Paul, its time to update your textbook

Textbooks get out of date and need revision in the light of recent data or events. Some textbooks are exposed as being just plain wrong and should be re-written completely. Obviously authors in the latter category are reluctant to admit that their textbook is not an adequate description of the way – for example, the economy works – and so they not only resist updating their offering but they also defend it against all the evidence. Anyway, after reading Paul Krugman’s most recent attempt to come to grips with Modern Monetary Theory (MMT) I concluded that it was way past the date that he should be rewriting his macroeconomics textbook. Otherwise he is misleading the students who are forced to use it in their studies. So Paul, its time to update your textbook.

The interchanges between Paul Krugman and MMT were last covered in my blog from last Friday (August 12, 2011) – To challenge something you have to represent it correctly.

Paul Krugman has decided to have another go at illustrating what he considers to be deficiencies in MMT in his August 15, 2011 blog – MMT, Again – and there has been some progress.

Now the debate is clearly about inflation/hyperinflation rather than solvency. I consider that progress. He clearly agrees that a national government that issues its own currency can never become bankrupt in terms of liabilities accumulated in that currency.

It means the debate is on more sensible ground rather than having to listen to critics who think a sovereign nation has run out of money. As I note below, one of the current crop of (hopeless) Republican candidates is against extending unemployment benefits in the US because the country has “run out of money”.

So by rejecting that stupidity and pushing the debate into the realm of what happens when aggregate demand is growing we have the basis of a more sensible interchange and one that can explicate the basic ideas of MMT relative to the mainstream macroeconomics.

The problem is that Paul Krugman, despite being one of the more reasonable commentators in the press with regard to the current need for more fiscal stimulus in the US (and elsewhere) still overlays a mainstream understanding of the monetary system onto his analysis and is seemingly “progressive” only because he considers the current period to be a “special case” (his liquidity trap obsession).

In his view, it is the special nature of the current situation that justifies quite aggressive fiscal action but in more “normal” times such action will be unsustainable and deficits become the problem.

The errors in his analysis (and depiction of MMT) are easy to highlight. When I read his most recent blog I decided to leave it go – how many times can you say the same thing? But many readers have asked me to address the issue – as if they think his view has some credence.

Paul Krugman says that:

In a way, I really should not spend time debating the Modern Monetary Theory guys. They’re on my side in current policy debates, and it’s unlikely that they’ll ever have the kind of real – and really bad – influence that the Austrians have lately acquired. But I really don’t feel like getting right back to textbook revision, so here’s another shot.

As above – it is past the time that Paul’s textbook should be revised.

As a matter of clarification. I am often asked by journalists and radio interviewers questions along the lines of “where has MMT been tried?” as if it is a regime that can be implemented. That sort of intent is echoed in the above quote – if we ever get our way we might be dangerous but not as bad as those loopy Austrian School types who now parade as Tea Party activists (although I am not sure that there is a 100 per cent overlap given that the views of the Tea Partiers are almost incoherent and difficult to catalogue).

The point is that MMT is a depiction of the monetary system we mostly live in – in the US, Australia, Japan, the UK and almost everywhere else. It isn’t a matter of waiting for it to be implemented – the system we explain is already operating. The problem is that the way in which the mainstream macroeconomists (and the vast majority of the journalists) represent this monetary system is at odds with reality.

Mainstream macroeconomics make erroneous conclusions because it doesn’t capture the essence of the monetary system and the behaviour of individuals and institutions within it. So you get ridiculous statements like “cutting spending increases spending” which then gain political traction despite the obvious evidence that cutting spending damages growth and increases unemployment.

Paul Krugman poses an example to demonstrate how the method of “financing” the deficit matters. Let me categorically say the following: a national government that issues its own currency does not need to “finance” its spending. It makes no sense to think otherwise. Such a government is not a household that uses the currency issued by the government. Users of the currency are always financially constrained and have to fund their spending either by earning income, running down savings, borrowing or selling prior accumulated assets.

A sovereign government is not remotely like that. So all the so-called “financing” operations that lead people to think they are funding government spending (tax collections; debt issuance; privatisation) etc serve other functions in a fiat monetary system.

A basic primer of these functions is provided in the suite of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3.

Paul Krugman says:

But I do get the premise that modern governments able to issue fiat money can’t go bankrupt, never mind whether investors are willing to buy their bonds. And it sounds right if you look at it from a certain angle. But it isn’t.

Let’s have a more or less concrete example. Suppose that at some future date – a date at which private demand for funds has revived, so that there are lending opportunities – the US government has committed itself to spending equal to 27 percent of GDP, while the tax laws only lead to 17 percent of GDP in revenues. And consider what happens in that case under two scenarios. In the first, investors believe that the government will eventually raise revenue and/or cut spending, and are willing to lend enough to cover the deficit. In the second, for whatever reason, investors refuse to buy US bonds.

We can accept this as an extreme example. The current US government spending is not equal to 27 per cent of GDP. The averages since 1950 have been around 20 per cent with tax revenue averaging about 18 per cent of GDP per annum.

Currently spending is around 25 per cent of GDP but that is because private spending has dropped markedly in recent years.

I realise that organisations such as the US Congressional Budget Office are forecasting much higher public spending as a percentage of GDP as a result of demographic change but they also the private capacity to spend will be lower because more people will be living on public pensions.

But whatever the reality is in the future the actual numbers involved are largely immaterial to the conceptual discussion.

So two scenarios:

1. The national government matches its net spending (deficit) dollar-for-dollar with debt issuance.

2. The national government does not match its net spending with debt issuance – that is, it doesn’t borrow but uses its intrinsic currency monopoly to spend without any accompanying monetary operation (selling debt).

As to the first scenario he outlines, you can see the mainstream roots poking out in his statement that the bond markets will only lend because they thing that the “government will eventually raise revenue and/or cut spending”. The reality is that the bond markets will lend because they want a stake in a risk-free (guaranteed) annuity. They enjoy the corporate welfare benefits that bonds provide – a risk-free assets in troubled times, a risk-free asset to price the risk embodied in their other private assets off. a guaranteed income.

Bond markets cannot get enough government debt in sovereign economies (that is, excluding the EMU) with stable political systems. They know there is no solvency or default risk.

Given that the US government (like most governments) have run budget deficits 85 per cent of the time since 1930, you would be rather foolish to think that they would regularly increase taxes and/or cut spending to run surpluses so they could “pay back” the outstanding debt. As I have noted often, governments rarely pay back debt (from a macroeconomic perspective) which is to say they do not continually honour specific debt liabilities as they mature.

Of the two scenarios, Paul Krugman then concludes that:

The second case poses no problem, say the MMTers, or at least no worse problem than the first: the US government can simply issue money, crediting it to banks, to pay its bills.

Yes, that is so – MMT doesn’t have a problem with this. One reason why this isn’t a problem is that the scenarios are not distinct in the way Paul Krugman thinks they are.

In this blog – The consolidated government – treasury and central bank – I explain that you have to take a consolidated approach to government in the first instance 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.

Considering the central bank to be independent and not part of government is a highly misleading basis on which to understand its operations and how they link with treasury operations.

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).

So when you consider the way the monetary system works from this perspective you quickly realise that the treasury operations are intrinsically linked to the central bank operations.

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 balances in the reserve accounts held by private banks with the central bank. Spending adds reserves while taxation drains them.

As I will explain in more detail below, in the first scenario the government is just borrowing back its own spending. The accounting for this involves shifting balances from central bank reserves to some “bond account”. Upon matury, the reverse transaction occurs.

Logically, we cannot loan the government its own currency until it has spent it. Bank reserves have to exist before the government can borrow from them.

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 reserve balances held by the private banks at the central bank.

So, if the government also issues debt $-for-$ to match its deficit then the impact on the reserve balances is neutralised as noted above. Mainstream textbooks (such as Paul Krugman’s text) 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.

So the two scenarios are rather blurred. In the second case, the central bank does not shift the added reserves into a “bond account” and depending on other monetary policy parameters has to address the consequences – as I will explain next.

Paul Krugman then seeks to tease out what he thinks “happens next”:

We’re assuming that there are lending opportunities out there, so the banks won’t leave their newly acquired reserves sitting idle; they’ll convert them into currency, which they lend to individuals. So the government indeed ends up financing itself by printing money, getting the private sector to accept pieces of green paper in return for goods and services. And I think the MMTers agree that this would lead to inflation; I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue.

For it is. And in my hypothetical example, it would be quite likely that the money-financed deficit would lead to hyperinflation.

And at that point you realise how mainstream Paul Krugman really is in his representation of the operations of the monetary system.

Why is this wrong?

Banks do not lend reserves as depicted. Underlying the Krugman narrative is a view of banks. They are conceived to be financial intermediaries who desire to maximise profits and take in deposits to build up reserves so that they can then on-lend the deposits at a higher rate. If the bank doesn’t have “reserves” it cannot lend – so goes the story.

However, the way banks actually operate is nothing like this depiction. They certainly seek to maximise return to their shareholders. In pursuing that charter, they seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share.

At present the lending standards are higher than they were at the peak of the last cycle.

Do banks need reserves to lend? The mainstream view is that reserves are deposits that haven’t been lend yet. All the standard macroeoconomics textbooks speak in those terms.

But banks do not lend reserves. The role of bank reserves is different. The commercial banks are required to keep reserve accounts at the central bank. These reserves are liabilities of the central bank and function to ensure the payments (or settlements) system functions smoothly. That system relates to the millions of transactions that occur daily between banks as cheques are tendered by citizens and firms and more.

Without a coherent system of reserves, banks could easily find themselves unable to fund another bank’s demands relating to cheques drawn on customer accounts for example.

Depending on the institutional arrangements (which relate to timing), all central banks stand by to provide any reserves that are required by the system to ensure that all the payments settle. The central bank charges a rate on their lending in this case which may penalise banks that continually draw on the so-called “discount window”.

Banks thus will have a reserve management area within their organisations to monitor on a daily basis their status and to seek ways to minimise the costs of maintaining the reserves that are necessary to ensure a smooth payments system.

The interbank market (say the federal funds market in the US) functions to shuffle the reserve balances that the member (private) banks keep with the central bank to ensure that each of these banks can meet their reserve targets which might be simply zero balances at the end of the “day”. I have put “day” in inverted commas because we should think that the central bank polices its reserve requirements per day. They requirements are usually expressed over some period of weeks rather than days and are averages. But that is a complication we can avoid here.

