“Funding” the Federal Response to COVID-19 is not the Issue: Inflation is the Issue

In response to COVID-19, The Federal Reserve (FED) has quickly flooded the capital markets with $1.5 trillion in short term funding; it has committed to an additional $700 billion in purchases of longer dated securities. This latter action is open ended and is likely to grow far larger than the current  commitment of $700 billion.

All of this raises the question as to why the Federal Government, for our purposes we will consider the Federal Reserve to be part of the Federal Government, has not likewise committed a similar amount of support for low to middle income people who will, from an economic  standpoint, suffer the most from the COVID-19. Current proposals for relief for low to middle income Americans are coalescing around the idea of sending workers up to $1,200. This is likely to be received around the end of April with an overall price tag of around $1 trillion: far too little, far too late.

Why is the federal government unable to adequately respond to the needs of the average American while it responds rapidly to the needs of the financial markets? Part of it is an infrastructure  issue. The mechanics of the Federal Reserve’s response to the crisis are part of its daily operations. The FED daily engages in both the purchase and sale of short term securities in its open market operations. As part of these operations it also lends  against short dated securities in the repo market. Both efforts occur as part of its daily interest rate targeting operations which occur through a well established network of large financial institutions known as primary dealers. With this infrastructure in place,  the FED is able to quickly flood the financial markets with cash during a crisis. Where does the FED get the money for purchases or loans during these Open Market Operations? It simply creates new money through a computer keystroke in which the recipient’s account is credited with new money.

So what is the barrier which prevents the U.S. Treasury Department from quickly responding to the cash needs of working Americans?  The problem is that an infrastructure similar to that which exists between the FED and the primary dealer network does not also exist between the Treasury Department and the U.S. taxpayer: this creates challenges. Additionally, but more importantly, orthodox thought would have us believe that federal spending needs to be funded through taxation and borrowing, unlike the Federal Reserve which can simply create new money through a computer keystroke. Operating under this belief, new spending  gets bogged down into the debate over how the new spending is to be funded: debates over deficits and tax rates follow. It’s the usual “who is going to pay for it” concern. 

But this is the wrong  concern. Let’s approach this issue from what is generally a Modern Monetary Theory (MMT) perspective or a close variation thereof. We have already touched on the idea that the Fed creates new money in the system through the purchase of securities or through the process of lending in the repo market. For our purposes,  the role of the Treasury Department in new money creation is more important. From an MMT perspective, new money is created when the federal government spends. Taxation and borrowing are not required to support this spending. Like the Federal Reserve, new money is created simply through a credit to a private sector bank account. Taxation and borrowing are tools necessary to achieve other policy objectives:  particularly the use of taxation as a money destruction measure in order to control inflation. This view is correct both from a technical accounting perspective and also through historical examples: notably the early American Colonial experience in which money was first spent into circulation by Colonial governments and then taxed in order to remove excessive money from the economy which would otherwise create  inflationary pressures.

So while nearly everyone in the financial industry understands that the Fed creates money when it purchases  securities or loans money against securities, when we speak of Federal Treasury spending we continue to be blinded by our household budgeting experience into believing that the federal government  must, like a household, fund its activities. This is simply untrue. Unlike a household which must match spending with income, borrowing, or the depletion of savings, and which does not have the power to create its own money,  the federal government is free to create all of the money it would like to create. It, ultimately, has the sole authority over the production of the U.S. currency. The Federal Government need not match its spending with taxation and borrowing. In practice this would require some legal and regulatory overhaul but that is a separate issue.

With its unlimited ability to create money, it can “fund” whatever policy measure it chooses to fund. Funding is not the issue; inflation is the issue. The increase in the money supply through the issuance of  checks to American workers, along with cutbacks in U.S. production due to the COVID-19, could increase inflationary pressures, i.e., too much money chasing too few goods. On the other hand, the mid to longer term impact of the virus through increased unemployment, falling demand for office space and reduced driving due to an increase in remote employment, the latter two of which will likely become a more permanent  feature of the U.S. economy, will likely have a deflationary impact on the U.S. economy. Once we understand these forces, then we can rightfully center the debate on what will be the overall inflationary impact of sending checks to American consumers and also what is an acceptable level of inflation in light of the pressing needs for cash amongst the American public. With a properly centered debate, we might discover that we are willing to engage in a greater  money creation through federal spending than we would otherwise if operating under the previously misunderstood need to fund federal spending through taxation and borrowing. 

The federal government need not fund the checks which it sends to low to middle income workers through taxation and borrowing. It can simply spend this money into circulation. The taxation and borrowing response to increased federal spending should be measured solely in terms of its impact on the potential inflationary  pressures which might result from the increased federal spending. 

Funding is not the issue; inflation is the issue.

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