‘Monetization’ of Budget Deficits

By L. Randall Wray [via CFEPS]

It is commonly believed that government faces a budget constraint according to which its spending must be “financed” by taxes, borrowing (bond sales), or “money creation”. Since many modern economies actually prohibit direct “money creation” by the government’s treasury, it is supposed that the last option is possible only through complicity of the central bank—which could buy the government’s bonds, and hence finance deficit spending by “printing money”.

Actually, in a floating rate regime, the government that issues the currency spends by crediting bank accounts. Tax payments result in debits to bank accounts. Deficit spending by government takes the form of net credits to bank accounts. Operationally, the entities receiving net payments from government hold banking system liabilities while banks hold reserves in the form of central bank liabilities (we can ignore leakages from deposits—and reserves—into cash held by the non-bank public as a simple complication that changes nothing of substance). While many economists find the coordinating activities between the central bank and the treasury quite confusing. I want to leave those issues mostly to the side and simply proceed from the logical point that deficit spending by the treasury results in net credits to banking system reserves, and that these fiscal operations can be huge. (See Bell 2000, Bell and Wray 2003, and Wray 2003/4)

If these net credits lead to excess reserve positions, overnight interest rates will be bid down by banks offering the excess in the overnight interbank lending market. Unless the central bank is operating with a zero interest rate target, declining overnight rates trigger open market bond sales to drain excess reserves. Hence, on a day-to-day basis, the central bank intervenes to offset undesired impacts of fiscal policy on reserves when they cause the overnight rate to move away from target. The process operates in reverse if the treasury runs a surplus, which results in net debits of reserves from the banking system and puts upward pressure on overnight rates—relieved by open market purchases. If fiscal policy were biased to run deficits (or surpluses) on a sustained basis, the central bank would run out of bonds to sell (or would accumulate too many bonds, offset on its balance sheet by a treasury deposit exceeding operating limits). Hence, policy is coordinated between the central bank and the treasury to ensure that the treasury will begin to issue new securities as it runs deficits (or retire old issues in the case of a budget surplus). Again, these coordinating activities can be varied and complicated, but they are not important to our analysis here. When all is said and done, a budget deficit that creates excess reserves leads to bond sales by the central bank (open market) and the treasury (new issues) to drain all excess reserves; a budget surplus causes the reverse to take place when the banking system is short of reserves.

Bond sales (or purchases) by the treasury and central bank are, then, ultimately triggered by deviation of reserves from the position desired (or required) by the banking system, which causes the overnight rate to move away from target (if the target is above zero). Bond sales by either the central bank or the treasury are properly seen as part of monetary policy designed to allow the central bank to hit its target. This target is exogenously “administered” by the central bank. Obviously, the central bank sets its target as a result of its belief about the impact of this rate on a range of economic variables that are included in its policy objectives. In other words, setting of this rate “exogenously” does not imply that the central bank is oblivious to economic and political constraints it believes to reign (whether these constraints and relationships actually exist is a different matter).

In conclusion, the notion of a “government budget constraint” only applies ex post, as a statement of an identity that has no significance as an economic constraint. When all is said and done, it is certainly true that any increase of government spending will be matched by an increase of taxes, an increase of high powered money (reserves and cash), and/or an increase of sovereign debt held. But this does not mean that taxes or bonds actually “financed” the government spending. Government might well enact provisions that dictate relations between changes to spending and changes to taxes revenues (a balanced budget, for example); it might require that bonds are issued before deficit spending actually takes place; it might require that the treasury have “money in the bank” (deposits at the central bank) before it can cut a check; and so on. These provisions might constrain government’s ability to spend at the desired level. Belief that these provisions are “right” and “just” and even “necessary” can make them politically popular and difficult to overturn. However, economic analysis shows that they are self-imposed and are not economically necessary—although they may well be politically necessary. From the vantage point of economic analysis, government can spend by crediting accounts in private banks, creating banking system reserves. Any number of operating procedures can be adopted to allow this to occur even in a system in which responsibilities are sharply divided between a central bank and a treasury. For example, in the US, complex procedures have been adopted to ensure that treasury can spend by cutting checks; that treasury checks never “bounce”; that deficit spending by treasury leads to net credits to banking system reserves; and that excess reserves are drained through new issues by treasury and open market sales by the Fed. That this all operates exceedingly smoothly is evidenced by a relatively stable overnight interbank interest rate—even with rather wild fluctuations of the Treasury’s budget positions. If there were significant hitches in these operations, the fed funds rate would be unstable.

