Coronavirus Archives

Can Central Bank Digital Currency Contain COVID-19 Crisis by Saving Small Businesses? (Part 2)

This piece is a follow up to our previous Money View article on the banking system during the COVID-19 crisis.

By Elham Saeidinezhad and Jack Krupinski |The COVID-19 crisis created numerous financial market dislocations in the U.S., including in the market for government support. The federal government’s Paycheck Protection Program offered small businesses hundreds of billions of dollars so they could keep paying employees. The program failed to a great extent. Big companies got small business relief money. The thorny problem for policymakers to solve is that the government support program is rooted in the faith that banks are willing to participate in. Banks were anticipated to act as an intermediary and transfer funds from the government to the small businesses. Yet, in the modern financial system, banks have already shifted gear away from their traditional role as a financial intermediary between surplus and deficit agents. Part l used the “Money View” and a historical lens to explain why banks are reluctant to be financial intermediaries and are more in tune with their modern function as dealers in the wholesale money markets. In Part ll, we are going to propose a possible resolution to this perplexity. In a monetary system where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most, including small and medium enterprises, who have no access to the capital market.

The history of central banking began with a simple task of managing the quantity of money. Yet, central bankers shortly faced a paradox between managing “survival constraint” in the financial market and the real economy. On the one hand, for banks, the survival constraint in the financial market takes the concrete form of a “reserve constraint” because banks settle net payments using their reserve accounts at the central bank. On the other hand, according to the monetarist idea, for money to have a real purchasing power in terms of goods and services, it should be scarce. Developed by the classical economists in the nineteenth and early twentieth centuries, the quantity theory of money asserted that the quantity of money should only reflect the level of transactions in the real economy.

The hybridity between the payment system and the central bank money created such a practical dilemma. Monetarist idea disregarded such hybridity and demanded that the central bank abandon its concern about the financial market and focus only on controlling the never-materializing threat of inflation. The monetarist idea was doomed to failure for its conjectures about the financial market, and its illusion of inflation. In the race to dominate the whole economy, an efficiently functioning financial market soon became a pre-condition to economic growth. In such a circumstance, the central bank must inject reserves or else risk a breakdown of the payments system. Any ambiguity about the liquidity problems (the survival constraint) for highly leveraged financial institutions would undermine central banks’ authority to maintain the monetary and financial stability for the whole economy. For highly leveraged institutions, with financial liabilities many times larger than their capital base, it doesn’t take much of a write-down to produce technical insolvency.

This essential hybridity, and the binding reality of reserve constraint, gave birth to two parallel phenomena. In the public sphere, the urge to control the scarce reserves originated monetary policy. The advantage that the central bank had over the financial system arose ultimately from the fact that a bank that does not have sufficient funds to make a payment must borrow from the central bank. Central bankers recognized that they could use this scarcity to affect the price of money, the interest rate, in the banking system. It is the central bank’s control over the price and availability of funds at this moment of necessity that is the source of its control over the financial system. The central bank started to utilize its balance sheet to impose discipline when there was an excess supply of money, and to offer elasticity when the shortage of cash is imposing excessive discipline. But ultimately central bank was small relative to the system it engages. Because the central bank was not all-powerful, it must choose its policy intervention carefully, with a full appreciation of the origins of the instability that it is trying to counter. Such difficult tasks motivated people to call central banking as the “art,” rather than the “science”.

In the private domain, the scarcity of central bank money significantly increased the reliance on the banking system liabilities. By acting as a special kind of intermediary, banks rose to the challenge of providing funding liquidity to the real economy. Their financial intermediation role also enabled them to establish the retail payment system. For a long time, the banking system’s major task was to manage this relationship between the (retail) payment system and the quantity of money. To do so, they transferred the funds from the surplus agents to the deficit agents and absorbed the imbalances into their own balance sheets. To strike a balance between the payment obligations, and the quantity of money, banks started to create their private money, which is called credit. Banks recognized that insufficient liquidity could lead to a cascade of missed payments and the failure of the payment system as a whole.

