I read an interesting report this morning, which resonated with some other work I had…
There was a recently published Federal Reserve Bank of New York Staff Report – Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks – by Kenneth D. Garbade, which recounts the way the central bank in the US could purchase unlimited amounts of treasury debt by creating funds out of thin air and how that capacity was eventually constrained. The Report is an understated account of the way in which the conservative ideological forces eventually prohibited this capacity and forced the US government to only issue debt to the private sector. He shows that between 1917 and 1935, this capacity was used often “without incident” but as the conservative antagonism grew it was limited (in 1935) and then abandoned altogether in the early 1980s. The Report demonstrates there were no intrinsic financial reasons for abandoning this capacity.
There was an article in the New York Times (March 28, 1917) – Reserve Banks Lend M’Adoo $50,000,000 – which said that:
To maintain the working level of the general fund of the Treasury, Secretary McAdoo has borrowed on Treasury certificates from the Federal Reserve Banks $50,000,000 at 2 per cent per annum … The Federal Reserve Banks subscribed with such promptness that at 3 P.M. today the entire amount had been taken.
The Secretary of the Treasury Mr McAdoo said that the “twelve Federal Reserve Banks … are fiscal agents of the Government”.
Part of the funds went to pay the sale price of the Danish West Indies, now the US Virgin Islands (note: Did you know this Warren?!).
The other interesting aspect of the ‘loan’ was that the private bond markets were not interested in the deal and a spokesperson said that “other institutions would not care to invest their funds in these securities at the very unattractive rate”.
The prevailing market rate at the time on short-term Treasury certificates was 3 per cent.
These developments are considered in detail by the recently published Federal Reserve Bank of New York Staff Report – Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks – by Kenneth D. Garbade, who has also written some interesting historical papers (and a book) on related topics.
The essential facts traversed in the Report are as follows.
1. “The original version of the Federal Reserve Act provided a robust safety net because the act implicitly authorized the new Reserve Banks to buy securities directly from the Treasury”.
2. “The Banks made active use of their “direct purchase authority” during, and for a decade and a half after, World War I. Congress acted to prohibit direct purchases in 1935, but reversed course and provided a limited wartime exemption in 1942. The exemption was renewed from time to time following the conclusion of the war but ultimately allowed to expire in 1981.”
The Report considers three questions:
(1) why did Congress prohibit direct purchases in 1935 (after they had been utilized without incident for eighteen years), (2) why did Congress provide a limited exemption in 1942 (instead of simply removing the prohibition), and (3) why did Congress allow the exemption to expire in 1981?
The analysis is important because similar situations and facts are found in most nations. But in the last three decades or so, the concept of direct purchases of government debt by the central bank has become taboo.
There is no good reason for that taboo status and many related problems of the operation of the monetary system would be resolved if central banks returned to that role – which in the current debate is being referred to as Overt Monetary Financing (OMF).
Please read my blog – OMF – paranoia for many but a solution for all – for more discussion on this point.
I also devote a chapter in my forthcoming book on the Eurozone to the topic of OMF.
Kenneth Garbade shows that the original legislation establishing the Federal Reserve Bank system in the US (the Federal Reserve Act) clearly allowed the the Federal Reserve Banks to buy unlimited amounts of Treasury bonds directly from the Treasury.
Prior to 1935, that power was used regularly. The first time was the matter I opened with that was covered in the New York Times article of March 1917.
He documents how the Federal Reserve Board has some reluctance to purchase directly and considered “that the normal services of the Bank as fiscal agent will best be rendered by assisting in distributing Government securities rather than by acting as a purchaser of them.”
That is, buying government bonds in the secondary markets (once they had been issued via tender) from non-government bond holders.
Between 1917 and 1935, the US Treasury regularly borrowed directly from the Federal Reserve Banks when they felt they were running short of cash.
Then in 1935, the Federal Reserve Act was qualified by the the Banking Act of August 23, 1935, which meant that the Federal Reserve Banks could only purchase government bonds “in the open market” – that is, the secondary market. The Report concludes that this “proviso explicitly prohibited direct purchases of Treasury securities by Federal Reserve Banks.”
What brought that change about? Kenneth Harbade notes that the original intent of the change was to allow the “Reserve Banks to buy obligations fully guaranteed by the United States as well as direct obligations of the government”.
It was observed by the US House of Representatives Committee on Banking and Currency, which was overseeing the legislation that:
There is no logic in discriminating against obligations which, being in effect obligations of the United States Government, differ from other such obligations only in that they are not issued directly by the Government.
