The Federal Reserve under Kevin Warsh has deliberately reduced its use of forward-looking language. The retreat goes beyond the wording of statements: Warsh has declined to contribute his own projections to the Fed’s Summary of Economic Projections and has floated reducing the number of FOMC meetings. A similar skepticism has emerged at the European Central Bank. The concern is understandable: central banks do not want to make promises that could constrain them when circumstances change.

Yet Warsh’s July press conference provides a good reason to reopen the discussion.

The press conference was followed by an unusual combination of market movements: the dollar weakened, long-term Treasury yields rose, and U.S. equities fell. At the same time, the two-year Treasury yield declined, producing a sharp steepening of the yield curve. The configuration was not identical to the market reaction that followed the April 2025 “Liberation Day” tariff announcement, but it rhymed with the same “sell America” pattern, in which stocks, Treasury securities, and the dollar weakened together. The comparison should be made cautiously, however, because geopolitical developments and oil prices were also important market forces that day.

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One of the most interesting elements of Warsh’s remarks was his view of the relationship between the central bank and financial markets. He argued that, with less forward guidance, market participants were learning to “play the ball, not the referee.” In his view, markets were responding more directly to economic data rather than simply anticipating the Fed’s next signal. He pointed to the increase in nominal and real market yields as evidence that financial conditions could change significantly even though the Fed had not altered its policy rate.

To be fair, Warsh did not say that markets should dictate monetary policy. He explicitly stated that the Fed does not endorse any particular market movement and that policy decisions remain the responsibility of the FOMC. His argument was narrower: market prices contain valuable information, and excessive central-bank communication may contaminate that information by inducing markets merely to echo the Fed’s own views.

Still, his remarks raise a fundamental question: can financial markets provide a substitute for a clearly specified monetary-policy strategy?

My answer is no—but an important distinction is needed.

A central bank does not have to announce the precise level of interest rates at every future date. Nor should it bind itself to a fixed path regardless of what happens to inflation, employment, or financial conditions. What it must provide, however, is a sufficiently clear description of how policy will respond as circumstances change. Economists usually call this the central bank’s reaction function.

Warsh did offer a minimalist version of such a function. He said that, when the labor market is close to equilibrium, rising underlying inflation should make a central banker more inclined to tighten policy, while falling inflation should make easing more likely. That is not an absence of guidance. The question is whether such a broad formulation provides enough information to anchor expectations.1

The thermostat analogy

Consider the analogy of a hotel room whose temperature is too high. The occupant enters, observes the temperature, and adjusts the thermostat to the desired level. In this analogy, the market determines the initial temperature, while the central bank intervenes only when an adjustment is required.

But the analogy is misleading.

The central bank is not simply an external regulator acting upon a nominal system that would otherwise settle naturally at a well-defined combination of interest rates and inflation. The expected conduct of monetary policy is itself part of the mechanism determining that equilibrium.

Markets can discover prices, but they do so conditional on beliefs about current and future central-bank policy. Even “data dependence” is undefined without a mapping from data to policy: markets cannot price incoming information unless they understand what that information implies for interest rates. There is no completely independent, market-generated nominal anchor that the central bank can simply observe and occasionally correct.

Critics of the new approach, such as former New York Fed President Bill Dudley, have made an operational version of this objection: if markets do not understand the Fed’s reaction function, they will price policy poorly, and the transmission of monetary policy will become slower and noisier. That critique is valid, but the problem runs deeper. Without a well-understood policy rule, several different paths for nominal interest rates and inflation may be consistent with private-sector behavior. In monetary theory, this is the problem of indeterminacy. The room does not possess a unique temperature independently of the thermostat’s operating rule.

This does not mean that the central bank must comment continuously or guide every small movement in asset prices. A credible policy rule may be inferred from consistent behavior even when communication is limited. But if the central bank withdraws both explicit guidance and an adequately informative description of its reaction function, it becomes harder for households, businesses, and markets to understand the nominal regime.

Inflation is a choice—but a choice over time

This is the other side of Warsh’s powerful intuition that inflation is a choice.

A central bank cannot choose the precise inflation rate in every month or quarter. Supply shocks, measurement problems, transmission lags, and unexpected events make such control impossible. But the central bank does determine the economy’s nominal anchor and therefore bears ultimate responsibility for the monetary regime governing inflation over time.

That choice cannot be expressed solely through today’s policy rate. It also depends on what the public expects the central bank to do tomorrow, next year, and under alternative economic conditions.

In that sense, the statement that inflation is a choice logically requires some specification of future policy. Expectations of future policy are not an optional supplement to monetary policy; they are one of the principal channels through which monetary policy operates.

Milton Friedman’s proposal for a constant money-growth rule illustrates the point. Friedman’s rule was not forward guidance in the narrow, modern sense of a central bank forecasting its next few interest-rate decisions. It was something stronger: a rule intended to govern monetary policy indefinitely.

Its significance did not lie in announcing the growth rate of money for a single quarter. It came from specifying a predictable regime that would continue into the future. Friedman’s rule was therefore an extreme form of policy predictability—even though it did not rely on press conferences, dot plots, or forecasts of the policy rate.

Commitment does not require rigidity

Central banks are understandably wary of forward guidance because they do not want to bind themselves when future conditions are uncertain. But this concern often confuses an unconditional promise with a state-contingent policy strategy.

A statement such as

“The policy rate will be 3 percent next December, regardless of economic conditions”

would indeed be an excessively rigid commitment.

But a statement such as

“If underlying inflation continues to rise while the labor market remains resilient, policy will become more restrictive”

is different. It specifies how policy will respond to a particular state of the economy while preserving flexibility if conditions change.

Suppose I say: “If it is sunny tomorrow, I will run.” If it rains and I do not run, I have not broken my promise. The contingency specified in the original statement did not occur.

Friedman’s particular money-growth rule was non-state-contingent: the same growth rate was to be followed regardless of circumstances. But monetary-policy rules more generally can—and often should—be state-contingent. Credibility does not require pretending that the future is known. It requires clarity about how policy will respond when the future arrives.

Forward guidance, properly understood

The lesson is not that central banks should return to calendar-based promises or provide artificial precision about the future path of interest rates. That form of forward guidance can create problems, especially when conditions change unexpectedly.

But eliminating forward guidance should not mean eliminating guidance about the policy regime.

Markets should process economic information rather than merely repeat the central bank’s latest signal. Yet they cannot replace the central bank as the source of the nominal anchor. The central bank must remain clear about its objectives, its instruments, and the contingencies that would cause policy to change.

Asked at his press conference about his forthcoming Jackson Hole address, Warsh said he currently looks at it “like a blank piece of paper.” As a statement of intellectual openness, that is admirable. As a metaphor for the monetary regime, it is precisely the problem: a nominal anchor cannot be written on a blank page.

Forward guidance, properly understood, is therefore not a constraint on good monetary policy. It is part of good monetary policy.

And a central bank that confidently declares that inflation is a choice should also be able to explain how that choice will be made.

References

Benigno, Pierpaolo (2025). Monetary Economics and Policy: A Foundation for Modern Currency Systems. Princeton University Press.