For a while, banks’ adoption of the intermediary role appeared to provide a partial solution to the puzzle faced by the central bankers. Banks’ traditional role, as a financial intermediary and providers of indirect finance, connected them with the retail depositors. In the process, they offered a retail payment- usually involve transactions between two consumers, between consumers and small businesses, or between two small to medium enterprises. In this brave new world, managing the payment services in the financial system became analogous to the management of the economy as a whole.

Most recently, the COVID-19 crisis has tested this partial equilibrium again. In the aftermath of the COVID-19 outbreak, both the Fed and the U.S. Treasury coordinated their fiscal and monetary actions to support small businesses and keep them afloat in this challenging time. So far, a design flaw at the heart of the CARES Act, which is an over-reliance on the banking system to transfer these funds to small businesses, has created a disappointing result. This failure caught central bankers and the governments by surprise and revealed a fatal flaw in their support packages. At the heart of this misunderstanding is the fact that banks have already switched their business models to reflect a payment system that has been divided into two parts: wholesale and retail. Banks have changed the gear towards providing wholesale payment-those made between financial institutions (e.g., banks, pension funds, insurance companies) and/or large (often multinational) corporations- and away from retail payment. They are so taken with their new functions as dealers in the money market and originators of asset-backed securities in the modern market-based finance that their traditional role of being a financial intermediary has become a less important part of their activities. In other words, by design, small businesses could not get the aid money as banks are not willing to use their balance sheets to lend to these small enterprises anymore.

In this context, the broader access to central bank money by small businesses could create new opportunities for retail payments and the way the central bank maintains monetary and financial stability. Currently, households and (non-financial) companies are only able to use central bank money in the form of banknotes. Central bank digital currency (CBDC) would enable them to hold central bank money in electronic form and use it to make payments. This would increase the availability and utility of central bank money, allowing it to be used in a much more extensive range of situations than physical cash. Central bank money (whether cash, central bank reserves or potentially CBDC) plays a fundamental role in supporting monetary and financial stability by acting as a risk-free form of money that provides the ultimate means of settlement for all sterling payments in the economy. This means that the introduction of CBDC could enhance the way the central bank maintains monetary and financial stability by providing a new form of central bank money and new payment infrastructure. This could have a range of benefits, including strengthening the pass-through of monetary policy changes to the broader economy, especially to small businesses and other retail depositors, and increasing the resilience of the payment system.

This increased availability of central bank money is likely to lead to some substitution away from the forms of payment currently used by households and businesses (i.e., cash and bank deposits). If this substitution was extensive, it could reduce the reliance on commercial bank funding, and the level of credit that banks could provide as CBDC would automatically give access to central bank money to non-banks. This would potentially be useful in conducting an unconventional monetary policy. For example, the COVID-19 precipitated increased demand for dollars both domestically and internationally. Small businesses in the U.S. are increasingly looking for liquidity through programs such as the Paycheck Protection Program Liquidity Facility (PPPLF) so that those businesses can keep workers employed. In the global dollar funding market, central banks swap lines with the Fed sent dollars into other countries, but transferring those dollars to end-users would be even easier for central banks if they could bypass the commercial banking system.

Further, CBDC can be used as intraday liquidity by its holders, whereas liquidity-absorbing instruments cannot achieve the same, or can do so only imperfectly. At the moment, there is no other short-term money market instrument featuring the liquidity and creditworthiness of CBDC. The central bank would thus use its comparative advantage as a liquidity provider when issuing CBDC. The introduction of CBDC could also decrease liquidity risk because any agent could immediately settle obligations to pay with the highest form of money.

If individuals can hold current accounts with the central bank, why would anyone hold an account with high st commercial banks? Banks can still offer other services that a CBDC account may not provide (e.g., overdrafts, credit facilities, etc.). Moreover, the rates offered on deposits by banks would likely increase to retain customers. Consumer banking preferences tend to be sticky, so even with the availability of CBDC, people will probably trust the commercial banking system enough to keep deposits in their bank. However, in times of crisis, when people flee for the highest form of money (central bank money), “digital runs” on banks could cause problems. The central bank would likely have to increase lending to commercial banks or expand open market operations to sustain an adequate level of reserves. This would ultimately affect the size and composition of balance sheets for both central banks and commercial banks, and it would force central banks to take a more active role in the economy, for better or worse.