So we might qualify the statement that banks do not lend reserves. In a sense, they can trade them between themselves on a commercial basis but in doing so cannot increase or reduce the volume of reserves in the system. Only government-non-government transactions (which in MMT are termed vertical transactions) can change the net reserve position. All transactions between non-government entities net to zero (and so cannot alter the volume of overall reserves). I explain that in deficit suite referred to above.

This is how the actual system operates. And it helps to understand why budget deficits place downward pressure on interest rates – which is contrary to the mainstream macroeconomics textbook depiction captured by “crowding out”. I will come back to that below.

The important point that when a bank originates a loan to a firm or a household it is not lending reserves. Bank lending is not easier if there are more reserves just as it is not harder if there are less. Bank reserves do not fund money creation in the way that the money multiplier and fractional-reserve deposit story has it.

MMT notes that bank loans create deposits not the other way around. Reserve balances have nothing to do with this – they are part of the banking system that ensure financial stability.

These loans are made independent of their reserve positions. So while the bank organisation will include a reserve management division it also will have a loan division. The two are functionally separate and the latter does not correspond with the former prior to making loans to appropriate credit-worthy customers.

Depending on the way the central bank accounts for commercial bank reserves, the banks will seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds.

At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend.

So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

The other point which is related to this is that total bank reserves do not fall when a loan is made which also should disabuse you of the mainstream notion that reserves are loaned out.

Please read my blog – The role of bank deposits in Modern Monetary Theory – for more discussion on this point.

I covered the argument pertaining to the inflation risk embodied in deficit spending in my response to Paul Krugman’s blog last week. Please see – To challenge something you have to represent it correctly.

Any spending that pushes nominal aggregate demand (spending) more quickly than the growth in real capacity will be inflation. That is the risk in all spending. There is nothing special about government spending in this regard.

So, yes, under certain circumstances, government deficits could be inflationary but that begs the question as to why a prudent government would want to expand its deficit beyond full employment. It might want to if it wanted to increase the public mix of total output. But if it seriously sought that outcome it would not do it via deficit expansion but rather would squeeze private spending capacity by increasing taxes.

Taxes in this context – consistent with functional finance – are a means of depriving the private sector of purchasing power. If a government increases taxes it must want the private sector to have less purchasing power.

Repeating Krugman’s point:

I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue. For it is.

No it isn’t.

The fact he is not clear means that he hasn’t read the academic literature that MMT proponents have provided over many years. His one link in this blog to a MMT article is a blog written by a non-academic who is a recent (but welcome) addition to the “school of thought”. So once again we have an academic waxing lyrical about what is right and wrong about a school of thought and it seems he hasn’t read the primary literature carefully.

That is a very un-academic approach.

The point is that we have been at pains to outline that the monetary operations that accompany deficit spending (in this case, debt issuance) do not alter the inflation risk of the spending. The inflation risk is embodied in the spending not subsequent monetary manouevres.

But here we can reflect on the last several paragraphs and really understand why the two scenarios are mainstream depictions and not akin to a MMT perspective.

In this blog – Understanding central bank operations – we learn about the parameters which pertain to the conduct of monetary policy. Another excellent source for readers is the paper by Scott Fullwiler – Modern Monetary Theory – A Primer on the Operational Realities of the Monetary System.

The reality is very clear. If the central bank has a positive interest rate target – that is, the policy rate that it sets as an expression of its monetary stance – then it cannot “monetise” deficit spending by the treasury – which Krugman calls printing money. Such a central bank has no option – it either has to issue debt to drain the reserves that are boosted by the deficit spending (on a daily basis) or it has to pay a return on the reserves that are held with it by the private banks.

The two options – debt-issuance or paying a support rate – are from an operational perspective equivalent.

If the central bank didn’t do either then it would immediately lose control over its target policy rate. Why? Because the private banks would seek to shed the excess reserves (over and above the balances they deemed necessary to ensure all cheques drawn on it cleared) via the interbank market. That is, to loan them to other banks which might need reserves.

But as noted above, when the system is in excess, this interbank lending does nothing other than shuffle the excess around. But the competition that accompanies this “shuffling” drives the overnight rate down to zero (in the case of no support rate being offered by the central bank) and so the central bank monetary policy stance is thwarted.

When the central bank pays a support rate on overnight reserves it is effectively making them equivalent to government bonds. Both provide a return to the bank which would be indifferent between them (in the jargon of economics, they become perfect subsitutes) .

So debt-issuance just allows the central bank to maintain a non-zero policy rate in the absence of a support rate being explicitly paid on reserves. Functionally, both can be seen as offering a support rate.

It is only when there is a Japanese-style zero interest rate policy target that the central bank can avoid selling government bonds or offering a support rate.

So then deficits will add to reserves and the private banks have no place to go. The deficits might be inflationary (depending on the overall state of the economy) but the reserve add is not.

To consider otherwise is to fall into the money multiplier myth which says that growth in bank reserves (the monetary base) will be inflationary. That mainstream textbook model does not explain how the system actually functions as noted above.

You can get additional explanations in the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

Paul Krugman however says:

The point is that under normal, non-liquidity-trap conditions, the direct effects of the deficit on aggregate demand are by no means the whole story; it matters whether the government can issue bonds or has to rely on the printing press. And while it may literally be true that a government with its own currency can’t go bankrupt, it can destroy that currency if it loses fiscal credibility.

Which means he hasn’t really come to grips with the way central bank and treasury operations work in liaison with the private banks.

The inflation risk is in the aggregate demand. The monetary operations that accompany the deficit spending are not the source of the inflation risk.

It is possible that holders of a particular currency will attempt to sell it off which drives its value down in foreign exchange markets. This may impart some cost pressures into the economy. But that is a finite process and with flexible exchange rates there is no necessity for the central bank to intervene nor is there a possibility of the nation running out of foreign exchange reserves. I discussed these option in this blog – To challenge something you have to represent it correctly.

Conclusion

I think it is way past the time that Paul Krugman updates his textbook. But MMT gets free advertising even though he hangs on to what are effectively classical Quantity Theory of Money views on inflation. So why should I complain.

Digression – extremism

I have been used to being labelled an extremist – radical leftist communist and all related terms. I have actually never advocated a radical overthrow of the state in any public statement I have made nor the abolition of private property. What my personal views are remain just that.

In public all I have really advocated is that if the private sector cannot see itself fit to provide enough work for all those wanting it so that they can have a stable income and bring up their families or support whatever arrangement they choose – then the state has to use its fiscal capacity to ensure those jobs are available.

I have also advocated regulating private market behaviour so that greed and corruption doesn’t get ahead of itself and cause crises such as we are enduring now.

But the current crop of US republican candidates seem to be outdoing themselves in a race to come up with the more radical – extreme – policies to tempt their constituencies with.

There is a site in the US – Think Progress – which is doing a sterling job of tracking the candidates and highlighting their views – which are often not covered by Fox News etc – because even they know how looney the positions are.

For example:

1. The US cannot continue to pay unemployment benefits “because we frankly don’t have the money” (Michele Bachmann – Source).

2. The poor should pay more taxes because “We’re dismayed at the injustice that nearly half of all Americans don’t even pay any income tax” (Rick Perry – Source).

3. One candidate now considers all Americans are less free than when the nation was founded – “Does anyone believe that our freedom is as whole as it was at the time of our founders? It is not” (Rick Santorum – Source).

4. Rick Perry thinks all regulation is evil and/or unconstitutional ((Source) and wants a “moratorium on regulations” in the US (Source).

5. Michele Bachmann does not consider gay families to be real (Source).

I could go on.

The funniest (and probably scariest) quote came from Perry during a rally in Iowa at the weekend just gone – referring to the Federal Reserve Chairman Ben Bernanke, Perry said:

If this guy prints more money between now and the election, I dunno what y’all would do to him in Iowa but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost is almost treacherous, er treasonous, in my opinion.

Under US law, treason carries the death sentence. Suggesting the central bank governor should be sentenced to death is extremism by any stretch.

Think Progress is also keeping track on propriety issues. For example, they have exposed Michele Bachmann for accepting federal government subsidies for their family farm and counselling clinic – then claiming “My husband and I have never gotten a penny of money from the farm” and then – disclosing tens of thousands of dollars on income from the farm in here financial disclosures statements. The word hypocrite comes to mind.

The confused language that these characters use as they race to better each other in the who can be more extreme stakes recalls the 1998 Simpson’s episode – King of the Hill – where a besieged Rainier Wolfcastle said:

McBain to base. Under attack by commie Nazis.

That sort of comment is downright intellectual compared to the recent utterances from the Republican hopefuls.

And I haven’t even considered their macroeconomics – which if implemented as a policy position would destroy millions of jobs, bankrupt a good percentage of US business, and impoverish a fair percentage of the US population.

And all I want to do is create some jobs.

That is enough for today!

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This Post Has 97 Comments

  1. Bill,

    Have you explained anywhere *why* a central bank would want to maintain a positive interest rate? (assuming that the inflation targeting is removed from their remit).

    In the functional finance rules there is the line “the government shall maintain that rate of interest that induces the optimum amount of investment.”.

    Has MMT thinking modified or progressed that idea any further – as in how to work out what is the optimum amount of investment?

  2. While delving into the current institutional arrangments in the UK, where you discover that the Treasury has moved its financing operations from the Bank of England to the Debt Managment Office, there is this little gem in a footnote

    “With the exception of a small and stable balance on the Debt Management Account held at the Bank of England and the Ways and Means Advance (the Government‟s account at the Bank of England), the short-term net cash position of the Exchequer will be held with market counterparts. This means that, in practice, financial transactions of the public sector would not affect monetary conditions.”

    From the pdf on this page: http://www.hm-treasury.gov.uk/2011budget_debtreserves.htm

    Why on earth do they think that this arrangement (which I’m assuming means that government money is held in several accounts at private banks rather than in an account at the Bank of England ) is going to avoid affecting ‘monetary conditions’?

  3. I usually say banks do not lend reserves to non-banks; i.e. they do not lend reserves in the case of almost all of their borrowing customers. Non-bank customers have no direct access to the bank reserve market.

    Bank lending is always a function of capital management; only rarely a function of liquidity management. The second part is normally vice versa.

    Krugman assumes an absurd premise in the example of banks “lending” currency (i.e. central bank notes). The misunderstanding of the supply and demand for currency is a deeply rooted and pivotal flaw in “monetarism”, along with the treatment of reserves and “the multiplier”.

