Earlier this week (April 25, 2023), I saw a Twitter exchange that demonstrated to me…
The consolidated government – treasury and central bank
In yesterday’s blog – If only the citizens knew what was going on! – I noted that it makes very little sense from a flow of funds perspective to consider the central bank not to be part of a consolidated government sector along with the treasury. The notion of a consolidated government sector is a basic Modern Monetary Theory starting point and allows us to demonstrate the essential relationship between the government and non-government sectors whereby net financial assets enter and exit the economy without complicating the analysis unduly. This simplicity leads to many insights all of which remain valid as operational options when we add more detail to the model. However, it still seems that readers are confused by this and somehow think that the consolidation is misleading. So for today’s blog I aim to explain in more detail what this consolidation is about. It should disabuse you of the notion that the mainstream macroeconomics obsession with central bank independence is nothing more than an ideological attack on the capacity of government to produce full employment which also undermines our democratic rights.
Regular readers will have seen this diagram which appeared along with discussion in the blog – Deficits 101 Part 3 – but was originally presented in my book Full Employment Abandoned: Shifting sands and policy failures which was published in 2008.
You should also read the blog – Deficits 101 Part 1 – to refresh your memory of the vertical relationship between the government and non-government sectors whereby net financial assets enter and exit the economy.
The diagram sought to elaborate on the vertical transactions between the government and non-government sectors and to explain the importance of them for understanding how the economy works? It was intended as a vehicle to help people connect the pieces of the monetary system in an orderly fashion and to re-educate those who have been poisoned by mainstream macroeconomics textbooks.
You will see that this diagram adds more detail to the diagram presented in Deficits 101 Part 1 – which showed the essential relationship between the government and non-government sectors arranged in a vertical fashion.
Focusing on the vertical train first, you will see that the tax liability lies at the bottom of the vertical, exogenous, component of the currency. The consolidated government sector (the treasury and central bank) is at the top of the vertical chain because it is the sole issuer of currency and the transactions that the treasury and the central bank make with the non-government are able to alter the net system balance (which I will explain presently).
The middle section of the graph is occupied by the private (non-government) sector. It exchanges goods and services for the currency units of the state, pays taxes, and accumulates the residual (which is in an accounting sense the federal deficit spending) in the form of cash in circulation, reserves (bank balances held by the commercial banks at the central bank) or government (Treasury) bonds or securities (deposits; offered by the central bank).
The currency units used for the payment of taxes are consumed (destroyed) in the process of payment. Given the national government can issue paper currency units or accounting information at the central bank at will, tax payments do not provide the state with any additional capacity (reflux) to spend.
The reason we take a consolidated approach to government in the first instance is because the two arms of government (treasury and central bank) have an impact on the stock of accumulated financial assets in the non-government sector and the composition of the assets.
The government deficit (treasury operation) determines the cumulative stock of financial assets in the private sector. Central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds with one exception (foreign exchange transactions).
The diagram also shows how the cumulative stock is held in what we term the non-government Tin Shed which stores fiat currency stocks, bank reserves and government bonds.
I invented this Tin Shed analogy to disabuse the Australian public of the notion that somewhere down in Canberra (our national capital) there was a storage area where the national government was putting all those surpluses away for later use. This is a constant misperception that pervades the policy debate. Even the mainstream macroeconomics textbooks call budget surpluses “national saving”.
The reality is that there is no storage because when a surplus is run, the purchasing power embodied in the net outflow of financial assets from the non-government sector to the government sector is destroyed forever. However, the non-government sector certainly does have a Tin Shed within the banking system and elsewhere.
Any payment flows from the government sector to the non-government sector that do not finance the taxation liabilities remain in the non-government sector as cash, reserves or bonds. So we can understand any storage of financial assets in the Tin Shed as being the reflection of the cumulative budget deficits.
Taxes are at the bottom of the exogenous vertical chain and go to rubbish, which emphasises that they do not finance anything. While taxes reduce balances in private sector bank accounts, the government doesn’t actually get anything – the reductions are accounted for but go nowhere.
Thus the concept of a fiat-issuing Government saving in its own currency has no meaning. Governments may use its net spending to purchase stored assets (spending the surpluses for instance on gold or in sovereign funds) but that is not the same as saying when governments run surpluses (taxes in excess of spending) the funds are stored and can be spent in the future. This concept is erroneous. Please read my blog – The Futures Fund scandal – for more discussion on this point.
Finally, payments for bond sales are also accounted for as a drain on liquidity but then also scrapped.
What are the implications of all this?
You will have heard of the term the monetary base which appears in most macroecoomics text-books as the precursor to outlining the erroneous concept of the money multiplier. Please read my blogs – Money multiplier and other myths and Money multiplier – missing feared dead – for more discussion about why there is no money multiplier.
The concept of the monetary base is a very narrow concept of what economists misleadingly call money. We will use the term net financial assets because it is less problematic.
The monetary base is comprised of:
- The currency (notes and coins) held by the public and issued by the government);
- The deposits that the commercial banks have with the central bank – the so-called reserves;
- The liabilities the central bank has to the non-bank financial intermediaries.
The term “base” is loaded (excuse pun) because it is seen by the mainstream as the base on which banks lend from. Of-course bank lending is not reserve constrained so the term lacks meaning in this context. Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion on this point.
The following table captures the relationship between the monetary aggregates but in no way supports a money multiplier interpretation of the linkages.
The Table helps to sort the vertical transactions (1 to 4) from the horizontal (6 and 8).
National government budget impacts
In isolation, a national government budget deficit, which results from the government spending more (via crediting bank accounts and/or posting cheques) than it drains via taxation revenue from the non-government sector, results in an overall injection of net financial assets to the monetary system. This boosts the monetary base.
Conversely a national government budget surplus, which results from the government spending less than it drains via taxation revenue from the non-government sector, results in an overall withdrawal of net financial assets from the monetary system. This reduces the monetary base.
However, if the government also issues debt $-for-$ to match its deficit then the impact on the monetary base is neutralised. Mainstream textbooks think this is a “funding” operation, whereas from a MMT perspective it is a bank reserve operation which allows the central bank to effective conduct its liquidity management tasks.
Please read my blog – Understanding central bank operations – for more discussion on this point.
Foreign exchange transactions
The external position of a nation impacts on the monetary base if there is official central bank foreign exchange transactions.
A nation’s currency is demanded in foreign exchange markets to facilitate the purchase of its exports by foreigners; to pay interest, profits and dividends to residents who have foreign investments; and to faciliate foreign direct investment in local companies.
Conversely, a nation’s currency is supplied to foreign exchange markets to facilitate the purchase of imports from other countries; to pay interest, profits and dividends to foreign investors; and to faciliate lending to foreign companies.
Ordinarily, where there is a balance of payments deficit the demand for a nation’s currency in foreign exchange markets will be less than the supply of that currency and there will be downward pressure on the exchange parities.
When there is a balance of payments surplus the demand for a nation’s currency in foreign exchange markets will be greater than the supply of that currency and there will be updward pressure on the exchange parities.
So exchange rate movements can arise from the real sector and the financial sectors with the latter increasingly dominating in the era of financialisation. That situation is one thing that needs to be changed if we are to restore stable growth with full employment but that is the topic of another blog.
A floating exchange rate system allows these supply and demand imbalances in currencies to resolve themselves via exchange rate movements with no impact on the monetary base.
However, under a fixed exchange rate system, a country with an external deficit (supply of currency greater than demand) would face downward pressure on its parity and the central bank was committed to easing that quantity imbalance by conducting official foreign exchange transactions. So in this case it would buy its own currency in the foreign exchange markets by selling foreign currencies until the demand and supply of the local currency was equal and consistent with the fixed exchange rate being targetted.
These transactions would drain the local currency from the economy (the foreign exchange market is considered part of the monetary system) and so the monetary base would shrink.
If the nation had an external surplus (supply of currency less than demand) it would face upward pressure on its parity and the central bank had to sell its own currency in the foreign exchange markets by buying foreign currencies until the demand and supply of the local currency was equal and consistent with the fixed exchange rate being targetted.
These transactions would inject the local currency from the economy (the foreign exchange market is considered part of the monetary system) and so the monetary base would increase.
In a pure floating regime with no official central bank intervention, there is no change in the volume of a nation’s currency as a result of the foreign exchange transactions. As an example, assume an exporting firm in Australia earns $USDs and seeks to convert them into $AUDs. It will sell them to a foreign exchange dealer who brokers a deal with a counterparty who desires to hold $USDs and already has $AUDs (perhaps an importing firm).
The exporting firm’s holdings of $AUDs rises as the counterparty’s holds fall. There is no change in the volume of AUDs on issue.
Clearly, things are different in a pure fixed exchange rate system as noted above. A floating exchange rate system thus does no hamper monetary or fiscal policy in the same way that monetary policy is forced to defend the parity in a fixed exchange rate system.
In reality, the central bank still conducts official foreign exchange transactions even if the currency mostly floats. So when the currency is weak (and the central bank fears an inflationary spike coming via increased import prices), it may intervene and buy foreign currency and vice versa when the currency is strong (and there is a fear that the competitiveness of the trading sector is compromised).
The following graphs show the scale of that intervention in Australia since 1973. The data is available from the Reserve Bank of Australia. The left-panel shows the total official FX transactions in $A millions (which include gold and foreign exchange less net overseas borrowing of the national government), the middle panel shows the change in reserve assets due to valuation in $A millions, while the right-panel shows the total change in reserve assets.
You can see the scale of the transactions has increased over time and there are huge swings in short periods of time.
I plan to write some more about the capacity of foreign exchange markets to wreak havoc on a nation, a point that some commentators seem to have become stuck on recently. I would note that Australia is an extremely open economy with litle industrial base. Our export sector is largely based on primary commodities and agriculture.
We have huge swings in our exchange rate. For example in September 2001, the $AUD was selling for 0.4923 $USD and all my US mates were laughing about how we were now the half-price country. By March 2007, it was back over 80 cents. In 1987, we lost about 10 per cent of our nominal GDP in valuation effects due to currency depreciation and terms of trade swings in two quarters! These are huge swings. Our standard of living was barely impacted.
Government bond sales
The impact of national budget outcomes and central bank official intervention on the monetary base can be offset by government bond sales/purchases. Why would the government desire this offset?
The fundamental principles that arise in a fiat monetary system are as follows.
- The central bank sets the short-term interest rate based on its policy aspirations.
- Government spending is independent of borrowing which the latter best thought of as coming after spending.
- Government spending provides the net financial assets (bank reserves) which ultimately represent the funds used by the non-government agents to purchase the debt.
- Budget deficits (and official foreign intervention which adds to the monetary base) put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about ‘crowding out’.
- The “penalty for not borrowing” is that the interest rate will fall to the bottom of the “corridor” prevailing in the country which may be zero if the central bank does not offer a return on reserves.
- Government debt-issuance is thus a “monetary policy” operation rather than being intrinsic to fiscal policy, although in a modern monetary paradigm the distinctions between monetary and fiscal policy as traditionally defined are moot.
To understand these points we need to understand the concept of a system balance which relates to the daily liquidity in the banking system. The system balance is another term for the monetary base. It is important to understand it because it impacts on the ability of the central bank to maintain its desired monetary policy stance – which involves setting a particular overnight interest rate.
Every day, official transactions are occurring (Items 1 to 3 in the Table above) and they impact on the system balance or the money market cash position.
Governmments spend and tax continuously and the central bank regularly conducts official foreign exchange transactions. Further public debt matures regularly and the central bank may conduct repos and rediscount treasury notes before their maturity date is reached.
When the flow of funds that accompany the vertical transactions is in favour of the government sector, we say the system balance is in deficit (or the system is “undersquare”) and vice versa (surplus or oversquare).
You can thus appreciate the particular transactions and balances that will deliver a system surplus or a system deficit.
A budget deficit, for example, will result in a system surplus or oversquare position. There will be excess reserves in the accounts held by the banks with the central bank.
If there is no support rate paid by the central bank on these excess reserves then the commercial banks will try to lend then on the interbank market. The possible borrowers will be other banks who lack reserves at the end of the day. But these horizontal transactions are incapable of clearing the overall system overall. All they do is shuffle which banks are carrying the excess.