Kevin Warsh is expected to begin his tenure as Chair of the Federal Reserve on May 15, when Jerome Powell’s term expires. In recent months, he has expressed an unusually forceful view of what the Federal Reserve should be, one that could signal a meaningful shift in how the Fed thinks about inflation, interest rates, and its own role in the broader macro regime. Practice can diverge from theory, of course. But a line he has repeated in interviews - including the Hoover Institution conversation “Inflation Is a Choice: Kevin Warsh on Fixing the Federal Reserve” - is a striking statement of intent: “inflation is a choice.” It points toward a very different policy posture than the one markets have grown accustomed to.

There are three main ideas I want to focus on:

• Inflation is a choice.

• Monetary policy has two core instruments: the policy interest rate and the size (and composition) of the Fed’s balance sheet.

• The balance sheet should be small, and the Fed should stop acting as a de facto conduit for financing fiscal policy.

Inflation Is a Choice

Start with the first claim: inflation is a choice. It echoes Milton Friedman’s dictum that inflation is “always and everywhere a monetary phenomenon” - in other words, that sustained inflation outcomes ultimately require monetary-policy accommodation.

In a modern fiat system, that is hard to dispute. The central bank is the only institution that can create base money - its own liabilities - and base money is what ultimately defines the currency. Ben Bernanke made a related point in his remarks on deflation: the United States has the effective equivalent of a “printing press” (today, electronic) that can create dollars at essentially no marginal cost, so deflation can, at least in principle, be defeated by monetary policy.

The flip side is equally important: persistent inflation is also a monetary phenomenon - something monetary policy can permit, accommodate, or engineer through its choices on interest rates, money creation, and system-wide liquidity conditions.

Two Instruments, Not One

The second element of Warsh’s framework is the “two tools” view: monetary policy operates not only through the policy rate, but also through the balance sheet. That framing is interesting precisely because it is relatively unconventional in the predominant paradigm - the New Keynesian framework - where the policy interest rate tends to be treated as the central bank’s primary instrument and “money” plays a less explicit role. Warsh remarks in the interview that the word money has effectively disappeared from the Fed’s statements; regardless of how literally one takes that claim, the underlying critique is clear: the Fed’s operating framework has de-emphasized monetary aggregates and balance-sheet dynamics.

i = r + π

where the nominal (policy) rate (i) equals the real rate (r) plus inflation (π). Few economists would dispute the logic of that relationship in the long run. In this simplified view, controlling inflation mainly becomes a matter of setting the policy rate relative to the economy’s real rate - what central bankers often refer to as r* (the neutral real rate). There is no explicit role for additional instruments.

In some recent work of mine, the “two tools” intuition can be expressed by allowing real liquidity conditions to enter the Fisher relationship, written in terms of the policy rate i:

i = r + π - f(q)

Here, f(q) is a decreasing function of real liquidity (q) in the economy, and f(q) = 0 once liquidity is above a certain threshold. This framing supports Warsh’s view: you can, in principle, have a lower policy rate that is still consistent with the same inflation target, provided system-wide liquidity is reduced. In a long-run equilibrium, market rates may end up similar whether the balance sheet is large or small. But the policy mix, transmission, and transition dynamics can differ meaningfully. More broadly, this perspective suggests that the central bank’s toolkit is larger than the policy rate alone, and that more attention should be paid to the connection between the Fed’s balance sheet, liquidity, and inflation.

The Balance Sheet, QE, and Fiscal Entanglement

This brings us to the last point: Warsh’s argument that the central bank has gone too far in creating - or implicitly guaranteeing - liquidity through QE and related balance-sheet operations. The effectiveness of QE has been widely debated in both academic and policy circles, especially beyond QE1. At the same time, the post-COVID inflationary surge has brought renewed scrutiny to the idea that crisis-era liquidity can linger long after the emergency has passed.

The deeper concern is institutional: persistent balance-sheet expansion can blur the boundary between monetary policy and fiscal finance. Over time, it can relax perceived constraints on government spending and create a political economy in which central bank accommodation becomes assumed rather than exceptional. Warsh’s prescription is essentially a reversion to clearer lines and narrower responsibilities: a smaller balance sheet, a more disciplined focus on price stability, and less entanglement - direct or indirect - with fiscal outcomes.

Conclusion

What to conclude? Warsh’s framework implies a Fed that is leaner, more tightly anchored to price stability, and less interdependent with fiscal policy. In theory, it is a coherent regime shift. Whether it can be delivered in practice - and under the inevitable stress tests of markets, politics, and shocks - is the real question.

References

Benigno Gianluca and Pierpaolo Benigno. Managing Monetary Policy Normalization.

Benigno Pierpaolo. Monetary Economics and Policy: Foundations of Modern Currency System. Princeton University Press.

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In an analysis1 covering five decades of uncertainty shocks, we find that the dollar’s safe-haven status is not a permanent attribute but a conditional property, one that activates depending on the nature of the shock and the state of the global economy.

The central result is clear: when financial stress, as measured by the VIX, spikes, the dollar appreciates. A one-standard-deviation VIX shock is associated with a same-day appreciation of about 4 to 5 basis points. During the Global Financial Crisis and the Covid shock, the response roughly doubled. The mechanism is straightforward: in a world where trillions in offshore liabilities are denominated in greenbacks, a sudden tightening produces a global dollar shortage. The scramble for dollars pushes the currency up. This is precisely what we have witnessed in recent weeks.

But not all uncertainty works in the same way. When the shock originates in U.S. economic policy, whether through fiscal standoffs, regulatory reversals, or trade-war escalation, the dollar tends, if anything, to weaken. If America is the source of the problem, flight to safety and flight from America pull in opposite directions. This is captured by the bar for the EPU (Economic Policy Uncertainty) index in the chart above. By contrast, geopolitical risk, as captured by the GPR index, does not appear to have an independent effect on the dollar.

The most striking feature, however, is regime dependence. During the Great Moderation, the VIX-dollar relationship was essentially zero. The safe-haven mechanism activated only during and after crises: the GFC, Covid, and now the Iran war. It is a feature of the global financial system under stress, not a permanent characteristic of the currency.

What about gold? Its performance during the Iran war has been disappointing, down more than 25% from its highs. The paradox is only apparent. In the acute phase of a crisis, investors liquidate positions to raise cash, which in practice means raising dollars. Gold pays no interest; when bond yields spike on inflation fears, the opportunity cost rises sharply. The longer-run evidence tells a different story: gold tends to appreciate over the months following extreme uncertainty shocks. But in the acute phase, liquidity trumps everything, and liquidity means dollars.

There is another side to the story: each episode in which the dollar appreciates during a geopolitical shock tightens financial conditions for the rest of the world and strengthens the incentive to reduce dollar dependence. The safe-haven mechanism, paradoxically, may contain the seeds of its own erosion. Whether the dollar’s safe-haven status proves durable is ultimately a question about institutions.

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The intuition is well-grounded. Objections typically emphasize tax evasion, money laundering, and other illicit uses that could occur within stablecoin ecosystems. Yet it is not evident that curtailing economic liberty and financial privacy is an appropriate remedy for risks the state has never fully eliminated—and may not eliminate even with a CBDC. The prospect of embedding a state‑run surveillance layer in everyday payments is not incidental; it follows from the institutional design of a retail CBDC.