  4. I’d be interested in a precise MMT explanation as to why governments have to borrow under a fixed rate convertible currency regime.

    I.e. why can’t they pay interest on reserves instead?

    The interest rate protection (i.e. the rate required to compete with “the object of conversion”) is pretty much the same for reserves as it is for bonds, according to standard MMT thinking.

    And if bonds under a convertible currency regime are assumed to be required for liquidity protection instead (i.e. to hold back the tide of conversion by spreading out bond maturities), that seems to contradict the standard MMT thinking that bonds are as liquid as deposits (e.g. Fullwiler).

    So why?

  5. Bill,

    “So the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is not constrained by the quantity of reserves it holds or any fractional reserve requirements. The bank expands its balance sheet by lending. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.”

    This paragraph is a perfectly accurate depiction of the lending process (as I’ve learned)

    But I feel it is incomplete and leaves a question in the minds of those readers coming upon this for the first time.

    I know it would have saved me a lot of unnecessary confusion had you included another brief paragraph along these lines:

    “The only restraint on a bank’s lending is the quantity (and quality) of its capital, which in its simplest form, is the shareholders equity, or common stock. Current Basel Accord guidelines mean that a bank can lend up to about 15 times its capital base, depending on the capital make-up”

  6. One question: Why US treasury does not simply stop issuing long term debt? It would be the most fancy squeeze in history..plus the cost of financing it would drop to nearly zero!! regards and thanks for the post.

  7. I think that Krugman’s point is that you can have BOTH temporily high deficits and low inflation outside of liquidity trap (slack etc.) if government has credible fiscal policy and can convince investors to buy bonds. But if you rely only on printing it can be impossible and can cause inflation (investors will buy real assets instead of bonds). That’s why printing is more inflationary outside of liquidity trap. But right now it’s a different story as Krugman said and we can maintain high deficits even financed with printing.

  8. Dear Bill,

    you write: “As I have noted often, governments rarely pay back debt (from a macroeconomic perspective) which is to say they do not continually honour specific debt liabilities as they mature.”

    It seems to me that there is a “not” missing (or too much) somewhere in the sentence or my understanding of English is lacking. Governments do continually honour specific debt liabilities, but the overall amount of debt rarely decreases.

  9. Hi Bill;

    Regarding:

    “…governments rarely pay back debt (from a macroeconomic perspective) which is to say they do not continually honour specific debt liabilities as they mature.”

    I think you must have meant:

    “…which is *not* to say they do not continually honour specific debt liabilities as they mature.”

    Cheers

  10. “I have been used to being labelled an extremist – radical leftist communist and all related terms. I have actually never advocated a radical overthrow of the state in any public statement I have made nor the abolition of private property. What my personal views are remain just that.

    In public all I have really advocated is that if the private sector cannot see itself fit to provide enough work for all those wanting it so that they can have a stable income and bring up their families or support whatever arrangement they choose – then the state has to use its fiscal capacity to ensure those jobs are available.”

    I presume here you are referring to Hyman Minsky’s ELR proposal and not the more typical Keynesian demand-based money multiplier effects? If so, have you considered the possibility of incorporating such a proposal into a fully socialized workforce/labour market policy? For example, ELR could go hand in hand with the state hiring everybody and then contracting workers out to the private sector, like a sort of state-based temp agency.

  11. @Nicolai & Dale,

    I’m not a native speaker and this got me confused for a couple of seconds. I think you guys are correct.

    Of course if you’ve been following Bill for a while you know what he means, but for a beginner, there’s no easiest way to get confused. Or is it teacher Bill trying to find out who’s paying attention and who isn’t? 🙂

  12. I think that the root cause of all the mistakes made by Paul Krugman is that he built his intuitive understanding of economy on the foundation of loanable funds theory. This theory is incorrect as mentioned in Scott Fullwiler’s paper. The theory only applies to the economy without any proper banks.

    As long as Krugman keeps using loanable funds approach for his own understanding of the reality he will never grasp the story that loans bring their own savings. This can even be shown within the money multiplier (fractional banking) model which itself is not correct. It is enough to analyse the following simplified scenario:

    Initial state – I added bank equity to satisfy both the reserve and capital requirements
    Bank has a 10% reserve requirement and 10% capital requirement.

    step 0
    bank assets $100 (cash) bank liabilities $0 bank equity $100

    step 1
    $100 in cash is deposited – saved (interest rate is determined by the interbank market funds rate, let’s say 5% p.a.)
    bank assets $200 (cash) bank liabilities $100 in deposits, bank equity $100.

    (That cash must have been created by the government so that we have G-T=S-I for the current period, these are flows)

    step 2
    Bank extends a loan. Instead of going through all the iterations what only obscures the main feature of baking – let’s illustrate a case when a single loan for $500 is extended what clearly won’t breach any of the limits.
    bank assets $700 ($200 in cash and $500 in loans) bank liabilities $600 in deposits, bank equity $100
    This operation leads to lending $500 at the interest rate determined by the bank so that it makes money let’s say 6%

    This action of lending $500 in one go is perfectly legal as both capital requirement and reserve requirement are met. We don’t need to go through all the iterations of cash withdrawals and subsequent deposits which only obscure the nature of the process.

    step 3
    The $500 is spent (usually invested) and at the same time it is accounted for as increased savings belonging to someone (for simplicity in the same bank so the aggregate balance sheet did not change). Again the statement that S-I = G-T (flows during the same period) holds water due to the accounting rules of double-entry bookkeeping.

    The interest rate at the “input” of the bank (deposit) has been transmitted to the “output” (loan) but not the quantity which was multiplied. This may not be the full picture in the real economy where the reserve bank sets the interest rates – but the transmission mechanism remains in place.

    The quantity of the money lent out in the step 2 is not equal to the quantity borrowed by the bank in step 1 – it is greater. This observation is critical to debunk the loanable market theory even on the ground of the money multiplier story.

    If multiplication occurs and we aggregate individual cases, the figure 10-4 page 264 and the comment “at the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds demanded” (Macroeconomics Second Edition Paul Krugman, Robin Wells, 2009), simply do not make any sense. I am not an economist just a software engineer but it is obvious to me where the mistake has been made.

    The the quantity of fresh loanable funds in that model on the saving side is much lower than the quantity for loanable funds on the investment side. The equilibrium is partially reached thanks to the funds self-supplied on the deposit (saving) side as a result of the process of credit expansion on the lending (investment) side. Loans bring about their own deposits.

    —
    The loanable funds market provides a closure to the Neo-Keynesian models. Without that market these models have no sense whatsoever and the only alternative for a Keynesian is to embrace the models created by Michal Kalecki, N. Kaldor and W. Godley but this is a completely different paradigm.

    The only model perfectly compatible with functional finance and the operational description of fiat monetary systems (the core of MMT) is the one originally provided by Kalecki.

    Krugman invested a lot of his reputation and energy in perfecting the mainstream models. His understanding of depressions is not based on the debt-deflation process affecting saving and investment which would require understanding the endogenous money creation and destruction processes. His understanding is based on the “liquidity trap” story which hinges on the loanable funds theory. I have zero doubts Paul Krugman believes in what he wrote in his textbooks – he seems to be an honest person. We also have to bear in mind that his grandparents left Poland (Brzesc Litewski) in 1923 during the period of acute hyperinflation. He must have heard the same stories about wages paid with briefcases of cash and absolute ruin wrought to savers which I heard from my grandparents. This family experience (which may only be my guess – I may be wrong here) only reinforces his intuitive understanding of the processes like inflation and depressions which is consistent with the mainstream story. That’s why he might have chosen to go after MMT as the expansion of monetary base must cause excessive lending if we are outside of the liquidity trap in his world.

    Anyway what I wanted to show is that Paul Krugman has much more at stake than just changing his mind about the impact of financing government deficit by money emission vs selling bonds. He would need to negate practically all his work on recessions and obviously rewrite all his textbooks if he starts having doubts in the loanable funds theory and the official interpretation of the money multiplier.

    This is not about intellectual dishonesty but simply being a human. This would be an enormous act of intellectual bravery.

    —
    Tom,
    The answer is that the central bank can set a non-zero interest rate even if no bonds are present in the system by offering interests on commercial bank deposits. So Krugman is wrong. It is possible to pay people interests on their deposits though the banking system to increase their saving propensity without issuing bonds. Whether this is desirable is another story.

  13. I have a question in regards to monetary policy. I have some monetarist friends who believe that they could copy Poland and Sweden by keeping things at a low interest rate (effectively 0), and produce a penalty/fee for keeping excess funds in their reserves. Thus forcing them to lend becuase it is more financially profitable for them.

    I fully undesrtand how MMT works with fiscal polcieis but would this monetary fix work under MMT theory?

    My understanding of MMT is that it wouldn’t work because banks are already able to lend as much as they want, because they aren’t reserve constrained.

  14. Anyway let’s assume that Krugman drops his opposition to Functional Finance. This is not enough to restore the sanity to the economic discourse in the West as the both sides need to speak the same language. The so-called “progressives” are inefficient and unable to achieve anything. Of course this is also a result of poisoning of the New Left with neoliberalism.

    But there is a much more serious problem facing the so-called Western democracies. If austerity is not ditched ASAP then there might be no room for reforms at all if “proper” fascists replace the current right-wing neoconservative parties. The radicalism of the Tea Party in the US might be just the first step but we may have not seen any real fascists yet…

    Therefore I believe that a set of memes which can be used to stop the austerity-mania spreading among the conservatives and right wingers needs to be created. I have been dabbling with these memes recently. One good candidate is to show the risk of losing the economic and military competition with China if the austerity measures are implemented.

    When the stability of states is at stake it is far less relevant whether a born-again Christian or a progressive gay-friendly humanist is in power as long as the economic insanity is not actively enforced. Obviously many may not agree with my ultra-pragmatic views…

  15. “But if you rely only on printing it can be impossible and can cause inflation (investors will buy real assets instead of bonds). That’s why printing is more inflationary outside of liquidity trap.”

    Isn’t this what is happening with QE? Monetarising debt through bond purchase is propping up other asset prices, as there are investors who need to buy assets – for example the pension funds. So there is an argument that the sale of bonds is a good thing, as it provides a safe investment for those that need it.

    But this is a side issue. “Printing money” need not be, of itself, inflationary, but there may be inflationary side effects that need to be managed.

  16. Adam:
    “The answer is that the central bank can set a non-zero interest rate even if no bonds are present in the system by offering interests on commercial bank deposits. So Krugman is wrong. It is possible to pay people interests on their deposits though the banking system to increase their saving propensity without issuing bonds. Whether this is desirable is another story.”