In other words, it was flim flam to prohibit the central bank from purchasing debt from the Treasury directly when it could simply signal to the private bond markets that upon issue, it would buy unlimited quantities of bonds from them (indirectly).
These sort of accounting ruses dominate government fiscal operations today and place a smokescreen over what is really the intrinsic nature of the monetary system.
They lead people to conclude that the private sector is ‘funding’ a government, which issues the currency in the first place and has to spend it first before it can borrow it back.
Of course, the effect of pointless exercises like that are that they provide the neo-liberals with ammunition by linking government deficits with public debt buildup and then all the rest of the nonsense about ‘mortgaging the grandchildrens’ futures’ and the like are wheeled out on a largely ignorant public to engender political support for austerity-type fiscal stances.
It is all a total ruse and the House Committee in 1935 clearly knew that.
But there colleagues in the US Senate changed the legislation to prohibit “direct purchases of Treasury securities by Federal Reserve Banks” although the Senate Banking Committee “did not explain the reason for the prohibition”.
Kenneth Harbade cannot find a clear answer to why they introduced this prohibition against the wishes of the Treasury at the time, which considered it essential to have that direct capacity in times of emergency.
The obvious reasons are entertained in the Report.
First, “direct purchases may have been prohibited to prevent excessive government expenditures”.
Second, to prevent “chronic deficits” and force the government to the “test of the market”. As if the private bond markets have the interests of the entire nation at their hearts.
In relation to these motivations, it is clear that the neo-liberal expression of this over the last three decades has overwhelmingly imposed massive political restrictions on the ability of the government to use its fiscal policy powers under a fiat monetary system to ensure we have full employment.
In Europe they took the constraints to one higher level of idiocy by banning any ECB bailout (since violated) and imposing the Stability and Growth Pact. But in other monetary systems where the national government still issues the currency, the voluntary constraints are also oppressive.
We now accept very high unemployment and underemployment rates as a more or less permanent feature of our economic lives because of the ideological constraints imposed on government.
The collapse of the Bretton Woods system in 1971, which freed currency-issuing governments of any financial constraints, did not prevent the logic that applied in the fixed exchange rate-convertibility days from being imposed despite the economic fact that it does not apply in the fiat currency era.
As a result, governments impose voluntary constraints on themselves to satisfy the dominant ideological demands of the elites.
To see how this ideology works you just have to examine the establishment of the Australian Office of Financial Management (AOFM), which was set up as a special part of the Federal Treasury to management federal debt in the 1980s. The Australian experience is common around the world in almost all countries.
While there was a lot of hoopla about it being an “independent agency”, the reality is that this is all largely cosmetic – the AOFM is still part of the consolidated government.
Prior to the establishment of the AOFM, government bond issues were made using the ‘tap system’. The government would announce some face value and coupon rate at which it would issue debt and ‘turn the tap on hard enough’ to meet the demand at that yield.
Occasionally, given other rates of return in the financial markets the issue would not be fully subscribed – meaning some of the net spending would be covered in an accounting sense by central bank buying treasury bills (government lending to itself!).
In other words, the government could sell bonds directly to the central bank at whatever rate it deemed useful and the private bond markets (just as in the 1917 issue reported above) could do little about it.
This system was highly criticised by private bond markets and the neo-liberal cheer squads in economics departments. In 2000, the Deputy Chief Executive Officer of AOFM (seemingly content on perpetuating neo-liberal myths) claimed the practice was:
… breaching what is today regarded as a central tenet of government financing – that the government fully fund itself in the market. It then became the central bank’s task to operate in the market to offset the obvious inflationary consequences of this form of financing, muddying the waters between monetary policy and debt management operations.
The so-called “central tenet” – is pure ideology and has no foundation in any economic theory. It is a political statement. But mainstream economics is happy to blur the boundaries between theory and ideology and students are left none the wiser.
But the impact of this antagonism to direct central bank purchase was to constrain the government from creating full employment, which the conservatives hated because it threatened to redistribute more of the national income toward labour.
Since the 1980s as governments maintained high rates of labour underutilisation under pressure to do so from the business lobby, the profit share in national income has burgeoned.
In the face of massive pressure from the neo-liberal lobbies, the Australian government introduced some really stupid reforms to the way government bond markets operated. All these policy choices and changes to the ‘operations’ of the bond markets were voluntary choices by the Government based on ideology. There is nothing essential about the changes. Further, they are largely cosmetic.
