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TK: Monetary Policy and the Worsening U.S. Debt Crisis


In the face of the coronavirus pandemic, the U.S. Congress, with the support of the administration, has so far enacted four major bills that will increase the federal deficit by $2.1 trillion during fiscal year (FY) 2020.1 Combined with the economic and fiscal effects of the economic lockdowns, the Congressional Budget Office (CBO) currently projects that the FY 2020 deficit will increase to $3.3 trillion.2 On May 15, the House passed an additional bill that is estimated to necessitate an additional $3 trillion in federal borrowing, heightening the possibility that even more will be added to the federal deficit and debt in the near future.3


The Federal Reserve is absorbing much of this new debt, but their new operating framework means that the traditional economic implications of central bank asset purchases have to be modified. The new framework separates the Fed’s monetary policy stance from the amount of assets it buys, thus blurring the distinction between fiscal policy and monetary policy. Consequently, the Fed has abruptly enlarged its balance sheet by nearly $3 trillion—an increase of more than 70 percent in the space of three months—as part of the government’s efforts to offset the economic consequences of the lockdown orders.4 Combined, these operations have put the U.S. government in fiscal circumstances that few other highly developed countries have ever experienced during peacetime. They also heighten the political pressure for the Fed to fund elected officials’ favored projects directly, thus subverting the congressional appropriations process.


During the past several years, especially, many advocates have been seeking to fund infrastructure projects (broadly defined) through central banks. For instance, in January 2020 the Bank of International Settlements (BIS) published a book titled The Green Swan: Central Banking and Financial Stability in the Age of Climate Change. Although it tends to equivocate on exactly how central banks should help stave off climate change, the book does call for central banks to be more proactive in coordinating new policies and supporting sustainable investments. The book fits squarely within the goals of the proponents of the Green New Deal and Modern Monetary Theory (MMT), two groups who see the central bank as pivotal in their efforts to




1Congressional Budget Office estimates of H.R. 6074, (accessed May 15, 2020); H.R. 6201, (accessed May 15, 2020); H.R. 748, (accessed May 15, 2020); and H.R. 266, (accessed May 15, 2020).


2Phill Swagel, “An Update to the Budget Outlook: 2020 to 2030,” Congressional Budget Office, September 20, 2020, (accessed October 26, 2020). In early October, the CBO also announced that the federal government “ran a budget deficit of $3.1 trillion in fiscal year 2020…more than triple the shortfall recorded in 2019.” The same publication states “2020 was the fifth consecutive year in which the deficit increased as a percentage of GDP,” and that this measure (15.2 percent of GDP) was the highest it has been since 1945. See Congressional Budget Office, “Monthly Budget Review for September 2020,” October 8, 2020, (accessed October 26, 2020).


3H.R. 6800, The Health and Economic Recovery Omnibus Emergency Solutions Act, (accessed May 15, 2020).


4Current deficits and debt are insufficient measures of the U.S. government’s financial sustainability because of the impending problems with entitlement spending. See Norbert J. Michel, Paul Winfree, and Doug Badger, “Potential Long-Term Economic Consequences of the Federal Response to the COVID-19 Lockdowns,” Heritage Foundation Backgrounder No. 3498, June 4, 2020, (accessed September 1, 2020).




increase government spending through creating and/or borrowing more money.5 For many of these advocates, fiscal crises—or even fiscal problems—are of no concern.


While it is true that one-time spikes in federal borrowing are not worrisome by themselves, high growth in federal debt unrelated to business cycles does raise substantial concerns. Moreover, growth in entitlement spending—which already accounts for roughly two out of every three dollars of federal spending—is the principal source of rising U.S. debt. Elected officials should heed the warning of the recent downgrade in the U.S. credit outlook: the current trajectory of U.S. federal debt is unsustainable. Fixing this problem would be difficult enough had the Federal Reserve not altered its operations in a way that make it easier to accommodate profligate fiscal behavior. Now, changing course will require a herculean effort on the part of elected officials and the leaders of the central bank.


Importantly, the Federal Reserve can no longer rely on its price-stability mandate to fend off congressional attempts to engage in massive spending programs. This new era of monetary policy poses the following dangers:


Subsidized financial repression. The Fed has created a new risk-free investment choice (interest on excess reserves, or IOER) for banks and other favored financial firms, and it literally administers the rate it pays on these investments. This arrangement is the equivalent of the federal government directly paying favored constituents to keep funds out of the private sector.


Decreased private investment. The Fed’s new operating policies encourage banks to park funds at the Fed instead of investing funds in private securities and loans. Each dollar of excess reserves held at the Fed represents a dollar that banks fail to invest in the private market, thus detracting from economic growth.


Credit market distortions. The Fed’s policies have eliminated the federal-funds market as a source of bank liquidity. They have also allocated credit directly to (among others) the housing and government sectors. The Fed now holds more than $7 trillion in total assets, with $1.98 trillion of that total in mortgage-backed securities (MBS). To put this figure in perspective, the entire commercial banking sector holds $2.3 trillion in MBS.6 Neither prices of MBS nor the federal-funds rate convey economic information as they have traditionally, a situation that will only worsen as the Fed expands its holdings of government and agency debt obligations.


Increased political risk for the Fed. The Fed’s large interest payments to banks pose an increasing political threat to the Fed’s operational independence.7 To deal with the



5Warren Coats, “Modern Monetary Theory: A Critique,” Cato Journal, Vol. 39, No. 3 (Fall 2019), (accessed September 1, 2020). Also, the first broad fiscal-quantitative-easing (QE) proposal was from a British economist who referred to the plan (in 2009) as “Green QE2.” See George Selgin, The Menace of Fiscal QE (Washington, DC: Cato Institute, 2020), p. 13.