As part 1 pointed out, banks are already reluctant to play the traditional role of financial intermediary. The addition of CBDC would likely cause people to substitute away from bank deposits, further reducing the reliance on commercial banks as intermediaries. CBDC poses some risks (e.g., disintermediation, digital bank runs, cybersecurity), but it would offer some new channels through which to conduct unconventional monetary policy. For example, the interest paid on CBDC could put an effective floor on money market rates. Because CBDC is risk-free (i.e., at the top of the money hierarchy), it would be preferred to other short-term debt instruments unless the yields of these instruments increased. While less reliance on banks by small businesses would contract bank funding, banks would also have more balance sheet freedom to engage in “market-making” operations, improving market liquidity. More importantly, it creates a direct liquidity channel between the central banks, such as the Fed, and non-bank institutions such as small and medium enterprises. Because central banks need not be motivated by profit, they could pay interest on CBDC without imposing fees and minimum balance requirements that profit-seeking banks employ (in general, providing a payment system is unprofitable, so banks extort profit wherever possible). In a sense, CBDC would be the manifestation of money as a public good. Everyone would have ready access to a risk-free store of value, which is especially relevant in the uncertain economic times precipitated by the COVID-19.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

Jack Krupinski is a student at UCLA, studying Mathematics and Economics. He is pursuing an actuarial associateship and is working to develop a statistical understanding of risk. Jack’s economic research interests involve using the “Money View” and empirical methods to analyze international finance and monetary policy.

New Thinking in the News

Can countries safely print money to combat the crisis? What ethical principles can we rely on in this pandemic? What policy does Soros think the US should implement right away? How does an understanding of gender theory improve our approach to doing economics? This week’s recommended read tackle these themes, and more. Enjoy.

1 | Finding the ‘Common Good’ in a Pandemic in the New York Times, with Michael Sandel

“Think about the two emblematic slogans of the pandemic: “social distancing” and “we’re all in this together.” In ordinary times, these slogans point to competing for ethical principles — setting ourselves apart from one another, and pulling together. As a response to the pandemic, we need both. We need to separate ourselves physically from our friends and co-workers in order to protect everyone, to prevent the virus from spreading. But ethically, these slogans highlight two different approaches to the common good: going it alone, with each of us fending for ourselves, versus hanging together, seeking solidarity. In a highly individualistic society like ours, we don’t do solidarity very well, except in moments of crisis, such as wartime.”

2 | Can We Print Infinite Money to Pause the Economy During the Coronavirus Pandemic? in Vice, featuring David Weil

“What are the consequences of just giving everyone enough cash to survive the next few months? […] It’s complicated.”

3 | With working Americans’ survival at stake, the US is bailing out the richest, in the Guardian, by Morris Pearl and Bill Lazonick

“Amid a humanitarian crisis compounded by mass layoffs and collapsing economic activity, the last course our legislators should be following is the one they appear to be on right now: bailing out shareholders and executives who, while enriching themselves, spent the past decade pushing business corporations to the edge of insolvency.”

4 | George Soros: Guarantee paychecks for all workers displaced by coronavirus to save the economy in the LA Times by George Soros and Eric Beinhocker

“History has shown the strategy works. Thanks to Germany’s “Kurzarbeit” program, unemployment there actually fell from 7.9% to 7% during the Great Recession, while average unemployment in other major developed economies rose by 3%. As a result, the German economy recovered more quickly than those of many other countries.”

5 | The Human-Capital Costs of the Crisis, in Project Syndicate, by Barry Eichengreen

“Unemployment and hardship can also lead to demoralization, depression, and other psychological traumas, lowering affected individuals’ productivity and attractiveness to employers. We saw this in the 1930s, not just in declining rates of labor force participation but also in rising rates of suicide and falling rates of marriage. Here, too, one worries especially about the US, given its relatively limited safety net, its opioid crisis, and its “deaths of despair.”

