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Policy Hub: Macroblog provides concise commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues for a broad audience.

Authors for Policy Hub: Macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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May 25, 2023

Credit Conditions Are Tightening. Are Firms Feeling the Pinch?

The recent banking turmoil has many folks talking about a credit crunchOff-site link. Indeed, according to the Federal Reserve's latest Senior Loan Officer Opinion Survey on Bank Lending PracticesOff-site link (SLOOS), just under half of banks surveyed have been tightening their lending standards, raising concerns that the flow of credit to the broader economy will choke off businesses' ability to engage in expansionary investment and fund operations (see figure 1).

Given the recent turmoil and reports of a constrained flow of credit, in mid-April (April 10–21) we posed a series of special questions to panelists in our Survey of Business Uncertainty (SBU)—a national, monthly survey that gathers responses from private, nonagricultural employer firms across all major industries and firm sizes—to gauge the demand side of the credit equation and see if firms are feeling the squeeze. What we found was quite interesting. Only about a quarter of our firms anticipate applying for new credit (or rolling over an existing line of credit) during the next 12 months, down from about a third of firms over the past year (see figure 2). Most firms do not anticipate seeking funding, and about 60 percent of respondents indicated having enough cash on hand to execute on their current plans. Additionally, about one-third of these firms said they did not want to accrue further debt. Put simply, if a pending "credit crunch" is going to send the economy into a tailspin, it might take a while for Main Street businesses to feel it.

In response to a backward-looking question on whether firms have recently applied for credit (or extended an existing line of credit), roughly a third of our panel indicated submitting a credit application during the past 12 months. About two-thirds of those applications were during the prior three months, with the overwhelming majority (89 percent) receiving the entire amount requested. Looking forward, only around 25 percent of the panel anticipates applying for credit during the next 12 months.

There are some differences across firm size embedded in these results. A greater share of large firms (those with 250 employees or more) applied for credit during the past year—roughly 40 percent, compared to about 30 percent of small firms, with a similar disparity over the year-ahead horizon. When looking across broad industrial classifications, the share of firms that sought credit during the past year was highest among firms in construction, real estate, mining, and utilities (42 percent) and in retail and wholesale trade (42 percent).

We can also relate these special question results to our core survey outcomes to see if firms that experienced or anticipate strong employment and sales revenue growth were disproportionately those that sought credit. A surprisingly similar share of the fastest-growing firms in terms of sales revenue compared to slower-growing firms submitted a credit application during the past year. For example, 35 percent of firms in the top tercile of sales revenue growth during the past 12 months sought credit, statistically indistinguishable from the 33 percent of firms in the lower two terciles of sales revenue growth.

Although the majority of firms do not anticipate applying for credit in the next 12 months, to the extent that turmoil in the banking system disproportionally affects smaller banks, it is also more likely to crimp smaller firms' access to credit. In our results, roughly 60 percent of large firms' most recent credit application was at a large bank (see figure 3). Smaller firms, on the other hand, are more likely to bank with small banks (44 percent, compared to just 17 percent of larger firms), which could increase smaller firms' exposure to a contraction in bank lending.

Among the one-quarter of firms seeking new credit, the rationale for why these firms plan to borrow sheds further light on the potential impact that tightening credit conditions may have on economic growth. In our April survey period, we posed a follow-up question to the one-quarter of firms that plan to apply for credit: "Looking ahead to the next 12 months, for what purpose does your firm plan to seek credit financing?" The question allowed respondents to select all applicable reasons from a list that included options such as expanding business, pursuing new opportunities, or acquiring business assets; meeting operating expenses; refinancing or paying down debt; and replacing capital assets or making repairs.

The results shown in figure 4 suggest that just over half of those anticipating applying for credit financing—or roughly 14 percent of the overall SBU panel—plan on using those funds to expand their business, pursue new opportunities, or acquire business assets. Another 27 percent (just under 7 percent of the overall panel) plan to replace capital assets or make repairs, and 25 percent (roughly 6 percent of the overall panel) anticipate seeking credit to refinance or pay down existing debt. To some extent, tighter credit conditions could affect these plans. However, the firms arguably most vulnerable in the event of a significant credit contraction—those anticipating seeking credit to meet operating expenses—amount to just a little less than 6 percent of our panel.

Given that the overwhelming majority of firms in the SBU have not sought credit in the past year and do not anticipate seeking credit in the next 12 months, one obvious question is: why not? The results in figure 5 detail the reasons firms gave for why they either didn't plan to apply for credit, or why they don't plan to.

For almost half the firms in our panel, the answer was that the firm had (or has) enough cash on hand to follow through on their current (anticipated) slate of activities. Looking at the year ahead, 60 percent of the 405 firms that received this follow-up question indicated they weren't seeking credit because they have enough cash on hand to cover their expected activity during the next 12 months. Out of a total of 540 responses, this amounts to 45 percent of the panel. Another third of the firms not planning on seeking credit said they did not want to accrue further debt. And—perhaps especially interesting to those attuned to monetary policy—just 21 percent of those not planning on seeking credit financing in the next 12 months (or 16 percent of our overall panel) indicated that interest rates are too high for them to consider taking on additional credit financing.

