Lori Walsh: Unexpected, unprecedented, uncharted, unconventional, we are living in unusual times and that means it's pretty hard to figure out what the future looks like, especially with the US economy. Joe Santos is the Professor of Economics and Dykhouse Scholar of Money, Banking and Regulation in the Ness School of Management and Economics at SDSU. You can find his blog online at schooled.blog.com and today he's the featured guest at the Rotary Club of Sioux Falls, a virtual event. He'll talk about money matters, macro economic policy in a pandemic, and the club's treasurer will host Professor Santos in the Zoom space to talk about macroeconomic policy, with particular attention to federal reserve monetary policy in the wake of the novel coronavirus. Joe Santos joins us now for a little preview on Morning Macro. Hey Joe, welcome back.
Joe Santos: Hi Lori. Thank you for having me.
Lori Walsh: You're still well. Every day that we're well is a good day, right?
Joe Santos: Everyday that we're well is a good day and I am still well. I trust that you are still well too?
Lori Walsh: I am fortunately still doing just fine. Let's talk a little bit about the current school.blog post because we need to go back a little bit, and then we'll go forward because we know what back looks like, but we really at this point, are having a hard time figuring out what forward looks like because there is a lot of new terrain that we're really ambling over here. So where do you want to begin, maybe five weeks ago or so?
Joe Santos: Yeah, so five weeks ago or so was that now famous March 15th, Sunday evening emergency meeting of the Federal Open Market Committee. And this is essentially the committee that sets the federal funds rate target for the Central Bank. And that's that interbank rate. I always say, "Think about reserves cash in vaults as inventories." And so banks borrow and lend these inventories from one another, much as a manufacturing firm may borrow and lend various inputs to the production process from one another. In any case, when there's an equilibrium, and there often is in this market, that equilibrium sets the federal funds rate. So on March 15th, the Fed met and said, "We need to take drastic measures in the fed funds Market." And now famously lowered that federal funds rate target down to between zero, and one quarter of 1%. So essentially taking it's federal funds rate target down to zero.
And so that sort of got the ball rolling. But as I emphasize in the blog, and you mentioned in your introduction, as amazing as that meeting may have been, and as much attention as it attracted, it was still, generally speaking, conventional monetary policy, in that if you had gone back to, I don't know, 2007 on an average Tuesday, you would see the Federal Reserve Open Market Committee targeting the federal funds rate, and raising, and lowering it as they thought necessary. So the action they took in magnitude was large, not unprecedented, but large. But what they were doing, moving around, and operating target as they saw fit, qualifies as conventional policy. The sort of thing we would have seen long before the great recession, nevermind this current crisis.
Lori Walsh: Right. But we did see it in 2008 and as you have this first... If listeners are following along at school.blog.com, this first figure where you kind of see, "Oh, we're right back to where we were right around the kickoff of the great recession." It looks, it looks sort of familiar, that downward a drop.
Joe Santos: That's right. And so we are back to what we, I think affectionately, referred to as the zero lower bound. The Federal Reserve has made it a policy of theirs not to impose on the economy negative interest rates. And in part because that makes everybody's head hurt. And there are questions as to whether or not it really is all that effective in stimulating economic activity. So the thinking is zero is as low as you can go and that's where we are again. And so that's where conventional monetary policy ends. That's where the story ends because you are now at zero, there's a decision not to go below zero, and so here we are. And so that introduces the notion of unconventional monetary policy, which I joke in the blog, unconventional is the new conventional because we've been doing some measure of unconventional monetary policy since the great recession and because, as you observed, interest rates were at the zero lower bound for much of the years following, or for many of the years following the great recession.
We've been doing this unconventional stuff for a while. So just briefly, I'll let you direct this, of course. But by unconventional, what we mean is essentially taking very large positions in financial markets. You can think of this as buying securities in very large quantities, we often think of this as large scale purchases, of everything from treasury bonds to mortgage backed securities and so forth, in an attempt to, often we think of this as unfreeze the credit markets. That's also what we to as credit easing. Or the more popular term probably is quantitative easing, where you're essentially trying to ensure that there is sufficient liquidity in the financial system so that credit doesn't essentially seize up. That's the sort of nightmare scenario that every central banker has, is that they're going to wake up one morning and recognize that lenders will simply not engage with borrowers. And so this is where unconventional monetary policy comes in. A sort of shock and awe, inundating the markets, if you'd like, with liquidity so that they do not seize up.