9 responses to “‘Monetization’ of Budget Deficits

  1. This has been an excellent series of articles on monetary operations.A point:It’s a fact that the operational default scenario of not issuing bonds or currency forces the “funding” of the entire deficit through the banking system. This is hardly a minor operational detail. But as far as I’ve seen, it’s never mentioned as such. It seems odd not to point it out as a major institutional consequence. And now that the central bank can pay interest on reserves, bond issuance is not necessary operationally in order to control the overnight rate according to the policy target. So the default “funding” of the deficit as a forced operation through the banking system is if anything even less constrained from both an operational and monetary policy perspective.BTW, I use the term “funding” in quotation marks, for fear I may be picked up by the word policy for questioning. In fact, I think the use of this term as well as “finance” is in no way inconsistent with the idea that loans create deposits. It’s only seen that way by focusing on loan origination causality. Deposits are also capable of “destroying” loans at loan maturity. So in the context of that contingency and its causality, it seems quite reasonable to use language portraying deposits funding loans in the interim. That is, unless you prohibit the repayment of loans and bonds, and the production of surpluses, as well.Understanding the modern monetary system is a necessary but not sufficient condition for sound policy. Good policy must acknowledgement limits or guidelines of some sort at some point (limits that have nothing to do with non-existent operational constraints) – for monetary and fiscal policy – that is, unless you believe there is no need for either monetary or fiscal policy of any sort, and therefore no need for any concept of limits. We shouldn’t be learning good things about the modern monetary system under the assumption that the world will be in a deflationary dead zone forever. It would be good to see the topic presented in the context of an enduring policy framework that is relevant to all environments, rather than as holy water to be sprinkled on the neoclassical beast and a stake to be driven through its heart, because of its failure to understand modern monetary operations.

  2. Hi JKHI think all of my colleagues would agree with your points and have understood as much from the very beginning. Seems to me we just had this discussion on Bill's blog, so I'm not sure why you still suggest we don't understand some of these points.A few others . . . Regarding "relevant to all environments," see the "functional finance" literature and the job guarantee/ELR as a way of implementing it. Again, we've always qualified our approach as you are suggesting we do in many, many publications and blogposts . . . Warren says ALL THE TIME that the "constraint" is inflation. And note that most of our previous literature was published when the economy wasn't in recession.Regarding finance/funding, if everyone understood it as you do, it wouldn't be a problem. But they don't unfortunately . . those terms are used 99% of the time by economists and the press in a different manner than you are suggesting. I certainly won't "critique" you for using them in the future, but you must understand that your understanding of the term (while correct) is the less prevalent one in this debate.Regarding interest payment on reserves, I said as much in "paying interest on reserve balances" and "interest rates and fiscal sustainability" on CFEPS website, FYI.Best,Scott

  3. Scott,“I'm not sure why you still suggest we don't understand some of these points.”I’m not suggesting that at all; or at least I’m not intending to suggest it. I’m sorry to say this is another example of where you are misinterpreting the general nature of the point I’m trying to make, as with my previous discussion on the difference between policy and operations first time around. I’m not questioning your knowledge of the very subject your group are experts at. My suggestion is about presentation, not comprehension. Sorry if I’m repeating points already made elsewhere.E.g. my point on the banking system default conduit case is merely a small observation on the way a particular idea is presented. I know you explain the effect very clearly in terms of the effect on money and reserves; I just think the macro perspective on the banking system as an exclusive conduit (in the default case) is an interesting one.E.g. I know you qualify the operations perspective. That’s the very point. Indeed, it comes across as a qualification, almost footnote style, rather than a policy issue of primary importance – e.g. the inflation qualification. My point is that it deserves a higher profile than as a qualification to the point that there aren’t operational constraints. I’m simply suggesting a rebalancing of the message. The fact that operational issues are no constraint is very comforting, but it’s not sufficiently comforting to relegate the attitude to inflation per se to a footnote qualification. That’s my impression of the current balancing of operations versus policy in these discussions.Somewhere on Warren’s blog he writes about a meeting with a Washington law maker or bureaucrat; I can’t remember which one, but the person was high level. The crux of the meeting as I recall it described was that Warren’s attempt to explain the monetary system was met with “MEGO” comprehension. My impression, rightly or wrongly, from reading his description of the encounter, was that perhaps if the discussion had been framed more generally as the importance of operational understanding to policy formulation, the outcome might have been slightly more productive, at least the way he described it. Then again, that’s just my impression of it. And maybe I'm naive on the point that some people are determined to be thick.Believe it or not, I’m actually trying to make some suggestions that are intended to help position your message more strongly in a marketing sense. That’s my intention. Perhaps you already know that and believe you have it covered. But in that case, I would have expected the rest of the profession and the government bureaucrats and law makers to have prioritized its homework more highly with respect to operational understanding. Really, is your current message working as well as it should be right now? You should have converts by the thousands for something that is factual and mostly reflects double entry bookkeeping. It seems to me you could use some push back here if you’re going to get the message out more effectively. If the rest of the economics profession doesn’t get the reality you describe, that’s almost unbelievable to somebody like me. Like Warren said recently, it’s a disgrace. But maybe they don’t get partly because they’re not being motivated properly by the nature of the presentation.That’s all for now, Scott.