There is also a macroeconomic dimension. A retail digital euro would centralize, in the hands of the monetary authority that issues the unit of account, not only monetary policy but a large portion of the payments function. To many, this may sound benign: a currency, after all, serves as a unit of account, a store of value, and a means of payment. One could even argue that nothing is safer than holding a digital account at the ECB. But the fact that something is technically feasible does not make it institutionally desirable. Even under a fiat‑money regime, there are good reasons to separate the management of the currency—and thus monetary policy—from the operation of the payments infrastructure, which can be entirely private. Blurring the two enlarges the scope for interference between functions that should remain distinct.

The extreme case clarifies the problem. In principle, a central bank could issue sufficient retail digital euros to displace the payment services now performed by private bank deposits. It could do so at negligible marginal cost and without acquiring offsetting assets. That expansion would be inflationary—or, at minimum, would collide with the ECB’s price‑stability mandate. To avoid this outcome, the ECB would need to hold safe assets sufficient to back the stock of digital euros in circulation. This implies a much larger balance sheet and, more subtly, a world in which the supply of risk‑free securities must be ample and credibly assessed. Inevitably, large‑scale asset purchases would confer privileged status on certain issuers, whether sovereign or corporate, bringing concerns about fiscal and financial dominance. The central bank already holds substantial volumes of government debt; expanding its role further risks creating dependencies that obscure the true sustainability of public finances.

History points in the same direction. Payment innovation has mostly originated in the private sector and remained institutionally separate from currency management. Medieval bills of exchange arose as a private solution to the cost and danger of moving coin across borders; as a result, bullion rarely crossed frontiers. In Renaissance Florence, the gold florin held its value for centuries while the payment system was developed by merchant banks; crises came and went, but the coin’s metallic content endured. Later, the Amsterdam Wisselbank created ledger‑based “bank money” that improved settlement. Over time, however, it extended credit to the Dutch East India Company and to the city; when those borrowers came under stress, confidence in the bank was undermined. The broader lesson is straightforward: when a monetary authority runs both the unit of account and the retail plumbing, credit allocation and payments safety become entangled, with attendant risks to currency stability.

Two lessons follow. First, preserve the institutional separation between monetary policy and the retail payments infrastructure. Second, a sovereign currency does not require a state monopoly over payments to be sound; such a monopoly would politicize the currency and constrain economic liberty.

It is tempting to approach the question as one would a corporate or household balance sheet: by asking whether the current value of the debt can be repaid in the future through dollars raised from taxation, net of public spending. In essence, we might try to evaluate the government as a bank would assess a mortgage borrower — by examining its ability to generate future income to service its obligations.

But there is a crucial distinction that changes both the evaluation and its implications. U.S. public debt is denominated in U.S. dollars, and Treasury securities are therefore claims on dollars. Understanding what the dollar actually represents is essential to grasping the core of the issue. The dollar is nothing more than a liability of the Federal Reserve — something that, in a modern fiat monetary system, can be created at will. A dollar at the Fed is a debt that, by definition, can always be fulfilled, since the Fed can issue as many dollars as needed.1

This brings us to the central complication in assessing U.S. sovereign solvency. Is the Federal Reserve truly independent? In a scenario where the Treasury faced difficulties meeting its obligations, would the Fed really refrain from ensuring that those payments are made? If not, then in the extreme case where the Fed fully guarantees Treasury debt, U.S. government bonds would no longer be distinct from dollars themselves. They would be dollars — and thus not subject to any conventional solvency constraint. In that sense, Treasury debt would always be “sustainable,” insofar as the Fed remains solvent — which, operationally, it always is.

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Of course, no private borrower enjoys this privilege. If I were unable to pay my mortgage, the Fed would not simply credit my account to make me whole. The relationship between the Fed and the Treasury is unique — a legacy of institutional design stretching back to the origins of the U.S. central bank. Over the years, attempts to draw a clear line between fiscal and monetary authority have never entirely dissolved the intimate, and at times ambiguous, connection between the two.

Readers following this argument might then conclude that public debt, while not sustainable on its own, becomes sustainable through inflation. That conclusion, however, deserves careful consideration. Treasury debt is sustainable not because it is inflated away, but because it is effectively guaranteed by the central bank. That alone is sufficient. Inflation may or may not follow from such an arrangement.

Inflation arises when the supply of currency exceeds what the real economy can absorb — that is, when the stock of dollars in circulation outpaces the economy’s productive capacity. Assessing that balance requires careful thought about where capacity constraints lie and how fast the economy can grow. A growing economy requires monetary “lubrication” to support expanding transactions. If that liquidity is not adequately provided through other channels, an increased supply of Treasury securities can be fully absorbed without generating inflationary pressure.

History offers instructive precedents for the interplay between fiscal and monetary power. A remarkable limiting case is that of seventeenth-century Venice and its Banco del Giro, when currency was issued directly by the Treasury. The ducato di banco—a unit of account credited to holders of the Republic’s public debt (Monte)—effectively functioned as money. Creditors received deposits at the Banco equal in value to their debt holdings, which they could then transfer in payment to others.

The backing of this currency was ultimately metallic specie, but only indirectly: it rested on the Republic’s promise to redeem the deposits from future tax revenues. The credibility of that fiscal commitment was so strong that, even without direct convertibility, the ducato di banco maintained a stable value relative to coin.

Two major shocks tested this stability, as detailed by Masciandaro, Romelli, and Ugolini (2025): the bubonic plague of 1629–31 and the war with the Ottomans over Crete in 1648–50, accompanied by famine. To finance extraordinary expenditures, the Republic expanded the issuance of ducati di banco. Predictably, the nominal unit of account remained unchanged—one ducato di banco still equaled one ducato di banco, just as one Treasury dollar always equals one dollar when defined by fiat—but its purchasing power fell relative to metallic currency.

Remarkably, Venice later restored that purchasing power by rebuilding its fiscal capacity and redeeming the ducati di banco in specie through the so-called Grand Deposit. The episode illustrates a timeless principle: the credibility of sovereign money depends not on convertibility per se, but on the strength and coherence of the fiscal-monetary framework that sustains it—provided that the monetary authority permits such fiscal interplay.

References

Benigno, Pierpaolo (2025). Monetary Economics and Policy: A Foundation of Modern Currency Sistems. Princeton University Press.

Masciandaro, Donato, Davide Romelli and Stefano Ugolini (2023). When credibility is not enough: Fiscal dominance, monetary policy, and exchange rates in early modern Venice. VoxEu September 11, 2023.

Masciandaro, Donato, Davide Romelli and Stefano Ugolini (2025). Credibility is not enough: Fiscal monetization and currency depreciation in early-modern Venice. Explorations in Economic History 98.

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Labour economists often describe balance in the jobs market as a situation in which the number of job seekers roughly matches the number of openings. But that balance is precarious. A vacancy‑to‑unemployment ratio (V/U) above one has historically been associated with rising wage pressures and, in turn, higher inflation. By contrast, inflation tends to stabilise only when V/U is lower, closer to its long‑run average.

The data bear this out. Since December 2000, when the Job Openings and Labor Turnover Survey (JOLTS) began, the average V/U ratio has been 0.716. During recessions it fell to an average of 0.48; in non‑recession periods it stood at 0.743. Excluding episodes of acute tightness (V/U above one), the average drops to 0.507. In “normal” times, then, the U.S. labour market has typically operated with nearly twice as many unemployed workers as vacancies—conditions consistent with inflation remaining on target.