These results are consistent with longer trends in corporate financing. A recent articleOff-site link out of Northwestern's Kellogg School of Management reports that firm's cash holdings have risen sharply since 2000—from $1.6 trillion to $5.8 trillion. The article cites uncertainty, tax strategy, and the need for some firms (especially those in the intellectual property space) to be nimble. After-tax corporate profits have risen sharply since the early 2000s, rising from around 5 percent of nominal gross domestic product (GDP) to roughly 10 percent by late 2019. Since the onset of the pandemic, they've only moved higher—reaching a peak of 12.3 percent of GDP in the second quarter of 2021.

Our results suggest that any significant tightening in credit conditions that has occurred in the wake of recent bank failures may take some time to impact the broad swath of Main Street businesses, as just 25 percent of firms in the SBU anticipate seeking credit financing during the next 12 months. And the majority of firms not seeking credit financing report having enough cash on hand to cover their plans during the next year. Indeed, although the SLOOS indicates that, on balance, the share of banks tightening credit has increased markedly, only a very small fraction of banks have tightened lending standards "considerably." To be clear, a significant and protracted contraction in the supply of credit would certainly constrain firms' ability to sustain and grow their businesses. However, our results do suggest that firms' demand for credit is expected to wane relative to the year prior and many firms report having ample cash on hand to move forward on business plans, perhaps splashing a bit of cold water on near-term fears of a looming credit crunch.

October 18, 2022

Decentralized Finance (DeFi): Potential and Risks

In a 2008 paperOff-site link by Satoshi Nakamoto, Bitcoin was proposed as a method of making electronic payments using a blockchain without the need to go through a financial institution. In a relatively short period of time, the basic idea laid out by Nakamoto has grown into a crypto finance world that at its recent peak in November 2021 was valued by CoinmarketcapOff-site link as being worth almost $3 trillion. However, contrary to Nakamoto's original vision, financial intermediaries have provided many of the financial services needed for the crypto finance world to grow to this level. Thus, it's not surprising to see the rise of an alternative method of providing many services not reliant on institutions. This method replaces centralized finance (or CeFi), which is delivered through institutions, with decentralized finance, or DeFi, which uses smart contracts (computer code) running on a blockchain.

DeFi had shown considerable growth starting in late 2020 through late 2021 (for more discussion of this growth, see here Adobe PDF file formatOff-site link). The standard measures of size, total value locked—saw DeFis reaching a peak of more than $180 billion in December 2021, according to one relatively broad measure (such as DeFiLlamaOff-site link, a total value locked data aggregator). Although these numbers may sound large, they are still a rather small part of the global financial system. For example, four US banks have total assets greater than $1.5 trillion. Moreover, the total value locked in DeFi has dropped dramatically since the start of the "crypto winter" earlier this year, reaching values below $55 billion in September 2022. Whether DeFi can become a major provider of financial services will likely depend upon the extent to which crypto finance either integrates with the existing financial system or evolves to become a parallel system for providing a wide range of financial services—or both.

Along with coauthors Francesca Carapella, Edward Dumas, Jacob Gerszten, and Nathan Swem, I recently posted an article on DeFi titled "Decentralized Finance (DeFi): Transformative Potential and Associated Risks" as part of the Atlanta Fed's Policy Hub series. (It is also available in the Board of Governors FEDS working paper series Adobe PDF file formatOff-site link and as a working paper Adobe PDF file formatOff-site link out of the Boston Fed's Supervisory Research and Analysis Unit.) This Policy Hub: Macroblog post summarizes some key ideas in our article.

DeFi overview
To understand developments in DeFi, it is helpful to understand the how and why of widely accessible (public, permissionless) blockchains. A blockchain is a database where the data are entered in time-stamped blocks and the blocks are cryptographically chained together so that any change in a prior record can easily be detected. Bitcoin facilitates the avoidance of financial intermediaries by using a public, permissionless blockchain, meaning that anyone can obtain a copy of the database, read the database, and potentially write to the database. The problem that such an open database can create is that of "double spending." An example of double spending would be Joe first making a payment to Jane and then trying to make a payment to Mary using the same funds. This circumstance could happen if Joe has ability to rewrite blocks that had been previously written. That is, he could rewrite the block he had used to pay Jane so that it no longer contains that payment and—using the funds he took back—make the payment to Mary.

Nakamoto's solution to double spending is to make it very costly to try to rewrite existing blocks. The person who gets to add a new block to a blockchain must win a computationally intensive contest called proof-of-work (participants in this contest are said to be "mining" Bitcoin). As this mining process is mandatory for adding each block, attempting to rewrite a previously written block requires the miner to rewrite every block thereafter to the present, solving the computationally difficult problem for each replacement block—a very costly process. The result is that the Bitcoin blockchain is highly resistant to tampering (often spurring exaggerated claims that blockchains are "immutable"). However, Bitcoin's protocol also takes a relatively long time to ensure that a transaction has been processed.