6These figures are as reported by Federal Reserve Economic Data (FRED), Federal Reserve Bank of St. Louis as of September 30, 2020. The data series are: Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level (WALCL); Assets: Securities Held Outright: Mortgage-Backed Securities: Wednesday Level (WSHOMCB); and, Treasury and Agency Securities: Mortgage-Backed Securities (MBS), All Commercial Banks (TMBACBW027SBOG).


7For more on how the Fed’s new operating framework endangers their operational independence, see Jerry Jordan and William Luther, “Central Bank Independence and the Federal Reserve’s New Operating Regime,” Quarterly Review of Economics and Finance (October 2020), (accessed October 27, 2020).





COVID-19 crisis, the Fed lowered the interest rate it pays on excess reserves to just 0.10 percent. However, in 2018, the rate was as high as 2.4 percent.8 In 2013 and 2014, the Fed paid banks $5.2 billion and $6.7 billion, respectively, and the amount increased to more than $10 billion in 2016.9 In 2018 and 2019, the amount paid fell to $1.3 billion and $0.95 billion, respectively.10 These payments reduce funds flowing to the Treasury and give the obvious appearance of providing generous government subsidies to large banks, especially when the IOER rate is greater than the basic deposit rate available to the public (as it has been for years). If the Fed has to raise the IOER rate to control inflation as market interest rates increase, these subsidies will also increase.


More accessible money spigot. The new framework divorces the Fed’s monetary policy stance from the size of the Fed’s balance sheet. It is designed to allow the Fed to purchase as many assets as it would like, all while paying firms to hold on to the excess cash that these purchases create. This framework can all too easily allow the Fed to be a pawn of the Treasury (or Congress), enabling the government to run larger deficits. It also opens new opportunities for political groups to pressure the Fed for direct funding.


Weakened monetary policy effectiveness. Because the new framework replaces market forces with bureaucratically administered rates, it prevents private markets from allocating credit without (potentially massive) ongoing government interference. This arrangement distorts prices and jeopardizes the Fed’s ability to maintain monetary control. That is, it endangers the Fed’s ability to regulate the economy’s overall liquidity so that it can meet its broader economic goals with respect to the general course of spending, prices, and employment.


After the Great Recession ended, the Fed failed to normalize monetary policy by both shrinking its balance sheet and getting rid of its IOER framework. That failure heightened the risk that this framework would still be in place when a new crisis occurred, and the COVID-19 pandemic was that crisis. The pandemic has worsened the near-term fiscal outlook, with ever-larger entitlement spending problems looming, thus further cementing the new operating framework and amplifying the risk and severity of the above-listed problems. The Federal Reserve is now further entrenched in credit allocation and outsized involvement in financial markets than prior to the Great Recession, and its new endeavors endanger the legitimacy of both fiscal and monetary policy.


The Federal Reserve’s Pre-2008 Operating Framework


A central bank implements monetary policy by regulating the economy’s overall liquidity (the availability of liquid, or cash-like, assets) to indirectly influence the economy’s general course of spending, prices, and employment. Prior to the 2008 financial crisis, the Federal Reserve exercised monetary policy mainly through open market operations, that is, the


8See Federal Reserve Economic Data (FRED), Federal Reserve Bank of St. Louis, Interest Rate on Excess Reserves (IOER), (accessed October 26, 2020).


9“Is the Federal Reserve Giving Banks a $12bn Subsidy?” The Economist, March 18, 2017, (accessed June 23, 2017).


10The totals for 2018 and 2019 are the “Interest payable to depository institutions and others” line item from the Federal Reserve’s consolidated income statement. See Federal Reserve Banks Combined Financial Statements, “As of and for the Years Ended December 31, 2019 and 2018 and Independent Auditors’ Report,” March 6, 2020, p. 3, (accessed October 26, 2020).




buying and selling of short-term Treasury securities on the open (public) market.11 Many economists focus on the relationship between open market operations and interest rates, but that focus ignores the underlying mechanics of the Fed’s traditional operating framework.


The Fed conducted these operations with the specific intent of increasing or decreasing the amount of reserves—a highly liquid asset—in the banking system, thereby increasing or decreasing the amount of money that banks could lend. This system worked because banks need reserves to make new loans,12 and only the Federal Reserve can increase (or decrease) the total amount of reserves in the banking system. While the Federal Reserve decided the total amount of reserves in the banking system, private banks ultimately determined how those reserves were allocated throughout the system.


Traditionally, banks regularly lent and borrowed reserves to satisfy their legal (and precautionary) reserve requirements in the federal-funds market, so named because banks hold reserve balances at the Federal Reserve. The interest rate in this lending market, the federal funds rate, was a market-determined rate. In other words, private banks’ lending negotiations— not the Federal Reserve—determined the federal-funds rate.13 While the Federal Reserve did not set the federal-funds rate itself, it did set a target for the federal-funds rate based on ensuring that overall liquidity was consistent with its broader macroeconomic goals.


In such a system, the target federal-funds rate is merely a means to an end—it is a policy instrument but it is not a policy objective. This policy framework depends on the Fed keeping a minimal footprint in the market for reserves, causing some economists to refer to the traditional framework as a reserve-scarcity regime.14 All else constant, a scarcity of reserve balances (relative to demand for reserves) results in a larger volume of reserve lending between banks. In that operating environment, the federal-funds rate conveys information based largely on conditions in private credit markets, as perceived by the private lenders and borrowers putting their capital at risk.