This is why “maximum employment”—a term often used by the Federal Reserve—does not automatically coincide with inflation at target. Today’s labour market, with V/U near one, may feel like full employment, but it also carries risks of persistent price pressures.

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Another key lens is the Beveridge curve—the empirical relationship between unemployment and vacancies. The curve is typically downward‑sloping and convex: when unemployment is high, vacancies are low, and vice versa. Movements along the curve reflect cyclical shifts in demand; shifts of the curve capture structural changes in matching efficiency, participation or frictions.

The recent data illustrate this clearly. Pre‑global financial crisis and crisis‑era observations (red) were tightly aligned on a stable curve, which shifted modestly upward in the post‑crisis period (green). The curve crossed unity before the pandemic (blue) and then moved sharply outward during COVID (purple). More recently (black), as inflation picked up, the V/U ratio peaked at roughly 2 and has since declined—tracing what appears to be a steeper segment of the Beveridge curve. In the above chart, a dashed blue line traces the current fitted Beveridge curve through the latest observation.

As we argued in our Jackson Hole paper last year, the Beveridge curve tends to be steeper when V/U exceeds one and flatter thereafter. As the economy cools from such tightness, unemployment is likely to vary more than vacancies. That pattern need not signal recession. Historically, recessions are often associated with abrupt moves along the curve or outward shifts; that is not what we are observing. The V/U ratio has been easing gradually—indeed, more slowly than many predicted a year ago.

Taken together, the labour market is normalising at a slow pace rather than deteriorating sharply. Meanwhile, inflation is stuck around 3 per cent on several measures and the effects of tariffs remain uncertain. It is hard to justify, on a balanced assessment of risks, a pivot towards prioritising full employment above all else. Such a stance would be defensible only if inflation were steadily converging to target in the absence of renewed pressures. Shifting attention now to the labour market alone risks playing with fire. The experience of the 1970s—when authorities relaxed policy into stubborn inflation—offers a clear cautionary tale.

References

Benigno, Pierpaolo and Gauti Eggertsson (2024). Revisiting the Phillips and Beveridge Curves: Insights from the 2020s Inflation Surge,” Jackson Hole Economic Policy Symposium Proceedings.

Stablecoins are under attack almost everywhere. This is surprising, given that we already live in a world where other forms of “stablecoins” dominate transactions — we just don’t call them that. They are bank deposits.

What are stablecoins like Tether and Circle? In essence, nothing more than synthetic dollars: a promise to deliver one “true” dollar, where a true dollar is, and can only be, a liability issued by the central bank. A true dollar — such as a physical banknote — is the perfect store of value: it always maintains its one-dollar value over time.

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The central bank can always honor that promise, as it can create currency at will. Any other entity in the economy can issue synthetic dollars only if they are fully backed in a way that replicates the properties of central bank currency — namely, preserving their value at one dollar. In this sense, deposits at commercial banks are simply synthetic dollars.

We already live in a world dominated by synthetic dollars, with true dollars representing only a small share. According to Federal Reserve data, the U.S. monetary base totals about $5.74tn, of which roughly $2.39tn is in cash and the remainder in central bank reserves. By contrast, deposits at commercial banks amount to $18.32tn.

Deposits and stablecoins are therefore similar in that both promise to replicate the value of a “true” dollar. They can serve as a store of value and as a means of payment. But there are important differences — both in how they maintain that promise and in how payments are executed.

Promises

A recent report by the Bank for International Settlements on the future of payment systems mounts a strong critique of stablecoins, arguing that they are inferior to bank deposits because they fail to preserve the singleness of money. Singleness of money means that a one-dollar claim is always valued at one dollar. Stablecoins, by contrast, trade in markets, and their price can deviate from par — sometimes above, sometimes below. Pegs have been lost during episodes of cryptocurrency turmoil, and different stablecoins can trade at different prices at the same time, complicating exchanges and undermining payment certainty. To some, these variations recall the discounted banknotes of the U.S. free banking era.

Bank deposits today do not have a market price: by convention, a one-dollar deposit at any insured bank is treated as worth one dollar everywhere in the payment system. But this is a legal and institutional convention, not an immutable truth. The bankruptcy of Silicon Valley Bank showed that, absent intervention, some deposits would have been worth less than one dollar on the dollar. In that case, the systemic risk exception was invoked — guaranteeing all deposits, insured and uninsured — to prevent losses and contain contagion.

The key challenge in maintaining these promises — for both stablecoins and banks — lies in the backing of the liabilities they issue. Banks are not immune to poor or opaque backing, as many crises have shown. Their cash and reserves are small relative to their total deposits, reflecting their leverage in creating more profitable but riskier loans. The fragility of traditional banks lies in their dual role: providing liquid deposits while extending credit to the economy.

The GENIUS Act and a narrow stablecoin model

The recently enacted GENIUS Act in the U.S. Congress — which endorses the potential for innovation in payment systems via synthetic dollars operating on blockchain — represents a clear break from the traditional combination of credit provision and liquidity issuance. It supports a framework resembling narrow banking applied to stablecoins.

In this “narrow stablecoin” model, issuers under U.S. jurisdiction may invest only in short-term, high-quality assets such as cash, demand deposits, Treasury bills with maturities no longer than 93 days, and fully collateralised repo and reverse repo transactions. Unless full cash backing is imposed, this is one of the strongest asset-backing requirements to minimise runs and liquidity crises — vulnerabilities from which traditional banks, again, are not immune.

If successful in shifting payment activity away from the standard banking sector, a narrow stablecoin system could achieve the separation, long advocated by Milton Friedman, between the markets for money and for credit. This would reduce the need for central bank lender-of-last-resort interventions and diminish the risks of financial dominance.

The macroeconomic implications of backing

The dominant role of government securities, rather than private short-term assets, in backing such stablecoins carries subtle macroeconomic implications. In the end, what matters when talking about money is what backs what. If stablecoins are backed by Treasuries, then the ultimate backing of those Treasuries is taxation. A large, developed stablecoin payments market backed entirely by Treasuries is not a free lunch for the government: it will boost demand for Treasuries and may lower short-term yields, but any increase in supply must still rest on sound tax revenues. For stablecoins to be safe, Treasury debt must itself be safe.

There is another, not unrealistic, possibility: that Treasury bills are seen as indistinguishable from true dollar bills — implying that their ultimate backing comes from the Federal Reserve. In that case, stablecoin issuance would in effect be implicitly guaranteed by central bank currency. From this perspective, a large-scale narrow stablecoin system could prove inflationary, as the Treasury would face fewer constraints on issuance. Far from strengthening the dollar’s role as the dominant international reserve currency, such a development could instead undermine it.

The way out of this possible situation of fiscal dominance lies in backing stablecoin issuance with short-term private assets.

The critical issue for any form of backing is verifiability — ensuring that the market can price stablecoins in line with their true credit and liquidity risk. The GENIUS Act requires monthly reporting and appropriate auditing. But the real innovation would come if stablecoin reserves were stored as smart contracts on blockchain. This would allow instantaneous proof of reserves and their quality, making pricing more transparent and efficient.