    You are right that it is possible to pay interests on banks reserves but it is equivalent to the the situation where investors want to buy government bonds. Because otherwise banks would decide to convert their reserves for other things. So again Krugman’s point is that if you want to have BOTH temporily high deficits and low inflation outside of liquidity trap you have to have credible fiscal policy. It’s simple logic so I cant understand why MMT people cant admit that Krugman is 100% right.

  17. Well, Bill, this is certainly a better approach to the debate than the condescending attitude evinced by Krugman in his MMT, again. Let me quote, for those who have not read how he began his post.

    “In a way, I really should not spend time debating the Modern Monetary Theory guys. They’re on my side in current policy debates, and it’s unlikely that they’ll ever have the kind of real – and really bad – influence that the Austrians have lately acquired. But I really don’t feel like getting right back to textbook revision, so here’s another shot.

    First of all, yes, I have read various MMT manifestos – this one is fairly clear as they go. I do dislike the style – the claims that fundamental principles of logic lead to a worldview that only fools would fail to understand has a sort of eerie resemblance to John Galt’s speech in Atlas Shrugged – but that shouldn’t matter.”

    The only logical principles that appear to be being used are those dealing with accounting identities, not fundamental theoretical principles. As Bill points out, these accounting identities function as definitions and thus have to empirical import. They are embedded within a particular accounting framework that encompasses some theoretical principles, but as I understand Bill’s approach, these accounting principles are not being disputed. Hence the style that Krugman so deplores is not a matter of logical differences.

    I think Krugman’s condescension in this post is regrettable. And, moreover, he himself provides no detailed justification for his disagreement other than to say that the MMT approach is worng-headed. Also regrettable are the philosophical ifelicities he introduces implicitly in his own discussion; for example, in claiming that he needn’t go back to macroeconomic principles, he implies that the foundations of economics/political economy are so well corroborated that only cranks or rebels could disagree. This suggests that economics is in this respect not unlike mainstream physics. I do not think it revolutionary to assert that economics still consists of competing schools, much like psychology in certain respects, and that therefore any such resemblance to physics is accidental and therefore essentially misleading.

  18. P.S.: It is of more than passing interest that Krugman, in his moaning that supporters of MMT do not seem to be able to understand first principles, and that most of the writing is difficult to understand, he fails to mention Bill’s direct response to his _Franc thoughts_ post. He claims to have read a number of MMT expositions, but it appears that he did not read this one, one that would appear to be most relevant to his complaint. I wonder about hsi failure to mention it however briefly.

  19. Sorry about the mistakes in the editing of the first comment. My edits in Word didn’t carry over. Arggh!

  20. @JP Hochbaum,

    The way I understand it (and please correct me if I’m wrong), whatever a bank lends, ends up as a deposit in the banking system eventually when the lent money is spent. When the private sector lends to the private sector, it just shifts reserves around, but the overall quantity of reserves does not change.

    So imposing penalties for excess reserves could be seen as a tax on the banking system, because the banking system as a whole would have no other choice than facing penalties for excess reserves. Or they could refuse to accept new deposits when they are in excess of reserves (not sure what that would mean, would it bring the payment system to a halt?).

    On the micro level, a bank would have already lent if there was enough demand for credit (and if borrowers were credit-worthy), so it means it is left with the choice between lending to non credit-worthy borrowers and face financial loss when they default or paying the so called excess reserves penalties. And even worse, if the non credit-worthy borrower’s loan money eventually end-up in the same bank (as a result of spending becominga deposit to the shop-keeper’s account who happens to be at the same bank), the bankwould face excess reserves penalties AND financial loss due to the likely borrower’s default. None of this makes sense to me.

  21. “still consists of competing schools, much like psychology in certain respects,”

    More like the Catholic and the Protestant churches.

  22. Tristan Lanfrey: “On the micro level, a bank would have already lent if there was enough demand for credit (and if borrowers were credit-worthy), so it means it is left with the choice between lending to non credit-worthy borrowers and face financial loss when they default or paying the so called excess reserves penalties.”

    But credit-worthiness is in part a function of the economic system as a whole. If “everybody” is forced by the negative interest on reserves to extend credit to more people, then most, if not all, of those people will become credit-worthy, right? The new lending will increase the money supply, which will increase aggregate demand, which will make it easier for those taking out the new loans to pay them back. What would be rather risky for one bank would become much less risky for all banks. No?

  23. Nice post. Gotta love the quote from Santorum — we are less free today than we were when slavery was legal!

  24. @Tristan, that is pretty much what I thought.

    @Min, if we lower credit standards to lend more aren’t we repeating what got us in this mess? Increasing private debt to make up for the lack of government spending?

  25. JKH

    I was wondering if you could expound a little more on this statement;

    “The misunderstanding of the supply and demand for currency is a deeply rooted and pivotal flaw in “monetarism”, along with the treatment of reserves and “the multiplier”.

    I have my own ideas what you are getting at here but I would like to hear you discuss this a little more in depth.

  26. Tom,

    Let me quote your comment to avoid any misunderstandings:

    “it is possible to pay interests on banks reserves but it is equivalent to the the situation where investors want to buy government bonds. Because otherwise banks would decide to convert their reserves for other things. So again Krugman’s point is that if you want to have BOTH temporily high deficits and low inflation outside of liquidity trap you have to have credible fiscal policy. It’s simple logic so I cant understand why MMT people cant admit that Krugman is 100% right.”

    I disagree. The Krugman’s point is different. Nobody argues against credible fiscal policy. He is very specific about issuing bonds. He stated that ” a deficit financed by money issue is more inflationary than a deficit financed by bond issue”. But you have agreed that money issue does not need to lead to zero interest rates.

    But his main mistake which you have happily accepted and repeated is that:
    “We’re assuming that there are lending opportunities out there, so the banks won’t leave their newly acquired reserves sitting idle; they’ll convert them into currency, which they lend to individuals.”
    or
    ” banks would decide to convert their reserves for other things”

    Banks do not lend reserves. His intuitive understanding of the banking system and as a consequence of the loanable funds market and credit money dynamics is wrong. If the Reserve Bank sets interests rates at 24% (as in Poland in 1998 what was 10% above the inflation) virtually noone would borrow anything from any commercial bank but people may start depositing more and more cash in the banking system. Commercial banks then deposit reserves at the Reserve Bank where they lend interests. What else can they do? S-I becomes big. The government can spend (if only they did that in Poland in 2000 – they didn’t because they wanted to choke inflation and 20% unemployment in 2003 followed).

    This is how monetary channel works – the volume of bank lending is determined by the market demand for credit and constrained by bank capital (which can be easily replenished). Market demand depends on the investment opportunities and on the interest rates.
    —
    Here is the offending section of Paul Krugman’s blog provided as a reference in full so that noone can claim that I twisted his words.

    “The second case poses no problem, say the MMTers, or at least no worse problem than the first: the US government can simply issue money, crediting it to banks, to pay its bills.
    But what happens next?
    We’re assuming that there are lending opportunities out there, so the banks won’t leave their newly acquired reserves sitting idle; they’ll convert them into currency, which they lend to individuals. So the government indeed ends up financing itself by printing money, getting the private sector to accept pieces of green paper in return for goods and services. And I think the MMTers agree that this would lead to inflation; I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue.
    For it is. And in my hypothetical example, it would be quite likely that the money-financed deficit would lead to hyperinflation.”

    —
    As Randall Wray on creditwritedowns stated there is not one but several mistakes made in that short comment. Please visit that site and have a look at his analysis – he writes more about the issues related to the mechanics of the financial system I am not an expert on.

  27. JP Hochbaum,
    Main interest rate in Poland is 4.5% while CPI inflation is 2.7%
    I do not follow everything they are doing there now but there is a lot of “creative accounting” involved to avoid hitting the constitutional public debt limit. The economic situation is not too bad because of the links with German economy and free floating currency. We will see how the situation develops in the next few months though.

  28. From Randall Wray’s HUFFPO piece – dialogue.

    Can only lead the horse to the water…
    __________

    HUFFPOST SUPER USER
    cheryl tobin

    I stand with Krugman.

    HUFFPOST SUPER USER
    joebhed

    Enjoy.
    https://billmitchell.org/blog/?p=15722

    HUFFPOST SUPER USER
    cheryl tobin

    Read the link to Billy’s Blog and I stand behind Krugman even more now because he makes a lot more sense and documents his theories much better then his critics.

    HUFFPOST SUPER USER
    joebhed

    Fair enough.

  29. “We’re assuming that there are lending opportunities out there, so the banks won’t leave their newly acquired reserves sitting idle; they’ll convert them into currency, which they lend to individuals. So the government indeed ends up financing itself by printing money, getting the private sector to accept pieces of green paper in return for goods and services.”

    JKH said: “Krugman assumes an absurd premise in the example of banks “lending” currency (i.e. central bank notes). The misunderstanding of the supply and demand for currency is a deeply rooted and pivotal flaw in “monetarism”, along with the treatment of reserves and “the multiplier”.”

    The way JKH and others have explained the debt creation process to me is that “their newly acquired reserves sitting idle; they’ll convert them into currency, which they lend to individuals” is completely wrong and not even close to what actually happens.

    Let’s see if I can do a simple example with a new bank and a mortgage. I save $10,000 in the medium of exchange of a demand deposit(s). I start a new bank so my savings gets converted to bank capital. My demand deposit is then converted to the highest yielding asset that is liquid and won’t be defaulted on (a gov’t treasury bill). With a 10% capital requirement, I make a $100,000 mortgage loan.

    Assets

    $10,000 treasury bond
    $100,000 loan

    Liabilities

    $10,000 owner’s equity
    $100,000 demand deposit liability

    The person buys the house (demand deposit velocity not equal zero). The homebuilder then redeposits the demand deposit back into my same bank using a savings account (reserve requirement is zero and demand deposit velocity now equals zero). The homebuyer pays the mortgage interest rate to the bank (along with some principal). The bank keeps the difference between the mortgage interest rate and the savings account rate. I don’t see ANY currency involved.

    Sound good?

  30. “Repeating Krugman’s point:

    I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue. For it is.

    No it isn’t.”

    I’ll keep trying. First, I junk the term money. Too many definitions. Next, creating more medium of exchange without a bond attached could be more price inflationary IN THE FUTURE, but is the same IN THE PRESENT as with a bond attached.

