What If the Government Just Prints Money?

By Scott Fullwiler

As Congress gets set in the near future to consider raising the debt ceiling yet again, my fellow blogger L. Randall Wray creatively suggests not raising the debt ceiling but instead having the Treasury continue spending as it always does: by simply crediting bank accounts. As he puts it:

The anti-deficit mania in Washington is getting crazier by the day. So here is what I propose: let’s support Senator Bayh’s proposal to “just say no” to raising the debt ceiling. Once the federal debt reaches $12.1 trillion, the Treasury would be prohibited from selling any more bonds. Treasury would continue to spend by crediting bank accounts of recipients, and reserve accounts of their banks. Banks would offer excess reserves in overnight markets, but would find no takers—hence would have to be content holding reserves and earning whatever rate the Fed wants to pay. But as Chairman Bernanke told Congress, this is no problem because the Fed spends simply by crediting bank accounts.
This would allow Senator Bayh and other deficit warriors to stop worrying about Treasury debt and move on to something important like the loss of millions of jobs.

Wray’s proposal is based upon modern monetary theory (MMT) that is the focus this blog and those by Bill Mitchell, Warren Mosler, and Winterspeak. Of course, given the lack of understanding of basic reserve accounting at the heart of MMT and Wray’s proposal on the part of the public, the financial press, and the vast majority of economists, one can already anticipate the outpouring of criticism suggesting that such a proposal amounts to “printing money” and thereby destroying the value of the currency. Some probably will even argue that this would put the US on the road to a fate much like Zimbabwe’s (for a good analysis of what’s actually happening in Zimbabwe, see here).

As such, this post considers whether a given deficit resulting in more reserves in circulation and fewer bonds held by the non-government sector raises the likelihood of spiraling inflation, as most interpretations of the government budget constraint (GBC) assume. The approach here recognizes the importance of understanding the balance sheet implications of both of these options that are central to MMT. While most economists typically assume a supply and demand relationship, as in the hypothesized loanable funds market, and then build models accordingly, such an approach can miss important relationships in the real world. In particular, any transaction in a capitalist economy results in changes in the agents’ financial statements; if the hypothesized supply and demand relations are not consistent with the actual changes occurring within the financial statements of the relevant agents, then the hypothesized model is irrelevant. In a modern money regime such as ours in which there is a sovereign currency issuer operating under flexible exchange rates, “monetization” versus “financing” as characterized both in the GBC and in the hypothesized loanable funds market fall into this category.
Consider first the case in which the federal government runs a deficit but neither the Treasury nor the Fed sells bonds. This is “monetization” as usually suggested by the GBC. As always, and as noted by Wray, the Treasury spends by crediting bank reserve accounts at the Fed, while simultaneously instructing the banks to credit the deposit accounts of the recipients of the spending. (The process is simply delayed a bit where the Treasury sends the recipient a check, triggered when the recipient deposits the check at his/her bank.) Taxes have the reverse effects. For a government deficit, the Treasury’s credits to accounts are greater than what has been debited via taxation. Figure 1 shows the balance sheet effects of a government deficit for the private sector, with the effects on banks and non-banks shown separately.

As the quantity of reserve balances banks desire to hold to settle payments and meet reserve requirements is already accommodated by the Fed, the deficit in Figure 1 creates excess balances. Prior to fall 2008, Fed operating procedures set the federal funds rate target above the rate paid on reserve balances; in that case, the federal funds target would be bid down—theoretically, to the rate paid on reserve balances. Figure 1—or, “monetization”—thus was not an operational possibility under previous Fed procedures that set the target rate above the rate paid on reserve balances. In other words, prior to fall 2008, even if the federal government wanted to “monetize” the deficit, either the Treasury or the Fed would still have been required to sell bonds to hit the Fed’s target rate. However, since the Fed now sets the target rate equal to the rate paid on reserve balances, no such bond sales by the Fed or the Treasury are necessary. Instead, as the Treasury spends and excess balances increase, the Fed’s target can still be achieved and the Fed can raise or lower its target as desired by simply announcing an equivalent change to both the target rate and the rate paid on reserve balances.