Payments

The other major difference between deposits and stablecoins lies in how payments are processed. Bank deposits move through the traditional two-tier banking system: payments between customers of the same bank settle instantly on the bank’s books, while payments across banks require settlement through central bank reserves. This process, though robust, can be slow and depends on the smooth functioning of interbank networks and central bank infrastructure.

Stablecoin payments, by contrast, can settle on-chain — directly between wallets — without relying on the central bank or interbank settlement. If properly designed, such payments can be near-instantaneous and operate 24/7, across borders and outside normal banking hours. Moreover, when payments occur from one stablecoin issuer to another, settlement could happen instantly, with reserves stored on-chain transferred directly from payer’s to payee’s issuer. This would make obsolete the current two-tier system of interbank payments, which requires settlement through central bank reserves.

In such a system, with proof of reserves running on blockchain, the singleness of money — so strongly defended by the BIS — would emerge as a market outcome, based on transparent reserve quality, rather than as a legal convention shielded by the opacity of bank balance sheets. And if the backing of stablecoins comes from sound private securities, or from taxation in the case of government securities, we could finally separate the management of the payments system, run by private stablecoin entities, from the management of the unit of account — the true dollar, issued by the Federal Reserve. The latter could then focus squarely on stabilising the purchasing power of money — keeping inflation at target.

As I conclude in my recent book, we could start to envision a monetary system that holds the promise of consigning currency manipulation to the pages of history.

References

Benigno, Pierpaolo. Monetary Economics and Policy: A Foundation of Modern Currency Systems. Princeton University Press, 2025.

Bank for International Settlements. Annual Report, 2025.

Calls to establish a deep and liquid Eurobond market are once again gaining traction among economists and policy-makers. As investors increasingly question the long-standing dominance of US Treasuries – amid rising fiscal imbalances and intensifying geopolitical risks – the euro area faces a strategic opportunity to develop its own safe asset. The question is no longer whether such an instrument is necessary, but whether Europe is prepared to deliver it – and on what terms.

The rationale for a permanent European safe asset is well established, but it must not be mistaken for a cost-free proposition. By definition, safe debt is debt that is repaid. That requires either the creation of new European Union-level revenues or a lasting reallocation of national fiscal capacity. It must be clearly understood: there is no free lunch.

It is all the more striking, then, that at a time when US Treasuries are under growing scrutiny over long-term fiscal sustainability, some Eurobond proposals understate the importance of solvency. This is not just misguided – it is anachronistic. The original proposition by Alexander Hamilton, first US Treasury secretary, was not simply about issuing federal debt. It was about establishing enforceable, centralised taxation to guarantee its repayment. A safe asset, ultimately, rests on sound revenue.

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Solutions must be built around credible repayment

Recent proposals, by contrast, are often premised on the notion that debt need not be repaid, or that public spending financed by so-called ‘good debt’ will eventually be covered by growth – while taxes are barely mentioned.

One such proposal, advanced by economist and professor Olivier Blanchard and Ángel Ubide, head of economic research for global fixed income and macro at Citadel, envisions replacing national debt – up to 25% of the euro area’s aggregate gross domestic product, or roughly €5tn – with jointly issued ‘blue bonds’ that would hold seniority over remaining national liabilities.

The structure, however, is deeply problematic. It foresees member states covering only the interest payments through value-added taxes, while the principal would be perpetually rolled over via new issuance. This relies on a precarious assumption: that sovereign debt can be indefinitely refinanced without credible fiscal backing. In today’s environment, that is a fragile bet.

Other proposals suggest replicating the Next Generation EU model across different thematic priorities. Yet, the implementation of NGEU in certain member states has exposed political weaknesses in directing funds towards truly productive uses – raising the risk of increased long-term taxation without corresponding economic returns.

Rather than operating in silos – first the European Stability Mechanism, then NGEU, then new instruments – Europe must articulate a unified vision. What is needed now is a stable and radical pathway, not an accumulation of ad hoc, one-off programmes. The EU, already complex in its multinational governance, cannot afford to operate through a patchwork of fragmented initiatives. A coherent, unified framework is essential.

Benefits and risks

Any serious plan for European debt mutualisation must confront the reality of already high national tax burdens and focus on establishing genuine EU-level fiscal capacity – one that substitutes for, rather than adds to, existing commitments.

Still, the case for a European safe asset is not without merit. Recent policy analysis has attempted to quantify the potential gains. Our own estimates suggest that a common instrument – backed by stronger credit quality and greater liquidity – could carry yields up to 50 basis points lower than national benchmarks. If 60% of the euro area’s roughly €13tn in sovereign debt were pooled, annual interest savings could reach €39bn. These gains reflect the so-called convenience yield that investors are willing to accept for holding liquid, low-risk assets.

But these benefits come with offsetting risks. A reallocation of investor demand towards the common instrument could increase borrowing costs for national sovereigns, especially those with weaker credit profiles. Without credible fiscal integration and prudent oversight, the result could easily turn into a zero-sum game.

The real challenge lies in turning economic logic into durable institutional design. Legal and political constraints remain formidable, and fiscal trade-offs cannot be ignored. A European safe asset can only succeed if it is embedded in a broader framework of fiscal responsibility, credible repayment structures and clearly defined rules.

A European safe asset is not just a technocratic fix – it is a long-term political and fiscal commitment. If Europe is to seize this moment, it must move beyond financial engineering and face the hard choices that true risk-sharing entails. That means building institutions capable of enforcing repayment, ensuring fiscal discipline and commanding public trust. Without these foundations, no design – however elegant – will stand the test of time.

References

Pierpaolo Benigno and Edoardo Reviglio. 2025. “European Safe Assets. Macroeconomic Context, Instruments, and Prospects.” ASTRID Working Paper, June 2025.

At its core, a reserve currency is a dominant form of money used globally—not only in international trade of goods and services, but also as a preferred unit of account for storing wealth and denominating debt. Understanding what defines a reserve currency is essential to understanding why such currencies emerge—and why they sometimes disappear.

History shows this is far from a modern concept. Reserve currencies existed even in the Middle Ages. In Money, Prices and Civilization in the Mediterranean World, the historian Carlo Cipolla recounts the prominence of the Byzantine gold solidus from the fifth to the seventh centuries, later joined by the Muslim dinar. At the time, the dominant currencies were of non-Western origin.

It was not until 1252 that the Italian merchant republics began minting gold coins that would come to dominate Mediterranean commerce. First came Florence’s fiorino d’oro, followed by Venice’s ducato—both signalling the rise of European financial influence.

These currencies shared a key characteristic: they were gold coins of a defined weight, typically between 3.5 and 4.5 grams. But what made them truly powerful was their intrinsic stability—particularly in fineness, or gold purity. While weight could be measured relatively easily, fineness was much harder to assess, especially in cross-border transactions. Yet merchants trusted these coins because the issuing states had a reputation for maintaining the integrity of their alloys. That trust—rooted in the credibility of the issuer—made them reserve currencies.

This credibility did not arise by chance. Many other currencies were debased—deliberately reducing their gold content—typically to finance public spending. What distinguished true reserve currencies was their ability to uphold their metallic promises, even under fiscal pressure. In this sense, the promise of a reserve currency was not symbolic but literal: a commitment to gold content, both in weight and purity.