  31. “The reality is very clear. If the central bank has a positive interest rate target – that is, the policy rate that it sets as an expression of its monetary stance – then it cannot “monetise” deficit spending by the treasury – which Krugman calls printing money. Such a central bank has no option – it either has to issue debt to drain the reserves that are boosted by the deficit spending (on a daily basis) or it has to pay a return on the reserves that are held with it by the private banks.

    The two options – debt-issuance or paying a support rate – are from an operational perspective equivalent.

    If the central bank didn’t do either then it would immediately lose control over its target policy rate. Why? Because the private banks would seek to shed the excess reserves (over and above the balances they deemed necessary to ensure all cheques drawn on it cleared) via the interbank market. That is, to loan them to other banks which might need reserves.”

    First, could the central bank raise the reserve requirement?

    Second, what would be the differences between the three possibilities (assuming raising the reserve requirement is correct)?

  32. “Let’s have a more or less concrete example. Suppose that at some future date – a date at which private demand for funds has revived, so that there are lending opportunities …”

    And, “The point is that under normal, non-liquidity-trap conditions, the direct effects of the deficit on aggregate demand are by no means the whole story; it matters whether the government can issue bonds or has to rely on the printing press. And while it may literally be true that a government with its own currency can’t go bankrupt, it can destroy that currency if it loses fiscal credibility.”

    Is the real argument about whether an economy has gone from mostly supply constrained to mostly demand constrained? Why should being supply constrained be considered the “normal” condition?

  33. “And all I want to do is create some jobs.”

    Maybe more retirement needs to be created?

    bill, could you PLEASE put some kind of warning to answer the math question when I hit the preview button. Thanks!!!

  34. JKH said: “I’d be interested in a precise MMT explanation as to why governments have to borrow under a fixed rate convertible currency regime.

    I.e. why can’t they pay interest on reserves instead?”

    First, I believe the assumption is always an aggregate demand shock.

    Second, where would the medium of exchange come from?

  35. Adam

    “The Krugman’s point is different. Nobody argues against credible fiscal policy. He is very specific about issuing bonds. He stated that ” a deficit financed by money issue is more inflationary than a deficit financed by bond issue”. But you have agreed that money issue does not need to lead to zero interest rates.”

    No, read my post again. I have just agreed with Krugman that printing is more inflationary outside of liquidity trap. And your remarks about positive interests on reserves are with contradiction on printing issue because they are equivalent to selling bonds (government and central bank can sterilize printing either by selling bonds or offering positive interests rates on reserves).
    And your statement that “Banks do not lend reserves” is not entirely true. It is true only partially true if we look on banks as intermiediaries on the market i.e. they make loans and then seek reserves. But banks can also be investors on their own and they dont have to hold all of these reserves. Besides when governent spends its money goes first to private sector and then returns to banks. And that is certainly inflationary.
    And I know works by Randall, Bill and Warren and stand with Krugman, because it’s logically impossible to disagree with him.

  36. Bill:

    I agree with 99% of your post, and all of the financial mechanics makes great sense. I just wish Krugman would take a couple hours and actually look for answers to the concerns (all it would take is a search of your blog or some others) rather than pontificating about it.

    However, as an American, I do have to comment on a couple of the “extreme” political positions you cite:

    ‘3. One candidate now considers all Americans are less free than when the nation was founded – “Does anyone believe that our freedom is as whole as it was at the time of our founders? It is not” (Rick Santorum – Source).’

    As one comment noted, we don’t have slavery anymore, and that is certainly significant. However, the expansion of the federal government has certainly restricted and regulated almost all other freedoms much more than it did in the 1700s. While state and local governments may have been interventionist, the federal government was originally restricted in its powers by design. Only in a series of court cases (mostly dating to the time of the New Deal) did the federal government acquire its current ability to regulate and restrict just about anything.

    I’m not arguing about whether or not this was a good thing. But it is certainly a fact that, as a whole, most Americans are less free than they were in 1789. And this doesn’t even get into the TSA, illegal wiretapping, and other such things the government does today to undermine previously protected freedoms.

    ‘4. Rick Perry thinks all regulation is evil and/or unconstitutional ((Source) and wants a “moratorium on regulations” in the US (Source).’

    See comment above. I don’t agree with Perry, but I have sympathy for his argument. The U.S. is not a common law nation, and the Constitution has special status. During the New Deal, political pressure on the Supreme Court and other factors resulted in the lifting of most of the very narrow restrictions that kept federal government power small. I think Perry has a point that most of the activities of the federal government would be unconstitutional under the meaning the Founders used when the Constitution was written.

    I don’t believe in illegal action, nor do I believe that the Supreme Court should have the power to overturn the Constitution on a whim. The danger of liberalism in the U.S. is that most federal government action now rests on certain court precedents that have interpreted the Constitution incredibly broadly. That means that all of those actions are at the mercy of nine people in robes who could start striking down things at any moment.

    Many liberals seem to have adopted the idea that we should just go with court precedent, no matter how it distorts the Constitution. I think that’s a recipe for disaster in the long run. What should have happened is that liberals should have fought to get appropriate Constitutional expansions in the 1930s through the next few decades, when government growth wasn’t seen as completely evil. Now, our political system has become too polemicized for such Constitutional amendments to take place — and I think that leaves the entire liberal agenda in real trouble. It can still take place at the state level, but lots of federal programs are ultimately on shaky legal ground… it just depends on how many precedents the Supreme Court is willing to overrule. If it goes back more than 75 years, we’re all screwed.

  37. Dear Fed Up (at 2011/08/18 at 8:01)

    bill, could you PLEASE put some kind of warning to answer the math question when I hit the preview button. Thanks!!!

    Done. I hope that makes things easier for you (and others).

    best wishes
    bill

  38. By the way, there’s only one legal precedent that really matters — Wickard v. Filburn (1942). It was the first case to allow the U.S. government to regulate private activities that might conceivably have any economic impact. (The case was about a farmer who was prosecuted for growing wheat to feed his own family and animals, but he grew more wheat than he was allowed by government quota.) Overturn that, and the majority of the federal government (much of its spending and much of its regulatory authority) comes crashing down.

    I didn’t think that was ever likely a few years ago. But the stupid health insurance (not health care) bill — which forces a purchase of private insurance rather than just giving us government health care — has introduced a new power that I really doubt will be ruled constitutional. It has caused people to start reconsidering the legal precedents that enable the U.S. government. The Supreme Court is almost certainly not crazy enough to overrule Wickard in dealing with the health insurance debacle, but I’m worried about the legal trail that we might start going down now.

  39. “And if bonds under a convertible currency regime are assumed to be required for liquidity protection instead (i.e. to hold back the tide of conversion by spreading out bond maturities), that seems to contradict the standard MMT thinking that bonds are as liquid as deposits (e.g. Fullwiler).”

    It’s sloppy to refer to “bonds” – as if short term bonds and long term bonds are the same. The market value of long term bonds fluctuates (regardless of liquidity), so they aren’t equivalent to short term bonds or cash.

  40. The re-writing of textbooks gerally takes place after the old paradigm is replaced by the new one – not before.

  41. “But banks can also be investors on their own and they dont have to hold all of these reserves.”

    the reserves cannot leave the banking system

  43. Bob said: “As one comment noted, we don’t have slavery anymore, and that is certainly significant.”

    But do we have debt slavery just like the spoiled and rich, the bankers, and almost all economists want?

  44. studentee

    “the reserves cannot leave the banking system”

    That is also not entirely true. When banks want to convert their money on real assets, it is certainly inflationary. If private investors put their money again in banks then banks can repeat this process and then investors may lose their confidence and may want to return to real assets. So in this scenario nobody wants to hold reserves and we have hyperinflartion. And Krugman presented model of this case on his blog. So again he’s right and it’s beyond me why any sane person can argue with him on this matter.

  45. “When banks want to convert their money on real assets, it is certainly inflationary.”

    No its not and there is no evidence that it is. The reserves just move to another bank. Any hard transaction within the private sector just changes the name on the assets.

    You cannot convert bank reserves.

    Bank reserves are only held by entities with accounts at the Central bank. The amount can only increase or decrease by transactions with the Currency Issuer directly – primarily taxation and spending, and they can only be converted into another government supplied liability, such as a bond.

    So it’s hardly surprising you agree with Krugman. You’re making the same mistakes he is.

  46. Tom,

    Bonds are as liquid as reserves. If a disorderly sell-of of bonds occurs, the central bank will most likely intervene. The only difference is that bond holders incur capital losses / gains when the yield curve shifts as a result of changes of the short-term interest rates. But this difference is not so relevant.

    What really matters is that savings of any form may become an inflationary overhang if the real interest rates are very negative. Then and only then the size (of the hoard of savings, often but not always related to the public debt) matters. When this happens everyone wants to get rid of any savings, bank runs occur and inflation becomes hyperinflation. This is not related to “expectations” but the experience of people watching the value of their savings melting down and businesses desperate to make any profits. Only in the hyperinflationary state the quantity of money directly determines the price level as nobody saves in the currency any more, the banking system becomes dysfunctional, etc.

    This initial inflationary jolt may be triggered by unsuccessful attempts to defend a fixed exchange rates of the local currency leading to cost-push inflation when the fx peg fails (Russia, Argentina). In that case the recovery may be swift. Another road to hyper-inflationary ruin leads through destruction of the productive capacities and weakening of the state authorities which are unable to raise taxes while still pushing for more spending (Zimbabwe).

    You may quote Krugman again but I remember perfectly well how it works from my own observations and experience (1989..1990, Poland).

    Finally, if banks are allowed to “invest” (speculate) on a large scale with whatever assets they have then certainly bad things do occur – but not because of not selling bonds. They do occur because of fraud.

  47. Dear Bill. I strongly disagree with you. You write long articles where you often sidestep important issues by using “this is not how bank operates” trying to cover simple facts.

    So let’s get into Paul’s example. Government systematically gathers in taxes less then it spends, so it simply creates money on accounts of its suppliers. So bank “reserves” are automatically increased, there is systematic overhang of cash on bank accounts that banks cannot get rid off – they may just pass it one at another decreasing interest rate in the process. In such situation interbank interest rate automatically spirals down to zero, as remember, CB does not issue bonds to siphon out reserves. Since government directly bought goods and services, and if we assume that private sector did not change its consumption/investment behavior, that means that velocity of money did not change, real output did not change, cash in the system increased so we may safely say that our economy starts experiencing inflation. So now we have combination of zero interest rates and positive inflation, right?