6 | Ecological and Feminist Economics, an interview with Julie Nelson in Real World Economics Review

“…the mainstream discipline of economics relies on a deeply gendered belief about what makes for good science. Economists like to think of economic life as confined to the market, driven by self-interest and competition, rational and controllable, and intrinsically governed by mathematics and physics-like “laws” not because the economy is intrinsically that way but because these ways of seeing it are all associated with masculinity and toughness. What about production in the home? Care for others and the environment? Human emotions, in the face of a future that is fundamentally unknowable? Ways of understanding that require hands-on investigation and broader sorts of reasoning? Acknowledging these things is, by comparison, seen as womanly and weak. And so those parts of reality and those parts of good science – which I define as open-minded and systematic investigation – were banished.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

The Social Determinants of Health in the Age of COVID19

With the ongoing pandemic and economic crisis, there is much to discuss. To inform the debates taking place in the YSI community, Luisa Scarcella and Aleksandar Stojanović have kicked off a special webinar series in which to unpack some of the accompanying challenges. For the first session, Luisa invited Professor Sir Michael Marmot, Professor of Epidemiology and Public Health at University College London, Director of the UCL Institute of Health Equity, and Past President of the World Medical Association. His work reveals the interrelated nature of health and socioeconomic inequality; a highly relevant topic today.

When economists talk about health, they usually talk about the healthcare system. They don’t often talk about what makes people sick in the first place. But Marmot does, and he finds that our people’s health is closely tied to the socio-economic conditions they are in; lower socio-economic conditions lead to worse health, and increasing socioeconomic inequality yields a widening health gap. His findings are compelling:

In the developed world, general life expectancy has stagnated since WW2; that is unprecedented for peacetime. But for the lower economic classes, it’s even worse. In the UK, the life expectancy of the poor has been decreasing for a decade now. It’s no coincidence, Marmot argues, that this trend emerged in a context of harsh austerity measures. Having reduced the purchasing power of the underprivileged, healthy living is increasingly out of reach.

Other advanced economies, the US in particular, show similar trends. There, too, structural inequalities give rise to job insecurity, housing insecurity, food insecurity, racism, and violence. These disadvantages translate into worse health for the poor. So, to improve the health of the American people, a better healthcare system would only be the beginning. To actually improve public health, the US would need to address the socio-economic inequalities that underlie it.

These insights offer a fresh take on the national responses to the COVID-19 outbreak, too. Many governmental remedies are receiving criticism for ‘treating the symptom and not the cause,’ echoing Professor Marmot’s plea. On top of that, most nations’ stimulus packages do not sufficiently alleviate the economic despair of the most vulnerable groups, leading to a worsening of the socio-economic conditions that are associated with bad health. The issues Marmot points out may only accelerate during this crisis.

Marmot’s work demonstrates the interconnected nature of many of the societal challenges we study in YSI: socioeconomic inequality, societal fragmentation, the concentration of economic and political power, and ultimately human despair. As Rob Johnson commented: “We must continue trying to understand how and why the political economy produces these conditions and tolerates them.”

A recording of Professor Marmot’s webinar is available here. Marmot’s book, the Health Gap, provides a more detailed account of his findings.

Why Does “Solvency” Rule in Derivatives Trading?

Hint: It Should Not

By Elham Saeidinezhad | The unprecedented increase in the Fed’s involvement since the COVID-19 has affected how financial markets function. The Fed has supported most corners of the financial market in an astonishingly short period. In the meantime, there have been growing anxieties that the Fed has not used its arsenals to help the derivatives market yet. To calm market sentiment, on March 27, 2020, regulatory agencies, led by the Fed, have taken steps to support market liquidity in the derivatives market by easing capital requirements for counterparties- typically banks who act as dealers. The agencies permit these firms to use a more indulgent methodology when measuring credit risk derivatives to account for the post-COVID-19 crisis credit loss. The goal is to encourage the provision of counterparty services to institutional hedgers while preventing dealers that are marginally solvent from becoming insolvent as a result of the increased counterparty credit exposure.