Figures 1 (above), 2 (below), and 3 (below) demonstrate that government deficits create increased net saving in the non-government sector. By definition, additional net saving flows to a given sector are shown on a balance sheet as additional net financial assets and net worth for that sector. The creation of any financial asset generates both an asset and a liability given the two-sided nature of financial assets; in the case of a government deficit, the liability remains on the government’s balance sheet while there is a simultaneous increase in net equity or wealth in the non-government sector.

In Figure 1, the new net financial assets for the non-government sector are the additional deposits—the M1 measure of money—on the non-bank sector’s balance sheet unaccompanied by an offsetting increase in its liabilities.

Figure 2 shows the same deficit accompanied by a bond sale that is purchased by banks. The Treasury security purchase by the banking sector is settled by a debit to reserve accounts. As already explained above, the operational effect of the reserve balance drain is to support the interest rate target under traditional operating procedures. There is still an increase in net financial assets or wealth of the non-government sector, as the deposits (M1) remain on the non-bank private sector’s balance sheet. Figure 3 shows the same deficit accompanied by a bond sale to the non-bank private sector, as in sales to non-bank Treasury dealers. As in Figure 2, the reserve drain enables the Fed to sustain the federal funds rate target under traditional operating procedures, and there are again net financial assets created for the private sector in the form of Treasuries on the non-bank private sector’s balance sheet. (While some may object to the placement of the deficit as the first event and the bond sale as the second event in Figures 2 and 3, note that the ultimate effect on net financial assets is identical regardless of how one orders the transactions.)

In terms of the effect on net financial assets for the non-government sector, the figures show that there is no difference between “monetization” or bond sales besides potential effects on the federal funds rate that depend on the Fed’s chosen method of achieving its target. But from the widely-held view that “monetization” is more inflationary than bond sales, Figure 1 is assumed to be more inflationary than Figures 2 and 3. Regarding Figure 1, though, recall that banks do not use reserve balances or deposits to make loans, as loans CREATE deposits; bank lending or money creation instead occurs when banks are presented with opportunities to lend at an expected profit (and have sufficient capital). Banks instead hold reserve balances ONLY for settling payments and meeting reserve requirements (see, for example, my previous post on bank lending and reserve balances here), and their desired holdings for these purposes are always accommodated by the Fed at its target rate. What this means is that the reserve balance drain shown in Figures 2 or 3 can in no way restrict potential money creation by banks.

Another implication, or (at least) interpretation, of the GBC view and the loanable funds market is that the Treasuries added to the non-bank private sector’s net wealth in Figure 3 are less stimulative than the deposits created in Figure 1. But this is also clearly false, as it ignores the fact that M1 money is left circulating when bonds are sold to banks, as well (as shown in Figure 2), so the distinction to be made in that case is actually between bond sales to the non-bank public and bond sales to banks (i.e., Figures 1 and 2 versus Figure 3) even though to my knowledge no economist has ever suggested that bond sales to banks were more inflationary than bond sales to the non-bank private sector.

Finally, that the non-bank private sector is holding Treasuries rather than deposits in Figure 3 does not somehow constrain its spending. Rather, just as current holders of deposits could choose to convert their new wealth to time deposits instead of spending, individuals holding Treasuries (which are essentially time deposits at the Fed) could opt alternatively to leverage their wealth (and Treasuries happen to be highly valuable as loan collateral). Indeed, whether holding deposits or Treasuries, with greater net wealth and net income flows provided by a government deficit, the non-government sector might logically be more likely to spend than without the deficit while also appearing more creditworthy to banks (who again themselves are never constrained by the quantity of reserve balances or deposits in the amount of lending or money creation they can engage in). In any event, in the presence of a government deficit, spending by the non-government sector is in no plausible way constrained by the fact that it currently might be holding Treasuries instead of deposits.