Lori Walsh: How much of this is based on those borrowers feeling confident to borrow, whether that's a business... That was one of the things with the payment protection program that I heard small business owners saying, "Yeah, I'll do this because it's a grant, not a loan. The last thing I need right now is another loan." How much of it depends on confidence and just a willingness of people to borrow, right? And then you hear other people saying, "Now is the perfect time to borrow because the interest rates are so low and this is going to be good for us longterm." How much is left up to that just creating the idea that this is going to be okay?
Joe Santos: Yeah, that's a really, really fundamental question in monetary policy. I know I've used this metaphor before, but it's so common in our field, that monetary policy is like pushing on a string, right? And so you don't know if you can get the other end of the string to move when you push on the end you control. And so when these unconventional monetary policies are implemented, these operational efforts are implemented, we know we can move markets in terms of the supply side, but we don't know if anyone will essentially respond. The nature of a lot of what the Central Bank is doing now unconventionally, we talk more about this, it really is quite fascinating. But what they're doing is exclusively, I should say, lending. So I know we use metaphors like they're printing money, and so forth. And the metaphor is useful to a point, but everything they have unleashed in the last five weeks, everything of an unconventional nature, this $2.23 trillion of potential lending capacity is just that. It's lending capacity.
Now to your point, whether anyone will actually borrow it or not. What they're doing mostly is engaging in what we call the secondary market. So if you'd like, these are IOUs that have already been issued by borrowers, so they have sold their bonds in the so called secondary markets. As I like to tell my students these are sort of used bonds. These have been sold once by the firm raising the money, and now they're being sold over and over again. And what the Central Bank is doing is essentially lending against that paper, those IOUs, and providing the market the means, if you will, to lend again the raw material, if you will.
But back to your fundamental question, whether or not this will stimulate a sufficient amount of demand for funds, the borrowers, is really an open one. There is some evidence that there has been activity in the primary market. So I've been batting around the term secondary. Those are the IOUs that have already been issued. Your fantastic question gets to the primary market as I like to say, the birthdays, when those bonds are initially sold for the purpose of raising new funds. There has been some activity in that primary market, suggesting perhaps that there's take up, if you will. But what you're asking is the fundamental question that leads us, by the way, analytically to the notion that may be fiscal policy in times like this could be at least as effective, if not more, because it's pushing on a string, you can lower interest rates, but you can't make borrowers borrow. Perhaps you can have spenders come in, in the form of the federal government. And again, we don't need to go down that rabbit hole perhaps, but that's what really analytically develops the notion that fiscal policy may need to take the baton at some point, precisely because of what you asked.
Lori Walsh: Right. Well, one of the other big questions we're trying to sort through in South Dakota, Joe, and I'm sure you understand, is this notion of the state budget, and Governor Kristi Noem saying, "We need the federal government to allow some flexibility in how stimulus money is spent to replace lost revenues because we're a sales tax state." You hear Mitch McConnell saying, "Some of these States weren't fiscally responsible, they'd be better off filing bankruptcy." Which of course does not apply for a number of reasons to South Dakota. And before we go on, I want to talk about more that's in your blog post specifically, but I'm wondering if you could give us some insight into that conversation, and the Federal Government coming in, and using some of that money, that fiscal policy, to help state revenues. Untangle that for me, please.
Joe Santos: Yeah, so that's, that's a really a big question right now. I think for macro economists, I always say, I can't speak for them all, but my guess is the sense that at a time like this where, as we just analytically deduced from your prompting of that question, that perhaps fiscal expansion is what's most appropriate right now. And given that states, almost all states operate according to a balanced budget, that states really don't have the immediate access credit markets, in the way that the Federal Government does. You can see how... Let's make no mistake, right? Everyone is borrowing, essentially, to smooth income right now, right? From 50, or perhaps 100,000 feet, looking down at what the Federal Government is doing, they are borrowing from savers who are say precautionary saving, and drawing those resources back into the economy. States mechanically do not have the power to do that.