These are the facts, but how shall we understand them? These accommodative rulings reveal that from the Fed’s perspective, the primary function of derivatives contracts is a store of value. As stores of value, financial instruments are a form of long-term investment that is thought to be better than money. Over time, they generate increases in wealth that, on average, exceed those we can obtain from holding cash in most of its forms. If the value of these long-term assets falls, the primary threat to financial stability is an insolvency crisis. The insolvency crisis happens when the balance sheet is not symmetrical: the side that shows what the banks own, the Assets, is less valuable than Liabilities and Equity (i.e. banks’ capital). From the Fed’s point of view, this fearful asymmetry is the principal catastrophe that can happen due to current surge in the counterparty credit risk.

From the Money View perspective, what is most troubling about this entire debate, is the unrelenting emphasis on solvency, not liquidity, and the following implicit assumption of efficient markets. The underlying cause of this bias is dismissing the other two inherent functions of derivatives, which are means of payment and means of transferring risk. This is not an accident but rather a byproduct of dealer-free models that are based on the premises of the efficient market hypothesis. Standard asset pricing models consider derivative contracts as financial assets that in the future, can generate cash flows. Derivatives’ prices are equal to their “fundamental value,” which is the present value of these future cash flows. In this dealer-free world, the present is too short to have any time value and the current deviation of price from the fundamental value only indicates potential market dislocations. On the contrary, from a dealer-centric point of view, such as the Money View, daily price changes can be fatal as they may call into question how smoothly US dollar funding conditions are. In other words, short-term fluctuations in derivative prices are not merely temporary market dislocations. Rather, they show the state of dealers’ balance sheet capacities and their access to liquidity.

To keep us focused on liquidity, we start by Fischer Black and his revolutionary idea of finance and then turn to the Money View. From Fischer Black’s perspective, a financial asset, such as a long-term corporate bond, could be sold as at least three separate instruments. The asset itself can be used as collateral to provide the necessary funding liquidity. The other instrument is interest rate swaps (IRS) that would shift the interest rate risk. The third instrument is a credit default swap (CDS) that would transfer the risk of default from the issuer of the derivative to the derivative holder. Importantly, although most derivatives do not require any initial payment, investors must post margin daily to protect the counterparties from the price risk. For Fischer Black, the key to understanding a credit derivative is that it is the price of insurance on risky assets and is one of the determinants of the asset prices. Therefore, derivatives are instrumental to the success of the Fed’s interventions; to make the financial system work smoothly, there should be a robust mechanism for shifting both assets and the risks. By focusing on transferring risks and intra-day liquidity requirements, Fischer Black’s understanding of the derivatives market already echoes the premises of modern finance more than the Fed’s does.

Money View starts where Fischer Black ended and extends his ideas to complete the big picture. Fischer Black considers derivatives chiefly as instruments for transferring risk. Money View, on the other hand, recognizes that there is hybridity between risk transfer and means of payment capacities of the derivatives. Further, the Money View uses analytical tools, such as balance sheet and Treynor’s Model, to shed new light on asset prices and derivatives. Using the Treynor Model of the economics of dealers’ function, this framework shows that asset prices are determined by the dealers’ inventory positions as well as their access to funding liquidity. Using balance sheets to translate derivatives, and their cash flow patterns, into parallel loans, the Money View demonstrates that the derivatives’ main role is cash flow management. In other words, derivatives’ primary function is to ensure that firms can continuously meet their survival constraint, both now and in the future.

The parallel loan construction treats derivatives, such as a CDS, as a swap of IOUs. The issuer of the derivatives makes periodic payments, as a kind of insurance premium, to the derivative dealers, who have long positions in those derivatives, whenever the debt issuer, makes periodic interest payment. The time pattern of the derivatives holders’ payments is the mirror image and the inverse of the debtors. This creates a counterparty risk for derivatives dealers. If the debtor defaults, the derivatives dealers face a loss as they must pay the liquidation value of the bond. Compared to the small periodic payments, the liquidation value is significant as it is equal to the face value. The recent announcements by the Fed and other regulatory agencies allow derivatives holders, especially banks and investment banks, to use a more relaxed approach when measuring counterparty credit risk and keep less capital against such losses. Regulators’ primary concern is to uphold the value of banks’ assets to cement their solvent status.

