Monetary liquidity operations and fiscal policy interventions

Today, is the official launch of my new book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale – in Maastricht, which is an appropriate geographic location given the book proposes to dismantle the Eurozone. It just happens to be the place (Maastricht University), where we established CofFEE-Europe (a sister centre to my research centre in Australia). There are two excellent guest speakers (see below) and I am very grateful that they agreed to accept the invitations. The upshot is that I haven’t all that much time today. Over the next few days I will address some points that were raised in question time or at the reception (aka cup of tea and cakes) after the event in London last Thursday evening. There is still work to be done if the progressive side of politics is to fully understand Modern Monetary Theory (MMT) and the implications of it for policy development and choice.

PQE will fail

A person challenged me on Thursday about the policy proposal advanced within the Jeremy Corbyn camp which they, unfortunately, call People’s Quantitative Easing (PQE).

I wrote about this proposal in detail in this blog – PQE is sound economics but is not in the QE family.

I think it was unwise to call a policy approach PQE and thus suggest it is related to QE in some way but is ‘fairer’ because the ‘people’ get the benefits rather than the ‘banksters’.

This is a case when so-called smart politics shoots itself in the foot because the language is wrong and introduces unwarranted criticism which derails the underlying policy sense of the proposal.

PQE is not related to QE in any fundamental way – the latter is an asset swap that does not change the net wealth (net financial assets) of the non-government sector and is best seen as a central bank liquidity management operation.

PQE is, in fact, what has been called Overt Monetary Financing and is clearly a fiscal operation because it would alter the net wealth (net financial assets) of the non-government sector – it would increase the net financial assets in the non-government sector.

The operational realities of QE and PQE, in this respect, are fundamentally different and the terminology used by the Corbyn camp is profoundly misleading and in my view unhelpful.

You just have to see some of the conservative responses to the proposal when it was launched to see how the language has diverted the debate into irrelevant and erroneous disputes.

Please read the blog – OMF – paranoia for many but a solution for all – for more discussion.

The mistakes continued on Thursday night in London. I was told that the proposal was not worthy of support – some rather unfortunate descriptors were used – because the central bank would apparently counteract or offset the fiscal stimulus by selling bonds anyway, apparently reversing the spending stimulus.

Dear me!

So let us get this straight.

The argument presented was this (I note it has been articulated in some detail on a blog the following day and the term “monetary snake oil” was used to describe PQE). I won’t link to it because it doesn’t warrant receiving traffic.

The points raised though are raised regularly by those who want to have input into the debate but do not really understand fully what they are writing.

The discussion is about operating factors that govern a central bank’s ability to maintain a stable interest rate as an expression of its policy stance.

Modern Monetary Theory (MMT) has articulated this process more accurately and clearly than the mainstream (and for that matter, the more standard Post Keynesian thought).

Central bank operations aim to manage the liquidity in the banking system such that short-term interest rates match the official targets which define the current monetary policy stance.

So the central bank sets a particular interest rate as its policy position, believing that rate will condition all the borrowing rates in the economy and produce desirable influences on total spending (via the interest rate sensitive components of spending – investment and consumer durables).

The fact that spending may not be particularly sensitive to interest rates movements (and levels) is beside the point in the context of our discussion.

Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly.

If the demand for reserves is higher than the supply at any point in time, then there will be upward pressure in what we call the interbank market which is where banks shuffle reserve balances between themselves according to their own particular needs on any one day.

The opposite pressure will occur if there are excess reserves (supply exceeds demand).

Banks need reserves to ensure all the transactions drawn against them will be honoured within the payments or clearing system. If they are caught short on a particular day then they seek the funds from other banks (who might have more reserves than they need) or, ultimately, from the central bank.

Banks have an incentive to hold minimal reserves because they usually earn low rates of return, which could include a zero return.

The central bank has to ensure that there is no excess demand or supply in this ‘cash’ market, which is what liquidity management is all about. By ensuring that all demands for reserves by the banks are met, the central bank can eliminate pressures on short-term interest rates and thus sustain its policy position – as represented by the current short-term interest rate.

In managing liquidity, the central bank may:

(a) conduct so-called open market operations which means they will buy from the banks to add reserves (when there is excess demand) or sell government bonds to the banks to drain reserves (when there is a shortage of reserves) to ensure there is no reserve imbalance in the cash market.

(b) buy certain financial assets at discounted rates from commercial banks in exchange for reserves (a ‘reserve drain’).

(c) impose penal lending rates (‘discount’ rates) on banks who require urgent funds (a ‘reserve add’).