So the thinking, I think, among most economists is why not essentially allow the Federal Government to act in this collective way, drawing on its good credit worthiness, and borrow in the credit markets, in ways that states cannot. In part because they are states, and they don't have the power to tax, and print money, and so on, in the way the Federal Government does. But in part again because of a mechanical statutory feature of their constitutions. So draw on the Federal Government's borrowing power and then transfer those funds to the states, in effect, allowing the states to borrow in the financial markets, with an intermediary, the Federal Government, serving as that go between.
So yeah, just analytically speaking, being strictly apolitical here, I think you could argue rather persuasively that given, again, the mechanical restrictions imposed on states that we should then borrow against the credits, if you will, of the Federal Government, and bring those resources to the state. And as I say from a 100,000 feet, you're essentially allowing the states to tap credit markets that they cannot otherwise tap because, at the very least, their constitutions prohibit it.
Lori Walsh: All right. I want to go back to this idea of the US monetary base, and how it is rather drastically changing. Help us understand what's happening right now, and why this is such a shocking or, I think you said, mind blowing transition for the US monetary base.
Joe Santos: Yeah, so this US monetary base, the way we want to think about this, economists often refer to it as outside money. It wouldn't be there unless the Central Bank introduced it into the economy from the outside. And what we're talking about here is actually something very, very familiar to all of us. Very relatable. It's currency in circulation, think ones, and fives, and 10s, and 20s, the paper, and then it's essentially you can think of it as that in a bank bowl. And those are what we call bank reserves. So you either have currency, or bank reserves, or economists like to say C+R, currency plus reserves. And that's the monetary base. And what is quirky about a Central Bank, and its defining feature of course, is that that monetary base is a liability to the Central Bank. So that's on the owe, O-W-E side of their balance sheet. For everyone else in the galaxy, it's on the own, O-W-N side.
What I'm getting at is the Central Bank is what we think of as the money supply, right? And so what the Central Bank has been doing, and will continue to do with all of this unconventional monetary policy, is essentially be the buyer of securities of last resort. And so if they buy a security, they don't do it the way you and I would it, which is to take away from one asset, cash, and then accumulate another asset, security. They accumulate the security, but then they just issue additional bank reserves to pay for it. So that sounds a little magical. It is. And so by accumulating all of these securities, the monetary base grows in size. The amount of reserves in particular. It's not currency, it's reserves that are growing so dramatically. So where the monetary base used to be, before the financial crisis, a number like 800 billion.
Again, I know these numbers tend to gloss everyone's eyes over, but I think 800 B, 800 billion. It's now about four, to five, or actually maybe right now about six trillion. So it has increased dramatically. And as we've been talking about, this has been five weeks. And these facilities, that are sort of ramping up, have about $2 trillion worth of lending capacity. That means the fed is going to end up with another $2 trillion of assets, which necessarily means it's going to get another $2 trillion of monetary base on it's books. So the monetary base is going to equal a number that is, just in magnitude roughly, 20% to 30% of GDP. It used to be something closer to four. So the monetary base is growing dramatically, and in and of itself, I suppose we don't have to lose sleep over that. But the long run concern, of course, as I'm sure listeners have already sort of gotten to, is that the monetary base and the money supply, what we buy lunch with, are very closely related in the long run.
So if you see this growth in the raw material of monetary base, you would assume, all else equal, that at some point, this will manifest itself in the money supply as well. Then you've got a lot of money, potentially chasing fewer goods, and of course that's a recipe for inflation. So that's where the growth in the monetary base is probably most concerning. There are other reasons though, I think, we should be concerned as well. And that has more to do with the fact that the Central Bank is now so intertwined as an institution into the goings-on of Main Street. I mean, literally, one of these facilities is called the Main Street Facility. So they are now very interconnected to the economy. And as you and I have talked about before, there are concerns among economies that perhaps the Fed's credibility, at some point, its independence could be compromised. So I'm not playing Chicken Little here, but I'm just saying that's something off in the distance. But I know many monetary economists think about.
Lori Walsh: Wow. You want to hear more of this conversation. Go to the Rotary Club of Sioux Falls event. I think that's available on Facebook. Joe Santos will be part of that in a Zoom conversation. That is at noon today, central time. Joe, thank you so much for being here. Thank you for Morning Macro and you can find more at school.blog.com. We really appreciate your time.
Joe Santos: Thank you, Lori, as always.