In practice, DeFi is a relatively small part of Bitcoin because Bitcoin was not designed for sophisticated programming. The Ethereum blockchain stepped into this gap and added the ability to run programs as part of creating new blocks. Consider a simple example of such a program: one for delivery versus payment (a crypto asset is delivered from agent A to agent B, if and only if B simultaneously pays A). These programs are referred to as dapps (distributed applications). One type of dapp is the smart contract, which automates the execution of financial transactions among different parties. Although some other blockchains have since followed Ethereum in allowing dapps, Ethereum has emerged as the most important blockchain for DeFi as measured by total value locked, according to DeFiLlama's blockchain pageOff-site link.

Ethereum originally adopted a version of Nakamoto's proof-of-work protocol to deal with the double-spending problem. However, on September 15, Ethereum replaced proof-of-work with proof-of-stake, in which the party who gets to add the next block is randomly chosen from a group who have locked up (or staked) the blockchain's native cryptocurrency (called Ether). The winner of this contest is called a validator. The switch to proof-of-stake is part of a long-term project to allow Ethereum to process more transactions in a given period.

DeFi uses
Our article discusses some of the most important financial services that decentralized finance is providing. Currently, one of DeFi's most important services is that of borrowing and lending. Decentralized lending platforms bring together borrowers and lenders. Borrowers incur fees (continuously accruing interest) from the time they take out the loan until its repayment. Lenders earn interest on the funds they lend.

Loans made through a DeFi are typically collateralized with other crypto assets. Participants in crypto finance are pseudonymous, meaning they are known only by their public address on the blockchain, which prevents lending based on reputation and the threat of resorting to bankruptcy courts. Moreover, because almost all the assets currently residing on blockchains are crypto assets, blockchain tokens representing off-chain assets such as equipment and real estate are generally not (yet, anyway) legally enforceable in law courts. As a result of the requirement for on-chain collateralization, borrowers take out many loans to finance off-chain consumption while retaining exposure to the crypto asset they are using as collateral—like a stock investor taking out a margin loan to buy a new car. (Another use of such loans is to increase leverage for those speculating on an increase in the value of a crypto asset—especially a cryptocurrency.)

A second important service type of DeFi service is decentralized exchanges (DEXs), which facilitate the trading of crypto assets with a centralized market maker or centralized order books. DEXs typically solicit investors to lock funds into so-called liquidity pools, rewarding these investors with fees (essentially, interest on their deposits). Users can exchange one cryptoasset for another by withdrawing a different cryptoasset than they deposited. A protocol called an "automated market maker" controls the rate at which one asset can be exchanged for another. If the price of one asset gets out of line with the views of investors or the prices on other exchanges, liquidity providers have an incentive to step in to close the price gap.

A third use of DeFi is the provision of derivatives, or claims whose value depends on (or is derived from) another asset. DeFi derivatives allow users to obtain price exposure to other assets, and this exposure is not limited to crypto assets but could include sovereign currencies, commodities, stocks, and indices. Like DEXs, DeFi derivatives connect buyers and sellers directly using collateral pools.

A fourth use of DeFi is to facilitate payments. One example discussed in our article is that of Flexa, which facilitates timely payments to merchants so that the transaction can be quickly completed despite delays inherent in the settlement of some cryptocurrencies. A second payments DeFi is the Lightning Network, which seeks to accelerate Bitcoin transactions by moving most of the work off the Bitcoin blockchain into what is called layer 2, with only the results recorded on the Bitcoin blockchain.

A third payments system our article discusses is Tornado Cash, a so-called "cryptocurrency tumbler," which is a service that obscures the relationship between the sending and receiving addresses of a cryptocurrency payment. Tornado Cash receives cryptocurrency funds from various sources and then, with some delay, distributes the funds to the intended recipient(s). The commingling of funds from various sources makes it more difficult to trace payments from one address to the intended recipient at another addresses. Tornado Cash was developed because although most cryptocurrencies are pseudonymous, everyone can nevertheless see payments sent from one address to another even though the blockchain itself does not reveal the identity of either party. However, information linking some addresses to specific parties, and some other analysis, can lead to discovery of many participants' identities. Thus, people who would prefer to send payments with reduced risk of revealing their identity might prefer to use a tumbler such as Tornado Cash. The problem is that in many cases the individuals seeking to hide their identity are engaged in illegal activities such as money laundering, ransomware schemes, and sanctions evasion. Thus, on August 8, the US Department of the Treasury's Office of Foreign Assets Control (OFAC) sanctionedOff-site link Tornado Cash. Among the consequences of this sanctioning is that Americans are prohibited from using Tornado Cash unless licensed by OFAC or the transaction has an exemption. This sanctioning has resulted in a sharp drop in the total value locked in Tornado Cash, according to Defi Llama (you can see a graph of historical values hereOff-site link).

The last type of DeFi service that we discuss in our article is asset management. Asset-management dapps are similar to mutual funds in that they pool investor funds so that they can be efficiently invested other assets. This ability to pool assets may be useful, for example, by facilitating investment in an index of cryptocurrency values.

DeFi risks
As noted earlier, the value of all cryptoassets and cryptoassets locked in DeFi is relatively small, given the scale of the global financial system. As such, DeFi is not yet large enough to pose a systemic risk to the financial system or to be a significant mitigant of systemic risk. Nevertheless, DeFi's potential risk implications merit careful review given its potential for growth.

