There are a few forms of money in the modern financial system, but not all of them are well known. We all know about currency (paper bills) and bank deposits (the numbers in your checking account). If you reading this blog then you also know about central bank reserves (money commercial banks use to pay each other). These are assets that are considered money in large part because they are both risk free and highly liquid. However, they cannot be used as money by institutional investors or the very rich. A big investment fund would not put stacks of $100 bills in the office, nor place huge sums in a bank account (bank deposits are only guaranteed by the government up to $250,000), and is ineligible to hold central bank reserves. When big money looks for safety and liquidity, they look at U.S. Treasuries. In the modern financial system, Treasuries are money.
In this post I will discuss the structural features of the Treasury market that allow it to become money, how the U.S. Treasury became the biggest printer in town, and what this means for economic growth.
The Deepest and Most Liquid Market in the World
U.S. Treasuries are money because they have no credit risk, and can be converted to bank deposits almost instantly if the investor wants to purchase real goods and services. This high degree of liquidity is possible because of a very deep cash market and repo market that does not exist for any other asset in the world.
Cash Treasuries are traded traded virtually around the clock from New York to Tokyo to London with the average daily volume exceeding $500 billion. In contrast, the most liquid ETF – the SPY – has average daily dollar volumes of around $30 billion. Anyone who wants to sell large amounts of Treasuries can usually do so effortlessly, especially when selling shorter dated Treasury bills or recently issued Treasury coupons. (Treasury bills are short dated debt issued with a discount that mature within a year, while Treasury coupons are longer dated debt issued with 2 to 30 year tenors and pay interest semi-annually.)
Treasury holders don’t have to sell their Treasuries when they need cash; instead they repo their Treasuries out for cash. A repo is a very short-term loan secured by the Treasury security as collateral. The Fed’s SOFR index shows that around a $1 trillion dollars of overnight repo loans are made each day against Treasury collateral. An institutional investor that needs cash can just repo out his Treasury for cash, renewing the overnight loan as long as he wants.
In practice, institutional investors don’t even have to convert their Treasury securities to bank deposits to spend them. If they are purchasing financial assets like corporate debt or equities, they can simply pledge their Treasuries as collateral with their broker to purchase financial assets. If they are doing a big M&A deal often they can just pay with Treasuries, kind of like paying with $1 million dollar bills.
The U.S. Treasury has a Big Printer
The U.S. Treasury is the printer of Treasury debt, and they have been on a rampage in the recent year with over $3 trillion in net issuance. In essence, the Treasury spent over $6 trillion in fiscal year 2020 of which half was paid for by printing Treasury paper. The investors in Treasuries exchanged their bank deposits for Treasuries, but they simply swapped one form of money for another. The U.S. government spent those bank deposits on goods and services, so the total level of bank deposits in the banking system in unchanged. At the end of the day, the financial system has more ‘money’ in the form of Treasury securities.
This is fundamentally different from the Fed’s quantitative easing, which is more about changing the composition of the money in the financial system to lower longer dated interest rates. After QE, non-banks are forced to hold fewer Treasuries and more bank deposits but the quantity of money available to them is unchanged. (Yes, bank reserves are higher as well. Bank reserves can be freely spent, but in practice is only spent by banks on very safe assets because of the high regulatory costs of holding risky assets).
In a previous post we noted the lack of relationship between M2 and GDP, but that is different for Treasury net issuance and GDP. M2 money can enter the financial system via the Fed’s printer converting Treasuries (not included in M2) to bank deposits (included in M2). But when the U.S. Treasury is printing money, it is essentially creating money (Treasuries) out of thin air and spending it on transactions that contribute to GDP such as defense goods and medical services. In fact, government spending is an explicit component in calculating GDP. Government deficit spending directly boosts GDP.
The Paradigm Shift
In the past, there have usually been political pushback against mass deficit spending. The chart above clearly show that is a losing battle, where total marketable Treasuries have jumped to $21 trillion. The trend suggests that deficit spending is not just increasing, but at an accelerating rate. The Fed’s printer forced the investment world to rebalance their portfolio and led to higher asset prices, with limited effect on GDP growth or inflation. But trillion dollar deficits are largely spent on real goods and services, and that directly boosts the real economy.
While central bank officials throughout the world lament low inflation, in practice the government has enormous control on inflation and deflation. Inflation can be slayed by raising interest rates significantly, and deflation can be fixed by printing trillions and spending it on goods and services. In the past, there were self-imposed constraints on deficit spending. But now the chains are off.