Yet, from the point of view of the derivatives dealers who are sellers of these insurances, liquidity is the leading concern. It is possible to create portfolios of such swaps, which pool the idiosyncratic default risk so that the risk of the pool is less than the risk of each asset. This diversification reduces the counterparty “credit” risk even though it does not eliminate it. However, they are severely exposed to liquidity risk. These banks receive a stream of small payments but face the possibility of having to make a single large payment in the event of default. Liquidity risk is a dire threat during the COVID-19 crisis because of two intertwined forces. First, there is a heightened probability that we will see a cascade of defaults by the debtor’s aftermath of the crisis. These defaults imply that banks must be equipped to pay a considerable amount of money to the issuers of these derivatives. The second force that contributes to this liquidity risk is the possibility that the money market funding dries up, and the dealers cannot raise funding.

Derivatives have three functions. They act as stores of value, a means of payment, and a transfer of risk. Thus, they offer two of the three uses of money. Remember that money is a means of payment, a unit of account, and a store of value. But financial instruments have a third function that can make them very different from money: They allow for the transfer of risk. Regulators’ focus is mostly on one of these functions- store of value. The store of value implies that these financial instruments are reported as long-term assets on a company’s balance sheet and their main function is to transfer purchasing power into the future. When it comes to the derivatives market, regulators ‘main concern is credit risks and the resulting long-term solvency problems. On the contrary, Money View uses the balance sheet approach to show the hybridity between means of payment and transferring risk functions of derivatives. This hybridity highlights that the firms use insurance instruments to shift the risk today and manage cash flow in the future.

Coronavirus Needs Not Kill Globalization

By Jack Gao | The COVID19 crisis is shaping up to be the most severe challenge the world has to confront since World War II. At present, almost 800,000 cases have been reported from virtually every country in the world, with the death toll nearing 40,000. Not only is much of the global economy frozen as we fight the virus, but national borders are also being shut down to contain its spread. As this battle goes on, many are already predicting that the world may never be the same again.

The knee-jerk reaction is to substantially roll back on the current globalization regime, so global pandemics may be eliminated for once and for all. But this reflex towards nationalism completely misses the point. Crises like this one reflect on the perversion of current globalization, not on globalization per se. We should not throw the baby out with the bathwater, but instead, take the crisis as an opportunity to improve on the version of globalization that prioritized some objectives but neglected others.

First of all, a more divided world in no way guarantees global pandemics will no longer happen. One only needs to turn to the 1918 Spanish flu pandemic that claimed 100 million lives or the even more lethal Black Death episode, both when the world was more divided, for some evidence. Periodic outbreaks of infectious diseases have plagued humanity throughout history, and, more than anything, it was progressing in science and healthcare that accounted for the gradual decline in fatality and damages, in spite of advances in globalization. In fact, we could reasonably argue that better health outcomes, nutrition access, sanitation facilities wrought by economic development are important reasons we have fewer and less deadly pandemics today, thanks to globalization. It’s wishful thinking that less globalization will result in fewer pandemics.

Second, when crises do strike, we are much better positioned to respond to them as a globally connected community. Although leaving much to be desired, information sharing has proved key to containing the coronavirus outbreak. China alerted the WHO by the end of last year of unusual pneumonia in Wuhan; within days, Chinese scientists posted the genome of the new virus, allowing virologists in Berlin to produce the diagnostic test of the disease for worldwide access. We often take for granted communications of this kind today, which we can ill-afford if balkanization was to rule the day.

Even as borders are shut to reduce human flow at the moment, global commerce continues to play a crucial role to ensure the supply of medical products and equipment as we fight the pandemic. For instance, the crisis may have already subsided in China, but Chinese companies are currently working around the clock as ventilator orders pour in from the rest of the world. Similarly, at least a few dozen pharmaceutical companies from around the world are racing to develop vaccines and treatments for the virus, knowing that they’ll have ready access to a global marketplace to recoup their investments. Just imagine how much harder this battle would be if countries were left to their domestic supply chains or scientific knowledge.