In sum, whether or not a deficit is accompanied by bond sales is irrelevant for understanding the potential inflationary effects of the deficit. Under normal Fed operating procedures in place until fall 2008, the operational function of bond sales was to support the interest rate target, not to “finance” a deficit. A government bond sale does not somehow reduce funds available for non-government agents to borrow as presumed in the loanable funds market approach, while the absence of a bond sale does not somehow mean there is a greater amount of liquid financial assets, income, or “funds available” for borrowing or spending than without the bond sale. Instead, a government deficit always adds to the non-government sector’s net financial wealth whether or not a bond sale occurs. Both the Treasury’s bond sales and the Fed’s operations affect only the relative quantities of securities, reserve balances, and currency held by the non-government sector; the total sum of these is set by the outstanding government debt. With or without bond sales, it is the non-government sector’s decision to spend or save that matters in regard to the potential inflationary impact of a given government deficit. Indeed, to be more precise, a deficit accompanied by bond sales is actually the MORE potentially inflationary option, as the net financial assets created by the deficit will be increased still further when additional debt service is paid.

46 Responses to What If the Government Just Prints Money?

  1. Lets for a second assume that you are right. Then why tax anbody at all. Why does the government just print the money it needs. After all it has no effect on inflation. The governemnt should just run a 4 Trillion defecit and who cares after all running a deficit is not a problem we can just print the money. We borrowed 800 billion from the Chinese. Why don't we just print the money and pay them back now. This way we won't have to pay intrest anymore. Oh wait a minute, they might come to the conclusion that our dollar is worthless since we are just priniting it.

  2. You've completely missed the point. I didn't say the government should never tax. What I said was, for a GIVEN deficit, it is not more inflationary to not sell bonds than it is to sell them. A deficit itself could very well be inflationary. Scott Fullwiler.

  3. Anonymous! Govt taxes to so that it can modulate the spending capacity of the non government sector. That way it can control inflation. As for borrowing money from chinese, that is again a misunderstanding propogated by the neoliberal mainstream economists.First of all, loans create deposits and not the other way round.Second of all, a sovereign currency issuer does not have a theoretical revenue constraint. Imagine you buy a something from some store and acquire financing to buy it. the process of financing creates the money needed to buy that something. It is not like the money has come from some deposit. This being the case the money hasn't come from China. It just so happens that the Chinese that got this money choose to buy treasuries with this money. It is like moving money from a checking account to an interest bearing savings account (treasuries).Dollar's worth is the result of the fact that you and I can fulfil our tax obligation to the US govt only in US Dollars.It does not matter if the Chinese come to the conlusion that USD is worthless since it does not impact the US governments ability to do deficit spending. I strongly recommend/suggest that you should read more of this blog and others like the billy blog before commenting as a matter of fact. Hopefully you will become a fellow traveller. Thanks Vinodh

  4. Scott,Good post. While I understand and agree with what you covered here, some who argue that this "printing money" is inflationary aren't thinking of expanded lending, but rather of asset bubbles that eventually drive higher spending through the "wealth effect", however illusionary it is. This is potentially inflationary (though for this crisis specifically I think the deflationary forces are likely too large for meaningful consumer price inflation to result) and such bubbles can take years to pop (see 2003-2007).Bill Gross gives the quintessential summary of this psychology here: "The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks." The key here is that holders of low nominal yield deposits (your Figure 1 scenario) at times seem to have a higher propensity to bid up financial asset prices than holders of treasuries (your figure 3 scenario) purely due to human psychology, and that even though this doesn't increase private sector wealth according to MMT accounting in which tradeable assets have implied matching liabilities, it does increase "wealth" with respect to how people actually think and make spending decisions.To be clear, I don't agree that low rates "force" any such behavior in any inevitable mechanical sense, and have other problems with these "liquidity" arguments, but enough people think this way at times to bid asset markets higher regardless of fundamentals, and such bubbles have generated their own inflationary momentum in the past. That seems to me to be the larger fear in the econoblogosphere behind the combination of negligible nominal short term rates and the use of quantitative easing. I realize this topic isn't at all new for you but it would be nice to see it addressed further from an MMT perspective.A quick separate question (FYI, I'd still like to see an MMT wiki with categorized topics, summaries, and links!) Some countries don't have reserve requirements now… did all countries have them before banks were allowed to engage in activities other than just making loans? If not, what reason would banks have had to compete for (and pay interest on) deposits? I don't think central banks were paying interest on reserves until recently…