Naturally, the Fed’s open market operations would have very little influence on the federal-funds market if holding reserves is regularly more attractive versus other uses of funds. In such an environment, with plentiful reserves that have little opportunity cost, banks would find it unnecessary to borrow reserves and the federal funds rate would no longer be the result of the same market process. In fact, the enormous buildup in reserves during the 2008 crisis



11Norbert J. Michel, “The Fed at 100: A Primer on Monetary Policy,” Heritage Foundation Backgrounder No. 2876, January 29, 2014, (accessed November 12, 2020), and George Selgin, “A Monetary Policy Primer, Part 7: Monetary Control, Then,” Alt-M, September 20, 2016, (accessed September 29, 2017).


12Whether banks find additional reserves before or after they arrange to make new loans is irrelevant. When a bank makes a loan, it credits the borrower’s account with newly created money. The borrower then withdraws money and pays another individual (the payee), who places the funds in his own bank. This transaction requires a transfer of reserves from the lending bank to the payee’s bank. Thus, the effect of making the loan is the same as if the lending bank simply lent its reserves.


13What is commonly referred to as the federal-funds rate actually refers to an average measure called the effective federal-funds rate. Norbert J. Michel, “Fascination with Interest Rates Hides the Fed’s Policy Blunders,” Heritage Foundation Issue Brief No. 4500, December 15, 2015, (accessed November 12, 2020).


14Alexander Kroeger, John McGowan, Asani Sarkar, “The Pre-Crisis Monetary Policy Implementation Framework,” Federal Reserve of New York Staff Report No. 809, March 2017, p. 15, (accessed September 29, 2017).





ultimately caused interbank lending markets to break down and contributed to the Fed abandoning its traditional operating procedures.


Interest on Excess Reserves: The Fed’s Post-2008 Operating Framework


In late 2007, the Federal Reserve began various emergency lending programs, such as the Term Auction Facility, that increased reserves in the banking system. In 2008, the Federal Reserve implemented the first of several quantitative easing (QE) programs, purchasing large quantities of long-term financial assets. These operations left the Fed with more than five times the amount of securities it had prior to 2008. In particular, the Fed was left with $4.5 trillion in assets, consisting mainly of long-term Treasuries as well as the debt and the mortgage-backed securities (MBS) of Fannie Mae and Freddie Mac.


According to Ben Bernanke’s memoir of the crisis, at the first signs of trouble in 2007, he quickly ordered the New York Fed to buy “large quantities of Treasury securities on the open market” to flood the federal-funds market with reserves.15 These initial actions were appropriate in that they provided systemwide liquidity. Soon after, however, the Fed began allocating credit directly to certain firms, operations that also increased reserves in the system.16 Some of these efforts may have kept several large financial firms afloat, but the Fed hamstrung its overall efforts by sterilizing its liquidity operations. Specifically, the Fed sold Treasury securities from its portfolio, thus taking reserves out of the system at the same time it was injecting reserves into the system.


To the extent that there was an increased demand for liquidity, the sterilization process hindered the Fed from meeting that demand. Ben Bernanke provides the following account of the Federal Open Market Committee’s (FOMC’s) decision during its August 2008 meeting:


We were facing what might prove to be a critical question: Could we continue our emergency lending to financial institutions and markets, while at the same time setting short-term interest rates at levels that kept a lid on inflation? Two key elements of our policy framework—lending to ease financial conditions, and setting short-term interest rates—could come into conflict.… Since April, we had set our target for the federal


funds rate at 2 percent—the right level, we thought, to balance our goals of supporting employment and keeping inflation under control. We needed to continue our emergency lending and at the same time prevent the federal funds rate from falling below 2 percent.17


Thus, the Fed was officially worried about meeting its overall macroeconomic goals and maintaining what control it had over the federal funds rate. Regardless of whether this was



15Ben Bernanke, The Courage to Act: A Memoir of a Crisis and Its Aftermath (New York: W.W. Norton & Company, 2015), p. 144. The first sign of trouble that Bernanke is referring to is when France’s largest publicly traded bank, BNP Paribas, suspended withdrawals from three of its subprime mortgage funds. Sudip Kar-Gupta and Yann Le Guernigou, “BNP Freezes $2.2 Bln of Funds Over Subprime,” Reuters, August 9, 2007, (accessed September 30, 2017).


16The Fed provided additional credit through open market purchases and various new lending programs, both of which have the same (positive) effect on reserves in the banking system. U.S. Government Accountability Office, “Federal Reserve System: Opportunities Exist to Strengthen Policies and Processes for Managing Emergency Assistance,” GAO–11–696, July 2011, (accessed September 30, 2017). 17Bernanke, The Courage to Act, pp. 236 and 237.





the right approach, by the time the Fed conducted the rescue of American International Group (AIG) in September 2008, they had exhausted the ability to sterilize their emergency lending by selling Treasuries. From August 2007 to September 2008, the Fed’s holdings of Treasury securities had fallen from approximately $791 billion to $480 billion. Given the size of its operations, the Fed believed it was nearly out of short-term Treasuries to sell.18


At the same time, the traditional interest-rate targeting approach was coming apart. In late 2007, the federal funds rate began to collapse, leaving the Fed no choice but to begin lowering its target federal-funds rate. In little more than one year, the Fed had to lower its target from 5.25 percent to 1 percent. By the end of 2008, the Fed was still having difficulty hitting its target, so it scrapped the idea of a single target rate in favor of a target range (from 0 percent to 0.25 percent).19 Ultimately, the Fed created a new policy framework that relied on bureaucratically administered interest rates rather than the traditional approach that depended on market forces and targeting a market rate.


