at the New York Federal Reserve,” showing that a fiat currency issuing country should never be financially constrained, but is instead resource constrained. As such, central banks do not have to worry about the normal repercussions of printing money, namely inflation, which is tamed through proper tax policy. With the current inflation entering the services sector consumers are starting to see the effects of this stimulus, contradicting Kelton’s notion that QE is not MMT.
This year President Biden signed into law the Executive Order on Ensuring Responsible Development of Digital Assets with the goal of “explor[ing] a U.S. Central Bank Digital Currency (CBDC) ” by adding a third liability to the Fed’s balance sheet. Maybe even more importantly, the Fed could be losing their ability to rid debt through the simple stroke of a keyboard.
In the current monetary system, there are three main forms of currency: central bank money, which is the liability of the central bank and “comes in the form of physical currency…and digital balances held by commercial banks at the Federal Reserve,” commercial bank money, which is, “the digital form of money that is most commonly used by the public…held in accounts at commercial banks,” and nonbank money, which is “digital money held as balances at nonbank financial service providers.”
A CBDC would be “a digital liability of the Federal Reserve that is widely available to the general public.” As a liability of the Fed, a CBDC would be like physical currency or reserves held at the Fed by commercial banks and could “affect monetary policy implementation and interest rate control by altering the supply of reserves in the banking system.”
The Federal Reserve will have to “substantially expand its holdings of securities ” to keep up with both domestic and foreign demand, and this would entail further expanding the balance sheet through continued quantitative easing measures.
If the Fed adds this third liability to their balance sheet without the proper regulation in place to control its issuance or restrict derivative creation, they are potentially losing their ability to bailout corporations, especially systemically important financial institutions (SIFI), in moments of economic turmoil. With most new financial products banks and financial institutions create financial derivatives, which are “financial instruments linked to a [different] financial instrument.”
This is what happened with the collapse of Bear Sterns and Lehman Brothers in 2007-08. Bear was leveraged at 33-1 and Lehman at 31-1 at the time of their respective bankruptcies. The aftermath led to the $700 billion Troubled Asset Relief Program (TARP), including broking a deal between Bear Stearns and JPMorgan Chase lending $28.82 billion to buy Bear financial assets and providing $141.8 billion of aid to another failing SIFI, American International Group (AIG), after steep derivative losses.
As Bernanke alluded, the Fed was able to provide this assistance quickly through simple accounting done by a stroke of its keyboard. Since all these assets were denominated as commercial bank money or nonbank money derived from the central bank reserve deposits, the Fed was able to add and subtract the money because it holds the monetary scorecard.
If these were CBDC derivatives with the underlying assets in the hands of a public citizen, the Federal Reserve would either have had a more difficult time retrieving these assets from CBDC holder or would cause upward pressure on the monetary system infusing it with additional CBDCs, potentially leading to more inflation.
For MMT to continue to hold true, the Federal Reserve will have to limit or eliminate the ability of financial institutions to create derivatives of CBDCs.
The introduction of CBDCs will not only change the payment system and monetary policy in the US, but it will also restrict the Fed from the freedom to delete deficits or deliver bailouts as they have done in the past. This contradicts MMT’s central notion that the system is not financially constrained, but resource constrained.
While the current MMT experiment our economy has benefitted from the last few years is still in full swing, the introduction of a Federal Reserve CBDC without the proper regulations could be the first financially constraining tool on our economy.
David is the Vice President at Kaye Capital Management where he works to bring peace of mind to his clients to make their hard financial decisions easy.
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