  4. JKHMakes sense . . . will work on not misinterpreting; it gets easier the more we do it, as we understand where the other's coming from better each time. It would be a lot easier to do this if we were just in a pub somewhere.Regarding balancing the message, right or wrong, the balance is mostly forced upon us since we're focusing on where the discussion is going wrong. But, agree completely with you overall. Bill put it well today on his blog: "In reaction to presentations I make, there seems to be an energy in question time (abusive or polite) that manifests as a stream of consciousness incorporating a confused cocktail of (neo-liberal) ideas which all spurt out in a row and get to the inflation, higher taxes, intergenerational burden in about 20 seconds – conflating accounting facts with other matters that are debatable and packaging them into the same conclusion – “your policy advice would be dangerous and bankrupt the country”. Never do these critiques remotely capture the argument from first principles and then agree that issues such as “the point we get to the inflation constraint” is the interesting one. The fact that government deficits add to private savings is an accounting statement and for me rather uninteresting. The real debate should be about full employment, inflation, income distribution, public versus private goods, education and skill building, productivity etc."Unfortunately, the terms of the debate aren't set on merit or marketing, but are instead quite deeply embedded in the academic economics, business, and political cultures (Veblen would call it ceremonial or even imbecilic). I suppose that strongly suggests we pay all the more attention to intelligent people like yourself that have suggestions for improving the message.Best,Scott

  5. JKHForgot to mention . . . regarding banking system as a conduit (I'm assuming by "default" you mean "standard case" and not "defaulting on the debt") . . . completely agree. The problem rhetorically here is that 99.9% of the profession, press, and politicians believe that not issuing securities is more inflationary than issuing them (i.e., "printing money"). So pointing out the standard case or the possibilities with interest on reserve balances isn't usually enough since most would think it a priori absolutely horrific to do so. And, of course, then we just have more "operational" or just accounting details to clear that up, and as Bill says, we never get to the interesting stuff that you really want to talk about.Best,Scott

  6. Scott you are really carrying the burden on these comments. Sorry. I am almost back into the swing of things, with start of school. Let me say, along with my good colleague Bill, that there is much confusion on accounting, descriptions of operations and policy proposals. So let me be clear here:a) money drives taxes, bond sales as reserve drain, central bank accommodation, and so on are descriptions.b) govt debt is private asset, govt deficit is private surplus and so on is accounting.c) ELR to stabilize economy and achieve full employment is policy proposal.I agree with Bill that it is very difficult to get this across to audiences. Thanks for your efforts to help sort it out. LR Wray

  7. It seems to me that "Chartalism" – money as a public monopoly – is the toughest nut to crack. Even PK sympathizers like Steve Keen and other circuitists don't buy into it, so it's no surprise that the mainstream is so resistant.Anyone who accepts Chartalism but doesn't buy into the rest of the Wray/Mosler/Mitchell/Fullwileret al program, is just not pushing the logic.

  8. What causes inflation, then, in Chartalist theory?Under Chartalism, what tools does the government and central bank have to control inflation?

  9. Here's a typicl layman's reaction: money is a government monopoly; it is the only item accepted for taxes. We get the money to pay our taxes because the government "spends" it into circulation by creating bank credit. But since money is a monopoly, why do we need to pay taxes in the first place. And what about the wealth created by production: transformaton of resources through knowledge and work?The great problem is words–words that have been politicized and therefore are laden with emotions. Technical language may try to skirt the problem, but for the layman it creates incomprension. It's all in the wording. First principles and their primary consequences need to be articulated in a way that causes no scurrying for an economics glossary, using concrete illustrations and ordinary language.