This new approach required the Fed to pay interest on reserves, something which it had not previously done. Initially, Fed officials believed this change would help the Fed hit its interest rate target, and that the rate they paid on reserves would serve as a floor for the federal funds rate.20 In other words, their original intent had been to create a corridor system, whereby the interest rate on reserves is set below the central bank’s policy rate (the target federal funds rate in the case of the Federal Reserve).21


Economists have long recognized that requiring banks to hold non-interest-bearing reserves acts as a tax on bank deposits and, therefore, on bank depositors. However, in 2008, the Fed asked Congress for the authority to pay interest on reserves for reasons that went well beyond merely offsetting the cost of reserve requirements. Congress subsequently granted the Fed the authority to pay interest on reserves by amending legislation that had passed in 2006.22 In his memoir, former Fed Chair Ben Bernanke explained the request as follows:


We had initially asked to pay interest on reserves for technical reasons. But in 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy. When banks have lots of reserves, they have less need



18Bernanke, The Courage to Act, p. 325. This figure ($480 billion) is the lowest reported balance since 2002, the first year in the full series reported by the Federal Reserve.


19Federal Reserve Board of Governors, Transcript of the joint Federal Open Market Committee and Federal Reserve Board of Governors meeting, held December 15–16, 2008, pp. 22 and 23, (accessed June 23, 2017).


20In 2005, Fed Governor Donald Kohn testified to Congress that “[i]f the Federal Reserve was authorized to pay interest on excess reserves, and did so, the rate paid would act as a minimum for overnight interest rates.” Donald Kohn, “Regulatory Relief,” testimony before the Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, U.S. House of Representatives, June 9, 2005, (accessed September 30, 2017).


21John Taylor, “Reserve Balances and the Fed’s Balance Sheet in the Future,” Economics One, June 24, 2017, (accessed September 30, 2017).


22Title II of the Financial Services Regulatory Relief Act of 2006, 120 Stat. 1966 Public Law 109–351, authorized the Fed to pay interest on reserves, beginning October 1, 2011. Section 128 of the Emergency Economic Stabilization Act of 2008, 122 Stat. 3766 Public Law 110–343, amending 12 U.S. Code § 461, accelerated the start date to October 1, 2008.





to borrow from each other, which pushes down the interest rate on that borrowing—the federal funds rate.


Until this point we had been selling Treasury securities we owned to offset the effect of our lending on reserves (the process called sterilization). But as our lending increased, that stopgap response would at some point no longer be possible because we would run out of Treasuries to sell. At that point, without legislative action, we would be forced to either limit the size of our interventions…or lose the ability to control the federal funds rate, the main instrument of monetary policy. So, by setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much lending we did.23


This new approach also required the Fed to pay interest on excess reserves (IOER) so that banks would hold their excess reserves—of which the Fed had created an enormous quantity—at the Fed rather than lend them in the federal-funds market.24 As Bernanke reasoned, the only possible way to accomplish this task was to offer banks a higher rate of interest on excess reserves than they could earn by lending those reserves in the federal-funds market.25 Thus, the IOER rate could not serve as a floor for the federal-funds rate and sterilize the Fed’s operations. As a result, the Fed did not create a traditional corridor system due to its conflicting goals.


When it began paying IOER in October 2008, the Fed set the IOER rate at 0.75 percent, well below the federal-funds target rate of 1.5 percent. In approximately two weeks, the Fed increased the IOER rate to 1.15 percent, reducing the spread between that rate and the prevailing federal-funds target rate to 0.35 percent. By November 2008, both the federal-funds target rate and the IOER rate were 1 percent. The Fed held the IOER rate above the effective federal-funds rate—the actual rate charged in the federal-funds market—from the end of October 2008 through 2017. In fact, for roughly the entire period it has paid IOER, the Fed has set this overnight interest rate above virtually all short-term low-risk rates available on the market.


This operating framework provides banks with a new risk-free investment choice, one for which the Fed can increase the rate in order to induce banks to hold excess reserves rather than make new loans. Naturally, the more banks hold in reserve, all else constant, the less money they create in the broader economy. Thus, this aspect of the new operating framework


—the decision to pay interest on reserves—has at least as far-reaching implications as the QE programs themselves.26


23Bernanke, The Courage to Act, pp. 325 and 326.

24The same economic justification for paying interest on required reserves does not apply to banks’ decisions to hold excess reserves, and it is long-standing bank management practice to minimize excess reserves. Timothy Koch, Bank Management, 3rd ed. (Orlando, FL: The Dryden Press, 1995), p. 462. The idea of paying interest on required reserves was considered, though ultimately rejected, when Congress created the Federal Reserve in 1913. Selgin, testimony Before the Monetary Policy and Trade Subcommittee, p. 2.


25Even though the Act (12 U.S. Code § 461 (b)(12)(A)) authorizes the Fed to pay interest on reserves “at a rate or rates not to exceed the general level of short-term interest rates,” the Fed has consistently paid rates on reserves higher than the federal-funds rate and other short-term interest rates. George Selgin, “Has the Fed Been Breaking the Law?” Alt-M, September 6, 2016, (accessed September 3, 2020).