    So now what would you do if you suddenly realized that you live in a country where there is going to be zero nominal interest rate and positive inflation from now on forever? That means that whatever you buy today by borrowing money will have the price increased tommorow, basically free lunch for you. But is it? You live in a country which prefers printing money to taxation. You would expect that the price level would not only increase steadily, but that the rate by which it increases would have to steadily increase out of boundaries. Unless of course government would promise that it would balance its expenditures and revenues somewhere in the future – which is preciselly Pauls argument.

    I think that whole MMT is bogus. You mire yourself in phrases “mainstream do not understand this”, “this is not how a monetary system operates” and into endless stream of meaningless word games like “bonds do not finacne anything – insert 3 page rant about how is that”.

    But at the end of the day you find out that even with functional finance you have to have a system in place which guarantees stability. If you do not have bonds, you have to have other system which will drain cash from economy to prevent inflation. Be it taxes/spending cuts (that means Krugman is right that government has to stabilize revenues and taxes in long run), paying interest on reserves (basically the same thing as T-Bills) or even possibly systematic minimum reserve requirement increase (i do not know how this would work like in a long run). But in the end you have nothing useful or new to say for current economic dispute.

  48. Just additional note, as it may be so that someone did not get the answer on question “So now what would you do if you suddenly realized that you live in a country where there is going to be zero nominal interest rate and positive inflation from now on forever?”

    You would stop using that currency. You would not want to be near anywhere such currency. You would use foreign currency or gold or barter. Only insane people would save anything on bank accounts on negative interest rate. You would basically render your currency inoperative.

    Oh, I can see that MMTer will respond “but government gathers taxes and thus you have to use whatever monopoly currency it issues”. Right, look at Russia in 90ties or on other collapsed countries how it worked out. It basically works like this – you conduct your business in dollars, and on day your taxes are due you exchange dollars for domestic currency for whatever price those poor people who are paid by it (government employees etc) are willing to sell it. And then you get rid of it as soon as you get it (pay taxes). Then you return to your stable dollar operations and don’t care about what government says about currency, it does not matter for you and your sane business partners.

  49. “paying interest on reserves (basically the same thing as T-Bills)”

    You’ve obviously not read the articles very well. For the central bank to hit a target rate MMT requires that they drain via bonds paying that rate or they pay interest on the reserves. The blogs and literature are very clear on that point.

    Deficit Spending 101 – part 3 if memory serves.

    Functional Finance rules require that you set the interest rate to the level that will induce the optimum amount of investment in the economy. Note investment, not consumption.

    It also says that you raise taxes and cut spending to maintain stable prices and low unemployment, allowing the currency rate to float as the buffer.

    So the model you put forward is not the MMT model for the economy. It is a caricature based on an imperfect understanding.

    Deficit spending will cause inflation if you do too much of it.

    So the solution is really simple, don’t do too much of it, just do enough.

  50. Neil Wilson,

    “You cannot convert bank reserves”. This is not true. Banking sector as a whole cannot do this but every particular bank may try it and this is certainly inflationary (chasing limited supply of real assets). So again printing outside of liquidity trap is more inflationary. And that’s why responsible fiscal policy is required so that government can find buyers of it’s bonds (or holders of reserves with positives interest rates). Krugman: ” But the MMT people are just wrong in believing that the only question you need to ask about the budget deficit is whether it supplies the right amount of aggregate demand; financeability matters too, even with fiat money.” I agree with that statement.

  51. Adam,
    We are discussing different case i.e. printing with not bad ecomomy (outside of liquidity trap). Then printing may be bad solution if not sterilized by bonds or reserves with positive interests rates and this sterilizng may occur if we have credible policy (otherwisse there is a risk of hyperinflation).
    And I am from Poland so I know polish economy very well.

  52. Neil – ok, so what is the difference against what Paul is saying? Because even issuing bonds (or paying interest on reserves) is not enough if government does not promise to balance revenues and expenditures in long run. Most governments now have expenditures between 20 – 60 percent of GDP. Let’s suppose for a moment that there are no taxes (only printing press), and that government spends 30% of GDP. That means that they increase monetary base by 30% a year which could mean 30% inflation if nothing is done about it. For private sector not to use real resources they will require government to pay at least 30% interest (on bonds, or reserves or whatever), so that private sector does not feel robbed of their purchasing power, right? But what about next year when government actually pays that 30% interest to those who have reserves? If workers expect this, that means that they will require wage rise so that they keep their purchasing power, which means that businesses will need to expect price increases … which will make government to print more money (if they want to buy the same real ammount of goods and services they mean to, or % of GDP) starting the vicious cycle again in wage-price spiral.

    You cannot print money and pay interest with newly printed money forever, government HAS budget constraint in the long run – see this article from Nick Rowe: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/04/functional-finance-vs-the-long-run-government-budget-constraint.html

    Now there is a free lunch, which is based on people trusting government and letting themselves be fooled by low inflation and loosing purchasing power on paper currency. However upper boundary on this stable level of seinorage si somwhere around 0,25% of GDP. It is not nearly significant enough to count on for financing government.

    So long story short, there always is long run Government Budget Constrain. So Paul is right, governments have to have to be revenue/spending responsible in the long run. So this Bill’s rant about how “governments dont have to be bond financed” and how Paul is stupid is totally out of place.

  53. @J.V. Dubois

    The weather must be nice where you are. You’re building men of Straw!

    Krugman made a fool of himself a few years ago waffling about Saltwater and freshwater economists. Back then he happened to be up against John Cochrane et al from the Chicago school who did him a favour by making bigger fools of themselves in sticking to their Scientology.

    Kaiser

  54. “Then printing may be bad solution if not sterilized by bonds or reserves with positive interests rates ”

    And where has such an approach been suggested?

  55. “Let’s suppose for a moment that there are no taxes (only printing press), and that government spends 30% of GDP.”

    Then that means 30% of GDP is being saved by the non-government sector.

    What is causing them to reverse that saving, and why wouldn’t the taxation system then rise to neutralise it at that point.

    In other words you have the mechanisms to deal with the problem in the future, so deal with it in the future.

    The approach you are suggesting is like refusing to live life today so that you are forgiven in the afterlife. And just as stupid.

  56. “For private sector not to use real resources they will require government to pay at least 30% interest”

    They’re not using real resources now, and we’re not paying anywhere near as much.

    So you’re mental model is based upon the full employment assumption – which is empirically false.

  57. Tom

    What “real assets” do you see the banks clamouring to buy with their unwanted excess reserves? Property? Jars of Aunty Madge’s homemade apricot jam?

    Banks don’t need reserves in order to purchase assets, btw. No different from the creation of a bank loan. So the bank asset purchase->customer redeposit->further bank asset purchase mutiplier you allude to is defunct.

  58. Dear J.V. Dubois (at 2011/08/18 at 19:23)

    So now what would you do if you suddenly realized that you live in a country where there is going to be zero nominal interest rate and positive inflation from now on forever?

    As far as I can recall Australia has had a positive inflation rate every day of my life. Most other countries too.

    best wishes
    bill

  59. Tom,

    You stated that:

    “We are discussing different case i.e. printing with not bad economy (outside of liquidity trap). Then printing may be bad solution if not sterilized by bonds or reserves with positive interests rates and this sterilizng may occur if we have credible policy (otherwisse there is a risk of hyperinflation).”

    But this is exactly Bill’s position as you have admitted that positive interest rates on reserves may be used to “sterilize”.

    “When the central bank pays a support rate on overnight reserves it is effectively making them equivalent to government bonds. Both provide a return to the bank which would be indifferent between them (in the jargon of economics, they become perfect subsitutes) .
    So debt-issuance just allows the central bank to maintain a non-zero policy rate in the absence of a support rate being explicitly paid on reserves. Functionally, both can be seen as offering a support rate.”

    Please compare this with Paul Krugman’s view:

    “And I think the MMTers agree that this would lead to inflation; I’m not clear on whether they realize that a deficit financed by money issue is more inflationary than a deficit financed by bond issue.
    For it is. And in my hypothetical example, it would be quite likely that the money-financed deficit would lead to hyperinflation.”
    —
    The word “credibility” has a rather limited meaning not only in Central Europe. Was the policy run by A. Greenspan credible?

  60. “What is causing them to reverse that saving, and why wouldn’t the taxation system then rise to neutralise it at that point.”

    What? Read Paul’s article again. This is what he talks about like here

    “In the first [scenario], investors believe that the government will eventually raise revenue and/or cut spending, and are willing to lend enough to cover the deficit. In the second, for whatever reason, investors refuse to buy US bonds. The second case poses no problem, say the MMTers, or at least no worse problem than the first: the US government can simply issue money, crediting it to banks, to pay its bills.”

    So we already are comparing two scenarios – one is a government with budget constraints in mind, that means it is willing to promise that taxes and revenues will be balanced in the long run. Second scenario is just ignore budget constrain (Government with sovereign currency needs not be financed – first MMT comandment, remember?) and print whatever money is needed for government operations. Let’s assume that long-term path of government spending is known in both scenarios. But clearly the second scenario (no taxes) is more inflationary. Is it so hard to understand?

    So that means,government revenue and spending needs to be balanced in order to maintain trust in its currency. In current mainstream, interest on government bonds may be used as a signal for inflation expectations of public. If interest is high, that means that there is elevated risk of inflation expectation (we are talking about sovereign countries) – and that means that government needs to stabilize its budget position (increase taxation/cut spending). So in a sense it is a good way to think of government as being financed by bonds, even if governments are not financially constrained. We may imagine that governments are financed by “trust”. People postpone spending (increase saving) because they trust that government will make it so that when this debt is due they will retain the purchasing power. And in this sense bonds are a good indicator of the trust of private sector in its government.

  61. Bill: “As far as I can recall Australia has had a positive inflation rate every day of my life. Most other countries too.” And do they also have zero nominal interest rate? I don’t think so. Or in other words, can you name me in what countries was common to have negative real interest rate all the time?

  62. ParadigmShift,

    “What “real assets” do you see the banks clamouring to buy with their unwanted excess reserves? Property? Jars of Aunty Madge’s homemade apricot jam?”

    We are talking about economy outside of liquidity trap. Read Krugman’s or mine posts again.

  63. Adam

    “But this is exactly Bill’s position as you have admitted that positive interest rates on reserves may be used to “sterilize”.

