A Global Replacement for the Fed
Do We Need a NATO for Central Banking?
A few weeks ago I worried here that Treasury Sec Bessent’s gold-standard mentality and Republican disgust at the recent and potential politicization of the US Federal Reserve are a dangerous combination.
Maybe the next time we have a crisis of 2008 or COVID-19 proportions, the Fed just might… sit this one out.
Do we have options?
When the Fed Saved the World, Twice
The global economy has dodged two financial bullets this century.
In 2008 the global financial markets were in flames and deflation was creeping in like fog over the Atlantic. Enter Ben Bernanke, a mild-mannered academic , future Nobel Prize-winner for analysis of the Great Depression, and the voice of a man who'd rather be writing footnotes. But he knew his history. When deflation shows up, it doesn’t knock. It breaks the door down, and it doesn’t leave until you’ve lost your job, your house, and maybe your democracy.
Read Kindleberger. Or Bernanke. Or even Steinbeck’s Grapes of Wrath.
Sounds dramatic? It is. That's what happened last time the Fed failed to act in a global financial emergency, in 1930.
Back to 2008. The US Fed, with the backing of the Treasury and the White House, flooded the system with cash—trillions, without apology. They bailed out banks, markets, even whole countries.
The Fed didn’t just save the U.S. economy. It became the de facto fire department for the entire global financial system.
Same story in 2020. Different fire. Same fire department, when COVID-19 hit the same fragile system we had before.
Hard Money, Harsh Lessons
To understand what made Bernanke’s actions so radical, you have to go back to a time when central bankers did the opposite. The early 1930s, the gold standard and the gold standard mentality still ruled economic orthodoxy. Inflation was evil (shades of Weimar 1923); money supply sacrosanct.
So when the Great Depression hit, the Fed did nothing. Britain was not able to help. The result? A global economic ice age with millions unemployed, rising factions of fascism and eventually WW2, the deadliest conflagration in history which took nearly 80 million lives.
Since the 18th century and Bagehot’s seminal economics work Lombard Street, central bankers have mostly understood that it is their job to “lend freely on good collateral” to stave off liquidity crisis in the banking (and now shadow banking) system. This simply means that a bank in crisis can pledge longer-dated and/or illiquid loans or bonds at the central bank and get cash in return, with a haircut (hence the name “discounting”). Liquidity crisis solved.
Historically, this financial maneuver stopped several banking collapses in Britain over the centuries. The Fed expanded its discounting in 1920-21 as best it could to stave off the worst deflation ever and an agricultural depression.
But there had always been a tension between the twin goals of pre-Bretton Woods US monetary policy of acting as the lender of last resort (LoLR) and maintaining so-called “hard “ (and inflexible) money, viz. the gold standard.
The fiat money experience post-Bretton Woods has certainly not been all roses. The immediate result of leaving the gold standard was long and destabilizing bouts of inflation. It can be argued that dependence on the Fed and Treasury post-2008 is what eventually led to the current inflationary environment.
Wall Street, and in this case Bessent is taking just a slightly more extreme view than his colleagues, believes that the Fed should return to predictable Friedmanite monetary policy, to keep inflation in check. If there is a crisis, Bessent would likely not feel obligated to bail out the financial system.
The Dollar's Global Burden
In past centuries, central banks kept their activities focused on a very limited circle of domestic counterparties, providing limited liquidity to financial institutions, in their own national currency.
But dollar markets are global, so financial firefighting must be global. In 2008 that meant the Fed was the fire department, because there was no plan B.
In 2008, for all the talk of central bank cooperation, the Fed dominated. The Fed’s dollar swap line to the ECB alone was over $1 trillion.
Not much has changed since. It’s a dollar based world, with all the strengths and weaknesses that entails. And the US is at the centre of that world. Effectively the Fed has become the global lender of last resort.
Who Will Save Us Next Time?