26For a thorough account of the Fed’s interest on reserve policies, see Hearing, Monetary Policy v. Fiscal Policy:

Risks to Price Stability and the Economy, George Selgin, testimony before the Monetary Policy and Trade





Perhaps the most important repercussion of the framework is that it divorces the Fed’s monetary policy stance from the size of its balance sheet: Federal Reserve asset purchases no longer automatically translate into expansionary monetary policy. Put differently, the framework is designed to allow the Fed to purchase as many assets as it would like regardless of its monetary policy stance because it allows the Fed to pay firms to hold the excess cash that these purchases create. While Federal Reserve asset purchases were traditionally tied to inflationary pressure, this relationship is no longer a given.27


The payments on excess reserves are critical to the Fed’s ability to maintain control of monetary policy, but they create several potential problems for the central bank. By paying billions of dollars in interest to large financial institutions to make it more attractive to place funds with the Fed rather than to lend in short-term markets, this framework gives the Fed an abnormally large presence (by historical standards) in credit markets. Moreover, it requires the Fed to pay interest to large private financial institutions to maintain its policy stance, a political problem that will worsen if interest rates rise, thus threatening the viability of the operating framework.


The new policy structure also makes it very difficult for the Fed to adequately regulate the overall availability of credit in private markets without allocating credit to specific groups. Good monetary policy, of course, requires the Fed to conduct policy in a neutral fashion, rather than allocate credit to preferred sectors of the economy. As the coronavirus epidemic drags on and the entitlement spending problems remain unresolved, the Fed’s new framework, along with its recent actions, makes it more likely that Congress (or Treasury) will call on the Fed to further blur the lines between monetary and fiscal policy.


The Fed’s New Framework, Fiscal Policy, and COVID-19


The new framework has stark implications for expansionary fiscal policy because the Fed can buy more government debt without regard to its monetary policy stance. Therefore, it is much easier for the Fed to become a pawn of the Treasury (or Congress), enabling the government to run larger deficits and take on higher levels of debt. Furthermore, it opens new opportunities for political groups to pressure the Fed for direct funding, a fact that has not gone unnoticed by Congress. For instance, House Financial Services Chairwoman Maxine Waters (D–CA) released a statement calling for the Fed to provide more than liquidity:


Unfortunately, the Fed appears to be using its old playbook in trying to calm funding markets by flooding them with liquidity. During this time of economic turbulence, it is





Subcommittee, Committee on Financial Services, U.S. House of Representatives, July 20, 2017, (accessed September 14, 2017). Also see Norbert J. Michel, “The Crisis Is Over: It Is Time to End Experimental Monetary Policy,” Heritage Foundation Backgrounder No. 3265, November 9, 2017, (accessed November 12, 2020); and, George Selgin, Floored!: How a Misguided Fed Experiment Deepened and Prolonged the Great Recession (Washington, DC: Cato Institute, 2018).


27See Donald Dutkowsky and David VanHoose, “Interest On Reserves, Regime Shifts, And Bank Behavior,” Journal of Economics and Business, Vol. 91 (2017):1–15, (accessed October 27, 2020); and Donald Dutkowsky and David VanHoose, “Breaking Up Isn’t Hard To Do: Interest On Reserves And Monetary Policy,” Journal of Economics and Business, Vol. 99 (2018):15–27, (accessed October 27, 2020).





critical that the Fed go beyond these steps and provide much-needed support to those who are on the front lines of this pandemic.28


In many ways, the Fed’s (and Congress’) response to the COVID-19 pandemic is a test case for the new operating framework and the Fed’s foray into fiscal policy. Between March 2020 and April 2020, the Fed injected trillions of dollars into short-term credit markets, announced a new $700 billion QE program (the Fed will purchase $500 billion in Treasuries and $200 billion in mortgage-backed securities), and created more than 10 new lending facilities.29 The Fed will use these facilities to lend directly to commercial firms, and to lend indirectly by supplying funds for banks to lend to small and medium-sized businesses.


One of the early facilities marked a troubling departure from the norm because the Fed uses this facility to lend directly to private companies.30 Specifically, the Fed will buy newly issued corporate bonds directly from commercial companies through the Primary Market Corporate Credit Facility. Although the stated purpose of this facility is to provide liquidity to the corporate bond market, even the promise of such “support” undermines market forces and potentially distorts prices. The facility represents subsidized lending to distressed companies and politicizes credit allocation. While the facility could induce private investors to purchase additional corporate bonds, the debt-issuing companies could simply use those funds to pay down existing debt rather than invest in productive capital. If losses continue, investors will have a vehicle for offloading their debt, effectively socializing their losses.31


The Fed also created several facilities that indirectly provide credit to private markets. For instance, through the Paycheck Protection Program Liquidity Facility, the Fed will provide loans to banks that make loans to small companies under the Small Business Administration’s Paycheck Protection Program (PPP).32 Separately, the Fed will use the Main Street New Loan Facility (MSNLF) and the Main Street Expanded Loan Facility (MSELF) to supply up to $600 billion to private banks that make loans to medium-sized businesses (those with no more than 10,000 employees or $2.5 billion in 2019 annual revenues).33 The Fed also created a similar facility for the state and local government debt market named the Municipal Liquidity Facility (MLF). The MLF allows any district Federal Reserve Bank to buy state and municipal bonds


28Waters Statement on Federal Reserve Response to Coronavirus, Washington DC, March 16, 2020, (accessed May 11, 2020).


29For a complete list of policy actions, see Norbert J. Michel, “The Federal Reserve Should Not Help Congress Duck Its Responsibilities,”, March 23, 2020, (accessed September 3, 2020), and Norbert J. Michel, “The Federal Reserve Should Not Help Congress Duck Its Responsibilities: Part 2,”, April 27, 2020, (accessed September 3, 2020).

30Michel, “The Federal Reserve Should Not Help Congress Duck Its Responsibilities: Part 2.”