In trying to chase a return on the excess reserves, the competition in the interbank market drives the overnight rate down to whatever support rate is in place (which might be zero). Effectively, if there was no central bank reaction, the official policy rate being maintained by the central bank would become irrelevant as the interbank rate fell.
The central bank can drain the excess reserves simply by selling government debt. Accordingly, debt is issued as an interest-maintenance strategy by the central bank. It has no correspondence with any need to fund government spending.
The analysis should be easily understood in the case of the impacts of budget surpluses and the impact of official foreign exchange transactions that add reserves and those that drain reserves.
Further, the idea that governments would simply get the central bank to “monetise” treasury debt (which is seen orthodox economists as the alternative “financing” method for government spending) is highly misleading. Debt monetisation is usually referred to as a process whereby the central bank buys government bonds directly from the treasury.
In other words, the federal government borrows money from the central bank rather than the public. Debt monetisation is the process usually implied when a government is said to be printing money. Debt monetisation, all else equal, is said to increase the money supply and can lead to severe inflation.
However, as long as the central bank has a mandate to maintain a target short-term interest rate and does not pay a support rate on excess reserves, the size of its purchases and sales of government debt are not discretionary. Once the central bank sets a short-term interest rate target, its portfolio of government securities changes only because of the transactions that are required to support the target interest rate.
The central bank’s lack of control over the quantity of reserves underscores the impossibility of debt monetisation. The central bank is unable to monetise the federal debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to the support rate. If the central bank purchased securities directly from the treasury and the treasury then spent the money, its expenditures would be excess reserves in the banking system. The central bank would be forced to sell an equal amount of securities to support the target interest rate.
The central bank would act only as an intermediary. The central bank would be buying securities from the treasury and selling them to the public. No monetisation would occur.
However, the central bank may agree to pay the short-term interest rate to banks who hold excess overnight reserves. This would eliminate the need by the commercial banks to access the interbank market to get rid of any excess reserves and would allow the central bank to maintain its target interest rate without issuing debt.
From a MMT perspective it is far preferable to eliminate the debt-issuance machinery altogether and pay a support rate on reserves if the central bank wants to target a non-zero short-term interest rate. But even more preferable is to allow the short-term interest rate to drop to zero by not issuing public debt or paying a support rate on excess reserves. Then the interbank market will compete the rate down to zero each day and fiscal policy would become the principle counter-stabilisation tool and the most effective means of disciplining price pressures in specific asset classes.
Please read the following blogs – Operational design arising from modern monetary theory – Asset bubbles and the conduct of banks and The natural rate of interest is zero! for further discussion of the preferred MMT position.
The vertical transactions which add to or drain the monetary base that I have outlined here are transactions between the government and the non-government sector. I note some people think the distinction between government and non-government is confusing but you should see it as an essential starting point to understanding the nature of the vertical transactions.
These transactions are thus unique – they change net financial assets in the economy.
All the transactions between private sector entities have no effect on the net financial assets in the economy at any point in time.
Anyway, we have now explicitly considered the impact of official foreign exchange transactions (which might include gold sales and purchases as well as straightforward currency deals).
Australian Federal Election
Tomorrow is our national election.
We are forced to vote here. Some democracy. The choices between the major parties are either bad or very bad. The Greens who are the third main party have no understanding of macroeconomics. Some democracy.
The Government may change tomorrow given the polls and Julia Gillard our first female prime minister will then have the record of the shortest prime minister in history. The Government should have kept the stimulus going and taken some hard decisions on climate change and stopped locking refugees up in prisons (including their children). They did not take any major progressive decisions in their term of office and were beguiled by their neo-liberal pretensions.
They deserve to be tossed out. But that is not to say that the conservatives deserve to be voted in. They are a disgrace and will seek to implement pernicious policies on the disadvantaged just like they did when they were in power last time (1996-2007). They deny climate change and want to make it even harder for refugees. They never deserve to be in government of a progressive forward-thinking nation.
The only policy that is separating them is on the construction of the national broadband network. The Government is promising to continue building a technology that will serve us well into the future whereas the conservatives want to keep us back in the past. All discussions about “costs” in that regard are irrelevant because the only costs that matter are the real resources being used and the Government’s plan is probably not much more “costly” than the status quo.
Most importantly, both major parties want to run surpluses without knowing what that means. They do not understand that at this stage of the business cycle even larger deficits are required. They will both run a macroeconomic strategy that will be detrimental to the unemployed and their families and then they will both turn on these same people and introduce punishing welfare-to-work changes that will just make the lives of the miserable even worse.
There is not much choice down here! I am not allowed under existing electoral law to encourage voters that instead of voting they should write essays on their ballot papers outlining why all major parties have lost the plot.
The Saturday Quiz will be back sometime tomorrow. It national election day in Australia so I might have some questions relevant to that event! Our democracy is in a sad state.
That is enough for today!
This Post Has 108 Comments
I could agree with being forced to vote, but only if there is a ‘none of the above’ option (or RON – reopen nominations, leading to the ‘vote for RON’ campaign slogan).
good post as always. a month or so ago i was at a talk steve keen gave here in nyc. i pushed him on his position of chartalism. while he said that he hadn’t gotten around to doing a formal critique, he thinks a fiscal policy like the one we suggest would lead to a “currency collapse”. i was wondering if you would respond to this critique and provide an alternative analysis of what determines the balance of trade
“taken some hard decisions on climate change”
Though to be fair, the conservatives blocked their policy proposal twice in a row in the senate, leaving taking the country to a double dissolution the only possible way to pass any such policy. I seem to recall that the last time government called such a move was in 1974 and it ended very badly for them.
While making such a move would have shown true courage of conviction and leadership, I suspect they felt it too risky – we Australians are a pretty apathetic bunch and the indignation of being forced to get off our arses and go to the polls early over a single issue could easily have seen a lethal protest backlash. After more than a decade in the political wilderness they did not want to risk losing in the middle of their first term.
Did I mention I saw a coalition flyer the other day emphasising the governments failure to take action on climate change – while conveniently forgetting to mention that it was them who blocked it in the senate!
I am sorry but I have to disagree with the statement that urging to vote informally is an offence in Australia. There had been initial media comments suggesting that triggered by Mark Latham’s remarks but the issue was then settled by the AEC itself.
This is what is banned:
“A person shall not, during the relevant period in relation to an election under this Act, print, publish or distribute, or cause, permit or authorize to be printed, published or distributed, any matter or thing that is likely to mislead or deceive an elector in relation to the casting of a vote.”
The following ABC article explains the controversy:
“The Australian Electoral Commission (AEC) says there is no law which prohibits the public from voicing an opinion on how people should vote, including casting an informal vote.”
I agree that all the 3 major parties either lie about or do not (fully) understand the economic issues. But in my opinion there is a difference between abstaining and allowing for the Coalition supporters to elect the “3 illegal boats per year” Tony Abbott or voting for the Greens and leaking the preferences to the ALP, possibly leading to a coalition government which could make first baby steps to address the climate change issue.
This is not that I am endorsing the ALP or if that really matters, the Greens. But knowing how the system works in Australia and having the following options: an informal vote, Coalition, ALP, Greens, other minnow parties or the independents I am going to vote for the Greens and then for ALP for both the House of Representatives and the Senate as I do have children and I don’t want them to see the effects of our global ignorance and negligence in regards to the environment.
This is what really matters to me not saving the United States of America from themselves.
Speaking of baby steps, here is footage of Tony “great big debt” Abbot being presented with Sean Carmody’s chart highlighting the difference between government debt and household debt in Australia. It isn’t an explanation of MMT but does reinforce how silly all the debt and deficit hysteria are, while making Abbot look like a prize goose at the same time.
And this is a pretty popular show – perhaps enough people saw it to tone down their fears of “great big debt and deficit”.
I for one, enjoyed watching Abbot squirm.
If the Fed can indeed set AND meet a target interest rate though the purchase/sale of bonds, does that also mean that it can set an inflation rate in the case of unconstrained real goods? Doesn’t the issuance/repurchase of long bonds attempt to control inflation by changing the cash supply for 30 years?
“Government spending is independent of borrowing which the latter best thought of as coming after spending.”
According to the existing US law (Federal Reserve Act), for the government(Treasury) there is no mechanism to borrow from the FRB directly. In other words, the USG does not have a Zimbabwe line of credit with the Feds. As a consequence of not having a ZLOC, the USG can finance its deficit only through selling T-paper on the primary market, aka borrowing. The Feds cannot, by the same law, participate in the primary auctions, but rather buy the treasuries on the secondary markets, the prohibition prevents bypassing the absence of ZLOC. So, the correct temporal sequence under the current law is for the government to borrow first and spend second.
Article 123 TEC (Treaty establishing the European Community) explicitly prohibits a Central bank ZLOC:
Overdraft facilities or any other type of credit facility with the European Central Bank or with
the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of
Union institutions, bodies, offices or agencies, central governments, regional, local or other public
authorities, other bodies governed by public law, or public undertakings of Member States shall be
prohibited, as shall the purchase directly from them by the European Central Bank or national central
banks of debt instruments.
The Bank of Canada offers a very limited and controlled line of credit for emergencies only, not for normal operations. I am not sure about details since I’ve been out of of touch with Canadian CB regulations for more than 10 years but I guess one can easily find laws/regulations applicable to BoC operations on-line if one is so motivated.
To re-iterate, US/Canada/EZ Government spending is *dependent* on borrowing with the latter coming *before spending*. Of course, you may have some other ‘Government’ in mind for which the no-overdraft restriction does not apply.
Agree with you. However note that for sovereign nations, these rules can be easily broken. Also note that the US Treasury still has seigniorage powers – the Treasury can mint coins of any denomination and has to be acceptable by the Federal Reserve. If this operation needs to be done, the Fed will record the coin as an asset and credit the Treasury General Account. The Treasury can then continue to spend.
Also, the Fed can participate in auctions: “…. as a consequence, at most the Desk’s acquisition at Treasury auctions can equal maturing holdings.” Understanding Open Market Operations, MA Akthar, p37 (Fed paper)
The argument that “spending necessarily comes first” or an equivalent should NOT be interpreted as suggesting that the Tsy doesn’t need to sell bonds under current law.
Spending or an overdraft to a bank’s CB account (loan from the consolidated Tsy/CB) is necessary to provide the RBs to the banking system that then settle tax liabilities or primary bond auctions with the Tsy. This is the case whether or not the Tsy receives an overdraft at the CB. But, this DOES NOT mean that the Tsy itself doesn’t have to sell bonds or otherwise obtain credits to its account at the CB in order to spend if the govt has imposed this constraint on itself (i.e., the govt forbids itself from receiving overdrafts from the CB). Both can be (and currently are) true without any inconsistency–the govt can and currently does require itself to obtain credits from bank reserve accounts that were created via previous spending or CB lending before it spends again.
So what is the MMT terminology “net financial assets”. Reading this post, leads me to believe that the monetary base is “net financial assets”
If that is the case, Canadian banks end up with zero settlement balances every day. So only currency in circulation is NFA ?
If net financial assets is the sum of currency in circulation, settlement balances and government debt, what about assets denominated in foreign currencies but held by citizens/institutions of a nation ?
When a government, or “Federal Government” in the Z.1 – US Flow of Funds language spends by instructing the central bank to transfer funds from its account at the central bank, banks’ clearing balances increase. However not all increases of settlement balances can be thought of as increasing financial assets. (A implies B does not mean B implies A). One example – the US Treasury purchases foreign currency from JP Morgan, it increases JP Morgan’s settlement balances at the Federal Reserve. The Fed just owes less to the Treasury and more to JPM. On the other hand, the increase in settlement balances does not increase the private sector’s net financial assets. (Whatever happens to fluctuations in the exchange rate comes later. Thats a small change.)
Also note that government deficits tend to increase demand and national income. Higher saving and wealth created by government deficits lead to chasing government bonds and higher demand for them – causing no “crowding out”
(1)”However note that for sovereign nations, these rules can be easily broken.”
Since here ‘rules’ = ‘law’, are you saying that the law can easily be broken ? I am sure that’s not what you have in mind, surely !
(2) Coin production is irrelevant. As I wrote elsewhere, “Banks *buy* cash from the Fed by having their reserve accounts debited – there is no money creation here.” The Fed pays the Treasury only the minute cost of coin production , not of course the cash face value.