In practice, most of the liquidity management is achieved through (a).

That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non-government sectors.

It is crucial to understand the last point about the effects of these monetary or liquidity operations on the net wealth of the non-government sector.

In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.

Prior to the GFC, many countries set the rate at zero (the US and Japan, for example), while other nations, such as Australia and Canada gave some return on surplus reserve accounts which was below the policy target rate.

The support rate becomes the interest-rate floor for the economy.

The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability.

It is this spread that the central bank manages in its daily operations.

At the end of each day commercial banks have to appraise the status of their reserve accounts. In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period.

Those that are in deficit can borrow the required funds from the central bank at the discount rate. Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing.

Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate.

When the system is in surplus overall this competition would drive the rate down to the support rate.

The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.

The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt.

When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate.

Importantly, we characterise the debt sales by the central bank as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.

It is also important to understand the impact that fiscal deficit spending (government spending in excess of taxation receipts) has on the ‘cash’ position of the economy each day. The obverse impacts occur for surpluses.

Government spending (G) adds to bank reserves and taxation (T) drains them. So on any particular day, if G > T (a fiscal deficit) then the level of bank reserves are rising overall.

Any particular bank might be short of reserves but overall the sum of the bank reserves are in excess. It is in the commercial banks interests to try to eliminate any unneeded reserves each day. Surplus banks will try to loan their excess reserves on the Interbank market. Some deficit banks will clearly be interested in these loans to shore up their position and avoid going to the central bank’s discount window which usually will be a more expensive option.

The upshot, however, is that the competition between the surplus banks to shed their excess reserves puts downward pressure on short-term interest rates.

But the non-government banking system cannot by itself eliminate a system-wide excess of reserves that the fiscal deficit created. A loan by one bank to another doesn’t alter the reserve position overall.

But the central bank can obviously alter the overall reserve position – in this case it would sell bonds to the banks to drain reserves. The bonds are attractive to the banks because they are risk-free and bear interest.

The alternative is to offer a support rate on the excess reserves. This decouples the relationship between the bond sales and the central bank interest rate maintenance operations.

This background is essential to understand and demonstrates why the “snake oil” accusation levelled at PQE is … um … snake oil.

We read from the un-cited article:

And here’s why People’s QE (PQE) is snake oil. So long as the BoE is still targeting inflation, it will still be pushing and pulling money in and out of the system, as required to meet demand for money at the interest rate it has set. If the BoE is still targeting inflation, then whatever money PQE puts into the economy on one hand, the BoE is going to be taking out with the other. Or, if the BoE happens not to take the money out, that implies it would have been putting it in, anyway. And that means that over the long run … the extent to which the government is able to spend without borrowing, is not affected by PQE.

Spot the confusion?

First, the central bank expresses its inflation target as a particular inflation rate and sets the interest rate that it thinks will scale total spending in the economy to be consistent with the available real productive capacity of the economy to produce goods and services for sale.

The reserve operations we described above are not designed to reduce or increase total spending in the economy but, are rather, designed, as explained, to manage the reserve position in the cash markets and ensure the interest rate target is met each period.

Second, there is a confusion here between the reserves in the banking system (stocks) and the flow of spending that the PQE would generate.

The implication that PQE adds “money” which is then taken out again by the central bank intent on controlling inflation is quaintly inaccurate.

The monetary operations influences the reserve position of the system and the way non-government wealth is expressed (the so-called portfolio composition of wealth) but not the spending capacity of non-government sector. That is quite another thing.

The central bank operations do not ‘take money out of the system’ – in the sense of taking purchasing power from the non-government sector. Reserves are not loaned out by banks to those seeking credit.

Please read the following blog – Building bank reserves will not expand credit – for further discussion.

Third, the central bank does not have to conduct any open market operations (reserve adds or drains) to sustain its target rate of interest. It can simply make it costless for banks to hold the extra reserves by matching the support rate to the target rate. Then the excess reserves are indistinguishable from holding an interest-bearing government bond.

Fourth, and most importantly, the fiscal effects of the PQE deficit spending, which increase net financial wealth (assets) in the non-government sector are not altered by the particular monetary operation that the central bank deploys to sustain its monetary policy interest rate target.

The latter operations do not alter the net financial assets in the non-government sector. They merely alter their composition (cash or bonds, for example). The fiscal intervention directly boosts spending whereas a bond sale has no obvious impact on overall spending given that it involves a swap of a reserve balance (cash) for the bond.

So depending on the operations conducted by the central bank to manage liquidity, there is no reason to every issue government debt to match deficit spending.