31James Dorn, “The Fed’s Corporate Lending Facilities: A Case of Pseudo Markets,” Alt-M, May 25, 2020, (accessed October 29, 2020); and James Dorn, “Fed’s Intervention in Corporate Credit: A Risky Venture,” Alt-M, July 13, 2020, (accessed October 29, 2020).


32Businesses with more than 500 employees can be eligible for these loans provided that they meet the existing statutory and regulatory definition of a “small business concern” under section 3 of the Small Business Act, 15 U.S. Code 632. See U.S. Treasury, “Paycheck Protection Program Loans Frequently Asked Questions (FAQs),” May 27, 2020, (accessed May 29, 2020).







(up to an aggregate total of $500 billion), opening it to political pressure to bail out profligate state and local governments.


While it is true that Treasury took an “equity stake” in most of these lending facilities, doing so was not required by the Federal Reserve Act. Moreover, it was not necessary as a matter of economics. The Fed is not a private bank, it does not have to meet capital requirements, and it does not have to redeem any of its liabilities. If the Fed loses money, it actually can just “print” more. The economic constraint on the central bank printing more money is how much of its excess money creation the public is willing to tolerate, an amount that has nothing to do with Treasury’s equity stake in the Fed’s operations. This quantity is not precisely knowable ex-ante, but it is most likely one that will be reached only in limited circumstances, such as if the Fed creates an inflation problem or if citizens revolt against profligate bailouts and spending.34


On the legal side, the question essentially comes down to who has the power of the purse, and the U.S. Constitution gives Congress that responsibility.35 To help create the current funding arrangement between Treasury and the Fed, Congress did not amend the Federal Reserve Act. Instead, the Coronavirus Aid, Relief and Economic Security (CARES) Act authorized a somewhat murky arrangement between the U.S. Treasury and the central bank. For instance, the CARES Act appropriates up to $454 billion to the Treasury to “make loans and loan guarantees to, and other investments in, programs or facilities established by the Board of Governors of the Federal Reserve System for the purpose of providing liquidity to the financial system that supports lending to eligible businesses, States, or municipalities.”36


The CARES Act leaves many of the details for those “other investments” up to the Fed and Treasury, but it does require that all of the applicable requirements of the Federal Reserve’s emergency lending authority (Section 13(3) of the Federal Reserve Act) apply to any “program or facility” established under the CARES Act.37 Using this authority, Treasury then took equity stakes in the various special purpose vehicles (SPVs) that the Fed used to establish the lending programs. The specific intent (at least among Treasury and the Fed) is for the Fed to “leverage” these equity stakes to provide loans that exceed the amount Congress appropriated.38 For instance, Treasury has a $75 billion stake in the SPV that established the two Main Street






34It is currently impossible to know precisely in how much lending the Fed will engage through all of its new facilities, or how large its balance sheet will grow. According to The Wall Street Journal, “Economists project the central bank’s portfolio of bonds, loans and new programs will swell to between $8 trillion and $11 trillion from less than $4 trillion last year. In that range, the portfolio would be twice the size reached after the 2007–09 financial crisis and nearly half the value of U.S. annual economic output.” Nick Timiraos and Jon Hilsenrath, “The Federal Reserve Is Changing What It Means to Be a Central Bank,” The Wall Street Journal, April 27, 2020, (accessed May 7, 2020).


35For a broader analysis, see George Selgin, “The Constitutional Case for the Fed’s Treasury Backstops,”, April 13, 2020, (accessed September 3, 2020).


3615 U.S. Code 9042(b)(4). Section 4027 of the CARES Act (15 U.S. Code 9061) appropriates this amount from the Exchange Stabilization Fund, the fund established under section 5302(a)(1) of title 31, United States Code.

3715 U.S. Code 9042(c)(3)(B).


38Jeanna Smialek, “How the Fed’s Magic Money Machine Will Turn $454 Billion into $4 Trillion,” New York Times, March 26, 2020 (accessed September 8, 2020).





lending facilities, and the Fed will use these two programs to provide up to $600 billion in loans.39


If the lending facilities lose the money that Treasury provided as an equity investment, then there is no problem in the sense that Congress explicitly appropriated those funds. However, if the losses exceed the appropriated funds, the additional money to cover those losses has to come from a new congressional appropriation or the Federal Reserve. If the latter, then the Fed would be spending more than Congress appropriated for a specific purpose. The fact that the Federal Reserve is not an on-budget federal agency is only a technical matter, and its action would still be in direct conflict with the underlying structure of the U.S. government—the Constitution gives the power of the purse to the elected members of Congress. Naturally, the same critique applies to any Fed lending program that does not include a congressional appropriation, as well as to any fiscal QE program the Fed undertakes on its own.


The fact that the Fed’s new operating framework divorces their monetary policy stance from the size of the Fed’s balance sheet means that, in theory, covering losses from such activities could have smaller monetary effects than asset purchases in traditional monetary policy operations. The new framework is designed to allow the Fed to purchase as many assets as it would like, or spend new base money for any particular reason, all while paying firms to hold on to the excess cash that these actions create. Still, the fact that the Fed can cover any such expenditures—or consequent losses—via creating new base money only gives the appearance that this arrangement is fiscally sound. The situation is ripe for allowing the Fed to be a pawn of Congress (or the Treasury), enabling the government to paper over larger and larger deficits, a trick that cannot continue indefinitely.