They replaced the tap system with an auction model to eliminate the alleged possibility of a ‘funding shortfall’. Accordingly, the system now ensures that that all net government spending is matched $-for-$ by borrowing from the private market. So net spending appeared to be ‘fully funded’ (in the erroneous neo-liberal terminology) by the market.
The central bank wasn’t prohibited by law from purchasing government debt (directly) for ‘liquidity management’ purposes but the change meant that the price (yield) would vary to accommodate even the most risk-averse private bond dealer and so the volumes would always be sold.
But in fact, all that was happening was that the Government was coincidently draining the same amount from reserves as it was adding to the banks each day via the fiscal deficit and swapping cash in reserves for government paper. The bond drain meant that competition in the interbank market to get rid of the excess reserves would not drive the interest rate down.
The auction model merely supplied the required volume of government paper at whatever price was bid in the market. So there was never any shortfall of bids because obviously the auction would drive the price (returns) up so that the desired holdings of bonds by the private sector increased accordingly.
As an aside, at that point the secondary bond market started to boom because institutions now saw they could create derivatives from these assets etc. The slippery slope was beginning to be built.
But you see the ideology behind the decision by examining the documentation of the day. This quote is from a speech from the Deputy Chief Executive Officer of AOFM. He is talking about the so-called captive arrangements, where financial institutions were required under prudential regulations to hold certain proportions of their reserves in the form of government bonds as a liquidity haven.
… the arrangements also ensured a continued demand from growing financial institutions for government securities and doubtless assisted the authorities to issue government bonds at lower interest rates than would otherwise have been the case … Because such arrangements provide governments with the scope to raise funds comparatively cheaply, an important fiscal discipline is removed and governments may be encouraged to be less careful in their spending decisions.
So you see the ideological slant. They wanted to change the system to voluntary limit what the Federal government could do in terms of fiscal policy. This was the period in which full employment was abandoned and the national government started to divest itself of its responsibilities to regulate and stimulate economic activity.
And in case you aren’t convinced, here is more from AOFM:
The reduced fiscal discipline associated with a government having a capacity to raise cheap funds from the central bank, the likely inflationary consequences of this form of ‘official sector’ funding … It is with good reason that it is now widely accepted that sound financial management requires that the two activities are kept separate.
Read it over: reduced fiscal discipline … that was the driving force. They were aiming to wind back the government and so they wanted to impose as many voluntary constraints on its operations as they could think off. All basically unnecessary (because there is no financing requirement), many largely cosmetic (the creation of the AOFM) and all easily able to be sold to us suckers by neo-liberal spin doctors as reflecting … read it again … “sound financial management”.
What this allowed was the relentless campaign by conservatives, still being fought, against the legitimate and responsible use of fiscal deficits. What this led to was the abandonment of full employment.
The third reason that Kenneth Harbade provides for the 1935 change was that “the prohibition was aimed at limiting the expansion of Federal Reserve Bank balance sheets”. The mainstream economists erroneously claimed then as they do now that this would lead to a rapid escalation in the money supply which was necessarily inflationary. As we have seen in the current crisis, no such causality exists.
Inflation is a product of spending rather than build up of bank reserves. Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.
Fourth, “the prohibition was inserted at the behest of Government securities dealers” (that is the bond traders who profit from the primary issue). The Report quotes Mariner Eccles, the Chairman of the Board of Governors of the Federal Reserve System at the time who said that:
I think the real reasons for writing the prohibition into the [Banking Act of 1935] … can be traced to certain Government bond dealers who quite naturally had their eyes on business that might be lost to them if direct purchasing were permitted.
Kenneth Harbade notes the fallacy in all of this. The Reserve Banks could still buy unlimited amounts of government debt in the open market “the idea of limiting expenditures, deficits, or Reserve Bank balance sheets by prohibiting direct purchases was clearly fallacious”.
Regular readers will recall the experience in Australia in 2001-02.
In the Budget Paper No 1 for 2012-13, under Statement 7 entitled Future of the Commonwealth Government Securities Market, there was the statement:
In 2002-03, the Review of the Commonwealth Government Securities Market was undertaken in response to concerns about the future viability of the declining CGS market. Since this review, successive governments have committed to retaining a liquid and efficient CGS market to support the three- and ten-year Treasury Bond futures market, even in the absence of a budget financing requirement.