(3) The full quote is as follows:
The Federal Reserve is prohibited by law from adding to its net position by direct purchases of securities from the Treasury-that is, the Federal Reserve
has no authority for direct lending to the Treasury. As a consequence, at most the Desk’s acquisition at Treasury auctions can equal maturing holdings.
What it says is that primary market operations are limited to rolling over maturing bills and coupons — the net result is that the Treasury account cash holding is unchanged, therefore (c.p.), amount of reserves in the system would remain the same. Hadthe Feds ‘desired’ to decrease liquidity, they would let the securities expire.
I do not think this is so straightforward. The Australian banks’ settlement balances at RBA do not change of course but other monetary aggregates can. There are many examples I can give. The simplest is when an international bank happens to be the broker itself e.g., Citibank in Australia and the US. Assume the exporter has two accounts. One in AUD and one in USD. Citibank Australia will credit the exporter’s AUD account and debit his USD account. Citibank Australia has an asset “Due from Citibank US” and Citibank US has a liability “Due to Citibank Australia”. Citibank may either get rid of these entries or decide not to. Ref: Fed’s H.8
The M2 or M3 or whatever it is called in Australia has increased.
Another example. Start afresh. When the exporter gets paid in AUD, he reduces his indebtedness to the Australian banking system. Its automatic. The money supply in Australia has gone down.
There have been various instances when the Treasury has had overdraft facilities at the Fed and also direct purchases of US Treasuries have been allowed in many periods.
Whatever the Fed pays the Treasury, if the Treasury hands the coin to the Fed, it has to accept it at the value inscribed on the coin. You may be talking of Fed picking up the bill on the production or something. You may be interested in reading “How the Costs and Earnings Associated with Producing Coins and Currency Are Budgeted and Accounted For” and Chicago Fed’s “Modern Money Mechanics.” The latter is nice but falls prey to the money multiplier.
Agree with you on Fed direct purchases. My point was just to get into geeky little things.
Some points on foreign currency purchases and fixed versus floating.
Many (most?) institutional setups have a big item on the central bank’s balance sheet “Claims on Banks”. If the central bank purchases foreign currency, – the central banks’ assets increase by the amount of foreign currency and the item “claims on banks” reduces by an equivalent amount. No change in the settlement balances occurs. Doesn’t matter fixed or floating.
Right you are:
“Whatever the Fed pays the Treasury, if the Treasury hands the coin to the Fed, it has to accept it at the value inscribed on the coin.”
Let me correct my sloppiness:
“(2) Coin production is irrelevant. As I wrote elsewhere, “Banks *buy* currency from the Fed by having their reserve accounts debited – there is no money creation here.” The Fed pays the Treasury only the minute cost of currency production , not of course the currency face value.
Coins are FRB assets(bought at the face value) or Treasury liabilities, but currency (federal reserve notes) is FRB liability painted by Treasury/Mint and bought at the production cost.
So, yes, technically Treasury can finance its spending through coin issuance — are you hinting at a return to the gold standard ?
“There have been various instances when the Treasury has had overdraft facilities at the Fed”
Article 14 of FRA contained an emergency loan provision between 1942 and 1980. It was removed, and I am not aware of any overdraft occurrence since.
and also direct purchases of US Treasuries have been allowed in many periods.
Could you provide a reference ? I am not aware of any such purchase.
No, I am not hinting at a return to Gold Standard!
Just pointing out a technicality which can be used. Its like a bazooka in your pocket. If others know it, you don’t have to use it. Unfortunately others think that the Fed or the Treasury can “print money” etc. They are right in some sense. Some people knowledgeable know about the seigniorage powers. However, they are wrong because they think that money is printed regularly on supply whereas currency notes are printed on demand. When banks face some pressure with cash, they ask the central bank. Its fully dependent on the demand of the household sector.
These two articles are nice
Has details on these arrangements you are looking for such as “Cash and securities draw authority”. Also during the WWII, the Fed set the yield curve for the Treasury.
Coming back to the Gold Standard, there was no mechanism for adjustment of the balance of payments problems. In my view its still problematic. MMTers keep talking of “net saving desire” and that its no problem. Formal Post Keynesian theorists know its an issue.
A deficit hawk can use the same argument “Our standard of living has barely impacted” etc. Its important to realize that the rest of the world is Australia’ creditor. The net claims of foreigners is 60% of GDP ? The cost of servicing this debt is high. I know the usual MMT argument “simply credit bank accounts”. Its important to realize that fiscal policy is restrictive because of current account deficits whereas MMTers think “its even better”.
Making any progress?
You mean all my efforts are going in vain ? 🙂
“The middle section of the graph is occupied by the private (non-government) sector. It exchanges goods and services for the currency units of the state, pays taxes, and accumulates the residual (which is in an accounting sense the federal deficit spending) in the form of cash in circulation, reserves (bank balances held by the commercial banks at the central bank) or government (Treasury) bonds or securities (deposits; offered by the central bank).”
Maybe I’m not reading that correctly, but where are the demand deposits created from debt? For example, I get a mortgage from a bank. I give the check from the bank to the builder. The builder then deposits it at the same bank in a checking account.
I would like to ask about what actually govt tax is paid from? does tax only paid by money received via vertical transaction i.e monetary base?
How about the monetary expansion from the non-goverment sectors economic activity (horizontal transaction)? although these horizontal transactions is net to zero, but if I assume correctly, it means that the broader the expansion is also an indiaction of non govt sectors are making more profit and govt would recieved larger amount of tax on that.
@ Fed Up
By balance sheet expansion at the bank when you ‘create’ the mortgage. All banks can do this trick but they are capital constrained and can only create so many mortgages before they need further working capital. The only bank that is not capital constrained is the central bank/government and effectively it only has political limits not financial ones.
It goes like this
Debit bank assets, credit reserves creates the mortgage and expands the balance sheet (leverage magic that actually expands money), Debit reserves, credit your checking account – then gives you the ability to withdraw something (the deposit is created). When the builder deposits it is debit reserves, credit their checking account (just a normal transaction and creates nothing).
In reality, monetary policy and fiscal policy are also is an indication of a government’s stance on the exchange rate. A central bank cannot set the rates to zero and neither can the ministry of finance choose its policy without keeping the foreign exchange rate in mind. Its quite a nice problem for game theorists to look into.
“But even more preferable is to allow the short-term interest rate to drop to zero by not issuing public debt or paying a support rate on excess reserves. Then the interbank market will compete the rate down to zero each day and fiscal policy would become the principle counter-stabilisation tool and the most effective means of disciplining price pressures in specific asset classes.”
Interesting. What would happen if the RBA permanently set the cash rate target to 0%? What would happen to interest rates in other parts of the economy?
All government bonds would then yield 0%, so there would be no effective difference between cash deposits at the RBA and government bonds.
Would this not hold the entire yield curves for all credits much lower than they would otherwise be? Why isn’t this a recipe for asset bubbles?
Thanks for putting all this together in one post, Bill. It is a very handy reference, and I’m sure it will be getting a lot of hits over time.
With no new bonds being issued new government deficits accumulate as excess settlement balances (excess reserves) in the banking system. Outstanding government bonds continue to be traded at market rates – short term bonds being heavily affected by the 0 interest rate on the overnight rate and longer term bonds affected by the zero rate and inflation expectations.
Bill has discussed house price bubbles, recommending they be controlled by restrictions on the availability of credit for mortgages. This was done to some extent in Canada, in part at the behest of the banks. More generally asset bubbles could be controlled by counter cyclical capital requirements for banks (see an earlier blog on this).
Keith, I think that all government bonds would be driven towards 0% yield. If the market (in particular the banks) truly believed that the central bank was going to keep the overnight cash rate of 0% indefinitely, then any yield would be preferable to the 0% on offer in the cash settlement accounts, hence banks would rather hold a bond that yielded something (even 20bps) to cash balances which yield nothing.
The reason that inflation expectations can effect long-term government yields in the market as it works at the moment is partly because the RBA has developed the credibility with investors that it will respond to inflation with higher rates.
The way I look at, you can think of 2 types of investors in the bond market:
1) Real money investors who actually have cash to invest – these people are concerned about inflation
2) Banks who borrow money from the RBA to invest – these people don’t care about inflation, they only care about what the cash rate will be for the life of the bond
With a 0% cash rate, the price of bonds would be determined by investor type 2, and type 1 would be driven out of the bond market and into real assets.
So with the possibility that this sort of policy could (potentially) cause such instability, why would we do it? What is the benefit of having 0% interest rates? What does it achieve?
I take your point about inflation and the bank rate, i.e. the long bond rate is actually a reflection of what investors believe the future bank rate will be – presumably influenced by expectations of future growth and inflation, for instance.
But I think your type 2 buyer of bonds will be out of luck. If the treasury no longer issues bonds there simply will be no additonal ones to buy. I suppose your point is the banks will try to buy all the remaining outstanding government bonds and bid the price down to zero. Nonetheless, collectively, the banking system will still be stuck with excess settlement balances paying zero interest. This will in fact be a burden on the banking system as it accumulates zero interest assets for which it has no outlet and so depress its profits. In effect the banks would carry all future government deficits with no compensation. I imagine the banks would then increase various charges, suppress wages, reduce interest on deposits, etc, to make up the shortfall. I guess I’m not entirely convinced this is necessary. Why not pay some small interest rate on excess settlement balances if you don’t want to issue bonds?
In any event I think Bill and Warren have made the point somewhere, in a presentation to a Parliamentary committee perhaps, that the issuance of bonds is a subsidy to the banks and is unnecessary. They note that while treasury securities are the risk free asset on which the banks base their rates, I believe they say the banks should develop their own debt instruments independently and not sponge off the State.
Why do you say the end of government bond issuance would lead to instability? There would still be a positive interest rate in the private bond market.
Keith, I think we agree that the commonwealth government bond market would no longer exist, and there would be little or no distinction between cash balances and government bonds – both would yield 0% irrespective of what inflation was, and was expected to be.
The problem is that these 0% rates across all government maturies would be likely to bias all other credit curves downwards.
For example, consider that you were a bank sitting on a large portfolio of federal government issued assets yielding 0% (cash balances and govvie bonds). You look over into another part of the market and see bonds issued by the Queensland State government trading at a non-zero yield. Queensland is considered a semi-government issuer, they have some powers of taxation and many people believe they possess an implicit guarantee from the federal government. They are a very strong credit, and you would definitely buy those bonds and pick up some yield, rather than sit on your portfolio that yields nothing.
And likewise out the credit spectrum, a similar effect would probably ensure all interest rates would be lower than they would have otherwise been.
What happens if interest rates are less than the rate of inflation? Why would anyone want to hold cash balances which yield nothing, or private-sector bond issues which yield something less than the rate of inflation?
Eventually everyone would be scrambling to get into real assets like real estate or financial assets without fixed interest and principal payments (ie equity/shares). This sounds like a highly unstable situation to me.
Gamma . . . if everyone goes into non-bond assets, then that by itself would raise the yield on non-govt bonds.
I think the consolidation of the central bank and treasury and the concept that taxes revenues are trashed tends to mask an important aspect of the monetary system. The economy runs on credit money which is sensitive to the interest rate on bank loans. The central bank therefore cannot choose not to set a target for the interest rate on interbank loans of reserves and control it through open its market operations. The alternative of controlling the quantity of banking system reserves and leaving the interest rate as a residual is impractical. Firms and households cannot plan efficiently unless they know the cost of credit going forward, at least for the relatively near term.
In reality the treasury can only spend what it has previously acquired through taxes and the sale of securities to the public. A more realistic representation would show a balanced circular flow of funds between the treasury and the private sector in which the treasury recaptures its deficit spending on average through the sale of securities to the public, and maintains its account at the central bank at a nominally fixed level to enable the central bank to control of the short term interest rate. Ultimately the government must ensure the value of its currency by widely enforcing tax collection and acting to maintain a modest rate of inflation through its control of the cost of credit money. I think this a fundamental constraint on any modern economy and should therefore be reflected in the flow funds model.
In reality the treasury can only spend what it has previously acquired through taxes and the sale of securities to the public. No, this the reverse of the truth, and logically impossible. Where did the first dollar come from? The public can only buy securities or pay taxes with what it has previously acquired from the treasury spending.
the treasury recaptures its deficit spending on average through the sale of securities to the public Yes, that is what reserve draining is about, which is a focus of MMT operational description.