In our article, we discuss how DeFi could reduce some risks but increase other risks in the financial system. Arguably the biggest potential for risk reduction is enhancing the ability of supervisors to track, in real time, major financial institutions' transactions on the blockchain, both as individual institutions and in aggregate. Having this ability would allow supervisors to respond nearly in real time. The cost, however, is that the complete record of transactions is available to everyone, and pseudo-anonymity can be broken in many circumstances. Thus, users of cryptofinance, including DeFi, have no guarantee that their transactions will remain private. This potential lack of privacy poses problems not only for individuals but also for businesses that would rather not have their financial transactions disclosed to competitors.

In terms of risks created by DeFi, many of them are like the risks that have always been part of traditional finance, including excessive leverage, maturity and liquidity transformation, and so forth. However, important operational differences exist between traditional finance and DeFi that could have significant risk implications. Some of these issues might have solutions, such as whether a blockchain can be made secure and scalable while remaining decentralized. However, many other problems are inherent in blockchains, dapps, and cryptofinance.

At the most basic level is governance of the blockchain and the individual dapps. In theory, the governance of blockchains and dapps is decentralized, with no one party exercising control. In practice, we observe a wide spectrum of governance arrangements. Some governance arrangements are de facto centralized with a small group—typically, the founders—exercising effective control (see, for example, hereOff-site link). Such centralized control facilitates correcting mistakes in programming and adapting to environmental changes. However, such centralization also allows those in control to change the operation of the dapp in ways that benefit themselves. At an extreme, this behavior can take the form of a "rug pull," in which the founders disappear with all the tokens locked in a smart contract. Conversely, as governance becomes more decentralized, making changes to the blockchain protocol or dapp might become more challenging, and the supervisors could have difficulty finding people to address regulatory concerns. Also, decentralization of governance does not guarantee against someone temporarily buying control to enact changes favorable to themselves, nor does it prevent a majority of the voters from taking actions that disadvantage a minority of the voters.

The process of creating new blocks introduces risks for DeFi users. New blocks typically contain multiple transactions with the miner (or validator) who "wins" the competition obtaining control over which transactions get entered in the block and in which order. One result is that the structure of blockchains allows something akin to front-running in traditional markets. The resulting profit accruing to miners (and validators) is called miner's extractable value (as discussed in detail hereOff-site link).

Focusing more specifically on smart contracts, this computer code is subject to two problems. First, mistakes in the programming (bugs) are common in computer code. Of course, traditional financial intermediaries' programs also have bugs. However, the resistance of blockchains to rewriting historical blocks makes reversing errors almost impossible unless the receiver of a payment agrees to reverse the transaction. Second, the code must state (explicitly or implicitly) what will happen in every possible circumstance. Yet as I have previously observed, traditional contracts are often intentionally left incomplete for a variety of good economic reasons.

A third issue related to risk is that of trust. Users of traditional financial intermediaries need to place considerable trust in their intermediary, its regulator, and the judicial system. On the other hand, cryptofinance is described as "trustless," meaning that its user can verify all transactions on a blockchain and inspect the code being used by a dapp. In practice, though, very few people would have the technical skills (or the time) needed to carefully analyze a dapp to find any programming bugs, fully understand the dapp's economic incentives, and understand how that dapp could interact with other dapps. Thus, as a practical matter, almost all users will need to trust third parties if DeFi is to become mainstream.

The issue of trust is exacerbated by something called "censorship resistance," which is a property of public, permissionless blockchains. In principle, anyone can initiate any transaction on a blockchain as long as it complies with the blockchain's protocol. This openness can have benefits, such as preventing governments from trying to financially cripple political opponents. However, it also means that the blockchain is open to every bad actor no matter where they are in the world. As a result, blockchains have been used to facilitate scams, theft, and money laundering. Although similar problems exist in traditional finance, the extent of such problems is reduced by financial intermediaries' incentive to build customer trust, regulators' ability to enforce regulations around financial conduct, and, in some cases, regulators and judicial authorities' ability to enforce the reversal of improper transactions.

One unusual feature of dapps is their interoperability, a potential advantage in that smart contract composability allows for dapps to interoperate and thus provide services and products that are not available from any single dapp. However, such interoperability also creates the risk that if a financial or operational issue arises with one dapp, the problem could spread to other parts of the DeFi ecosystem.

Another risk we discuss in the article is DeFi's interconnections with the traditional financial system. In part, this risk arises because traditional finance and DeFi simply have different mindsets and take different risk-mitigation approaches. Participants in DeFi might not appreciate the potential risks they are incurring from involvement with traditional finance, such as the risks that the investment portfolios of some stablecoins have taken. Similarly, traditional financial institutions might not fully appreciate their risks through DeFi when they interact with crypto finance. Moreover, traditional financial institutions could face greater exposure to legal risk as they—unlike almost all dapps—can be readily identified, and their deep pockets make them attractive targets.

DeFi is opening a new avenue for the provision of financial services and might provide significant benefits. However, alongside exposure to most of the risks incurred in traditional finance, DeFi introduces new risks that arise from its unique operational structure. While DeFi is still a relatively small part of the financial system, policymakers should try to get ahead of developments in this area and decide what regulatory controls would be appropriate.