In our overly-financialized economy, borrowing short to lend long is commonplace. Even the US Treasury is short duration in its liabilities, with way more T-Bills than is prudent. Every refinancing wave is a chance for another dislocation. The risk in a dislocation is that the Fed would be unable to offset a negative, damaging economic trend.
If short term funding dries up for any reason, the global house of cards falls.That is not alarmist, it is a fact known to every banker.
We should have learned some lessons about financial market fragility. Instead we kept the status quo and lurch from one small liquidity shock to another, generally rescued by the Fed.
Whether it be the basis trade in 2020, the taper tantrum of 2013, or the Silicon Valley Bank bailout of 2023. There were indicators of this instability as recently as the first week of April with the Liberation Day volatility.
It’s not hard to imagine some future crisis, where once again liabilities will be impossible to roll forward, and the prices of collateral for repos and other loans fall so fast that the assets end up being fire-sold into the market.
But while the US might bail out its own banks, there is a very minor risk it doesn’t feel the need to counter global liquidity crashes.
Sounds crazy? Well it might have happened in 2008 without Bernanke around to lecture Bush and the fiscal conservative Obama in closed-door sessions in the White House.
So what would a Trump/Bessent/Warsh coalition do?
Well we know the current administration’s views on defence (that Europe and Ukraine should each be left to fight for themselves). Trump might (rightly?) ask why the Fed should bail out a weak and unfriendly world that takes advantage of US profligacy?
What if the Fed doesn’t step in the next time around?
The Coalition of the Dollar-Willing
In a very timely piece released Monday, Robert N McCauley has an answer, though it has been proposed as far back as 1995 by Jeffery Sachs.
If the world can’t rely on the US, why not create a global alternative?
What could that look like? Sachs and others think it should be the IMF. As the IMF lacks the resources to step in, McCauley thinks otherwise. I’ll let two economists explain.
A Beachside Conversation
Imagine two Euro wonks—let’s call them Charles and Alex— sipping Negronis on a beach somewhere expensive.
Charles: “So here we are again. Another grand proposal to build a backup for the Fed. A sort of dollar NATO.”
Alex (grinning): “Right. A ‘coalition of the willing,’ except instead of tanks, it’s balance sheets.”
Charles: “Well, we can’t rely on the hegemon every time. What happens if the next Fed chair is...let’s say, less enthusiastic about helping foreigners?” We might end up the financial equivalent of Ukraine. And 2030 could look like 1930. Making the Great Depression great again.”
Alex: “Hence McCauley’s idea. Get the 14 biggest non-U.S. central banks together. Pool their Treasuries. Create a shared backstop. No printing press, but room to repo plenty of collateral. A sort of international Lombard Street.”
Charles: “Well, it’s not unlimited firepower. But it’s firepower. Better a flawed lender of last resort than none at all.”
Alex: “Markets don’t panic because there’s no money. They panic because they’re not sure anyone’s willing to use it.”
Charles: “It’s psychological. It’s about confidence. Bernanke knew that. So did Draghi. ‘Whatever it takes,’ remember?”
Alex (chuckling): “Imagine Christine Lagarde with a Bloomberg terminal and an ECB repo line.”
Charles: “Right. It's not about interest rates or macroprudential buffers. It’s about who you can call at 3 a.m. when repo spreads blow out and everyone's dumping Treasuries.”
Alex “If you can't call whoever replaces Powell, maybe you call Lagarde, or Kuroda. Or text a WhatsApp group of 14 central banks with $1.9 trillion and mild insomnia.”
Charles: “A group chat for global financial stability. You could do worse.”
The waves break gently. Espresso cups clink. Fade out.
The Time to Plan Is Before the Panic
No one’s saying this is easy. And it’s far from a perfect solution. But it’s necessary. The Fed might be willing “the next time”. Or it might not. A backup plan beats a meltdown.
And while we’re at it, maybe fix shadow banking too. But one miracle at a time.