“In reality the treasury can only spend what it has previously acquired through taxes and the sale of securities to the public.”
“No, this the reverse of the truth, and logically impossible. Where did the first dollar come from?”
Answer: The first dollar was created long before the modern fiat money system came into existence. Thus the MMT model of a fiat money system being initially funded out of Treasury spending has no basis in reality.
In normal times the Treasury (1) balances its inflows against outflows on average to avoid affecting the money supply; (2) targets a constant balance in its account at the central bank to minimize the effect on aggregate reserves in the banking system; (3) which enables the central bank to maintain control of the short-term interest rate by adding or draining reserves as required. This is entirely consistent with MMT, but I think it provides a more realistic and useful picture of flows in the “vertical” component.
“the MMT model of a fiat money system being initially funded out of Treasury spending has no basis”
If you look at this archeological find, you can see that the Romans were using 250 year old coins (denarius from 200 BC) in Brittannia
after they first arrived there around 64 AD.
They had to have brought these coins with them and initially spent them into circulation as I doubt the native residents of Brittannia could have acquired them otherwise before the arrival of the Romans in the first place. Or could the Romans demand payment of poll tax from the Brittans in 64 AD payable in 200 BC Roman denarius without ever having been there before? Ancient Brittans from 200 BC trading goods for an external currency for 250 years?
“If you look at this archeological find, you can see that the Romans were using 250 year old coins (denarius from 200 BC) in Brittannia after they first arrived there around 64 AD.”
What do Roman coins have to do with a modern monetary system based on FIAT money that began in 1934?
I thought you were writing about the sequence of events “in general” for a ‘fiat’ type currency, not the specific sequence of events wrt the US monetary system in the 20th century.
The balanced circular flow of funds model applies equally to many other fiat money systems, not just the current US monetary system. It derives from the need to manage the short term interest rate. The flow from government spending to its recapture through taxes and the sale of bonds can be easily traced. The consolidated government model (Treasury and central bank) showing a one way flow ending with the destruction of tax revenues gives no hint of that constraint.
” The flow from government spending to its recapture through taxes and the sale of bonds can be easily traced.”
I follow this if I look back for instance at the Romans in Brittannia as seen through my link above to the archeological record. The Romans had to recycle the physical 250 year old tokens as these coins “did not grow on trees”, so they of course had to get them back (physically) to be able to spend them again, they literally had to collect the coins back as taxes to be able to spend, I think this is clear.
But why do we have to look at it the same way now, 2,000 years later when we have modern information technology and “money” can exist on computers?
It seems to me that Prof Mitchell here (MMT) looks at things in the context of our present society’s contemporary information technology. Is it not possible to look at it the way Bill does here and still manage the interest rate if you think that is necessary? Do we have to pretend that we are still back in the BC days to manage interest rates?
It can be useful at times to consolidate the Treasury and the central bank (CB) in understanding MMT. However consolidation can also mask important aspects of the monetary system, and is not essential to understanding MMT.
Only the central bank can create deposits of fiat money out of thin air. The Treasury cannot pay for its spending by simply creating deposits at the CB for the seller’s bank. Every dollar it spends means a debit to its own account at the CB. The Treasury must acquire its fiat money through taxes and the sale of debt securities. In the US system, the Treasury deposits its tax and loan receipts in the banking system and then transfers what it needs to cover its spending to its account at the CB. This is the reflux part of the balanced circular flow that I previously alluded to. The notion that payments to the government, e.g. tax receipts, are shredded by the Treasury must be viewed as a metaphor, not as reality.
The horizontal component of the MMT model is a function of the short-term interest rate which is controlled by the vertical component. That sets a constraint on the vertical component which is economically important in terms of policy. However that constraint is not apparent in the consolidated government model, although I have seen it mentioned briefly in the text of some MMT articles. In my view it deserves more than that.
I believe I understand the current process as you descibe it, I am aware how the different balances can effect monetary policy, etc.. but please let’s remember that this is all just an accounting, and should take a back seat to outcomes imo.
The “shredding” ok it is a metaphor, but could you not consider the ‘netting’ that goes on in the various Treasury and CB accounts the modern IT system equivalent of ‘shredding’, your use of the word “flow” is a metaphor also, these ‘funds’ do not actually “flow” now do they? Also, do you view these procedures any differently now the the US CB can pay interest on reserve balances, does this not give the US the ability to cease bond issuance as now bonds are not needed to maintain a non-zero monetary policy?
You may be comfortable with your view of this process, but then tell me, how do we disabuse the general public of their perception that the Treasury is “borrowing from our grandchildren” by issuing a Treasury security? Do you agree that the current mainstream framework is easier to use to deceive the public perhaps to the advantage of a select few? Or if you wont go that far, do you agree that most if not all of our US policymakers do not have the correct level of understanding of these procedures that would be appropriate for them to successfully run fiscal and oversee monetary policies?
How do you view these non-operational issues?
“I believe I understand the current process as you describe it, I am aware how the different balances can effect monetary policy, etc.. but please let’s remember that this is all just an accounting, and should take a back seat to outcomes imo.”
I don’t know what balances you are referring to, or what you mean by “this is all just an accounting”. In the US today, monetary policy is about the only government tool available for managing credit money. Fiscal policy is now virtually non-existent. Congress has become a captive of moneyed interests, primarily the mega-banks.
“The “shredding” ok it is a metaphor, but could you not consider the ‘netting’ that goes on in the various Treasury and CB accounts the modern IT system equivalent of ‘shredding’, your use of the word “flow” is a metaphor also, these ‘funds’ do not actually “flow” now do they?”
I don’t see any relation between “netting” and “shredding”. The latter implies that the Treasury creates the money it spends, which is untrue in normal times. Only in extremis (as in WW2) when it borrowed directly from the CB would it be fair to say that it created the money it spent.
You could consider the term “flow” as a metaphor for the movement of money, but it is widely used and understood. It certainly doesn’t carry the baggage of “shredding” as a metaphor.
“Also, do you view these procedures any differently now that the US CB can pay interest on reserve balances, does this not give the US the ability to cease bond issuance as now bonds are not needed to maintain a non-zero monetary policy?”
No, the paying of interest on excess reserve balances is a free lunch for banks just for being depositories. I don’t consider that to be an acceptable alternative to the Treasury issuing interest-earning bonds to the public. The size of the budget deficit is far too large on average. Without selling bonds to the public, the free lunch for banks would quickly grow to outlandish proportions. It’s OK to pay interest on reserves at a rate somewhat below the target rate, as is done in Australia and Canada for example. Banks would then have no incentive to sit on reserves as an alternative to lending to the public in normal times.
“Do you agree that most if not all of our US policymakers do not have the correct level of understanding of these procedures that would be appropriate for them to successfully run fiscal and oversee monetary policies?
I agree that very few in government understand a fiat monetary system, and economic issues that it affects. However the term “fiscal policy” is an oxymoron. It almost always works to the exclusive advantage of the moneyed interests, at the expense of the general public. Consequently we cannot depend on it on a continuing basis. That appears to leave monetary policy as the only potentially effective policy tool.
Why would paying interest on reserves give banks no incentive to lend to the public in normal times? Bill has many blogs on the fact that lending is not reserve constrained.
I can understand your frustration with the current US political system vis-a-vis its fiscal policy, but I think you are confusing artificial constraints placed on the US Treasury with the true operational reality.
“Why would paying interest on reserves give banks no incentive to lend to the public in normal times? Bill has many blogs on the fact that lending is not reserve constrained.”
Bank lending is capital-constrained, not reserve-constrained, as I’m sure Bill would acknowledge. But you appear to have misunderstood what I said: It’s OK to pay interest on reserves at a rate somewhat below the target rate, as is done in Australia and Canada for example. Banks would then have no incentive to sit on reserves as an alternative to lending to the public in normal times.
Of course these are not normal times. Large US banks currently hold a huge excess of reserves, and they receive interest on those reserves. That inclines them to hold a sizable fraction of the excess simply to draw interest rather than risk losses through bad loans, especially when the economy is in recession and there are relatively few creditworthy borrowers.
“I can understand your frustration with the current US political system vis-a-vis its fiscal policy, but I think you are confusing artificial constraints placed on the US Treasury with the true operational reality.”
I’d like to know what artificial constraints on the Treasury you think I am assuming. Surely you don’t mean to imply the Treasury can spend by simply crediting sellers accounts without covering them with its own funds. Indeed there is no need to do so because it can acquire what it needs through the sale of its own securities, which is exactly what it does when tax revenues fall short. In extremis it could borrow directly from the Fed, but that hasn’t happened since 1951.
The “interest on reserves is an opportunity cost to lending” argument is simply wrong. Interest paid is 0.25%. At best, offsetting liabilities are 0%, probably more, especially when you factor in non-interest costs of liabilities. IOR hurts bank asset turnover, and probably (at least now) profit margins. If a creditworthy customer comes in the doors, the bank will make the loan, but for reasons unrelated to IOR banks have increased their standards for creditworthiness (as they always do in recessions/slowdowns) and there are many fewer who see reason to borrow at this time. IOR isn’t the problem.
Even if IOR were higher, it’s still the equivalent of interest earned on a Tbill, basically, and I almost never hear anyone say “why are all these Tbills floating around . . . banks won’t lend since they can just hold Tbills!” Any loan, with or without IOR, has to be a better investment than the risk-free rate. IOR doesn’t change that.
That inclines them to hold a sizable fraction of the excess simply to draw interest rather than risk losses through bad loans,
The banks simply cannot get rid of the excess reserves on their own without outside Fed’s help. That means that they do not have a choice but to sit on the reserves and collect the free lunch. Therefore, it is hardly fair to blame the banks for the existing extra reserves situation even though they may deserve plenty of blame elsewhere.
In extremis it could borrow directly from the Fed, but that hasn’t happened since 1951
No, it could not because it would be illegal in the current operational reality. Although, it could in 1951 when a special provision existed to let the Treasury do that.
Also, there were excellent comments by JKH on this issue several months ago at http://macromarketmusings.blogspot.com/2010/02/feds-exit-strategy.html
Excess reserves are risk free assets. Risk free assets earn the risk free rate of interest.
Risky assets earn the risk free rate plus an expected spread. The purpose of capital is to underpin the risk around the expected spread.
Banks must allocate capital to risk. Therefore, the decision to take risk depends on the availability of capital.
A bank with adequate capital is itself an acceptable credit risk. That means it does not have a problem in attracting reserves required for settlement purposes. It can do this in the normal course by selling liquid assets or attracting new liabilities.
Therefore, the risk taking exercise does not depend on the availability of a stock of reserves. Any bank that formulates a strategy of risk taking based on reserves is simply being irrational and reckless. The textbook multiplier theory is an outrage in terms of its ignorance of risk and capital issues.
The Fed controls the supply of aggregate system reserves. When individual banks do engage in new lending, the best they can do is push the aggregate reserve distribution in the direction of other banks as a result. That is simply the result of the settlement mechanism. It does not reflect a process of “using” reserves.
Any bank CEO that would formulate a strategy of risk taking primarily in an effort to “use” reserves would be foolish. The best the bank could do is contribute in a minor way to the conversion of system excess reserves to system required reserves. The effective reserve ratio of the system prior to the crisis was less than one per cent, due to the preponderance of non-reservable time deposits in the total checking/savings/time deposit mix. Based on that mix tendency, the US banking system would have to create more than $ 100 trillion in new loans and deposits in order to “use up” excess reserves. This line of thinking is just preposterous, and those who pursue it should spend more time on their numbers. Moreover, any strategy of risk taking designed simply to push existing system reserves over to the competition, regardless of normal risk analysis and capital considerations, is just outrageously reckless.
The proper strategy has to be risk and capital based on a loan by loan basis. So yes, I do expect those banks to behave in the same way.
And JKH later in the thread writes:
There is no opportunity cost associated with excess reserves provided that excess reserves are earning the risk free rate. This is because excess reserves are zero risk weighted for capital allocation purposes. Accordingly, they require no capital allocation on a risk weighted basis.