July 6, 2022

Workshop on Monetary and Financial History: Day Two

In yesterday's post, I discussed the first day of the Atlanta Fed's two-day virtual workshop on monetary and financial history. In today's post, I'll discuss the workshop's second day, which began with presentations by Maylis Avaro (University of Pennsylvania) and Caroline Fohlin (Emory University).

Avaro's paper Adobe PDF file format, coauthored with Vincent Bignon (Banque de France), examined the historical (19th-century) credit policies of the Banque de France using a comprehensive dataset of credits that the Banque extended during one year (1898). In its credit operations, the Banque attempted to offset regional economic shocks by providing directed credit to the affected regions. It provided credit only against collateral, and it intensely monitored counterparties, especially for riskiness of their business model. Econometric analyses show that the Banque tended to extend credit at branches experiencing regional shocks, but usually only to parties judged to be sufficiently prudent. This analysis also shows that the Banque favored banks over nonfinancial firms and existing over new counterparties. Avaro concluded by arguing that this historical example illustrates the potential benefits of central bank credit operations when appropriate risk management can limit moral hazard.

The discussant for this paper was Angela Redish (University of British Columbia). Redish argued Adobe PDF file format that the credit operations documented in the paper were somewhat different from what might be expected in other lender-of-last-resort situations, in which market disruptions might hinder assessments of risk and impair the value of collateral. Redish also questioned why private banks did not lend against the same sorts of collateral as the Banque, suggesting that some of the Banque's lending success might have been the result of its market power as the monopoly issuer of banknotes within France.

Fohlin's presentation Adobe PDF file format described a research program, undertaken with Stephanie Collet (Deutsche Bundesbank), to construct a comprehensive dataset of interwar German stock prices. Fohlin's presentation focused on data from the 1920s. These data span a number of major disruptions to the German economy, including the 1921–23 hyperinflation, the 1927 stock market crash, and the rise of the Nazi party. Volatility of individual stock prices and bid-ask prices were high during this unsettled period. Despite this volatility, micro analysis of the data shows that the German stock market was surprisingly liquid for most of the sample, with buy orders typically exceeding sell orders. Another surprise was that shares of new companies were as liquid as those of existing companies. Market illiquidity increased during the late 1920s, however, in the wake of the 1927 stock market bubble and ensuing market crash.

The discussant was Eugene White (Rutgers University), who suggested that the data collected by the authors could be applied to a number of interesting research topics. For example, the data could provide additional perspective on the performance of the interwar stock market if its performance were contrasted with the pre-1913 market. A greater understanding of the institutional background of the market—for example, regulatory structure and stock voting rights—would also be useful. White also questioned how much the release from wartime capital controls in1919 was behind the apparent vitality of the 1920s market. Finally, White suggested that the authors investigate the impact of Reichsbank regulatory policy, margin requirements in particular, on market liquidity.

Looking back, and ahead
The fourth session of the workshop consisted of a panel discussion of the past and future of money. The panelists were François Velde (Federal Reserve Bank of Chicago), Gary Gorton (Yale University), and Marc Flandreau (University of Pennsylvania),

Velde's presentation Adobe PDF file format considered possible roles for central bank digital currencies (CBDC) in the context of historical examples of monetary innovation. Velde observed that central banks arose from earlier, coin-based monetary systems, to fill gaps in those systems, first through giro transfers (a type of payment transfer between banks) and later through circulating currency. Originally most central banks only dealt with large-value payments, and even today most central banks are not retail-oriented. That could change with CBDCs, Velde noted, especially if future CBDCs incorporate innovative features such as smart contracts, although the property rights of information collected on CBDC users will be a contentious policy issue. Another unresolved issue regarding CBDCs is their role with respect to private digital currencies. Velde argued that competition between public and private moneys could be beneficial. Velde concluded by noting the monetary innovations are often the product of accidents or strong underlying trends, rather than conscious policy choices.

Gorton's presentation Adobe PDF file format focused on new forms of private money and associated policy issues. Gorton argued that all private money inherently has the problem of information asymmetry and that the classic solution to this problem is to create money with a par value so that its value does not have to constantly be reassessed in market transactions. Typically, par money is debt that is backed by other debt. This solution creates another problem, Gorton argued, which is that debt-backed money can be subject to runs and sudden loss of value when confidence is lost in the money's backing. Stablecoins—digital tokens that have safe asset backing—are susceptible to the same problems as paper-based forms of private money, as recent runs on stablecoins show. Gorton concluded by drawing on the history of paper currency to suggest that the only viable long-term solution to the run problem will be central bank monopoly of digital token issue.

Flandreau's presentation considered the impact of monetary innovations on international currency competition. Flandreau rejected the "unipolar" and "multipolar" interpretations of monetary history literature (basically, a tendency to converge toward one or more dominant currencies), instead arguing that the true nature of monetary evolution has been one of currency competition regimes. As an example, he cited a currency competition regime that centered around the bill of exchange, an important international payment instrument from the 14th through the early 20th centuries. Major European currencies competed for international status within this regime by developing dense markets for bills of exchange. However, latecomers to this currency competition (Germany, Japan, and the United States) increased their competitiveness through new infrastructure, such as international branch banking, and new payment instruments, such as telegraphic transfers. These innovations supported the rise of the US dollar as an international currency when bills of exchange fell from use during the 1930s. Flandreau saw this history as illustrating the idea that currency regimes depend on their underlying financial infrastructure and monetary instruments.