The term ‘budget financing requirement’ is highly misleading. It is not a financial requirement that is intrinsic to the monetary system. It is a voluntarily imposed rule that the government issue debt to match its deficit spending. The rule could be abandoned at any time without any change in the government’s capacity to spend resulting.
The 2002 Review was initiated by the Federal government. In effect, the Commonwealth government was retiring its net debt position as it ran surpluses and were pressured by the big financial market institutions (particularly the Sydney Futures Exchange) to continue issuing public debt despite the increasing surpluses.
At the time, the contradiction involved in this position was not evident in the debate although I did a lot of radio interviews trying to get the ridiculous nature of the discussion into the public arena.
The federal government was continually claiming that it was financially constrained and had to issue debt to ‘finance’ itself. But, given they were generating surpluses, then it was clear that according to this logic, the debt-issuance should have stopped.
While the logic is nonsense at the most elemental level, the Treasury bowed to pressure from the large financial institutions and in December 2002, Review to consider “the issues raised by the significant reduction in Commonwealth general government net debt for the viability of the Commonwealth Government Securities (CGS) market”.
I made a Submission (written with Warren Mosler) to that Review.
The Treasury’s (2002) Review Of The Commonwealth Government Securities Market, Discussion Paper claimed that purported CGS benefits include:
… assisting the pricing and referencing of financial products; facilitating management of financial risk; providing a long-term investment vehicle; assisting the implementation of monetary policy; providing a safe haven in times of financial instability; attracting foreign capital inflow; and promoting Australia as a global financial centre.
That is the logic noted above that during the GFC, the liquid and risk-free government bond market allowed many speculators to find a safe haven. Which means that the public bonds play a welfare role to the rich speculators.
The Sydney Futures Exchange Submission to the 2002 Enquiry considered these functions to be equivalent to public goods.
It was very interesting watching the nuances of the federal government at the time. On the one hand, it was caught up in its ideological obsession with “getting the debt monkey off our backs” – which was tantamount to destroying private wealth and the associated income streams and forcing the non-government sector to become increasingly indebted to maintain spending growth.
But it was also under pressure to maintain the corporate welfare. There was no public goods element to the offering of public debt. The argument from the financial institutions amounted to special pleading for sectional interests.
Private markets under-produce public goods. When economic activity provides benefits beyond the space defined by the immediate ‘private’ transaction, there is a prima facie case for collective provision. If CGS markets could be shown to produce public goods that enhance national interest, which cannot be produced in any other (more efficient) way, then this would be a strong, pro-CGS argument.
We argued in our submission that: (a) the benefits identified by Treasury which are used to justify the retention of the CGS market can be enjoyed without CGS issuance; and (b) more importantly, these benefits cannot be conceived as public goods, and rather, at best, appear to accrue to narrow special interests.
We also argued that:
They appear to be special pleading by an industry sector for public assistance in the form of risk-free CGS for investors as well as opportunities for trading profits, commissions, management fees, and consulting service and research fees.
Furthermore, and ironically, their arguments are inconsistent with rhetoric forthcoming from the same financial sector interests in general about the urgency for less government intervention, more privatisation (for example, Telstra), more welfare cutbacks, and the deregulation of markets in general, including various utilities and labour markets.
We justified this conclusion by closely examining futures markets, the superannuation markets and related issues. It should be understood that CGS are in fact government annuities.
The continued issuance of debt despite the Government running surpluses was really a form of corporate welfare – to provide safe investment vehicles to private investment banks.
We argued that with a flexible exchange rate, where monetary policy is freed from supporting the exchange rate, there is no reason for public debt issuance to private bond markets.
In this context the real policy issue was how well the Government was performing relative to the essential goal of full employment.
Our conclusion at the time, that the macroeconomic strategy had failed badly, also predicted the current crisis:
Despite the government rhetoric that the “strategy has contributed to Australia’s sound macroeconomic framework and continuing strong economic performance”, the recent economic growth has been in spite of the contractionary fiscal policy. Growth since 1996 has largely reflected increased private sector leveraging as private deficits have risen. Further, the recent ability of the Australian economy to partially withstand the world slowdown is due to the election-motivated reversal of the Government’s fiscal strategy, which generated the first deficit in 2001-02 since 1996-97.
A return to the pursuit of surpluses will ultimately be self-defeating. For all practical purposes any fiscal strategy ultimately results in a fiscal deficit as unsustainable private deficits unwind. But these deficits will be associated with a much weaker economy than would have been the case if appropriate levels of net government spending had have been maintained.