It is irrational for any bank risk/capital manager to allocate capital to risk simply on the basis of perceiving a nominal opportunity cost when earning the risk free rate on a risk free asset. It is wrong to view earning a higher risk adjusted return on risky assets as a substitute for lower earning risk free assets, without reference to capital requirements. A higher compensation for risk is a requirement with or without the alternative presence of risk free assets. So the presence of risk free assets is a red herring in terms of opportunity cost.
In terms of deposit costs, I referenced the fact that in this environment banks will be careful to review the interest rate structure (and the fee structure) on deposit accounts to ensure that net interest margins and related costs are reasonable compared to the risk free rate.
Excess bank reserves now total about $1 trillion. Those reserves are mainly the result of Fed purchases of MBS and Treasurys from the non-bank sector. Banks were simply the beneficiaries as depositories.
Eventually the Fed will have to recapture most of those reserves. However that cannot be done quickly because of its impact on the market and the economy. If the Fed raised its target rate on Fed funds to say 4% before it recaptured those reserves, it would have to pay about $40 billion per year in interest on them, most of which would be a free lunch for banks. I would call that a problem.
I don’t understand your comment: “The “interest on reserves is an opportunity cost to lending” argument is simply wrong.” I didn’t say anything related to that.
“fiscal policy” is an oxymoron. It almost always works to the exclusive advantage of the moneyed interests”
It doesn’t have to. In fact, I believe that perpetuation of modern day myths about the US monetary system act to deceive the public into believing that our options wrt fiscal are much more limited than they are in reality, or many folks, looks like yourself included, have sadly led themselves to believe that there are no fiscal options, William your comment in this regard sounds defeatist. This is a shame as monetary policy alone can never deliver continuous full employment/output , today’s zero rates and 10% unemployment being a prime empirical example.
I’d like you to consider: The US CB system (The Fed) only acts as the ‘fiscal agent’ of the US Treasury by the leave of that same US Treasury. It is not correct to believe that the US Treasury has to borrow it’s own ‘money’, in the same way, did the Roman govt borrow the coins that appear in the pictures in the article I linked to above, or just spend them into existence?
“The banks simply cannot get rid of the excess reserves on their own without outside Fed’s help. That means that they do not have a choice but to sit on the reserves and collect the free lunch. Therefore, it is hardly fair to blame the banks for the existing extra reserves situation even though they may deserve plenty of blame elsewhere.”
I don’t blame the banks for collecting that free lunch. I blame the Fed for monetizing all those securities, thus loading up the banks with the reserves, and then paying interest on the reserves. The Fed had fought a long time for authority to pay interest on reserves and finally got it in Oct 2008, but the timing was bad. The original intent was to pay interest at a lower rate than the target Fed funds rate. That would have cost the Fed a trivial amount because banks would not hold much in excess reserves when they could lend them at the target rate. The QE1 program started at about the same time, and I think the Fed would have felt embarrassed to turn off IOR then. At an interest rate of .25%, the amount it has to pay is pretty small. However comes the day that the Fed wants to raise the target rate back to its historical level of 3 to 5 percent, the cost of the free lunch could be significant if there is still a very large amount of excess reserves outstanding.
In extremis it could borrow directly from the Fed, but that hasn’t happened since 1951.
“No, it could not because it would be illegal in the current operational reality. Although, it could in 1951 when a special provision existed to let the Treasury do that.”
Of course that assumes that Congress would ignore extremis conditions and deny the Treasury that authority.
Agree with you at 11:44. Regarding IOR as an increased opportunity cost of lending, you said interest on reserves “inclines them to hold a sizable fraction of the excess simply to draw interest rather than risk losses through bad loans”–that means they are less likely to lend than without IOR, and IOR is thus an increase in the opportunity cost of lending. Yes, true with long-term Treasuries where the return can be significantly higher than cost of funds (such as the early 1990s, but not true now), but not with Tbills or reserves earning interest.
I agree that monetary policy alone cannot achieve the goal of continuous full employment. But don’t blame the Fed’s monetary policy itself for the 10% unemployment problem. Much more blameworthy was Greenspan’s laissez faire attitude regarding the products the financial system was creating. Too bad Warren Buffett wasn’t in charge.
“I’d like you to consider: The US CB system (The Fed) only acts as the ‘fiscal agent’ of the US Treasury by the leave of that same US Treasury. It is not correct to believe that the US Treasury has to borrow it’s own ‘money’, in the same way, did the Roman govt borrow the coins that appear in the pictures in the article I linked to above, or just spend them into existence?”
The US Treasury reports to the President and therefore has a political agenda as well as being a financial manager. I would never support the merger of the central bank with the Treasury. In spite of its sometimes dismal record, the central bank is one of the few bulwarks of our system. With its independence from the administration and its quasi-independence from an unruly and incompetent Congress, at least we know who is in charge.
The real problem with our government is Congress which has been thoroughly compromised by the money that members need to get reelected. The amount of money spent on lobbying Congressmen by megabanks and large corporations makes it obvious how serious the problem has become. How can one expect a coherent fiscal policy being generated under such conditions?
However comes the day that the Fed wants to raise the target rate back to its historical level of 3 to 5 percent, the cost of the free lunch could be significant if there is still a very large amount of excess reserves outstanding.
When such a day finally arrives, the Feds can as easily stop paying any interest on reserves. I do not really see why they cannot do that today.
In any case, to stop paying that interest is fully within the existing Feds’s powers as opposed to the hypothetical with the Feds lending directly to the Treasury which would have required a legislative action.
However comes the day that the Fed wants to raise the target rate back to its historical level of 3 to 5 percent, the cost of the free lunch could be significant if there is still a very large amount of excess reserves outstanding.
“When such a day finally arrives, the Feds can as easily stop paying any interest on reserves. I do not really see why they cannot do that today. In any case, to stop paying that interest is fully within the existing Feds’s powers as opposed to the hypothetical with the Feds lending directly to the Treasury which would have required a legislative action.”
If there is a substantial supply of excess reserves in the banking system, and the Fed pays no interest on them, the Fed funds rate will fall to zero. The only way the Fed could get the interbank lending rate up to say 4% is to offer 4% on the excess reserves. That sets a floor under the interbank lending rate.
Absolutely agree with VJK.
The purpose of paying interest on reserves is to raise the cost of funds for banks, so that credit growth it limited.
Well, I just got a parking ticket.
It seems absolutely crazy to assume that paying banks money is the only way that the government can raise the cost of funds for the banking system.
Have we been so captured by finance that this is the only thing we can think of doing? How about imposing a 3% asset tax on all non reserve assets held by the banking system. Wouldn’t that raise their cost of funds by 3%? And wouldn’t this be disiniflationary as well? Isn’t this the simple, direct, and the obvious thing to do?
Why is no one thinking rationally about this, and instead proposing paying interest as a way of imposing costs on banks?
Based on some of your comments here, to me you have a handle on how this stuff works which puts you ahead of 99.9% of the voters here in the US. I submit, if this was the level of the general knowledge of the electorate, we would elect a better government.
The people would demand a government that delivered a fiscal policy that would result in full employment/output and the highest quality of life. Sure there would still be bribes/patronage/sweetheart deals/depravity, etc.. in govt, resulting out of a robust fiscal policy, but William we already have that with the raw deal we are currently suffering under.
Dont let the perfect be the enemy of the good here. With the right education/information/understanding, the voters will do the right thing politically. Fiscal policy is the power of the people, monetary policy is the power of the elites.
“With the right education/information/understanding, the voters will do the right thing politically. Fiscal policy is the power of the people, monetary policy is the power of the elites.”
Regardless of their education/information/understanding, the first priority of most voters is their own perceived well-being. However that often conflicts with the social and economic welfare of the nation as a whole. Furthermore voters seldom vote directly on the issues; rather they vote on personalities to represent them in government. One can only hope that elected officials act in the broad interests of the nation rather than their own personal interests. Unfortunately, under the influence of moneyed interests, the record has been pretty dismal in that respect.
Fiscal policy should be the primary means of ensuring the best economic outcome for the general public. However in our separation of powers type government, it is very difficult to establish coherent policy. Perhaps more important than taxes versus spending is the actual use of government funds. While paying for two wars and a bloated military edifice, Congress has virtually ignored the infrastructure that underpins the domestic economy.
Monetary policy is not an alternative to fiscal policy; it should complement fiscal policy, but often needs to compensate for the lack of coherent fiscal policy. Wise monetary policy can be difficult because of the lags in system, but it is much simpler to implement. The officials responsible are fairly well insulated from government politics by the length of the term they serve (14 years).
“Monetary policy is not an alternative to fiscal policy; it should complement fiscal policy,”
What do you then think of Bernanke sticking his nose into the fiscal side every chance he gets? Lamenting to the Congress that they have no “plans for reducing the budget deficit”. Is that complementary? No.
The problem with monetary policy “complementing” fiscal policy is that it gets Congress and the president off the hook. Instead of taking the political heat, they foist the problem onto the Fed, even though if the Fed can do anything it isn’t usually very salutary except for the vested interests they represent owing to intellectual capture at minimum.
@William Hummel :
William Hummel: “In reality the treasury can only spend what it has previously acquired through taxes and the sale of securities to the public.”
Some Guy: “No, this the reverse of the truth, and logically impossible. Where did the first dollar come from?”
Answer: The first dollar was created long before the modern fiat money system came into existence.
Thus the MMT model of a fiat money system being initially funded out of Treasury spending has no basis in reality.
“Thus” is a non-sequitur – which it must be, since the second sentence contains an impossibility. The “modern money” in modern monetary theory should be understood as in Keynes’ statement “modern money is 4,000 years old”. MMT applies to all (monetary) economies, because all (government) money is and always has been fiat money, credit money, debt. That artificial constraints like the gold standard, convertibility, etc were historically (relatively recently) imposed is not relevant to fundamental conceptual understanding. These are best understood as constraints imposed on the constraint-free essence, fiat money. To answer my question, the first US dollars were the Spanish dollars the US government recognized, as I think you would agree based on http://groups.google.com/group/understandingmoney/browse_thread/thread/8ff3345b8567a258/297316b2434de60f?lnk=gst&q=fetish#297316b2434de60f This was in essence the first federal spending, “where the first US dollars came from”. Federal taxation in US dollars was not possible before this.
… the Treasury creates the money it spends, which is untrue in normal times. No, this is true always, because it is true by definition. MMT defines Treasury (i.e. government) spending as creation of (government) money & vice versa.
The notion that payments to the government, e.g. tax receipts, are shredded by the Treasury must be viewed as a metaphor, not as reality. No, this notion is fundamental, natural and completely correct if you understand and use the MMT definition of what money is – credit – and you understand the fundamental capacity of money/credit/debt to be transferred and opposing debts to be cancelled against each other. The “shredding” – tax liabilities and tax receipts cancelling each other – is “what really happens.” Money is fundamentally not “a thing”, but credit, a social relation.
Of course for some purposes it may be helpful to think of it as a thing, which flows from one hand to another, even thinking of government money flowing in and out of the government, not being destroyed or created and only the net deficit/surplus being the creation/destruction of money. But this is a description on top of the underlying mechanics, a metaphor, not a reality, in your terms.
Neo-C(h)artalism/ Credit/State Theory of Money/Functional Finance/MMT is typical of developed mathematical/scientific theories, where everything flows easily from the definitions. These definitions may be hard to discover or grasp or take some historical effort to see how to apply to empirical phenomena, but once understood, are much simpler than previous, more familiar, perhaps more initially plausible theories. I was going to recommend Wray’s recent paper on Money until I saw you had seen it – http://groups.google.com/group/understandingmoney/browse_thread/thread/a968ee11e40e1ecb# This may look like “an exercise in semantics”, but then so is modern science.
“The “modern money” in modern monetary theory should be understood as in Keynes’ statement “modern money is 4,000 years old”. MMT applies to all (monetary) economies, because all (government) money is and always has been fiat money, credit money, debt.”
If MMT applies to monetary systems as old as 4,000 years, then it is poorly named. I think of “modern” in the context of contemporary. And I think of MMT as applying to the monetary systems of the major industrial nations today. Why else would anyone bother to develop and promote a theory of money?
“… the Treasury creates the money it spends, which is untrue in normal times…. No, this is true always, because it is true by definition. MMT defines Treasury (i.e. government) spending as creation of (government) money & vice versa.”