The central bank would not have to conduct any open market operations and could just leave the reserves in the system, which effectively means the interest-earning reserve accounts are identical to interest-earning bonds, just the name of the ‘account’ with the central bank (government) is changed. Trivial.

Which means the statement that “that over the long run … the extent to which the government is able to spend without borrowing, is not affected by PQE” misses the point entirely. The PQE changes the net financial assets in the non-government sector, the monetary operations do not.

The author indicated that PQE was different to QE because the latter is an asset swap that has little impact on total spending (if any), whereas PQE directly impacts on total spending.

Which makes the previous comments about the central bank effectively stifling the expansionary impact of PQE rather odd to say the least.

But apparently this means PQE will cause inflation:

For PQE inflation is a feature, not a bug. Now it’s true that there may be some slack in the economy and some of the things the envisaged PQE-financed National Development Bank would do might raise productive capacity, so there might be some scope to raise demand without inflationary pressure. But step beyond that and either the BoE would neutralise it, or, if prevented from doing so, we’d get inflation.

First, inflation is not a feature of what has been termed PQE. Inflation is a risk associated with all spending – government or non-government.

Second, it is also not an inevitability of an ever expanding money supply. As long as there is real productive capacity available to absorb the nominal growth in spending, firms will increase output when sales demand increases.

Third, issuing bonds to the non-government sector does not reduce the inflation risk of government deficit spending. That operation just alters the cash-bond-other financial asset mix of non-government wealth.

Fourth, of course inflation will result if nominal spending (whether it is called PQE or whatever) outstrips the real productive capacity to respond. Hardly insightful and a point that is not exclusive to ‘PQE’ or what I would prefer to call Overt Monetary Financing (OMF).

Stephanie came up with the extension – Overt Monetary Financing for Government (OMFG), which I thought was cute but ranks up there with my original name for the Job Guarantee – the Buffer Stock Employment scheme (BSE). That acronym fell into disrepute into the 1990s when cows became ill in Britain!

So essentially all this nonsense about monetary operations etc come down to an argument that OMF would be inflationary. Well a well managed policy framework would take care of that.

It would not be up to the central bank to “neutralise it” How actually would it do that? The only tool it has is to try to raise interest rates, which might actually deliver perverse results.

Given inflation risk is about spending not these monetary operations, the sensible policy framework, should the government consider it desirable to utilise a particular quantity of real productive resources in an infrastructure program and know that that spending would drive the system beyond its real limits, is to deprive the non-government sector of purchasing power through taxation increases.

The taxation increases directly reduce net financial assets in the non-government sector just as the spending adds to them. The central bank would have nothing to do with these policy shifts.

The rest of the un-cited diatribe is more inflation scaremongering – out of control left-wing politicians sacking central bank governors and spending too much.

It also propagates neo-liberal myths that governments should finance deficits with debt issuance especially when interest rates are low which, according to this economist, makes OMF “entirely unnecessary”.

Same old.

Conclusion

There were several other issues raised that I will address in the coming days (maybe).

But the arguments about OMF (or ‘PQE’) are a good vehicle to really demonstrate the difference between a monetary operation and a fiscal policy intervention.

Unfortunately, the differences are no well understood which leads to the conclusions that OMF would be inflationary. It might be but not because there is no debt issued. It would be inflationary if it pushed nominal spending beyond the capacity of the economy to respond in terms of producing more real output.

A related issue that came up was the need to issue bonds at all. OMF is criticised by some who seem to understand the operational differences I have discussed in this blog because, as best I can understand, the workers need a safe asset in which to park their savings.

We might agree on the last bit but that doesn’t require any public debt being issued. I will come to that argument in the following days.

Today’s Event – Book Launch Maastricht, August 31, 2015

The official book launch for my new book – Eurozone Dystopia – Groupthink and Denial on a Grand Scale – will be held on Monday, August 31, 2015 at the Maastricht University, the Netherlands.

The Launch will be held at the SBE Building, Tongersestraat 53, Maastricht University.

Room: A0.4.

The event will run from 13:15 to 14:30. Refreshments will be served afterwards (aka tea and biscuits) with drinks to follow.

There will be two excellent speakers:

1. Dr László Andor, former Commissioner for Employment, Social Affairs and Inclusion in the Barroso II administration of the European Commission.

2. Professor Arjo Klamer, Professor of Economics of Art and Culture at Erasmus University in Rotterdam, The Netherlands. He “holds the world’s only chair in the field of cultural economics”.

The public is welcome to the event.

I hope to see a lot of people there in Maastricht today.

Just rock up to the venue.