    What I have said was that you shouldnt print outside of liquidity trap without sterilizing (in either form). And that is Krugman’s point. MMT people deny it (for example Cullen or Randall) they say that sterilizng doesnt matter because banks can alway lend (I dont agree).

    “The word “credibility” has a rather limited meaning not only in Central Europe. Was the policy run by A. Greenspan credible?”
    That’s a different issue. I am critical about a lot of issues but we are talking about logical reasoning. And it’s clear that sterilizing may be important outside of liquidity trap.

  64. “What I have said was that you shouldnt print outside of liquidity trap without sterilizing (in either form).”

    Tom, your cognitive dissonance may have caused you to miss my earlier comment.

    I will ask again. Who is suggesting that approach?

    Whether the monetary interest rate is positive, zero or negative depends upon what is required to induce the optimum amount of investment in the economy, ie the demand for Credit. And it would stay stable around that rate. MMT frees up monetary policy so that it can concentrate on encouraging the correct level of investment – rather than trying to control inflation and crippling investment or causing asset bubbles because the rate is set wrong.

    Fiscal policy takes the strain of maintaining aggregate demand, by targeting inflation and the unemployment rates – while leaving the currency exchange rate to float.

    What you’re suggesting is running the economy with the handbrake permanently on because you think there might be a problem with the engine overrevving. MMT just says fix the engine so it doesn’t overrev.

  65. ” But clearly the second scenario (no taxes) is more inflationary.”

    It might be, but that’s not the MMT scenario. The MMT scenario targets low unemployment and stable prices by offsetting the non-government sectors current desire to stock/hoard/save financial assets. And it can do this because the exchange rate floats providing the necessary degree of freedom.

    So I’m not sure what you’re describing, but it is not an economy that MMT influenced policies would create.

  66. Interesting how the vexing questions come down to the relationship between excess reserves and bonding effects on investments, economic activityand job-creation, all within the context of the present, unworkable, debt-based private fractional-reserve banking system.
    These questions would evaporate under a publicly-owned, full-reserve banking system where all money is issued without debt. And where debt becomes the financial function of allocating money to where it is needed for commerce.

    It has been several generations since Atlanta Fed Credit Manager Robert Hemphill made this statement, one which for some reason, neither liberal nor progressive economists seem to grasp.

    “”This is a staggering thought. We are completely dependent on the
    commercial Banks. Someone has to borrow every dollar we have in
    circulation, cash or credit. If the Banks create ample synthetic money
    we are prosperous; if not, we starve. We are absolutely without a
    permanent money system. When one gets a complete grasp of the picture,
    the tragic absurdity of our hopeless position is almost incredible, but
    there it is. It is the most important subject intelligent persons can
    investigate and reflect upon. It is so important that our present
    civilization may collapse unless it becomes widely understood and the
    defects remedied very soon.””

    To repeat:

    The Tragic absurdity of our hopeless position is almost incredible, but
    there it is.

    So, if you GET the picture, the solution is the divorcing of the monetary system from the debt-finance system.
    Simple as that. The provision of the economic means of exchange without the NEED for bank lending.
    A permanent public money system.

    http://www.monetary.org/wp-content/uploads/2011/08/yamaguchipaper.pdf

  67. Neil: What? Are you trying to dodge this discussion again? Could you please for a moment stick with the current topic of this blog, without any sidesteps? This is what Bill wrote in this blog.

    “1. The national government matches its net spending (deficit) dollar-for-dollar with debt issuance.

    2. The national government does not match its net spending with debt issuance – that is, it doesn’t borrow but uses its intrinsic currency monopoly to spend without any accompanying monetary operation (selling debt).

    As to the first scenario he outlines, you can see the mainstream roots poking out in his statement that the bond markets will only lend because they thing that the “government will eventually raise revenue and/or cut spending”. The reality is that the bond markets will lend because they want a stake in a risk-free (guaranteed) annuity. They enjoy the corporate welfare benefits that bonds provide – a risk-free assets in troubled times, a risk-free asset to price the risk embodied in their other private assets off. a guaranteed income.”

    Clearly what Bill says nonsense and Paul is right. If you read all my posts above, and you are honest you must admit it. People would never buy any bonds (or would never hold money even on interest bearing reserve account) if government committed to abolish taxes and finance everything by printing press. For currency to remain credible its issuer has to be credible. Having power to tax is not enough, as was proved countless times in a history.

  68. “I will ask again. Who is suggesting that approach?”

    This statement is from Scott Fulwiller (from Krugman’s blog): “Fourth, no, a deficit financed by “money” is NOT more inflationary than a deficit financed by bonds.”
    and this one is from Randall Wray (from creditwritedowns): “But selling bonds does not help! Bonds just mop up excess reserves. ”
    I cant agree with these statements (especially if economy is outside of liquidity trap.)

    Krugman: ” But the MMT people are just wrong in believing that the only question you need to ask about the budget deficit is whether it supplies the right amount of aggregate demand; financeability matters too, even with fiat money.”
    I agree with that statement

  69. Here is an explanation in the MMT paradigm of why spending without bond issue is more inflationary than with bond issue.

    The govt spends 10% of GDP (say, as in PK’s example) via ‘keystrokes’. This becomes bank reserves. But the banks wont hold these excess reserves, they will buy interest bearing treasuries with them. If the tsy has issued no corresponding bonds this will cause tsy prices to rise (until the total value increases by the amount of excess reserves) and yields to fall.

    Now bank lending is determined by demand, but the level of that demand is determined by the interest rate charged for loans. That in turn is determined by arbitrage with the risk free rate – tsys. In our example that rate has fallen, so the level of loan demand rises. Banks make more loans, which adds to AD over and above that caused by the govt. spending.

    How much it adds depends on how loan demand changes with rates. In a liquidity trap it is relatively inelastic, but not usually.
    A (overly simplistic) first guess might be that the banks make extra loans until the level of required reserves rises by the amount of ‘unfinanced’ spending (here 10% of GDP), at which point treasury prices (and hence rates) would return to their previous level.

    If the tsy does issue the corresponding bonds, the banks buy these with the excess reserves, the rate doesn’t change, so no extra credit creation.

  70. “I cant agree with these statements (especially if economy is outside of liquidity trap.)”

    They are not saying print though are they. Have you taken the time to understand the model context those statements are made in?

    To maintain a target rate of monetary policy, the monetary authority must issue Open Market Operation bonds at the rate or pay interest at the rate, or the interest rate will drop to zero. That’s in the deficit spending blogs on this site. It’s in the first three posts ever made here.

    And leaving the interest rate at zero just means that commercial bank price off zero and that the amount of credit they issue will likely be constrained by their capital ratios first before they run out of eligible borrowers. But it might not – it depends on how precautionary the population is feeling.

    Whether zero is an appropriate rate for an economy is another thing entirely.

  71. “Could you please for a moment stick with the current topic of this blog, without any sidesteps?”

    I’ll do that when you do. We generally discuss MMT here. Perhaps you’d like to make your description fit that model first.

  72. “They are not saying print though are they”
    They are saying that you can print with or without bonds because it doesnt matter. It is not true.

    “To maintain a target rate of monetary policy, the monetary authority must issue Open Market Operation bonds at the rate or pay interest at the rate, or the interest rate will drop to zero.”
    It is not true. Nobody can be forced to buy bonds. Investors may escape from financial markets and buy real assets.
    And interest rates certainly will not drop to zero in this case.

    And the last thing: if issuing bonds was not important and all US debt was in the form of monetary base (100% of GDP) how would you react if people wanted to spend it? Certainly you would not be able to decrease government spending by such aomunt of money.

  73. @ Tom, Friday, August 19, 2011 at 5:32

    Nobody can be forced to buy bonds.

    That is not true. Primary dealers are forced to buy Treasuries under current rules. But the real point is, there is no need for the Government to sell the bonds in the first place. It is a holdover from a previous currency system.

    Debates (and bad fiscal decisions) persist precisely because of the completely unnecessary issuance of Government bonds. The Government (in this case, referring to the US Federal Government), should just stop issuing bonds: see this post

  74. “I’ll do that when you do. We generally discuss MMT here. Perhaps you’d like to make your description fit that model first.”

    This is sooo frustrating. You are not presenting any models, only smokescreen of word games. Whenever you cannot respond to a single argument, you wander into completely different topic. It seems to me that not only you do not understand what mainstream economists talk about, but you do not understand MMT as well. But I will continue with your response to Toms post.

    “To maintain a target rate of monetary policy, the monetary authority must issue Open Market Operation bonds at the rate or pay interest at the rate, or the interest rate will drop to zero.”

    This is so untrue. If you would actually pay attention to what MMT critics say about the theory, you would see that this is nonsense. Just check this article by Scott Sumner: http://www.themoneyillusion.com/?p=10116

    What happens is that once government prints money (under normal times, not in liquidity trap) and it tries to sell the bonds at the REAL rate it chooses – which is not consistent with what private sector expects? Of course private sector cannot get rid of the money in the system (as only government can create and destroy money), but they cannot be forced to buy bonds. Instead, they may decide but to buy real world asset in a circle – diluting the purchasing power of money – until it again reaches the level at which they are willing to trust it enough to hold it.

  75. Why do people buy USG tsys? Because it is the safest and most liquid place to park money.

    What if there were no USG tsys issued at all? Then those funds would flow to the next safest and most liquid place to park money.

    Treasury issuance is operationally unnecessary under the present non-convertible floating rate monetary regime. Being unnecessary, the interest paid on tsys constitutes a subsidy to bondholders. It is a deadweight and inefficient and should be eliminated. This would encourage finance were it is needed operationally rather than taking away from were it is needed and putting it where it is not needed operationally. Or some of the funds would be invested.

    The funds that would have found a subsidized default risk-free parking place would have to park in the next best place, like triple A state, munis or corporates, where they would earn their keep, since these entities are currency users and need to borrow to finance themselves.

    Why subsidize inefficiency? There would be no inflationary effect from this change in asset ownership. The stimulation of effective demand from deficit spending that might become inflationary toward full employment comes from the initial spending that resulted in the deficit that required the tys offset. Then the answer is to reduce the deficit by cutting discretionary spending or raising taxes, which happens to some degree anyway through automatic stabilization falling and tax revenues rising.

  76. binve,

    “Primary dealers are forced to buy Treasuries under current rules”
    This certainly cant be true. They may be obliged to quote but not to buy at prices determined by the government.