In other words, it must be true because MMT declares it to be true! Hardly. One cannot define something to be true when it is obviously false. The truth is that the Treasury cannot create the money it spends in most modern monetary systems. Only the central bank can do so. If one defines the “government” to include both the Treasury and the central bank, AND the central bank is free to lend to the Treasury at any time, then one can say the “government” creates the money it spends.
“The notion that payments to the government, e.g. tax receipts, are shredded by the Treasury must be viewed as a metaphor, not as reality…. No, this notion is fundamental, natural and completely correct if you understand and use the MMT definition of what money is”
I have offered a completely “natural” alternative to that model, which is entirely compatible with the economic goals of MMT. The flow of funds between the Treasury and the private sector is balanced and reciprocal. What the Treasury spends is all recaptured on average through taxes and the sale of securities when required. The reason I consider it to be a superior model is because (1) it is what actually happens, and (2) it is needed in the control of the short term interest rate on credit money. Credit money, not government fiat money, is what the economy mainly uses, and the cost of credit can only be controlled by the government through its monetary policy measures. Fiscal policy is too slow and crude a means of control.
I read Prof Wray’s recent paper and this started me thinking in the same direction wrt metallic standards/convertability; as far as those concepts being recently employed procedures (although the advocates of those metallic arrangements would lead you to believe otherwise), and it has in fact ALWAYS been about government sovereignty and authority as far as “money”. This is empirically supported by the archeological records of many Roman fiat coins shown to be counterfeited (but still made out of solid silver!), and the Roman use of “countermarks”, a form of secondary imprimatur, on their previously issued silver coins in certain cases when the govt changed over. It obviously wasn’t about the silver content with the Romans.
Here, I like your description (consider it stolen!) of metallic/convertabilty being another “self-imposed constraint” that was used recently in the west (without success). This form of self-imposed constraint is the same type of thing as, in William’s world view, that a govt/sovereign Treasury cannot run an overdraft in it’s OWN central bank’s account; needlessly self-imposed.
Here in the US we have this guy Ron Paul (a US Congressman can you believe it) running around advocating for use of the “gold standard” like it is some sort of historically credible, “conservative”, successful procedure or something, that is patently BS. Good post. Resp,
William, if you want to argue this position in more detail, discussions about monetary principles relative to MMT, such as you are bringing up, also go on at Warren Mosler’s, for instance, here. You might find some people interested in getting into this there, too, especially on active threads where there is a lot of current participation.
My main concern with what I have read on MMT is that it treats money almost exclusively as government-issued fiat money, i.e. the monetary base. It largely ignores the fact that a modern industrial nation operates primarily on credit money (bank deposits) issued through private bank loans.
As the ultimate form of money, the monetary base plays a vital but limited role in the economy. Aside from its “back office” role in the payment system, base money actually plays a minor part, mainly as wallet money in hand-to-hand payments. The amount of credit money far exceeds base money and is the key measure of liquidity. Thus aggregate demand is a function mainly of the stock of credit money.
The stock of credit money is determined endogenously within the private sector, as influenced by the short-term interest rate controlled by the central bank. The result is that aggregate bank reserves are also determined by the private sector, not by the central bank. Base money is injected into or removed from the banking system by the central bank only as needed to keep the interest rate in line with the target as set by monetary policy. Recognizing that the private sector runs on credit money, the Treasury balances its inflows versus outflows to avoid affecting total bank deposits on average. That results in a balanced reciprocal flow of base money with the private sector.
That’s the way it works, folks. If any advocates of MMT find it unacceptable, I’d like to know what changes they would propose.
“My main concern with what I have read on MMT is that it treats money almost exclusively as government-issued fiat money, i.e. the monetary base. It largely ignores the fact that a modern industrial nation operates primarily on credit money (bank deposits) issued through private bank loans.”
If that’s what you think, William, then you really haven’t read much MMT. I don’t see anything in your 4:42 post that isn’t already part of the core of MMT. Randy Wray wrote a book on endogenous money back in 1990, for heaven’s sake!
I’m always eager to engage in a serious discussion about economics. And it seems to me you are serious to challenge the MMT paradigma. I must yet read your website to fully understand your point. As far as I can opine right now I do not not understand your problems with MMT? For me this looks mostly like a semantic problem? But let me start with a question. You seem to have another idea where money originally came from. So is money a creature of the state (Abba P. Lerner)? What’s your take on this crucial issue?
” Thus aggregate demand is a function mainly of the stock of credit money.”
Would you consider that demand is a function of the flow (amount per unit time) measure of “money” creation and how the distributional aspects of said newly created money end up?
For instance what if ‘the stock of credit money’ is increasing but the entities in the economy that end up acquiring most of it have little propensity to spend it (they already have 3 homes, 5 cars, 2 boats, and a private plane, and only one mouth to feed)?
It seems to me that the flow measure (amount per unit time) and how it is distributed would have a lot to do with final AD. It has to be more than some stock measure of “money” in the system alone.
Endogenous money was understood before 1990. That was the main theme of Basil Moore’s book , “Horizontalists and Verticalists”. But endogeneity was not the point of my 4:42. Mosler’s latest book proposes a number of specific policy measures, all presumably consistent with MMT, but the entire focus was on government fiat money. The fact that the economy actually runs mainly on credit money in a modern economy was never addressed.
If you disagree with my representation in 4:42 on how a modern monetary system operates, then I would like to hear your objections. Most of the criticism so far has been over semantics. For example, it shouldn’t matter whether money is defined as a token or the credit it represents. They are two ways of referring to the same thing.
“I’m always eager to engage in a serious discussion about economics. And it seems to me you are serious to challenge the MMT paradigma. I must yet read your website to fully understand your point. As far as I can opine right now I do not understand your problems with MMT. For me this looks mostly like a semantic problem. But let me start with a question. You seem to have another idea where money originally came from. So is money a creature of the state (Abba P. Lerner)? What’s your take on this crucial issue?
I agree that the critique of my comments has been largely semantic in nature. I am sympathetic to the goals of MMT, and generally agree with many (but not all) of the arguments in support of the theory as I understand it.
I don’t think there is a simple answer to your question: is money a creature of the state? Certainly all modern industrial states issue their own currency, which is fiat by definition. However they also support fractional reserve banking and recognize bank deposits as money. Regarding Abba Lerner, I have never seen enough detail of the monetary system he proposes. As long as we have a two-tier system money (base money and credit money), I think we need to control the cost of credit. I don’t see how that can be done satisfactorily through fiscal policy alone. In a democratic government, fiscal policy is a political football, and it bounces in strange ways.
” Thus aggregate demand is a function mainly of the stock of credit money.”
“Would you consider that demand is a function of the flow (amount per unit time) measure of “money” creation and how the distributional aspects of said newly created money end up?”
Absolutely, the distribution of money is of primary importance in terms of how it impacts aggregate demand. I am now reading Robert Reich’s latest book “Aftershock” which deals eloquently with the role that maldistribution of income played in creating the conditions for the Great Recession. While the financial sector was the main culprit in the meltdown, the underlying cause as Reich explains was the squeeze on income of the large middle class since the late 1970s.
“For instance what if ‘the stock of credit money’ is increasing but the entities in the economy that end up acquiring most of it have little propensity to spend it (they already have 3 homes, 5 cars, 2 boats, and a private plane, and only one mouth to feed)?”
This is precisely what was wrong with the recent income tax compromise that Obama negotiated. The generous tax savings benefiting the top income earners will be largely wasted.
It seems to me that the flow measure (amount per unit time) and how it is distributed would have a lot to do with final AD. It has to be more than some stock measure of “money” in the system alone.
Agree, as noted above.
William, what you say about endogenous money being most numerous in the economy is true, and MMT’ers are quite aware of this, as well as about how banking works endogenously from an operational vantage. MMT’ers are neither ignorant of nor ignore endogenous money and its creation. They tend to focus attention on exogenous money because there is a great deal of misunderstanding about it at present, which they see as getting in the way of an effective and efficient approach to policy, specifically wrt unemployment and price stability, a principal focus of theirs.
It is also true that all final transactions are settled in HPM, that is, cash in the case of direct settlement or bank reserves in the case of indirect. Endogenous money goes proxy for HPM since endogenous money is created by banks (loans create deposits) and HPM is created exogenously by government operations (consolidating the operatons of the treasury and cb).
MMT’ers are also quite aware that government doesn’t control endogenous money since banks lend to creditworthy customers and obtain reserves later. Since the Fed is the lender of last resort and always provides reserves as required for settlement, it does not control the quantity of reserve directly, but rather it adjusts price through the target and discount rates.
What MMT’ers do assert is that following Abba Lerner’s principles of functional finance updated for the present (see Michael Forstater’s Reinventing Functional Finance) provide a more effective and efficient guide for achieving full employment with price stability than monetary policy iaw NAIRU, when a job guantee or employer of last resort program is added in order to provide a price anchor by anchoring the wage.
The fundamentals of MMT are set forth in L. Randall Wray’s book, Understanding Modern Money. Scott Fullwiler also sets forth the basics in a short article, Modern Monetary Theory – A Primer on the Operational Realities of the Monetary System. You might also wish to look at Warren Mosler’s Mandatory Readings, especially “Soft Currency Economics.” Warren also provides his recommendations for reforming the financial system, including banking, there.
I have read all the sources you cited, except for Mathew Forstater’s recent update of Functional Finance. None of them provide the sort of specifics I have been looking for, especially regarding the credit money supply. How is to be “managed” to meet the basic objectives of functional finance? Credit money being endogenous and the primary form of money in the economy, one must have a coherent system of dealing with that question. If you can provide a brief explanation, I would much appreciate it.
As you said, the focus in the literature has been primarily on government fiat money. I am quite familiar with the basic concepts involved even though my model differs from the spreadsheet (mathematical) model favored by the MMTers.
We’re quite aware of Moore. We know him and other horizontalists well. Horizontalists like Lavoie and Seccareccia are using virtually the same overall model as we are. There’s no difference on credit money. Horizontalism is completely integrated into MMT.
My point in mentioning Wray’s book is not to suggest that endogenous money started there (duh!), but rather to point out that if you haven’t seen credit money in MMT, you are about 20 years behind on the MMT literature. As another example, Wray/Bell edited a book in 2004 with an interdisciplinary group of authors (archaeologists, historians, sociologists) describing the history of both state and credit moneys.
William, the questions to be asking about aggregate demand have to do with source, that is the degree to which it is income-based or credit-financed, and the quality of debt if credit-financed, that is paid down, rolled over, or Ponzi. It is also important to examine why debt is incurred, as well as the type of debt. This is the Minskian aspect that lies at the core of MMT with respect to endogenous money. The GFC resulted from the financial instability that Minsky predicted. It was and remains the culmination of the long financial cycle that ends in Ponzi finance, which is in the process of unwinding.
As far as money funneling up goes, the Minskian solution is to tax away economic rent and discourage rent-seeking, which is parasitical since it is unproductive. Most wealth that collects at the top accrues from economic rent – land rent, monopoly rent, and financial rent – skimming the surplus. See Michael Hudson on this.
BTW, I inadvertently wrote Michael Forstater above, when it should have been Mathew. I had just been reading something by Michael Hudson and it apparently got mixed up in my mind. I got the “M” right anyway. Edward J. Nell & Mathew Forstater are co-editors of Reinventing Functional Finance: Transformational Growth and Full Employment
Instead of dancing around the subject, why don’t you explain briefly for my benefit just how MMTers deal with the management of endogenous money? I have yet to find any satisfactory explanation in the literature going back to Mosler’s “Soft Currency Economics” which I read in about 1995 when he sent me a copy.
How would MMT deal with endogenous money? All credit creation results in “money-ness” as potential claims on real resources, so both the institutional and shadow banking systems are involved. Warren Moser deals with this in his proposal for reform here.
The conventional approach is to try to deal with the asset side while decreasing regulation in general, and the MMT approach is to dea with the liability side of the balance sheet, as well as targeted regulation.
Let me ask a couple of questions to focus on the issue of credit money management.
Do MMT/Functinal Finance advocates propose to set the interbank lending rate (Fed funds rate) at zero?
If so, what mechanism(s) will be used to limit the growth of the credit money supply?