The collapse of the Bretton Woods system marked a structural break in monetary history, moving the world from a framework of precious-metal-backed currencies to one of fiduciary money—currencies with no intrinsic value. The key shift is that fiduciary currencies make only one formal promise: to be redeemed in units of themselves. That promise, while easy to fulfill, is insufficient to sustain reserve status. A true reserve currency must preserve purchasing power for international holders. And much like in the Middle Ages, that depends on monetary and fiscal discipline: the ability to maintain low inflation and long-term credibility.

Recent developments in U.S. economic policy during the Trump administration revealed a marked shift in attitude: the United States no longer signals any obligation beyond delivering “a dollar for a dollar.” That minimal promise exposes what has long been evident. The dollar is not backed by any commodity, and its long-run credibility—like all reserve currencies in history—depends on fiscal sustainability. With deficits widening and public debt reaching historic levels, the financial position of the United States is facing increased scrutiny from global investors—underscored by the recent downgrade by Moody’s.

A simple exercise comparing post–Liberation Day returns up to May 16 from the perspective of a U.S. investor reveals an intriguing pattern: Bitcoin posted the highest return, followed by the Swiss franc, the euro, the yen, gold—and finally the dollar, which was the worst performer. The figure above also shows the returns from the perspective of euro, Swiss franc, and yen investors. While this evidence is preliminary and warrants further investigation, it is nonetheless suggestive. Gold’s resilience is unsurprising: it continues to honor its promise in tangible form and remains free from the influence of any single state.

More striking is the performance of Bitcoin. With its fixed supply and independence from government control, Bitcoin offers a form of immutability shielded from political manipulation. It is not tied to the success or failure of any single nation. These qualities—scarcity, autonomy, and immutability—are precisely what make a currency attractive as a store of value in a modern world of intrinsically worthless money. They are also the very properties that allow a currency to uphold its promises. The path to reserve currency status is long and takes decades—but after Liberation Day, the world has been warned: the king is naked.

Reference

Benigno Pierpaolo. 2025. Monetary Economics and Policy: A Foundation for Modern Currency Systems. Princeton University Press.

The ultimate outcome of Trump's economic strategy, intentional or not, could very well be the monetization of U.S. Treasury debt through Federal Reserve purchases. Although this is unlikely to have been Trump's explicitly intended endgame, it is a plausible consequence of his administration's protectionist trade policies.

The Trump administration's protectionist stance—particularly through the imposition of tariffs—is ostensibly aimed at reducing the U.S. trade deficit by making domestically produced goods more competitive relative to imports. While this might appear logical on the surface, such a strategy overlooks crucial implications regarding capital flows. A persistent trade deficit reflects in general an increase in the country’s net debtor position relative to the rest of the world. Consequently, switching from a deficit to a surplus would imply repaying accumulated external debt.

This is the insightful perspective—and the key to understanding the economic challenge: viewing the issue as a matter of repaying debt.

To repay debt, the U.S. must increase savings. Given that the Treasury is unlikely to contribute significantly to national savings, U.S. consumers would bear this responsibility. Without an accompanying rise in income, consumers must cut consumption—a scenario likely to require higher real interest rates and possibly lead the economy into recession.

An easier alternative to outright repayment or default is currency depreciation—something increasingly observable as the dollar weakens against major currencies. For example, a depreciation from 1.10 to 1.60 against the euro would represent approximately a 50% loss in value, severely impacting international investors holding U.S. equities and bonds. Anticipating such a loss, investors could rapidly withdraw funds, exacerbating currency depreciation and driving up Treasury yields further.

Consequently, financing the U.S. Treasury debt under these conditions becomes increasingly problematic. Higher yields might attract savings domestically, but at the cost of reduced consumer spending—again, a potentially painful adjustment. Alternatively, the Federal Reserve could resume quantitative easing to maintain low long-term interest rates and avert a financial crisis.1 Interestingly enough, such an action, effectively monetizing debt, would provide the administration with financing needed to pursue the desired tax cuts on their agenda.

This scenario—debt monetization and tax cuts coupled with substantial dollar depreciation—would inevitably fuel inflationary pressures, and adverse effects on economic activity cannot be ruled out. Nonetheless, it would achieve the desired outcome: the trade balance would eventually shift to a surplus!

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The above figure shows a prediction of where inflation is heading, assuming an average tariff rate of 22% on import prices takes effect in the second quarter of 2025. Core CPI inflation, at annual rates, is expected to rise above 4.3% by the end of the year. Its persistence implies a return to current levels only by late 2026.

This scenario assumes that other conditions—such as the labor market and inflation expectations—remain at their current levels. The incoming recession would help moderate inflation somewhat, but not enough to change the overall picture. In this case, inflation would still peak well above 3%.1 In any case, it implies that, all else equal, the Fed should raise rates rather than lower them by the end of the year. Failing to respond with rate hikes would risk unanchoring inflation expectations, worsening the situation and potentially triggering an inflationary spiral that could become difficult to control.

The framework

The figure is based on a simple forecasting model derived from an aggregate supply equation of the following form:

Inflation is regressed on a constant, its lagged value, a measure of economic activity captured by θ (defined as the vacancy-to-unemployment ratio), and a supply shock term (u), proxied by the inflation in import prices relative to GDP inflation, averaged over four quarters. The fit of the estimated model over the 1960–2024 sample is quite high, with an R-squared of 0.82. To produce the forecast, the supply shock is subjected to a one-time increase in import prices of 22%, reflecting the average tariff rate implemented on Liberation Day. The estimated coefficient on the supply shock in the inflation equation is 0.038.

The forecast further assumes that the other drivers of inflation remain fixed at their most recent observed values, except for the lagged inflation term, which updates recursively over time. Accounting for a contraction in economic activity due to the tariffs—and therefore a decline in the vacancy-to-unemployment ratio—would result in a dampening of the inflation surge. On the other hand, the current value of inflation expectations, set at 2.4% based on the two-year measure from the Federal Reserve Bank of Cleveland used in the forecast, could prove overly optimistic if inflation picks up and the Fed does not respond.

The bottom line is that this analysis sees no room for Fed rate cuts in 2025. The inflation outlook demands firm action from every angle, with restrictive policy likely extending well into next year. As a result, a contraction appears unavoidable—and potentially significant.

Caveats

There are some obvious words of caution about the above analysis. The model is a simple reduced-form relationship that fits past data very well, but—as always—the future can turn out differently.

Most importantly, I have assumed a 22% shock to import prices. The actual impact could be higher or lower depending on how firms and consumers adjust: substitution away from imported goods toward domestic production, pricing strategies that absorb part of the tariff, or exchange rate movements that offset some of the price increase could all mitigate the effect. Conversely, if these mitigating factors are weak, the inflationary impact could be as large as shown.

Temporary Tariffs

The above figure also includes an alternative scenario in which all tariffs are reversed by the end of 2025, assuming a benign outcome where a future Trump administration rolls back the duties it imposed. In this case, the inflationary surge is more modest—but still warrants careful attention. Even a temporary tariff shock can produce meaningful upward pressure on inflation.