    “Debates (and bad fiscal decisions) persist precisely because of the completely unnecessary issuance of Government bonds. The Government (in this case, referring to the US Federal Government), should just stop issuing bonds”

    So I will repeat my question: if issuing bonds was not important and all US debt was in the form of monetary base (100% of GDP) how would you react if people wanted to spend it? Certainly you would not be able to decrease government spending by such aomunt of money.

  77. Tom Hickey
    “Treasury issuance is operationally unnecessary ”
    “the answer is to reduce the deficit by cutting discretionary spending or raising taxes, which happens to some degree anyway through automatic stabilization falling and tax revenues rising.”

    The same question for you: if issuing bonds was not important and all US debt was in the form of monetary base (100% of GDP) how would you react if people wanted to spend it? Certainly you would not be able to decrease government spending by such aomunt of money.

  78. “The same question for you: if issuing bonds was not important and all US debt was in the form of monetary base (100% of GDP) how would you react if people wanted to spend it?”

    this would probably be a good thing. but set up smart automatic stabilizers to prevent it from getting out of hand.

    who’s prevented from spending because they have a tsy?

  79. “Of course private sector cannot get rid of the money in the system (as only government can create and destroy money), but they cannot be forced to buy bonds.”

    are we talking about banks? they have reserves. which can only be traded among banks. and if the banks have reserves which pay no interest and the fed is offering tsy’s which pay interest of course they will buy tsy’s. if the banks can’t buy treasuries, and cannot do anything else with them, the rates will of course fall to zero.

    all of sumner’s arguments assume no banks. this is useless

  80. “but set up smart automatic stabilizers to prevent it from getting out of hand.”
    What do you mean? How would you manage monetary base of this magnitude (100% of GDP).

    “who’s prevented from spending because they have a tsy?”
    If you have bond you can only spend if you get loan from the bank (with bond as collateral). And if too may people want to spend the value of colateral and loan must decrease. So it’s a different story than spending MB.

  81. “if the banks can’t buy treasuries, and cannot do anything else with them, the rates will of course fall to zero.”
    It is not true because every bank can do what it wants with its money and it doesnt have to buy financial assets but for example real assets or foreign assets.

  83. ” Instead, they may decide but to buy real world asset in a circle”

    Nope. Those decisions have already been resolved at that point. The holders of the reserves are holding them as their indifference point. They have rejected real world assets by definition.

    In other words the Horizontal transactions have completed. Spending decisions have been made and real assets purchased with reference to the central bank rate *set by the central bank*.

    The only decision left then is whether to hold the reserves, or swap for government bonds.

    That is a more accurate model of the way things work in practice.

  84. “how would you react if people wanted to spend it?”

    Bonds do not stop people from spending, any more than bank deposit accounts stop people from spending. There is a liquid market in both of them.

    There is no ‘magic’ in bonds.

  85. “Whenever you cannot respond to a single argument,”

    J.V

    You haven’t presented any arguments. You have just come out with the usual “I’m right and you’re wrong” line. Fine if that’s what you want to believe off you go.

    Now if you want to understand what the assumptions are underlying the MMT model then we may be able to get somewhere. Otherwise I’m struggling to see how I can help here.

  86. “What do you mean? How would you manage monetary base of this magnitude (100% of GDP).”

    what the hell are you even talking about? what does in system do when every single person ever everywhere tries to spend? it’s a stupid scenario and you’re lazy for bringing it up

  87. “It is not true because every bank can do what it wants with its money and it doesnt have to buy financial assets but for example real assets or foreign assets.”

    you don’t understand the us reserve system. sorry.

  88. “It is not true because every bank can do what it wants with its money and it doesnt have to buy financial assets but for example real assets or foreign assets.”

    It doesn’t buy real assets. It exchanges the reserves for assets with somebody else. You have to aggregate to several institutions.

    Example:

    Bank A has $100 of reserves.

    Person A has $100 of gold and $0 demand deposits in Bank B

    Bank B has $0 of reserves.

    Bank A buys the gold

    Bank A now has $0 of reserves and $100 of gold.
    Person A now has $100 demand deposit at Bank B
    Bank B now has $100 of reserves.

    And those horizontal transactions shuffle backwards and forward until the entities decide to hold the reserves *at the interest rate set by the central bank* (or taxation extinguishes the reserves if there is a transaction tax). You reach an indifference level in the Horizontal Transactions.

    At that point the only decision left relates to the Vertical Transactions – are there any other government liabilities with a better return.

    Clearly that is how it works in the real world because there is £150 billion of reserves in the UK banks and asset prices are crumbling. No evidence of a bid up from the banks there.

    Bear in mind that a bank can create money out of thin air so the only limit on what the banks can hold as assets is their capital ratios. They don’t need reserves to buy assets.

  89. “But the banks wont hold these excess reserves, they will buy interest bearing treasuries with them.”

    The MMT model states that reserves either have to bear interest at the target rate, or there are OMO bonds issued from the central bank at the target rate that drain the excess reserves.

    This seems to be the key misunderstanding. Unless the target rate is zero there will be interest paid on reserves somehow – either directly, via central bank market operations or via Treasury ‘funding’ bond auctions.

    This will be at the point where all the Horizontal Transactions have resolved in full knowledge of the target rate set by the central bank (and their OMO bond arrangements if they have them) and the bond issuing arrangements proposed by the Treasury. So the only decision left then by the entities left holding the net-financial-savings of the non-government sector is which Government liability to swap into.

    So the model AIUI is: Horizontal Transactions resolve to an indifference level based on the Vertical options available, then the Vertical Transactions resolve.

    And that is completes the cycle in MMT’s ‘government spending best thought of as coming first’ spending model.

  90. Tom says (Friday, August 19, 2011 at 8:57):
    “The same question for you: if issuing bonds was not important and all US debt was in the form of monetary base (100% of GDP) how would you react if people wanted to spend it? Certainly you would not be able to decrease government spending by such aomunt of money.”

    I just gave you the answer. If there were no USG tsys, then those that would have purchased tsys would purchase the closest substitute. Why would they spend when their proclivity is to save with safety and liquidity as indicated as a desire to hold tsys if they were available? The existence or non-existence of tsys or the amount of reserves/deposits doesn’t directly affect desire to consume.

    Spending is not curtailed by holding tsys because tsys are highly liquid and the one of the best forms of collateral, too. Holding tsys is immaterial to ability to spend. When a person holding tsys decides to spend, they simply sell the tsy to someone who desires to save. In aggregate the amount of reserves and tsys doesn’t change. Only asset ownership changes. There is a huge turnover in tsys and this is happening all the time. Some of that is used for consumption and investment, and the rest goes into other saving vehicles, or is left in deposit accounts for later use. If there are no tsys, then that saving vehicle is unavailable, and substitute saving vehicles will replace them.

  91. Neil Wilson said: “The MMT model states that reserves either have to bear interest at the target rate, or there are OMO bonds issued from the central bank at the target rate that drain the excess reserves.”

    Others have said something similar.

    What about raising the reserve requirement? Hasn’t china done this recently?

  92. “What about raising the reserve requirement? Hasn’t china done this recently?”

    Doesn’t that just mean the central bank has to supply more reserves when demanded to keep its target rate intact?

    To make that stick the monetary system has to choke off reserves at some point and just let the interest rate go up – which is how a 100% reserve system has to function if you want it to control Credit creation.

    So I don’t think it is the amount of reserves, ISTM that it is the monetary authority defending its target rate that is the kicker.

    We saw this in the UK during the last credit crunch period as LIBOR separated significantly from the Bank of England base rate, and it continued to do so until the BoE started supplying liquidity to bring it down.

    Not sure if there are any MMT blogs that explain whether it is a good idea for the monetary policy authority to defend its rate, or whether it should be a ‘collared rate’ (ie allowed to rise, but not fall).

  93. Just as much as MMTers criticize others when they point out that ‘banks are not reserve constrained when making loans’, there are things I’ve read MMTers say that are equally false. One I’ve seen often repeated is that “Loans create deposits”. If that was true, the treasury departments of Australian banks would have very little to do.

    Just take a quick look at the balance sheet of any of the big four Australian banks (and most US/UK banks for that matter, except names such as HSBC or Standard Chartered) and you will see that ‘customer deposits’ is only a fraction the size of the loan book.

    Banks have to fund loans BEFORE they make the loan. Australian banks very carefully manage their funding position which is mostly via borrowing medium/long term in the international market (mostly from US institutional investors) – because the deposit base in Australia is simply not big enough. No bank treasurer who wants to keep his job would make it his habit to borrow from another Aussie bank or, worse, from the lender of last resort (the RBA), to fund his loan book. Why do you think the Rudd government stepped in to offer sovereign guarantees to Australian banks post Lehman?!

    Take a hypothetical but not unrealistic example: Aussie bank finances, say, a US$20 billion takeover of a Chilean mining company by its Australian mining company client (say Rio or BHP). Do you reckon the “loan creates the deposit” mechanism works here? Do you really think Chilean shareholders convert their US$20b proceeds into AUD and deposit the money in Australian bank accounts? Of course not. They convert their US$20b into pesos and deposit the money into Chilean bank accounts. Aussie bank never sees the deposit.

  94. Neil Wilson’s post said: “”What about raising the reserve requirement? Hasn’t china done this recently?”

    Doesn’t that just mean the central bank has to supply more reserves when demanded to keep its target rate intact?”

    Maybe I wasn’t clear enough. I was referring to excess reserves, meaning the central bank wants the overnight risk-free rate to be higher than zero.

  96. Great bond-financed inflation discussion! One thing I could never understand about monetarists is why they care so much whether government is issuing bonds to “finance” its inflation-safe spending but never-ever I have heard anyone asking whether banks finance their loans only with term deposits? Maybe we should require them to do so? Actually, I know the answer. It is because government is bad and banks are good. Therefore government money-printed spending is always bad (inflation) but banks demand deposit printed spending is good (why actually?). In this whole “bond issuance a-la deficit spending” bla-bla-bla noone remembers that banks stand way ahead of any government in abusing the “inflation” scare of monetarist religion.

  97. “To maintain a target rate of monetary policy, the monetary authority must issue Open Market Operation bonds at the rate or pay interest at the rate, or the interest rate will drop to zero.”

    This is so untrue. If you would actually pay attention to what MMT critics say about the theory, you would see that this is nonsense. Just check this article by Scott Sumner: http://www.themoneyillusion.com/?p=10116

    What is so bizarre is that I can recall numerous Reserve Bank of Australia papers saying exactly that, if OMO are not conducted in the face of a government deficit, then the interbank rate will drop to zero.

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