William: “As you said, the focus in the literature has been primarily on government fiat money. I am quite familiar with the basic concepts involved even though my model differs from the spreadsheet (mathematical) model favored by the MMTers.”
The MMT’ers in general use the SFC (stock-flow consistent) macro modeling approach developed by Wynne Godley and set forth in detail in Godley & Lavoie, Monetary Economics (2007), as I am sure your are aware. (I am stating things with which you are likely already familiar since others may be reading this at some point.) In general, MMT’ers are distrustful of economic models based on untested assumptions. SFC models differ since they are based on readily available data/projections and national accounting identities. I am neither a economist, nor do I work in this field, so wading through these large SFC models is something I haven’t done. I have simply attempted to get a handle on what they are driving at, and what I have come up with is that they use such models to determine whether the system is working effectively and efficiently, as well as for discovering areas needing improvement.
As you undoubtedly are also aware, there are movements afoot both to end private banking altogether and also to end the Fed and get government out of money creation, too. Conversely, MMT is fine with the dual structure of exogenous and endogenous money creation now in place but would like to see it improved by removing inefficiencies. MMT’ers generally believe that the banking system is best qualified to assess creditworthiness and extend credit, rather than government. So they are quite concerned with getting endogenous money creation and its effects right.
MMT’ers emphasize that banking is a public/private partnership oriented to public purpose, like a public utility. Problems arise in banking and finance for essentially two reasons. First, there are holes in the system through which excessive rent can be extracted that need to be plugged, and there are also poorly designed incentives that encourage bad behavior relative to the public purpose that banking serves.
The MMT’ers working in this area are recommending a fiduciary model to replace a loose agency one, since as Bill Black has observed, agency is where the problems arise in finance. Therefore, banking and finance should be subject to scrutiny and regulation in a way that private business is not. The present crisis reveals that reform is much needed. Randy Wray and Bill Black are coming down hard on control fraud, for example, calling for BoA to be put into resolution immediately. They are especially concerned with the TBTF’s, which comprise the bulk of US banking. In their view, preferential treatment of the TBTF’s is giving them an edge over the rest of the banking system, which is generally well managed. This is a problem for the economy both because the TBTF’s are less efficient than the rest of the system and also because of the moral hazard involved with size.
Moreover, those teaching at University of Missouri at Kansas City are holding themselves out as “the Kansas City School” rather than strictly MMT. This includes Profs. Wray, Black and Hudson, all of whom are quite involved with issues relating to money and banking, and the US (and global) banking system. It is clear from their writings that they regard the present system as essentially corrupt, not to mention ill-designed for its purpose in intermediation and capital allocation.
A lot of these things don’t show up in mainstream models. But those with deep knowledge of the financial system as well as where criminogenic conditions were developing, especially at the Ponzi stage of the long financial cycles, had been warning for some time that things were amiss and needed the attention of regulators. These warnings went unheeded, and the normal models indicated that everything was going just fine – as Greenspan famously said, just a little regional frothiness that would work itself out.
William: “Do MMT/Functinal Finance advocates propose to set the interbank lending rate (Fed funds rate) at zero If so, what mechanism(s) will be used to limit the growth of the credit money supply?”
I don’t know about all MMT’ers, but I believe that Bill Mitchell and Warren Mosler would set the overnight rate at zero, and then use fiscal policy rather than monetary policy to inject or withdraw nongovernment net financial assets as conditions warrant, using the employment rate as the key measure.
The basic thrust of MMT is achieving full employment with price stability using fiscal policy as the chief tool. The claim is that fiscal policy can be tightly targeted whereas monetary policy cannot.
Its objection to monetary policy is twofold. First, monetary policy is a blunt instrument that cannot be targeted. Secondly, the present execution of monetary policy uses unemployment as a tool instead of a target.
Now I am quite aware of the objection that fiscal policy is impractical for political reasons, as well as the view that monetary policy can be effective. Rodger Mitchell has been making this point for some time. We have gone around and around on this here on this blog on a number of occasions, and the MMT’ers are sticking to their guns. I don’t think you will change any minds here at this point. But you will find an ally in Rodger anyway. 🙂
I appreciate the objection, and I agree that at this level of divisiveness in US politics broaching anything to do with fiscal policy is doomed to failure. However, the MMT position is that an MMT solution would not be be adopted anyway without the people in charge understanding how the modern (post-1971) monetary system actually operates and what this implies for policy. If people understood operations, then we could have a debate over viable policy options rather than ideology.
MMT’ers would also point out that Art Laffer crafted Reaganomics on this basis, so to a great extent this knowledge of monetary operations has already been in place and operative when the GOP has been in power. They are just not letting on, although Dick Cheney did let it spip out that deficits don’t matter. They have just used deficits for their purposes, such as increasing the military and engaging in wars of choice. The deficit hawkery coming from the GOP establishment is just nod to the nutter base, as well as a ploy to cut social programs they oppose as “socialism.”
How can I be dancing around an issue you hadn’t yet asked about? You were suggesting that MMT didn’t understand credit money, and I was pointing out that wasn’t true (in fact, the MMT understanding seems to be much like yours, near as I can tell). Now you’ve changed the subject to regulation of credit money. OK, fine, no problem.
Regarding managing credit creation and asset price bubbles, there’s a lot there–start with Minsky. Wray was his student.
Bill has some posts here on a basic approach to banking, but I can’t find them because I don’t recall the dates. Perhaps someone else can and will link to those posts.
Tymoigne, WRay, and Kregel have published much on this issue the past few years on the Levy Institute’s site. I haven’t seen anyone with a better grasp of this than these three.
Basically, the approach is to manage credit creation through strong oversight and adjustment of credit terms (there’s more, and lots of nuances, but that’s the nutshell explanation). Short-term interest rate target changes don’t work very well for managing credit creation (very blunt instrument, as is well known), and manipulating them can bring Minskian instability, as well. Fiscal policy should also be strongly countercyclical, via good automatic stabilizers as much as possible.
For instance, as I think RSJ suggested, introduce an asset-based tax for banks. A tax of 3% would increase funding costs for banks by 3%.
Sergei and William (and RSJ),
Tom Palley suggested asset-based reserve requirements over 10 years ago, which have virtually the same effect as the asset-based tax. I haven’t seen other MMT’ers explicitly suggest this, but my view is that their approach would yield much the same outcome. That’s a much better approach then manipulating the overnight rate. At the same time, it is true that most of the MMT literature on this deals with managing/avoiding systemic risk, not managing aggregate demand.
In http://neweconomicperspectives.blogspot.com/2010/02/warren-moslers-proposals-for-treasury.html, Mosler has proposed specific changes to the US financial system. Many of them are simply aimed at eliminating the inefficiencies and high risk practices in banking that now exist. I assume they are consistent with the goals of functional finance. However there are some whose practicability and/or logic I question.
I agree with his rules on bank lending and on the types of assets they should be allowed to hold. However some of his proposals appear to be mutually inconsistent. For example he proposes to cease all issuance of Treasury securities and let deficit spending accumulate as excess reserves balances at the Fed. Over time that would build up a huge excess of reserves in the banking system. At the same time, Mosler would require the Fed to lend unsecured to member banks in unlimited quantities at its target Fed funds rate by simply trading in the Fed funds market. However with the abundance of excess reserves, there would be no Fed funds market unless it paid on Fed funds. Fed funds would then trade at or about that interest rate. But elsewhere he proposes to make permanent the current zero interest policy.
By allowing reserve balances to grow without limit and paying interest on them, banks would enjoy a very generous free lunch which in my view is totally unacceptable. If no interest is paid on reserve balances, the Fed funds rate would be zero, which then raises the question — what would limit the issue of bank credit, other than bank capital which can grow with retained earnings and new investments in bank shares? I can’t find anything in Mosler’s writing that answers that question.
Even assuming optimistically that Congress could get its act together on a continuing basis, I don’t believe fiscal policy alone could simultaneously control general price inflation and create continuous full employment. However I am ready to be persuaded otherwise if someone can offer a coherent plan.
I wouldn’t play down the differences. Asset requirements are not the same as a broad based asset tax. And at least from the readings on Mosler’s site, the purpose of his credit requirements and the like are to ensure that loans are repaid, which has nothing to do with what I’m talking about. I’m suggesting that a direct numerical minimum floor be set under the opportunity cost of extending a loan, not just to manage aggregate demand, but to prevent resources from being marshaled for less than their best use.
That direct numerical cost can take the form of a 3% FedFunds target, or a 3% asset tax, but both examples would be opposed by MMT.
At the end of the day, the economy will either produce capital goods or consumption goods, and it will produce whichever goods is more profitable. The opportunity cost of producing capital goods is never zero in real terms — it is the cost of the foregone consumption.
But if you make it possible to borrow to create capital goods as long as the loan is repaid with 0% interest (after adjusting for default risk), then regardless of the (real economic) opportunity cost of creating capital goods, it will be financially more profitable to create capital rather than consumption.
Whether this results in high consumer prices or high asset prices with growing income inequality doesn’t really matter. At the end of the day, less consumption will be delivered to households and living standards will fall, not to mention asset bubbles or a misallocated capital. None of this has anything to do with credit risk of the banks, balance sheet quality of the banks, or even managing aggregate demand. It has to do with not distorting relative prices in the non-financial sector. It doesn’t seem to me that the MMT side as espoused here has ever acknowledged that even apart from default risk, that there is a real non-zero opportunity cost to creating more money, and that the government needs to make sure that banks pay this cost before creating more money.
And I would add that fiscal policy to address the discrepancy wont really work.
Yes, you can, by means of increasing taxes, lower the income of households so that as the economy shifts from producing consumption to producing capital, price inflation is kept stable.
Nevertheless, you are still taking consumption opportunities away from households because resources are allocated towards producing the things that banks will lend against rather than producing things that households will consume.
The household sector is still suffering from less consumption than the optimal amount, and fiscal policy isn’t going to help.
The only way to address this imbalance is to make sure that borrowers are not able to pull resources away from the production of consumption unless they pay some minimal cost for doing this, and this cost is going to be more than just the default risk of the borrower.
It seems like you’re defining the current legal framework as a benchmark for what’s ‘best’.
Why 3%, why not 7% or 85%? Wouldn’t each rate produce a distinct mix of consumption vs. investment that reflects what the markets decides is ‘best’ in light of precisely that rate? The way I’ve understood MMT, ‘best’ is a market determined result of the costs imposed, not some exogenously determinable distributional mix that must subsequently be ‘met’ or ‘reflected’ in a (politically) set rate. Distortions and instability arise not through the wrong rate but through inherent uncertainty (nothing one can do about that except to keep rates stable), bad regulation and/or fraudulent practice, (both of which must be dealt with legally). That holds whether the rate is 0% or 99%. Of course, at 99% there wouldn’t be much lending left to regulate, but that doesn’t make it better or worse – it’s just a politically motivated ‘starve the beast’ statement. The question is, why should the rate be any other than 0%?
Would the prices of consumption goods relative to capital goods not reflect that opportunity cost, no matter what the nominal base rate says? Isn’t that what markets are supposed to do?
It seems to me that MMT distinguishes between political and economic by placing the prior hierarchically above the latter, the preferred policy tool being fiscal, not monetary for reasons mentioned above. To me, this makes the argument less circular, but I’m still not 100% certain that also means it reflects or reacts to reality in any ‘better’ way. Maybe reality is circular. Oh well…
1. reserves are a ‘bank tax’ and not a free lunch, regardless of the interest paid on reserves.
2. with the liability side of banking not the place for market discipline, and no operational limit to credit expansion, regulation comes to bear on the asset/capital side of banking as per my proposals:
warren mosler says:
Tuesday, January 25, 2011 at 4:43
“1. reserves are a ‘bank tax’ and not a free lunch, regardless of the interest paid on reserves.”
Suppose for example under QE2 the sellers of securities to the Fed deposit the proceeds in Wells Fargo. The Fed credits the bank with $50B in new reserves. If the Fed pays interest of say 4% on Fed funds, the bank will receive $2B per year from the Fed for simply being a depository. Why is that not a free lunch for the bank?
“Why is that not a free lunch for the bank?”
Because you will take your deposit to a bank which will pay you 3.99%. And as long as there is some competition you will be able to secure your deposit %. And 0.01% service fee is what banks can get as intermediaries.