Finally, while much is still unclear about how the current outbreak unfolded, from the evidence we do have, it is national mishandling or in some cases deglobalization factors that contributed the lion’s share to its unbridled spread. China’s earlier misstep on information reporting, America’s testing debacle and obsession with travel bans, and UK’s initial flirtation with herd immunity are just a few examples of national blunders that hastened the transmission of the virus, which have little to do with globalization. Meanwhile, in a bid to have America go it alone, Trump’s elimination of epistemologist based in China, staff cuts at the CDC, and heightened tariffs on Chinese medical products may well have made this health crisis worse than it has to be.

Each crisis is an opportunity in disguise, the coronavirus is no different. It should be taken as a reminder that our disregard to some objectives and narrow-minded pursuit of others have tilted the world off-balance. In a globalization solely focused on promoting international trade and financial flows and centered around organizations such as the World Bank and the IMF, this outbreak caught the incumbent international regime completely off-guard. Either in funding, capacity, or power, the World Health Organization has been no match to its counterparts charged with commercial and financial affairs. Seen in this light, the outbreak should serve as a rude awakening to a world economy that prioritizes economic integration over public health, environmental, and climate concerns.

As the fight to contain the coronavirus continues, many believe this crisis will bring an end to globalization as we know it, some may even work hard to make sure this is so out of self-interest. However, it bears emphasizing that a balkanized and disintegrated world is neither feasible nor desirable. The coronavirus does not have to kill globalization, instead, it is our chance to rebalance the world economy to better serve collective social goals and tackle future challenges as a coordinated global community.

Jack Gao is a Program Economist at the Institute for New Economic Thinking. He is interested in international economics and finance, energy policy, economic development, and the Chinese economy. He previously worked in financial product and data departments in Bloomberg Singapore, and reported on Asian financial markets in Bloomberg News from Shanghai. Jack holds a MPA in International Development from Harvard Kennedy School, and a B.S. in Economics from Singapore Management University. He has published articles on China Policy Review and Harvard Kennedy School Review.

Is our Monetary System as Systemic and International as Coronavirus?

By Elham Saeidinezhad | The coronavirus crisis has sparked different policy responses from different countries. The common thread among these reactions is that states are putting globalization on pause. Yet, re-establishment of central bank swap lines is making “money,” chiefly Eurodollars, the first element that has become more global in the wake of the Coronavirus outbreak. This is not an unexpected phenomenon for those of us who are armed with insights from the Perry Mehrling’s “Money View” framework. The fact that the monetary system is inherently international explains why the Fed reinstalled its standing U.S. dollar liquidity swap line arrangements with five other central banks just after it lowered its domestic federal fund’s target to zero percent. However, the crisis also forces us to see global dollar funding from a lens closer to home; the fact that the Eurodollar market, at its core, is a domestic macro-financial linkage. In other words, its breakdown is a source of systemic risk within communities as it disrupts the two-way connection between the real economy and the financial sector. This perspective clarifies the Fed’s reactions to the crisis in hand. It also helps us understand the recent debate in the economics profession about the future of central bank tools.

The Great Financial Crisis of 2008-09 confirmed the vital importance of advancing our understanding of macro-financial linkages. The Coronavirus crisis is testing this understanding on a global scale. Most of the literature highlights the impact of sharp fluctuations in long-term fundamentals such as asset prices and capital flows on the financial positions of firms and the economy. In doing so, economists underestimate the effects of disturbances in the Eurodollar market, which provides short-term dollar funding globally, on real economic activities such as trade. These miscalculations, which flow from economists’ natural approach to money as a veil over the real economy, could be costly. Foreign banks play a significant role in the wholesale Eurodollar market to raise US dollar financing for their clients. These clients, usually multinational corporations, are part of a global supply chain that covers different activities from receiving an order to producing the final goods and services. Depending on their financial positions, these firms either wish to hold large dollar balances or receive dollar–denominated loans. The deficit firms use the dollar funding to make payments for their purchases. The surplus firms, on the other hand, expect to receive payments in the dollar after selling their products. The interconnectedness between the payment system and global supply chains causes the Eurodollar market to act as a bridge between the real economy and the financial sector.