The conference's fifth session featured paper presentations by Sasha Indarte (University of Pennsylvania) and Marc Weidenmier (Chapman University). Indarte's paper Adobe PDF file format analyzed a dataset of sovereign bond defaults from 1869 to 1914, which was matched to a dataset of sovereign bond prices during the same period. Indarte described how a critical aspect of sovereign bond issue during this period was the reputation of the party underwriting the bond in the London financial markets. Econometric analyses show the presence of underwriter-related spillovers. More specifically, default of one sovereign bond issue typically depressed the prices of bonds with the same underwriter, after taking into account other observable factors. The reputation spillover effect is economically significant and evident for at least two years following a default. Indarte concluded by observing that this same pattern of underwriter spillover effects might be present in modern contexts such as syndicated lending.

Jonathan Rose (Federal Reserve Bank of Chicago) provided the discussion Adobe PDF file format . Rose noted that the effect of underwriter reputation, while well documented in the paper, was perhaps more critical in historical than modern contexts (citing mortgage-backed securities as an example), due to the sovereign bonds' lack of regulation or credit enhancement features. Rose also raised the possibility of self-selection in the data sample, with weaker bond issuers seeking out underwriters who were more willing to risk their reputations.

Weidenmier presented Adobe PDF file format new data series of US industrial production in the decades surrounding the Civil War (1840–1900), taken from a recent paper coauthored with Joseph David (Vanguard Group). The data series uses hand-collected, city-level data and are separated by Northern and Southern states. The data show that growth in Northern-state industrial production was little affected by the war. Southern-state industrial production, on the other hand, fell precipitously during the war and did not return to prewar levels until about 1875. Capital-intensive industrial production in Southern states was especially slow to recover. However, rapid growth resumed in the 1880s, perhaps because of the resolution of uncertainty regarding investor property rights following the end of Reconstruction.

The discussant for this paper was Mark Carlson (Board of Governors), who noted Adobe PDF file format that some of the regional differences documented in the paper might have been the result of the population's westward expansion, which was more pronounced in the North. He also suggested that the quality of some of the immediate postwar data in the South might have been poor, possibly biasing statistical results. Those concerns aside, a striking feature of the data is that the North did not see a postwar contraction, as occurred in the United States after World War II. Finally, Carlson proposed that the observed regional differentials might be attributable to the disruption of the banking system that the South experienced during the Civil War and its immediate aftermath.

The conference's final panel was a discussion of the evolution of the Fed's mission and governance. The panelists were Sarah Binder (George Washington University), Lev Menand (Columbia University), and Ned Prescott (Federal Reserve Bank of Cleveland).

Binder began the panel with an analysis Adobe PDF file format of the Fed's political independence drawn from her recent book with Mark Spindel. Binder proposed that the conventional view of the Fed as an agency insulated from short-term political pressures is incorrect, arguing that this view is overly rooted in struggles to control inflation during the 1970s and 1980s. Moreover, it overlooks both the historical importance of financial crises in shaping the Fed and the partisan context in which the Fed operates. Under this view, the Fed and Congress display interdependence, the Fed gaining political support and the Congress gaining the Fed's ability to quickly react in crises, as well as to absorb blame for unfavorable economic outcomes. Binder went on to argue that this interdependence has driven the structural evolution of the Fed, in the form of cycles whereby successive crises result in Congressional reforms of the Fed. Sensitivity of Fed policymakers to this cycle of reform has influenced many Fed policy decisions, Binder noted, its structural independence notwithstanding.

Menand's presentation Adobe PDF file format focused on the role of the Fed within the broader legal framework of the US monetary system. Although some legal scholars see the Fed as a "hodgepodge agency" with many unrelated functions, Menand argued that the Fed's role is a coherent one within the US monetary tradition, which "outsources" money creation to independent entities, including chartered commercial banks but, since 1913, also the Fed. The structure of the Fed also resonates with the US tradition of geographic diffusion of banking, as well as the tradition of bank supervision. In addition, independence of the Fed from the executive branch coheres with the general US tradition of outsourcing the task of money creation. However, Menand proposed that more recently, the Fed has ventured beyond its traditional boundaries through its interactions with shadow banks, which are entities that issue deposit-like liabilities but lack bank charters. Menand concluded by arguing that Fed actions to support shadow banks during financial disruptions in 2008 and 2020 have eroded traditional political limits regarding what the Fed is expected to accomplish.

Prescott's presentation Adobe PDF file format focused on the evolution of the research function at the Reserve Banks, drawing on a recent paper Adobe PDF file format coauthored with Michael Bordo. Prescott described how research was not emphasized at the Reserve Banks until the 1951 Treasury-Fed Accord, which granted the Federal Open Market Committee more independence in setting monetary policy. Prescott noted that during the 1950s and 1960s, this independence led to an increased emphasis on research, in part because more economists had become Reserve Bank presidents. During this period, the St. Louis Fed assumed the role of a "dissenting Reserve Bank," articulating policy positions based on monetarist ideas. During the 1970s, research conducted at the Minneapolis Fed fostered new approaches to monetary policy that incorporated the concept of rational expectations. Later, ideas promoted by researchers at the Richmond Fed (policy transparency) and the Cleveland Fed (inflation targeting) also came to influence Fed policymaking. Prescott concluded with the observation that these historical examples illustrate the value of the Fed's decentralized structure, in which alternative approaches to policy can be formulated and incorporated into the policy process.