“Suppose for example under QE2 the seller of securities to the Fed deposits the proceeds, say $50B, in Wells Fargo. The Fed credits the bank with $50B in new reserves. If the Fed pays interest of say 4% on Fed funds, the bank will receive $2B per year from the Fed for simply being a depository. Why is that not a free lunch for the bank?
“Why is that not a free lunch for the bank?”
Sergei answered: Because you will take your deposit to a bank which will pay you 3.99%. And as long as there is some competition you will be able to secure your deposit %. And 0.01% service fee is what banks can get as intermediaries.
If paying interest on reserves is a bank tax, the bank would not accept the deposit unless it could pass the tax on to the borrowing public, in which case the tax would be on the public, not the bank. The bank would end up with a profit equal to the net return on its loan to the public, made possible by virtue of the reserves acquired at no cost through the QE2 program.
My mistake, I should have said: If *reserves* are a bank tax, a bank would not accept a new deposit unless it could pass the tax on to the borrowing public, in which case the tax would be on the borrowing public, not the bank. If the Fed paid interest on reserves as the means of controlling the short-term interest rate on bank loans, the bank would end up with a profit equal to the net return on its loans to the public, made possible in this case by reserves acquired at no cost through the QE program.
It seems to me the same rationale applies when the government deficit spends, assuming the Treasury ceased selling securities to cover. In either case, if the Fed paid no interest on reserves, there would have to be some independent means of limiting the growth of bank credit. Leaving that to fiscal policy is not a viable option in my opinion.
The liability side of bank balance sheets is exactly the place for market discipline. Only someone believing that banks should be able to earn rents would argue otherwise.
RSJ, rents can be taxed.
It is just another view on institutional structure of the financial system. The amount of efforts that banks waste on ALM gives at least one real reason to consider alternatives. You can not argue a priory that this is bad and that is good. However I agree that “demanding” unlimited liquidity without discussions of all related and obvious issues is just plain wrong and short-sighted. Such proposals simply kill the idea before it even learns how to walk.
Households demand a return for their deposits. If banks do not compete to offer competitive CD and savings rates, then this is effectively price-fixing in order to subsidize banks. Banks must know that unless they offer competitive rates, they will need to tap the wholesale funding markets. They must never be allowed to access government lending facilities as an alternative to offering competitive rates. That’s what Mosler wants — along with government bailouts, and it’s what anyone who isn’t a banker should oppose.
I see no problem to pay households risk-free inflation adjusted rates on their deposits assuming free retail savings accounts at the central bank. No doubt current level of technology permits it with any bells and whistles you can imagine.
We can even have the best of both worlds and make sure banks compete for wholesale funding which will then include full credit risk. At the end of the day one can say that households save in cash (yes, stretched but effectively true) and cash comes from central bank. And then loans create deposits meaning that overall banking system is in principle balanced. So funding is about redistribution of those deposits and redistribution means competition. Just take households out of this competition. There is no social or economic value in it.
That too uncollateralized, because there is no government securities to begin with in the picture.
” If the Fed paid interest on reserves as the means of controlling the short-term interest rate on bank loans” > I think they are already doing that. Bernanke has said that they are currently paying the support IOR rate so as to keep the market for fed funds running despite all of the excess reserves currently in the system from the Fed programs.
” its loan to the public, made possible by virtue of the reserves acquired at no cost through the QE2 program” > This reads like ‘banks lend out the reserves’, I’m not following you here. Would not banks be constrained by capital as to the amount of lending they can do as presently? I dont see how QE2 can increase a banks ability to lend? Are not loans and reserves both on the left side of a banks balance sheet?
(Nothing that follows has to do with the discussion running … )
“Capital constrained” can be used with different meaning.
Several senior Post Keynesians have tried to make points on this issue and written at length. Such as: banks shouldn’t be looked at as asset allocators. Lending being constrained by capital is like sneaking in Neoclassical economics through the back door. So one talks of a capital multiplier sometimes. As if borrowers are waiting outside a queue and are rejected not because they are not creditworthy, but because the banking system has less capital. There is money scarcity in this picture.
Except the recent crisis, there is hardly any evidence that banks have been constrained in lending. (Even here is not done if put it in this simple form of stating it). The constraint is always on the demand side. Of course, to make it more complicated, banks themselves have their animal spirits and this may reduce exactly when the animal spirits of borrowers increase.
One single bank can lend a lot and end up being ‘constrained’ though higher income will take it back from that ‘constrained’ state. It has the choice of tapping the financial markets. Also, when this bank has captured the market, others have more capital.
It is known to some New “Keynesian” economists that banks hold excess capital and they have wondered why. Forgetting the fact that there is lack of creditworthy demand. Capital doesn’t decide how much borrowing there is in the economy. Thats like Say’s law. The opposite is true. Demand creates its own supply.
“One single bank can lend a lot”
A single bank can create an infinite amount of its own deposits – restricted only by the borrowers on the doorstep they are prepared to accept and the acceptability of their deposits as money.
William Black made the point that banks can concoct capital if they need to which sidesteps capital regulation over on New Economic Perspectives: http://neweconomicperspectives.blogspot.com/2011/01/why-our-fundamental-approach-to-banking.html
I think I read you here. Bank capital could never be expected to act as an effective systemic “throttle” for lending as any individual bank can always go get more capital. But then, can we expect policy interest rates to be effective either? I think not.
WM in fact makes the opposite argument that as policy rates increase, the flows from the govt to non-govt sector govt debt holders can increase and interest incomes can be greatly increased which just “fuels the fire”, (btw with the latest policy rate increases in India, do you look for this effect there currently? Does the Indian govt have a lot of Treasury debt out there that may start to re-set at higher rates and increase the interest incomes of local debt holders there ? Things may really start to take off for you folks over there….)
What about an effective regulatory regime that uses the “asset side”? One that truly wipes out the equity holders if they make bad loans and jails the fraudsters? I think this is what WM means when he says “the liability side is NOT the place”…
” its loan to the public, made possible by virtue of the reserves acquired at no cost through the QE2 program”
> This reads like ‘banks lend out the reserves’, I’m not following you here. Would not banks be constrained by capital as to the amount of lending they can do as presently? I dont see how QE2 can increase a banks ability to lend? Are not loans and reserves both on the left side of a banks balance sheet?
Banks don’t lend reserves to the borrowing public. However a bank must hold enough reserves to cover a loan since it may have to surrender that much in reserves to another bank when the borrower spends the funds.
The huge excess of reserves created from the purchase of securities by the Fed under QE has resulted in a corresponding increase of deposits in the banking system. As Sergei pointed out, depositors seeking the best return on their funds, will cause the excess reserves to be redistributed within the banking system at a cost to individual banks nearly equal to the interest paid on them by the Fed. I was mistaken in saying banks were enjoying a free lunch due to the interest paid on the excess reserves. However I don’t think I implied that QE increased the ability of banks to lend. Banks in good standing can always borrow what they need to meet the reserve requirements and cover their loans.
The current supply of excess reserves is probably an order of magnitude greater than will ever be used or needed to support bank lending. On the asset side, capital adequacy would be a constraint on bank lending if we had proper regulation by the authorities. Relatively few banks actually operate at that limit. However the mega-banks use all sorts of artifices to reduce their official assets-at-risk in order to satisfy the capital adequacy constraint. Hopefully much of that subterfuge will be ended by a new era of bank regulation, but don’t hold your breath.
Yes borrowing is demand-led. There are some nice articles about PKEists writing on New Keynesians about the latter’s models on lending. Can’t find them. Will try to find a few to link. New Keynesians understand there is no multiplier and money is endogenous but because the money multiplier is built into their mental system, they end up making a lot of mistakes.
The government sector is a big sector and the control of demand is in its hand. If the central banking is trying to increase rates and if the government sector is simultaneously creating more demand, the central bank’s policy won’t work (borrowing won’t reduce). On the other hand if the central bank is reducing rates and the government is reducing demand, it won’t work either (borrowing won’t increase).
The question of how much effect interest rates have is not so straightforward. While it is true that that more interest income goes to the private sector, its possible that the interest income goes to the rentiers. On the other hand, increasing interest rates also increases prices because it adds to producers’ costs and the price increase causes demand to decrease. This process is interesting because raising interest rates causes prices to go up a little and that reduces demand in a ceteris paribus sense and increases unemployment and controls prices.
Also when the public debt starts rising due to increase in interest payments from the government sector, they tighten policy or at least are austerity-biased.
So its a complicated question and the answer depends on which variables one is assuming to be held fixed when one is thinking of these things and hence situation-specific.
However high interest rates are bad for employment is a reasonable to be called a stylized fact.
India is suffering inflation due to many factors such as shortage of food – which may well be the result of hoarding. Its also due to rising commodity prices due to the financial world speculating on them. Prices can only be controlled by direct political intervention and Indian case proves the point. The central bank action can’t do much. I however believe that asset prices (property) can be prevented from inflating by central bank action not just by regulation but by interest rates.
Major error in this diagram, though it’s not essential to the text (which is about how to analyze government operations). I think it’s important though. The private financial sector is capable of creating money, even under a “government-issued’ money system. Consider the conversion of mortgages into “AAA” MBS and the conversion of MBS into money market investments. The conversion of illiquid loans to liquid money can be expressed as “increasing the velocity of money” or as increasing the monetary base, but it amounts to the same thing. When banks lend money against existing collateral, they replace long-term illiquid assets with money. The bank is not generally required to replace the money with “real money” from any other source, unless the assessed value of the collateral drops.
To put in the same “accounting” terms MMTers like to use: when a bank lends money against an existing paid-off house, it credits the borrower with a balance in his bank account, and it credits the bank with the future title to the property and/or future payments from the borrower. The central bank and the bank regulators shrug their shoulders, but the bank has *just manufactured money*.
This is too oversimplified. You need a version which can account for the behavior of banks.
It is simply false to say that the financial sector transactions all net out to zero. In terms of *money* they do not. The financial sector can manufacture money *even without the assistance of the central bank* (by recording long-term loans against demand deposits) and it can destroy money (by calling in long-term loans and hoarding reserves at the central bank; or by recording short-term loans against long-term income streams if they’re allowed to get away with it — the banking regulators usually prevent THIS one, as it’s called “illiquidity”).
Fundamentally, there is a principle that money doesn’t exist if it isn’t being spent. The “tin shed” describes the way the private sector can remove money from circulation, with the intent to reinject it later; but it doesn’t cover the fact that *one portion* of the private sector, the banks, can inject money *without* putting it in the tin shed first. The claim is that this money will be repaid in ‘the future’, but in fact it may or may not be (in the case of bankruptcy, it isn’t) — in any case it affects the economy right now.
Fundamentally, “all transactions net to 0” in that left box is false. Private banks, and even other corporations with sufficient “financialization”, can engage in plenty of shenanigans which amount to the creation of money. These have a tendency to BLOW UP as trust in the private money evaporates — such as the money market fund freezeup after the 2008 crash — but there’s no denying they can create private money (medium of exchange, at least among big companies/store of value), albeit denominated in the same unit of account as the public money. I think it’s not a coincidence that the boom in the private money business in the US coincided with the “surplus mania” of the Clinton years; if the government isn’t supplying the demand for money, someone else will, and they’ll do a worse and less responsible job of it.
Speaking of bankruptcy, it also has to be accounted for. Private bankruptcies have a meaningful effect on the money supply when the bankrupt entity was printing money, as it results in the elimination of that private money. Hence, the Lehman Brothers bankruptcy mattered (printing “commercial paper” used in “money market” accounts!) and the GM bankruptcy did too (same reason).
The moral of this is that private entities can and will create money and you should put that in your diagram.
That simply means “The banks are not in the mood to lend”. Modern megabanks do no actual creditworthiness analysis and are basically scam shops who are trying to create debt slavery.
Which is really the biggest underlying problem; any solution which attempts to work through a bunch of criminal scam shops isn’t going to work, which is why any solution must cut the megabanks out of the picture. Sigh.
Dear Nathanael (at 2011/04/02 at 3:56)
There is no error in the diagram. You just haven’t understood the point. No-one denies that the private sector cannot create “money” in its own right. The whole analysis is in terms of net financial assets. The private financial sector, unlike the government, cannot create net positions overall.