Lev Menand and Josh Younger on *Money and the Public Debt: Treasury Market Liquidity as a Legal Phenomenon*
Oct 2, 2023
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Lev Menand, associate professor of law, and Josh Younger, senior policy advisor, discuss their paper on Treasury market liquidity as a legal phenomenon. They cover the transition from bank to market financing, the impact of increasing debt on instability, recent regulations on the primary dealer system, and restoring balance between public debt and money creation.
The transition from bank financing to market financing for the public debt relied heavily on the role of dealers and the use of repo agreements.
Regulatory changes and leverage constraints on the primary dealer system post-2008 led to the emergence of alternative forms of financing and challenges in providing necessary liquidity.
Effective monetary system design is crucial for ensuring treasury market liquidity, requiring the redistribution and creation of money to meet the demand for cash during large volumes of selling.
Deep dives
The Transition to Market Financing and the Role of Dealers
The podcast episode discusses the transition from bank financing to market financing for the public debt, specifically focusing on the role of dealers. Prior to World War II, bank financing and the money supply were closely linked through the banking system. However, the post-war environment led to a shift towards non-bank financing, requiring a distribution mechanism for government debt. Dealers became central to this new system, facilitating market-making and stabilizing the treasury market. One significant development during this period was the use of repo agreements to provide funding to dealers, making dealing a profitable business. The primary dealer system, developed under the leadership of Federal Reserve Chairman William McChesney Martin, played a crucial role in this transition. This period marked a shift towards a secondary market strategy and the creation of a new market of quasi-moneys, such as repos.
The Impact of Regulatory Changes and Leverage Constraints
The podcast highlights the impact of regulatory changes and leverage constraints on the primary dealer system. The 2008 financial crisis revealed vulnerabilities in the system, leading to runs on primary dealers and the need for greater safety measures. Legislation and regulations, such as Basel III, aimed to address these concerns. However, these regulations imposed leverage ratios and requirements on banks, limiting their balance sheet capacity and ability to provide liquidity in times of stress. As a result, alternative forms of financing, including shadow dealers and shadow money creation, gained prominence. The mutated system that emerged after 2008 faced challenges in providing the necessary liquidity amid increased government debt and changing market dynamics.
The Importance of Monetary System Design and the Future of Treasury Market Reform
The podcast episode emphasizes the critical role of monetary system design in ensuring treasury market liquidity. The episode asserts that highly liquid markets in US government debt are a function of effective monetary system design. The design must enable the rapid expansion of the money supply to support the monetary intensiveness of treasury trading. The system requires both redistribution of existing money and the creation of new money, either in the form of commercial bank money or central bank money, to meet the demand for cash in times of large volumes of selling. Looking ahead, the discussion revolves around optimizing policy to align with the goals of maintaining treasury market liquidity while ensuring a safe and sound financial system. The volume of debt and the potential for future selling are factors to consider in evaluating market structure and the need for monetary elasticity.
The Civil War Period and the National Banking System
During the Civil War, the US government shifted to printing money as a core strategy for dealing with a mismatch between revenues and expenditures. In 1863, Congress created the national banking system, which entangled monetary and fiscal activities. The government essentially chartered investor-owned banks to print money and buy treasury securities. This system, though not direct money printing, still facilitated government financing and lacked a full fiscal-monetary separation.
The Federal Reserve and the Shadow Dealer System
The Federal Reserve initially did not see itself as directly involved in the government securities market. However, during World War I, with the need for substantial funding, the Fed underwent fundamental changes to support federal finance. This included lending to banks against Treasury collateral and facilitating bank lending to individuals for holding Liberty Bonds. Post-2008, due to changes in regulation, the balance sheet capacity of primary dealers decreased, leading to the rise of shadow dealers such as high-frequency traders and hedge funds. The use of repos as a quasi-money alternative increased, causing concerns about the stability of the treasury market.
Lev Menand is an associate professor of law at Columbia University and Josh Younger is a senior policy advisor at the Federal Reserve Bank of New York and a lecturer at Columbia Law School. Lev and Josh also recently co-authored a paper titled, *Money and the Public Debt: Treasury Market Liquidity as a Legal Phenomenon.* They are also returning guests to Macro Musings, and rejoin the podcast to talk about this paper and its implications for the Treasury market. Lev, Josh, and David also discuss the transition from bank to market financing, whether an increasing level of debt is leading to more instability, the impact of recent regulations on the primary dealer system, how to restore the balance between public debt and money creation, and a lot more.