Exotic Monetary Policy and Systemic Fiscal Imbalances


As of this writing, most of the Fed’s existing QE programs can be viewed as quasi-fiscal QE programs because they have been used to serve the central bank’s monetary mandates as well as various fiscal ends.40 The Federal Reserve’s purchases of Fannie and Freddie MBS, for example, are part of a QE program designed to increase aggregate investment by reducing longer-term interest rates (a monetary function), and also to support the housing market (a fiscal function). Yet, this breaching of the traditional boundaries between the monetary and fiscal authorities makes it easier for the Fed to engage in strictly fiscal QE operations, the type of financing favored by supporters of MMT, large-scale infrastructure projects, and helicopter money proposals (QE for the people).41


Proponents of MMT effectively argue that governments can run unlimited deficits because they have control over their sovereign currencies. This position, which Cato’s George Selgin has referred to as “an especially naïve sort of Keynesianism,” essentially assumes that monetary expansion can costlessly finance unlimited projects because real resource constraints are not a problem.42 In truth, the federal government’s spending can only be financed if it raises


39Federal Reserve Board of Governors, “Main Street New Loan Facility,” April 9, 2020, (accessed September 3, 2020).

40Selgin, The Menace of Fiscal QE, p. 9.

41Ibid., pp. 14–18 and 22–26.


42George Selgin, “The Modern New Deal That’s Too Good to Be True,” Alt-M, February 8, 2019, (accessed October 29, 2020). For a more detailed dissection of the subtleties of the MMT arguments, see George Selgin, “On Empty Purses and MMT Rhetoric,” Alt-





funds through taxation or borrowing. Although the Federal Reserve can help the U.S. Treasury by purchasing more Treasury securities, it cannot magically erase resource constraints.


While proponents sometimes offer Japan as a positive example of MMT being put into practice, such assertions are based on no empirical or historical evidence.43 Nonetheless, MMT advocates see the central bank as pivotal in their efforts to increase government spending, and they will likely try to convince Congress to force the Fed to engage in fiscal QE operations to implement large spending programs.44 Indeed, proponents of the Green New Deal, large-scale infrastructure projects, or any other large spending proposals could similarly pressure Congress (and the Executive branch) to rely on the Fed to implement their preferred policies.


Aside from any specific fiscal QE proposals, the Fed could face increasing pressure to address the systemic fiscal imbalances caused by entitlement spending.45 Federal debt is now largely driven by entitlement spending and, if left unchecked, will continue to necessitate massive new borrowings well into the future. Research shows, for instance, that less than 2 percent of the nearly 1,800 spending accounts that fund all government activities drive the long-run unsustainability of the federal budget.46 Spending from just those accounts is equivalent to 60 percent of gross spending projected over the next 10 years, with spending on government-funded health care programs contributing the largest component to fiscal unsustainability.47


Separately, the Congressional Budget Office recently projected that the Social Security Old Age and Survivors Insurance fund faces insolvency in less than a decade, and that the Social Security Disability Insurance program could run out in 2026.48 Faced with possible sharp benefit cuts, some members of Congress will be tempted to call on the Federal Reserve. The risk of such an occurrence appears especially heightened given Congress’s recent raiding of the Fed’s capital surplus to pay for a highway bill, the Fed’s recent foray into quasi-fiscal QE programs, and the central bank’s novel responses to the COVID-19 crisis.49 At the very least, the Fed will no longer be able to point to its price stability mandate as a reason that it cannot help fund larger payouts and debt absorption. The Fed’s new operating framework





M, March 5, 2019, (accessed October 29, 2020); and, George Selgin, “The Nice Limits of Modern Monetary Theory,” Alt-M, May 10, 2019, (accessed October 29, 2020).

43John Greenwood and Steve H. Hanke, “Magical Monetary Theory,” The Wall Street Journal, June 4, 2019.

44Selgin, The Menace of Fiscal QE, pp. 22–26.

45Michel, Winfree, and Badger, “Potential Long-Term Economic Consequences.”

46Paul Winfree, “Causes of the Federal Government’s Unsustainable Spending,” Heritage Foundation Backgrounder No. 3133, July 7, 2016, (accessed November 12, 2020).


47The trust fund for Medicare Part A (hospital insurance) will be depleted by 2024. See David Ditch and Rachel Greszler, “New Report Shows Why Congress Must Address National Debt,” Heritage Foundation, Forthcoming.


48Megan Henney, “Social Security Benefit Cuts Could Be Coming — Here’s Who It Will Affect First,” Fox Business, September 4, 2020, (accessed September 6, 2020).


49For more on Congress using the Fed’s capital surplus to pay for the highway bill, see Norbert J. Michel, “Banks Should Not Be Forced To Buy ‘Stock’ in the Federal Reserve,” Forbes, December 21, 2015, (accessed October 29, 2020). For a broader discussion on the heightened risk that Congress might compel the Fed to use its fiscal QE powers to finance new projects, see Selgin, The Menace of Fiscal QE, pp. 27–38.





separates its monetary policy stance from its asset purchases, so it is more likely than ever that calls will mount for the Fed to engage in more fiscal/quasi-fiscal operations.50




Good monetary policy ensures that the economy does not stall due to an insufficient supply of money or overheat due to an excessive supply of money. To achieve this balance, the Federal Reserve needs to conduct policy in a neutral fashion, passively providing liquidity for the economy. Similarly, the Fed must maintain a minimal footprint in the market so that it does not create moral hazards, crowd out private credit and investment, or transfer financial risks to taxpayers. Many of the Federal Reserve’s recent actions, along with its post-2008 operating framework, make it increasingly unlikely that they will achieve sound monetary policy in the near future. Indeed, it is clear that the Fed no longer engages in pure monetary policy, more so now than at any other point in the post-WWII era.