The Coronavirus outbreak is putting a strain on this link, both domestically and globally: it disrupts the supply chain and forces every firm along the chain to become a deficit agent in the process. The supply chain moves products or services from one supplier to another and is essentially the sum of all firms’ sales. These sales (revenues) are, in effect, a measure of payments, the majority of which occur in the Eurodollar market. A sharp shock to the sale, as a result of the outbreak, precipitates a lower ability to make payments. When an output is not being shipped, the producer of final goods in China does not have dollar funding to pay the suppliers of intermediate products. As a result, firms in other countries do not have a dollar either. The trauma that coronavirus crisis injects into manufacturing and other industries thus leads to missed payments internationally. Missed payments will make more firms become deficit agents. This includes banks, which are lower down in the hierarchy, and the central banks, which are responsible for relaxing the survival constraints for the banking system. By focusing on the payments system and Eurodollar market, we were able to see the “survival constraint” in action.

The question for monetary policy is how far the central bank decides to relax that survival constraint by lowering the bank rate. This is why central banks, including the Fed, are reducing interest rates to zero percent. However, the ability to relax the survival constraint for banks further down in the hierarchy depends also on the strength of foreign central banks to inject dollar funding into their financial system. The Fed has therefore re-established the dollar swap line with five other major central banks. The swap lines are available standing facilities and serve as a vital liquidity backstop to ease strains in global funding markets. The point to hold on to here is that the U.S. central bank is at a level in the hierarchy above other central banks

Central banks’ main concern is about missed payments of U.S. dollars, as they can deal with missed payments in local currency efficiently. In normal circumstances, the fact that non-U.S. central banks hold foreign exchange reserves enables them to intervene in the market seamlessly if private FX dealers are unable to do so. In these periods, customer-led demand causes some banks to have a natural surplus position (more dollar deposits than loans) and other banks to have an inherent deficit position (more dollar loans than deposits). FX dealers connect the deficit banks with the surplus banks by absorbing the imbalances into their balance sheets. Financial globalization has enabled each FX dealer to resolve the imbalance by doing business with some U.S. banks, but it seems more natural all around for them to do business with each other. During this crisis, however, even U.S. banks have started to feel the liquidity crunch due to the negative impacts of the outbreak on financial conditions. When U.S. banks pull back from market-making in the Eurodollar market, there will be a shortage of dollar funding globally. Traditionally, in these circumstances, foreign central banks assume the role of the lender of last resort to lend dollars to both banks and non-banks in their jurisdiction. However, the severity of the Coronavirus crisis is creating a growing risk that such intermediation will fracture. This is the case as speculators and investors alike have become uncertain of the size of foreign central banks’ dollar reserve holding.

To address these concerns, the Fed has re-established swap lines to lend dollars to other central banks, which then lend it to banks. The swap lines were originally designed to help the funding needs of banks during 2008. However, these swap lines might be inadequate to ease the tension in the market. The problem is that the geographic reach of the swap lines is too narrow. The Fed has swap lines only with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. The reason is that the 2008-09 financial crisis affected banks in these particular jurisdictions severely. But the breadth of the current crisis is more extensive as every country along the supply chain is struggling to get dollars. In other words, the Fed’s dollar swap lines should become more global, and the international hierarchy needs to flatten.

To ease the pressure of missed payments internationally, and prevent the systemic risk outbreak domestically, the Fed and its five major central bank partners have coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements. These tools help to mitigate the effects of strains on the supply chain, both domestically and abroad. Such temporary agreements have been part of central banks’ set of monetary policy instruments for decades. The main lessons from the Coronavirus outbreak for central bank watchers is that swap lines and central bank collaborations, are here to stay — indeed, they should become more expansive than before. These operations are becoming a permanent tool of monetary policy as financial stability becomes a more natural mandate of the central banks. As Zoltan Pozsar has recently shown, the supply chain of goods and services is the reverse of the dollar funding payment system. Central banks’ collaboration prevents this hybridity from becoming a source of systemic risk, both domestically and internationally.

This piece was originally part of “Special Edition Roundtable: Money in the Time of Coronavirus” by JustMoney.org platform.