July 5, 2022

Workshop on Monetary and Financial History: Day One

On May 23 and 24, the Federal Reserve Bank of Atlanta hosted a workshop on monetary and financial history. The workshop was organized by Atlanta Fed economist William Roberds, in cooperation with Michael Bordo (Rutgers University) and Warren Weber (Federal Reserve Bank of Minneapolis, retired). The workshop featured seven paper presentations, along with three panel discussions and a keynote lecture.

Exploring fiscal-monetary interaction
The first session of day one of the workshop featured three papers that examine interactions between monetary and fiscal policy.

The first paper Adobe PDF file format of the session was presented by Michael Bordo and Oliver Bush (Bank of England) and coauthored with Ryland Thomas (Bank of England). Their paper examines causes of the 1970s inflation in the United Kingdom, which was higher than in other advanced economies at the time. Bordo and Bush presented structural decompositions of the 1970s UK inflation. These decompositions suggest that a combination of fiscal responses to external shocks and passive monetary policy was the principal causal factor. The same decompositions suggest that fiscal reforms enacted during the 1980s and early 1990s enabled the Bank of England to reduce inflation to more acceptable levels.

In the discussion Adobe PDF file format, Joshua Hausman (University of Michigan) proposed that the authors emphasize narrative aspects of this historical episode. What economic models were most conducive to policies that led to double-digit inflation? Given that other countries were using the same models, why did reliance on these models result in worse inflation outcomes in the UK than elsewhere? Hausman also noted that the lower inflation rates achieved from the 1980s onward did not lead to uniformly better economic outcomes, in the form of higher trend economic growth, lower unemployment, and higher growth of real wages.

The fiscal-monetary theme continued with the second paper Adobe PDF file format of the session, which was presented by George Hall (Brandeis University) and co-authored with Thomas Sargent (New York University). Their paper compares the financing of US government expenditures associated with the COVID-19 pandemic to the financing of World Wars I and II, which gave rise to expenditures of comparable magnitude. Hall presented an accounting framework that decomposes wartime financing into three main components: taxes, debt, and money creation. This decomposition indicates that in contrast to expenditures during the two world wars, COVID-19 expenditures have been funded very little by taxes and largely by debt. Also different from the world wars is the fact that much of the COVID-19 debt has taken the form of monetary assets, interest-bearing Fed reserves, and reverse repos. Hall suggested that the experience of the world wars indicates that inflation will eventually amortize much of the debt induced by COVID-19.

The Hall and Sargent paper was discussed Adobe PDF file format by Chris Meissner (University of California, Davis). Meissner argued that the COVID-19 shock was different from the world wars insofar as it was largely unanticipated, simultaneously global, and associated with widespread financial market disruptions. For this reason, reliance on debt funding might have been a more appropriate policy than for either of the war episodes. However, Meissner also suggested that reliance on debt financing might have significantly reduced the United States' ability to respond to future external shocks.

The final paper Adobe PDF file format of the first session was presented by Eric Leeper (University of Virginia) and coauthored with Margaret Jacobson (Board of Governors) and Bruce Preston (University of Melbourne). Their paper focuses on the performance of the US economy during the Great Depression and argues that the economy's initial recovery in the early years of the Roosevelt administration can be attributed to fiscal expansion combined with the repeal of the gold standard. Leeper argued that latter policy enabled the Fed to finance much of Roosevelt's fiscal expansion via unbacked bonds, but that the recovery was then paused by more restrictive fiscal policies adopted after 1937.

Kris Mitchener (Santa Clara University) discussed Adobe PDF file format this paper in the context of the large literature on the Great Depression, which has generally emphasized monetary rather than fiscal policy as a driving force in the initial Roosevelt recovery. Mitchener noted that for this reason, the paper's fiscal-monetary focus represents a new explanation of the post-1933 recovery. However, Mitchener also noted that during the Depression, most individual Treasury bond holdings were limited to higher-income households and that this heterogeneity would matter for the paper's arguments. In addition, banks held many bonds, and it would be desirable to model the effects of fiscal expansion on banks' balance sheets. Additionally, Mitchener recommended that the authors consider the effects of US policies on its international trade.

Putting inflation into historical perspective
The second session of the conference featured a panel discussion of the current inflationary outlook in the context of earlier inflationary episodes. The panelists were Robert Hetzel (Federal Reserve Bank of Richmond, retired), Jeremy Rudd (Board of Governors), and Mickey Levy (Berenberg Capital Markets).

Hetzel proposed that there are enough commonalities of the current situation with historical episodes—particularly the inflationary acceleration experienced in the 1960s and 1970s—for the Federal Open Market Committee to consider formally integrating monetary history into the policymaking process. He argued Adobe PDF file format that this integration would lead to a more transparent statement of the FOMC's monetary standard.