The Fed is now on the brink of being a mere pawn of Congress, forced to finance government expenditures in a manner that endangers the legitimacy of both monetary and fiscal policy. At minimum, this situation runs the risk of grossly distorting credit markets. It boosts the likelihood that the Fed will not be able to maintain monetary control, and risks both decreased private investment and above-average capital outflows. The idea that a government can run unlimited deficits with no real economic consequences is a dangerous fantasy. The federal government can finance spending only if it raises funds through taxation or borrowing. The fact that the Federal Reserve can buy Treasury bonds or “print” the sovereign currency does not erase real resource constraints or enable to the Fed to “fine tune” the economy to meet macroeconomic goals.


Many of the Fed’s actions during the COVID-19 crisis have further blurred the lines between monetary and fiscal policy, but U.S. monetary policy would remain in unchartered territory even without these recent policy changes. Prior to the coronavirus pandemic, the U.S. government’s finances were in poor shape due to pre-existing structural deficits (in all but five of the past 50 years, the U.S. budget was in cash deficit) and unfunded obligations in entitlement programs. The continuous level of deficit spending has increased public debt which, during the same period, rose from 32 percent to 79 percent of GDP. Prior to the onset of the novel coronavirus, the CBO estimated that the 2020 federal budget deficit would be $1.1 trillion.51


Now that Congress has passed several coronavirus spending bills, the CBO expects the 2020 deficit to reach at least $3.3 trillion, the largest (as a share of the economy) since World War II. The CBO projects the combined deficits for 2021 through 2030 at just under $13


50Senator Ted Cruz (R–TX), for instance, has already called on the Fed to “provide emergency liquidity for small-and-medium sized businesses that work directly or indirectly with the oil and gas industry.” News release, “Sen. Cruz Urges Treasury and Federal Reserve to Ensure Critical Access to Capital for America’s Energy Producers,” Senator Ted Cruz, April 24, 2020, (accessed May 11, 2020). Similarly, Bharat Ramamurti, a member of the congressional oversight commission charged with overseeing the federal coronavirus relief efforts, has criticized the Fed’s Municipal Liquidity Facility because it excludes “certain cities and counties with strong credit ratings and great need—including the 35 cities in America with the highest percentage of black residents, such as Atlanta, Detroit, and Baltimore.” Victoria Guida, “Pressure Mounts as Fed Chief Shepherds Massive Economic Rescue,” Politico, April 20, 2020, (accessed May 29, 2020).

51Michel, Winfree, Badger, “Potential Long-Term Economic Consequences of the Federal Response to the COVID-

19 Lockdowns.”





trillion. Given that the current gross debt is $26.7 trillion, the per-household share could stand at approximately $275,000 in just ten years. While one-time spikes in federal borrowing are not worrisome by themselves, high growth in federal debt unrelated to business cycles does raise substantial concerns, and entitlement spending—which already accounts for roughly two out of every three dollars of federal spending—is the principal source of this rising debt.


The recent downgrade of the U.S. credit outlook is a warning signal that the trajectory of federal debt is unsustainable. If left unchecked, the debt will continue to necessitate massive new borrowings well into the future, and the Fed already holds 21 percent of all federal debt held by the public (as of October 30, 2020).52 Still, many elected officials are clamoring for enormous new spending programs that would require even more debt, and some of them want to rely on the Federal Reserve for funding support. There is no doubt that the Fed can facilitate government borrowing and new spending programs, but this fact does not change the true economic costs of such undertakings. Moreover, these new endeavors come with additional risks that endanger the legitimacy of both fiscal and monetary policy to a greater degree than they would have prior to 2008.


Largely by accident, the Fed now finds itself with an operating framework that makes it much easier to facilitate new federal debt and spending. The Fed created the new framework in the midst of the 2008 crisis to maintain monetary control by placing a check on the excess reserves their emergency operations had created. However, after the Great Recession ended in 2009, the Fed decided against systematically normalizing monetary policy in a timely fashion. Instead, they maintained an abnormally large balance sheet for much longer than necessary and kept the crisis-era operating framework in place, thus heightening the risk that a new economic shock would shrink their policy options. Before the Fed fully normalized, the coronavirus pandemic and subsequent government lockdowns caused major economic difficulties, and now the Fed is even further entrenched in credit allocation and outsized involvement in financial markets. They are also less able to maintain their operational independence because they can no longer rely on their price stability mandate to fend off congressional attempts to finance profligate spending.


Currently, elected officials do not appear to be considering any viable plan to curb rising U.S. debt and entitlement spending, thus leaving the nation’s fiscal health on an unsustainable trajectory. To remedy this situation, now more than ever, the Federal Reserve will have to play a major role in developing such a plan. One option is for the Fed to take its own stance against fiscal-QE-type programs and announce that it will revert to its traditional (pre-crisis) operating framework over a specific period. Alternatively, the Fed will have to work with congressional leaders to develop legislation that restores the Fed’s traditional operating framework and that restricts the Fed’s ability to engage in fiscal operations. The immediate prospects for either solution appear rather remote, but the longer policymakers delay, the more severe the consequences become.








52Federal Reserve, “Securities Held Outright: U.S. Treasury Securities: All: Wednesday Level,” FRED Economic Data, Federal Reserve Bank of St. Louis, October 30, 2020 (accessed October 30, 2020); and U.S. Treasury, “The Debt to the Penny and Who Holds It,” Treasury Direct, (accessed October 30, 2020).



Monetary policy and the debt crisis

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