A Treasury bond is cash right up until everyone wants cash.
In 2020, people wanted dollars, and they tried to get them by selling Treasuries. That should have been easy. A Treasury is the debt of the U.S. government, the one asset that is supposed to be equivalent to cash. Instead Treasuries traded at a sudden discount, and the Fed had to step in, buying them and providing the liquidity the market could not. Why would the asset that is supposed to be cash need rescuing?
The common pictures of the Fed do not explain it. One says the Fed prints money and causes inflation; a more sophisticated one says it sets interest rates to balance growth against inflation. Both treat the Fed as steering the economy. The 2020 episode points to a quieter job: keeping several kinds of money that are not the same thing behaving as if they were.
Money in layers
What we call money is a stack of different instruments, and in a functional system all of them are interchangeable with dollars.
Bank deposits, the number in your account, are an IOU from your bank to you; they are not loaned to others, because loans are created out of thin air, with the deposit appearing as the bank’s liability and the loan as its asset. Central bank reserves are real digital dollars that only banks can hold at the Fed, the settlement layer that makes bank-to-bank transfers work. Treasuries are the debt of the U.S. government, backed by nothing but faith. For the very wealthy they are the only form of “money” that makes sense: FDIC insurance caps at $250K, you cannot own reserves directly, and hoarding cash is impractical. Treasuries are the savings account of the ultra-rich and of foreign central banks.
Treasuries are stable if held to maturity, but their market value fluctuates, and that fluctuation is the price of instant liquidity. When money is chasing some shiny new thing, you have to discount your Treasury to compete for attention; when money dries up and Treasuries are the only arks remaining, their price rises. The same asset changes price purely on how desperately the market needs liquidity, the liquidity extrinsic at work.
Around this stack sits the shadow banking system: money market funds, ETFs, mortgage REITs, private investment vehicles. They function like banks without the same regulatory protections. Money market funds are the bank deposits of the shadow world, and ETFs and mortgage REITs promise instant redemption backed by assets that are not instantly liquid, the maturity mismatch that kills banks. Each new shadow entity extends the system’s reach while reducing the Fed’s control.
Shaping the waveform
The Fed’s visible tool is interest rates, the price of moving money between the present and the future. Think of it as shaping a waveform: if the slope is too steep, money rushes into the present and causes inflation; if it is too flat, money dries up and a crisis looms. The neutral rate where the economy neither expands nor contracts is r* (r-star), and much of central banking is an attempt to keep the slope near it.
The Fed controls short-term rates directly, by paying interest on reserves and on cash that money market funds park with it. For longer rates it buys longer-dated Treasuries, which raises their price and lowers their yield. But money always finds a way around the barriers. Lower rates can push money into asset prices, making people feel rich without directly increasing economic activity, which only fiscal spending does.
The rate is just the most visible lever. Underneath it, the Fed is not managing the economy — it is maintaining the interchangeability of multiple forms of pseudo-money, any one of which could trigger a systemic crisis if the market stops treating it as equivalent to dollars. Bank deposits must stay equivalent to reserves, Treasuries to cash, money market shares to deposits.
When the equivalence breaks
The system works because nobody tests it. All those layers are treated as the same thing precisely because nobody tries to convert them all at once, and the system cannot afford a “final settlement” run. In 2008 the equivalence broke for mortgage-backed securities and the shadow system ran on itself. Bear Stearns, a primary dealer, was refused repo loans when its subprime exposure came out, had to offload assets at fire-sale prices, and the losses cascaded to every financial institution. The Fed could not normally lend to primary dealers, so it improvised an emergency window. In 2020 the break reached Treasuries themselves, and the Fed restored the interchangeability fiction by buying them.
The rescues carry their own cost. Many participants now believe in a central bank “put”, the implicit promise that the Fed will step in to prop up prices. If everyone assumes a rescue, they take more risk, which creates the conditions that will require one: the Minsky mechanism in its purest form. So each rescue that preserves the equivalence also encourages the leverage that will test it next time.
The layers also lean on each other in a circle. Reserves are backed by Treasuries, Treasuries are backed by nothing but faith, and as the Fed holds more Treasuries, it too is backed only by faith. Central banking is less like steering a ship than like maintaining the belief that the ship is seaworthy while quietly patching leaks faster than water comes in. The bankers who run it are the maintenance crew of a machine whose continued operation depends on nobody looking too closely at the engine. In 2020, a great many people looked at once.
References:
- Joseph Wang, Central Banking 101