The Fedcoin is Coming, Part 2

In Part One, we said that a Fedcoin is coming. The Fed will have no choice but to issue its own digital currency. But not because of the propaganda that we’re competing against China, or including the unbankables. If they issue a Fedcoin (which is not certain right now), it will be because they are attempting to respond to monetary forces that are like plate tectonics: slow but inexorable.

The interest rate is going to sink below zero. And the Fed must respond by imposing negative interest rates on cash. The easiest way to do this may be to replace paper cash with a Fedcoin.

The second reason for them to issue a Fedcoin is to address a fatal flaw in the dollar. The dollar cannot extinguish a debt. The dollar is a liability, a credit instrument, an “IOU”. When you pay a debt using an IOU, you may get out of the debt loop personally. But the debt does not go out of existence. It is merely shifted.

Interest is added to the debt, every year. So the debt is not constant. It must grow by at least the rate of the accrued debt. And more—potentially much more—because there must be enough dollars sloshing around that even the marginal debtor can get its hands on enough dollars to service its debt.

This is the Fed’s prime directive. Forget about inflation and unemployment, which are just window dressing. The Fed wants to enable the government and its cronies to borrow more, at cheaper rates. But what it must do, if it wants to keep the game going, is ensure that the debtors can service the debts. Otherwise, there will be defaults. First this will occur at the margin, but the default of the marginal debtors will hit the creditors like hot lead at 2000 feet per second.

The Fed must constantly engineer a credit expansion.

Engineering a Credit Expansion

Let’s consider the problem of “zombie” corporations. This is the term used by the Bank for International Settlements for firms whose profits are less than their interest expense. In other words, they are the marginal firm who are most desperate to get their hands on dollars to service their debts. If they don’t, they don’t stay alive. And maybe their creditors don’t survive their passing.

15% of public companies are zombie firms. This means that this margin is a wide swathe of the market.

How do you get the dollars out there, so that even the zombie firms can earn enough revenues—or at least attract enough bond buyers—to service their debts? The Fed has several tricks in its bag.

One, lower the interest rate. This works its magic in three ways. First, it lowers the monthly interest bill when the debt is rolled over. With a lower payment, the firm may no longer be a zombie.

Second, it helps make the business case for expansion. If a hamburger restaurant can make 10% return on capital when opening a new store, then the Fed juices up new store openings by lowering the rate from, say, 10% to 9%. With more stores eking out at least a bit of profit, the firm may no longer be a zombie.

Third, it forces investors to reach for yield. Every pension fund, for example, must earn a certain return on its portfolio. Every drop in the Treasury yield forces them buy bonds of riskier companies, in order to try to generate their required returns. This may not help a firm get out of zombieland, but at least it gives it a ready source of funding to feed its hunger for brains cash.

Additional Tools in The Fed’s Toolbox

However, sooner or later the Fed arrives at a major roadblock. At some point, even lowering the interest rate to zero (for short maturities) is not sufficient to pump the (ever-increasing) quantity of credit into the economy.

They can stave off this day with various Treasury guarantees of debt: home mortgages and student loans have long been favorites. The Export-Import Bank and other programs can guarantee business lending. A guarantee acts as a subsidy. Even if the lenders are private, they lend at a rate close to the Treasury bond, as opposed to whatever it would have been if left to the market. A glaring example today is home mortgages. Does anyone really believe that private lenders would lend at 2.5% for 30 years?

At some point, even this isn’t enough.

Next, the Fed can buy bad loans from the banks. This kills two birds with one stone. It bails out the bank, by removing a bad credit from its balance sheet. And it gives the bank an incentive to make another loan.

At some point, even this isn’t enough.

The Fed can change the interest rate it pays on banks’ so-called excess reserves. These are balances held at the Fed itself. On March 16, 2020, the Fed smashed this rate from 1.1% to 0.1% (not a typo). This is supposed to be an inducement for banks to reduce their holdings of these reserves. Less than two weeks later, the Fed eliminated the requirement that banks hold any reserves at all.

One can imagine the contraction of lending that was beginning as governments were shutting down whole sectors of the economy in their flailing responses to Covid. So the Fed did some flailing of its own.

Total bank reserves went from $46 billion in August of 2008, to $860 billion by January 2009, while reserves in excess of the requirement went from around $2 billion to $800 billion. In the current crisis, total bank reserves went from $1.7 trillion in February to $3.2 trillion by May.

It doesn’t work the way it used to, prior to the global financial crisis. Now, bank reserves go up, no matter what the Fed does.

If their theory is that the Fed could induce the banks to lend these reserves out, then the practice turns out that the banks increase their reserves in each crisis. And their balance of reserves did not decrease much after the last crisis, even when it was declared to be over.

And Now, Fedcoin

This brings us to the Fedcoin. If the banks will not (or cannot be) be a conduit for the Fed to pump credit into the economy, then the Fed must construct a pipeline around the banks, that can carry the necessary pressure.

Obviously, we do not have any specific details of what the Fedcoin would even look like, much less what the Fed would do with it. However, we can make an educated guess.

The Fedcoin would bypass the banking system as we know it today. This would be a big step towards communism, with the government not merely centrally planning interest rates—but holding retail deposits and directly making loan decisions.

The Fed could lend to anyone directly. It would not need to somehow induce the banks to make such loans. It would not have to overcome the banks’ reluctance to descend into outright madness.

The Fed can turn up the pressure on its dollar pump to 10, if that is what it determines is necessary to feed the zombies, so they are able to service their debts. And the next year, it could turn it up to 11.

A central planning agency of this sort has few impediments to achieving its will. Other than reality, anyways. But reality will intrude at some point.

So far, the Fed has a positive spread between its interest expense (paid on its liabilities) and interest revenues (earned on its assets). So far, it has assets > liabilities. The Fed has been solvent, and hence there has not been hyperinflation. Despite numerous and notable predictions of it. The Fed has seemingly been able to get away with all manner of corruption of credit that it has so far attempted. The Keynesians seem vindicated. The Modern Monetary Theory cultists are emboldened. However, reality will have its revenge in the end.

If the Fed begins to make loans to consumers and small to medium enterprises, and those loans go bad, watch out. Of course, if the Fed does not begin to make such loans, watch out.

In chess, the concept is called zugzwang.