So the bottom line in this debate (which led to a Treasury Inquiry) was that the demand for continued public debt-issuance even though the federal government was running increasing surpluses appeared to be special pleading by an industry sector to lazy to develop its own low risk profit and too bloated on the guaranteed annuities forthcoming from the public debt.
Nothing much has changed in the 12 years since that Review. In the 2012-13 ‘Budget Paper No 1″, the Government clearly supported the retention of corporate welfare in the form of debt issuance.
… the Government consulted a panel of financial market participants and financial regulators on the future of the CGS market … The panel underlined the crucial role of a liquid, AAA-rated CGS market and associated futures market during the crisis and supported retaining liquidity in these markets as the primary objective for the CGS market in the future … Maintaining liquidity in the CGS market to support the three- and ten-year bond futures market will continue to be the Government’s primary objective, in particular as Australian banks prepare for the 2015 commencement of the Basel III liquidity requirements. In addition, the Government will: support liquidity in the Treasury Indexed Bond market by maintaining around 10 to 15 per cent of the size of the total CGS market in indexed securities; and continue to lengthen the CGS yield curve incrementally, in a manner consistent with prudent sovereign debt management and market demand … These objectives will mean that at some stage after the budget has returned to surplus, the Government will need to transition from reducing the level of CGS on issue to maintaining an appropriately sized CGS market … To ensure flexibility in implementing the Government’s objectives for maintaining a deep and liquid CGS market, and to meet the Government’s financing needs over the forward estimates, the Government will seek an amendment to the Commonwealth Inscribed Stock Act 1911 to increase the legislative limit on CGS issuance.
Back to the FRBNY Report.
Kenneth Harbade recounts how the 1935 probition was relaxed in 1942 to allow the “Treasury would have to borrow huge sums of money” to prosecute its war effort.
Mariner Eccles wrote at the time that by allowing direct purchase of debt by the central bank the nation “avoid the necessity of having the Treasury offer Government obligations for sale on the open market at a time when the market is demoralized and an additional public offering might add to the confusion and demoralization of the market and do incalculable harm to the Government’s credit and to the holders of outstanding Government obligations.”
Eccles went further though and believed that the Treasury should never be at the behest of the private bond markets. He said:
If the market situation happens to be unfavorable on any given day when a financing operation is up … the Federal Reserve System should be in a position where it can take care of it by a direct purchase from the Treasury of an issue of securities.
Of course, as the ECB demonstrated in May 2010 when it launched its Securities Market Program, the capacity of the central bank to control government bond yields is unlimited. It can simply offer to purchase whatever is available at a fixed price in the open markets and that will effectively set the yield at the particular maturity in question.
Whether they buy the debt directly from the Treasury or indirectly makes little difference in this respect. The former avenue is always preferable from a Modern Monetary Theory (MMT) perspective because it cuts out the corporate welfare element inherent in exclusive primary issuance to non-government dealers.
The 1942 amendment allowed the central bank to buy debt directly from the Treasury but only up to a certain limit ($US5 billion).
That situation persisted into the 1970s.
Kenneth Harbade notes that there were:
Two innovations in Treasury cash management in the mid-1970s – short-term cash management bills and payment of interest on Treasury Tax and Loan accounts at commercial banks – had important consequences for the ultimate fate of the direct purchase exemption.
I haven’t time today to discuss this in detail. The essence is that the new innovations gave the treasury access to “obvious alternative source of short-term funding”.
Since 1981, “Treasury never again issued securities directly to the Federal Reserve” and the capacity to do so expired under the legislation in June 1981.
The most effective way for governments to run their fiscal affairs is to use the currency-issuing capacity embedded in the consolidated government (treasury and central bank) directly without erecting a labyrythincic structure of voluntary constraints, which make it look like the funding is coming from the private sector savings.
Public sector welfare provision should only be targetted at those who are disadvantaged with the aim of providing opportunities for all to be included in society at acceptable real living standards.
It should never be provided to private (rich) bond traders nor be used to create derivative financial products that spread this wealth among the financial market casino.
In that sense, while direct purchase of government debt by the central bank is preferable to issuing the debt in the private bond markets, the more obvious solution is to have an arrangement where the central bank credits and debits bank accounts to reflect spending and taxation flows, without having to issue any ‘debt’ instrument at all.
After all, it is just taking something from the left pocket and putting it in the right pocket of the same jeans!
That is enough for today!
(c) Copyright 2014 Bill Mitchell. All Rights Reserved.