A More Gloomy Scenario

Things could get worse if the model is estimated allowing for dummy variables that capture non-linearities observed during the recent inflationary surge—particularly those arising under tight labor market conditions. In Benigno and Eggertsson (2024), we show that under such conditions, supply shocks become supercharged in their effects on inflation. In this case, the coefficient on the steeper part of the Phillips curve—reflecting the impact of the supply shock—rises to as high as 0.10. This explains the more dramatic inflation spike, with rates climbing up to 6% by the end of the year following the shock.

That said, this latter scenario may now be less realistic, as labor market conditions have returned to more balanced levels and are unlikely to become overheated in the near future.

References

Benigno, Pierpaolo and Gauti Eggertsson. 2024. “It is Baaack. The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve.'

Imagine being able to freely choose in which currency to receive your salary, make daily purchases, open a bank account, or take out a mortgage. A possibility that today seems unthinkable, but that could become reality in a world where money is no longer imposed by governments, but selected by citizens based on its characteristics. Some would choose stability, others returns, and still others independence from government policies.

In such a scenario, competition among currencies would naturally lead to the emergence of the best ones: those capable of preserving purchasing power, generating trust, and simplifying transactions. Less efficient currencies would gradually be abandoned, and currency areas would no longer coincide with national borders, but with global networks of users who share similar monetary preferences. Public and private currencies could thus coexist, in a system where individual choices shape the evolution of alternative currency supply.

This vision, though surprising, is not new. Already in 1976, Friedrich von Hayek theorized in his book The Denationalization of Money a system where private currencies could circulate freely, competing with state-issued ones. According to Hayek, ending the state monopoly on money would lead to greater discipline, reducing the risks of inflation and instability.

Hayek was surprised that even Milton Friedman, a staunch supporter of economic freedom, still defended state-issued money. Yet, just a few years later, Friedman himself, together with Anna Schwartz, acknowledged that “the course of events has strengthened the belief that relying on the government as an alternative was a cure worse than the disease.”1 Monetary history, in fact, is full of examples where states abused their power: from debasing metallic coins to excessively printing paper money to fund wars and public spending, systematically eroding citizens’ purchasing power.

Even the recent inflationary waves in advanced economies reflect a failure of the political management of money. Centralization and lack of competition have often led to opaque, ineffective, or interest-driven decisions. In this context, currency competition could offer a way out, restoring money’s original nature as an institution of spontaneous cooperation rather than governmental imposition.

With the invention of Bitcoin in 2009, a new concept of money emerged: digital, decentralized, and governed by a fixed and transparent monetary policy, based on a supply of tokens that will reach a maximum cap of 21 million by 2140. The system relies on blockchain technology, which allows transactions to be validated without any central authority. Thus, a currency was born that is not backed by a state, but by a public, auditable, and immutable protocol.

Many still argue that Bitcoin is not real money because it lacks intrinsic value. However, this same argument could be made about today’s fiat currencies, which are no longer backed by real assets: a €10 banknote simply represents the promise of payment of another €10 banknote. Similarly, someone who owns Bitcoin can redeem from the network nothing other than a Bitcoin.

Of course, Bitcoin is not perfect: its short-term volatility is well known, and its use as a payment method, while existent, remains limited. However, it is a store of value in its unit of account, simply because one Bitcoin today will still be one Bitcoin tomorrow. The real purchasing power—i.e., the amount of goods and services a currency can buy—depends on monetary policy and the nature of the assets used as collateral for issuance. Despite its limits, and without being backed by any financial or real asset, Bitcoin has already shown that it can significantly increase its purchasing power in the long term. One striking comparison: in 2013, one Bitcoin was worth about $260; today, it is worth over $87,000, allowing the purchase of far more goods and services.

It is by no means inconceivable to design private currencies capable of maintaining stable purchasing power over time—especially if structured according to transparent and automatic criteria regarding different dimensions of monetary policy, such as money supply, interest rates, and the composition of the asset portfolio.

This is the context in which stablecoins arise—digital currencies designed to maintain a stable value relative to a reference currency. A relevant example is Tether, which replicates the value of the dollar by investing in U.S. Treasury securities. With a market capitalization of over $140 billion, Tether is now one of the largest holders of U.S. public debt. Its profits mainly come from the yields offered by Treasuries, currently around 4.25%. Initiatives like USD1, launched by World Liberty Financial and supported by the Trump family, aim to benefit precisely from these returns.

Even here, however, more could be done: for example, designing a competing currency that redistributes part of those profits to its holders—thus offering a "more profitable dollar" that could quickly become the preferred alternative among users. If accepted for everyday transactions, such a currency could even challenge the dominance of the traditional dollar.

This shows that currency competition is not just a theoretical exercise, but a concrete and already unfolding reality. The real challenge in the coming years will be to understand whether these alternatives can be adopted on a broader scale in everyday life.

As I write in the conclusion of my recent book Monetary Economics and Policy:

“In the near future, there is hope that competition among currencies might give rise to a “stable monetary framework” capable of transcending national borders—something to which world citizens could readily and freely adhere.This vision holds the promise of consigning currency manipulations to the pages of history.”

The monetary revolution has already begun.
And with it comes a broader reflection: perhaps true modernity lies not so much in technological innovation, but in the newfound freedom to choose which money to use each day—beyond the impositions of governments.

References

Pierpaolo Benigno. 2025. Monetary Economics and Policy: A Foundation for Modern Currency Systems. Princeton University Press.

Friedman, Milton and Anna J. Schwartz. 1986. “Has Government Any Role in Money?” Journal of Monetary Economics 17.1: 37-62.

Hayek, Friedrich. 1976. The Denationalization of Money. Institute of Economic Affairs, London. Trad. it. (2018), La denazionalizzazione della moneta, Rubbettino Editore, con prefazione di Lorenzo Infantino.

At its core, MMT’s reasoning hinges on the concept of currency. While some may conflate this with money, the distinction is crucial. Currency is always a form of money, but money is not necessarily currency. Whether issued by governments or as cryptocurrencies, modern currency is inherently an intrinsically worthless instrument—whether a piece of paper or a digital token. However, this characterization does not fully define it. As I outline in my book, an intrinsically worthless currency is best understood as a claim that promises payment in units of itself. In practical terms, this means that an issuer—such as a central bank—can create a note valued at one dollar, which represents a liability for the issuer. The holder of this claim can return it to the issuer and receive another identical note valued one dollar in return. Importantly, because the issuer controls the supply of these claims, it can always fulfill this obligation, rendering it immune to default.

While this self-referential definition may seem counterintuitive, a persuasive illustration lies in the British pound. A five-pound note, as shown below, explicitly states that the Bank of England “promises to pay the bearer on demand the sum of five pounds.” This highlights the circular nature of currency issuance—one in which the obligation of the issuer is simply to provide more of the same.

The Role of Governments in Currency Issuance

Modern Monetary Theorists would likely accept this definition but go further in asserting that only governments can issue currency. Here, however, their position is questionable. The rapid rise of cryptocurrencies demonstrates that private entities, too, can create currency aligned with the definition given. Moreover, issuance does not necessarily require a single, centralized authority. Bitcoin, for example, is a decentralized system in which new currency units—ledger entries recorded as liabilities in the Bitcoin network—are distributed to miners.