Drawing on his experience at the Richmond Fed during the 1970s, Hetzel recalled the Federal Reserve's intense resistance at that time to explicitly articulating policy objectives. He argued that although there have since been improvements, the Federal Open Market Committee (FOMC) could better articulate a monetary standard through integration of historical perspectives into policymaking. More specifically, this proposal would include (1) establishment of a committee of monetary historians that would report directly to the FOMC, (2) a restructuring of the Teal Book (the briefing document prepared by the Board of Governors staff for FOMC meetings) to include a historical breakdown of how the economy got to its current state, and (3) replacement of the FOMC's current Summary of Economic Projections, which reports a collection of individual forecasts, with a consensus FOMC forecast that would be informed by consultations with the historian committee in part (1) of the proposal and the historical breakdown in part (2).

Rudd's presentation Adobe PDF file format focused on potential changes in underlying inflation dynamics observed since the start of the COVID-19 pandemic. Rudd observed that prepandemic, Fed policymakers had been able to rely on stable long-term trend inflation in the US economy, as well as a flat Phillips curve (a negative correlation between unemployment and inflation), although the factors giving rise to these favorable conditions were not well understood. This lack of understanding has hindered Fed policymaking post-COVID, when inflation has increased in part due to large relative price shocks, creating uncertainty as to whether trend inflation has now moved higher. To overcome this uncertainty, Rudd argued that it might be useful to examine historical episodes and, particularly, the increase in trend inflation observed during the late 1960s.

Rudd proposed that the underlying dynamics in the 1960s were different from those of the current economy, because of less anchored long-term inflation trends and a steeper Phillips curve. Hence, we should reject a repeat of 1960s-style overheating as an explanation for the recent pickup in inflation. A commonality with the 1960s, however, is that policies adopted then seemed reasonable at the time, and policymakers didn't foresee them as fostering persistent inflation. A major question for policymakers, then as now, is whether the recent acceleration in inflation reflects a fundamental shift in the structure of the economy. Rudd concluded by noting that by the time this question is answered, reversing any increase in trend inflation could be difficult.

Levy's discussion Adobe PDF file format focused on a recent research paper coauthored Michael Bordo. The paper surveys cyclical patterns of Fed policymaking over its entire history, from 1914 until present. Bordo and Levy argue that in these cycles, the Fed has had a general tendency to wait too long to remove monetary accommodation. They cite four factors behind this tendency: shifting doctrines about how monetary policy should be conducted, ambiguity surrounding the Fed's dual mandate, misreads of data on the state of the economy, and political pressures.

Levy proposed that these same factors have been present in the most recent policy cycle, leading to delayed removal of accommodation. Movement to a neutral level of policy interest rates will now be difficult, he argued, and—given current negative real interest rates—a hard landing has a high probability. Levy concluded with three recommendations for Fed policy going forward. First, the Fed should place more emphasis on rules-based policy (for example, a type of Taylor rule) as a benchmark. Second, the Fed should adopt a less ambiguous interpretation of its dual mandate. Third, the Fed should pay more attention to the lessons of history and incorporate these lessons into its policy doctrine.

The conference's keynote lecture Adobe PDF file format was delivered by Barry Eichengreen (University of California, Berkeley). Eichengreen's presentation surveyed the evolution of payments instruments over the past millennium, from medieval-era banknotes in China to today's digital forms of payment. A theme of the presentation was increasing technological efficiency: transactions in paper money were more efficient than the physical transfer of coins, and modern types of electronic transactions are more efficient still. The shift towards digital forms of payment has recently accelerated, Eichengreen observed, because of the COVID-19 epidemic, which led consumers to prefer online forms of payment. This shift has occurred in virtually every nation with a sufficiently advanced cellphone network, but especially in Sweden, which coincidentally was also an early adopter of printed banknotes.

Eichengreen noted that a factor that has worked against more widespread adoption of advanced digital forms of payment is that in most countries (with exceptions such as Sweden) these are not ubiquitous. Network externalities may soon lead to the emergence of dominant private forms of digital payment, however, but such dominance could result in monopoly pricing and the need for regulation. Blockchain technology alone will not by itself resolve issues with digital payments. Stablecoins have the potential to supplant paper currency for many purposes, but monetary history teaches that fractionally backed stablecoins might be susceptible to runs, again suggesting a role for regulation.

The lecture concluded with the observation that retail-level central bank digital currencies (CBDCs) might offer advantages in terms of ubiquity and stability, but CBDCs would simultaneously pose operational challenges for central banks and could encourage disintermediation of commercial banks. For these reasons, Eichengreen suggested that CBDCs are more likely to be issued at the wholesale level—for example, to commercial banks—and these banks would in turn manage CBDC transactions that their customers initiate.

In his closing remarks, Eichengreen argued that although paper currency has been a ubiquitous form of money only within a relatively short period of human history, its advantages mean that it will likely persist even as digital forms of payment become more widespread. As the latter become more prevalent, strong network externalities will necessitate government involvement, both through the provision of CBDCs and the regulation of private forms of money.

In tomorrow's post, I'll cover the presentations and discussions in the workshop's second day.