MMT proponents further argue that government spending must precede the circulation of currency. According to their view, public expenditure is necessary to introduce money into the economy, allowing transactions to take place. Yet this claim is misleading. Currency could just as easily enter circulation through alternative mechanisms, including random distribution, as seen in various cryptocurrency models. There is no inherent reason why government spending must be the primary source of money creation.

The Fallacy of Default Immunity

A key implication of the intrinsically worthless currency is that currency issuers are immune to default, as they can always meet obligations in the unit they issue. However, this does not apply to all government entities equally. The central bank, as the issuer of government currency, may indeed be protected from default. The same cannot be said for the treasury, which must meet obligations in a currency it does not control.

For instance, bank deposits are claims to dollars, but those dollars are issued by the Federal Reserve, making them a finite resource for commercial banks when customers demand withdrawals. Similarly, treasuries issuing bonds are fundamentally distinct from central banks creating currency. While credit rating agencies do not assess the solvency of central banks, they do evaluate the creditworthiness of treasuries, banks, and other institutions precisely because these entities face solvency constraints.

Thus, the first MMT proposition—that governments cannot default—is not universally true. It applies only when the central bank and treasury are so closely intertwined that treasury bonds are effectively indistinguishable from central bank liabilities. While such an arrangement is often assumed to be the case, even in advanced economies, it is not an inherent feature of currency. Rather, it represents a political and institutional distortion—one designed to exploit the benefits of currency issuance. This is a long-standing practice, but one that perhaps deserves greater scrutiny.

A case in point is the European Central Bank (ECB), which was explicitly designed to operate independently from national treasuries. However, the sovereign debt crisis of the past decade has steadily eroded this separation, leading to a partial reversion that resembles implicit monetary financing—an outcome many had hoped to avoid.

Full Employment Without Inflation?

If governments indeed face no borrowing constraints, it follows logically that they could spend freely to achieve full employment by directly hiring workers. The second core MMT proposition is therefore a natural extension of the first. But does this approach truly create jobs without inflationary consequences?

MMT advocates argue that most economies operate below full employment, meaning additional government hiring could expand output without generating inflation. This view relies on a Keynesian framework in which the aggregate supply (AS) curve remains flat until full employment is reached, only then becoming vertical. In theory, fiscal spending moves aggregate demand (AD) from a point of underemployment (point A in the above graph) to full employment (point B in the above graph), with no inflationary effects.

However, this assumption is fraught with risks. It presumes that governments can precisely calibrate their spending, stopping at full employment without exceeding it (like in point C in the above graph). In practice, historical experience suggests that governments struggle to resist the temptation to overspend. Excessive unbacked fiscal expansion fuels inflation, raises inflation expectations, and distorts income distribution—ultimately depressing consumption, investment, and overall economic stability. Rather than fostering sustainable growth, such dynamics often trigger economic contractions, prompting even more government intervention and perpetuating inflationary spirals.

Even in the unlikely scenario where a government halts spending precisely at full employment, the strategy remains problematic. The state lacks the ability to efficiently allocate resources across sectors. If fiscal expansion directs labor into unproductive industries, employment may rise, but productivity growth stagnates. Misallocating human capital in this manner distorts incentives, discourages careers in high-value fields such as engineering, weakens innovation, and dampens long-term economic growth.

While inflation is a disease, a low-productivity trap is arguably an even greater threat. Many economies that engaged in large-scale public employment programs have found themselves struggling with stagnation for years afterward. The notion that government planners, unrestricted by budgetary discipline, can act as efficient allocators of labor is a frequently repeated but rarely validated claim.

Unfortunately, the myth of unlimited government spending remains pervasive on both sides of the Atlantic. In Europe, proposals for expanded joint borrowing rarely mention the tax increases that will eventually be required to finance such spending. The implicit assumption is that debt will either be rolled over indefinitely or monetized outright.

This mindset reflects a broader political tendency to defer financial discipline in favor of short-term policy objectives. The ability to print money does not equate to the ability to create real wealth without limits. As history has repeatedly shown, sound economic management requires recognizing constraints, not disregarding them. The allure of costless government spending is a dangerous illusion—one that prudent policymakers should approach with the utmost caution.

Pierpaolo Benigno. 2025. Monetary Economics and Policy: A Foundation of Modern Currency Systems. Princeton University Press.

We initially tested an early version of this model at the end of 2022 and finalized it by February 2023, when inflation was still significantly elevated. At that time, our model effectively captured the inflationary surge, offering a compelling explanation for its escalation. More remarkably, it also provides strong support for the subsequent disinflationary period, demonstrating its robustness across different inflationary phases.

As illustrated in the graph above, the sharp rise in inflation—measured using core CPI at quarter-to-quarter annualized rates—began in the first quarter of 2021. This was largely driven by supply shocks (red bars) and labor market tightness (gold bars). Notably, the model’s residual (gray bars) is sizable in that quarter, possibly reflecting the limitations of traditional supply indicators in fully capturing the supply-chain disruptions that occurred at the time.

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From then until the first quarter of 2022, inflation continued to rise, primarily fueled by labor market tightness, though supply shocks also played a role. This was the period when the Federal Reserve initiated its rate-hiking cycle, which continued until July 2023. Interestingly, as the Fed began tightening monetary policy, inflation expectations had already started to become unanchored, further contributing to inflationary pressures—as indicated by the blue bars. However, these expectations quickly stabilized following the Fed’s actions.

The disinflationary process eventually took hold, initially driven by falling energy prices and the easing of supply constraints. Over time, loosening labor market conditions played an increasingly important role. However, by the second quarter of 2024, the impact of declining energy prices had largely faded.

The third quarter of 2024 appeared to be the point at which inflation nearly converged to the Fed’s target. However, in the final quarter of the year, inflation ticked back up. What changed? The labor market had initially loosened, bringing the vacancy-to-unemployment ratio down to 1.08. But by the last quarter of the year, it had tightened again, rising to 1.12. This suggests that labor market conditions remain a key factor in explaining inflation’s persistence.

Background on the model

The econometric model of inflation we present in Benigno and Eggertsson (2023) is a simple yet structured framework grounded in our theoretical approach to understanding the post-pandemic inflationary surge in the U.S.

At the core of our approach is a Phillips curve framework, but with a key innovation: instead of using the unemployment rate or the output gap as a measure of economic slack, we use the vacancy-to-unemployed ratio. This choice aligns with recent studies that emphasize the importance of this variable in driving inflation dynamics (see references in our paper).

The novel aspect of our model is the introduction of non-linearity in the Phillips curve, specifically a piecewise linear function that becomes significantly steeper when the vacancy rate exceeds the unemployment rate. We identify this threshold—the point where vacancies equal unemployment—as the Beveridge threshold, representing a balanced labor market.

Like any Phillips curve model, proper identification is crucial. To address this, we control for multiple proxies of supply shocks and inflation expectations. Our benchmark specification captures supply shocks using a principal component of non-core price variations and import prices, while inflation expectations are proxied by 2-year Cleveland Fed inflation expectations. Further details on the econometric specificaiton and estimates are provided in the paper.

References

Benigno, Pierpaolo and Gauti Eggertsson (2023).“It is Baaack. The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve,” NBER Working Paper No. 31197. (April 2023.)