  5. Scott, your logic is impeccable, but some missing facts would reveal its limited applicability. If the Fed pays interest on reserves, apart from issues of central bank independence, it does not matter whether the government sells bonds or not – indeed if the bonds offered a lower interest rate than was expected to accrue (at a floating rate) on reserves, the bonds would not sell anyway. As accumulated deficits increase the interest payable on reserves or bonds, even if the interest is entirely due to citizens, payment will still probably generate distributional conflict. If the Fed does not pay interest on reserves, then the terms of trade that the government gets when it pays for its deficit spending in reserve balances are going to get worse – in other words, prices will rise. The degree of inflation that this causes will depend on the non-state's willingness to hold non-interest-bearing state liabilitiies (ie reserves, convertible on demand into currency). Since that has been typically rather small in relation to government spending (ie base money is typically no more than a few percent of GDP), I doubt that there is much scope for non-inflationary deficit spending. (I made similar points on LRW's previous post, but, at the time of writing he has not answered them).But ultimately, all this monetary discussion is vacuous. China is effectively lending the US real resources, and while the Chinese can be cheated once by changing the real value of the dollar in which contracts with them have been written, if the US does so, it will pay in other ways. Either future contracts will be less favourable to the US or the net flow of real resources will stop and the US will be forced to cut its consumption abruptly. Not to mention the damage to creditors' goodwill towards the US.

  6. Rebel . . . thanks for the thoughtful comments!1. Regarding cb independence, if target rate = rate paid on rbs, then I don’t see how cb independence has been compromised.2. Not the point of my paper, but the Tsy can certainly sell Tbills at below the Fed’s target rate . . . they’ve been doing it for decades. 3. Not completely following you on the int pmt generating distributional conflict.4. Regarding terms of trade and no int pmt on rbs, I’m assuming you think there will be a move out of the $ as earnings on govt liabilities go to zero. Possibly, of course (though they could hold non govt liabilities earning a higher rate), but they have to move “somewhere,” and that can ultimately only be some other nation that has chosen to run a trade deficit, by definition. Regarding inflation impact, if no interest on govt liabilities leads to lower saving desires of the pvt sector, then, yes, the deficit should be smaller to avoid inflation. Don’t know that I agree this would necessarily happen (it’s not happening in Japan, for instance, whose liabilities are at or close to zero for the majority of the term structure), but if it did, then a smaller deficit would be called for.5. Regarding China, yes, they may at some point decide to run trade deficits instead of surpluses, which would worsen our real terms of trade. That doesn’t stop us from fully utilizing our own capacity, though, but our consumption could then be limited to more closely follow what we produce than now. Again, though, this assumes that the rest of the world stops desiring to run trade surpluses with the US . . . I’m still waiting to hear which countries are going to be lining up for trade deficits.Best,Scott Fullwiler

  7. HBL . . .thanks for the comments!Regarding your points surrounding the Gross quote, agree with you regarding the likelihood (lower interest pmts may stimulate borrowing, but the net effect has to consider the effect on interest income earners . . . in Japan for instance, the latter appear to dominate the effects of low interest rates). And if Gross and others you refer to end up being right, then the deficit can be smaller. No problem. Again, though, it hasn’t worked in Japan, and they actually tried very proactively to do the sort of things Gross describes. (Note, though, that private sector wealth can increase without deficits, but not “net financial” wealth.)Good idea on the Wiki.Regarding reserve requirements, this paper may be of interest: http://www.cfeps.org/ss2008/ss08r/fulwiller/Fullwiler%20Modern%20CB%20Operations.pdf Best,Scott Fullwiler

  8. Even with the repeal of Glass-Steagal, it's still the case that unlike a deposit account, in a brokerage account the customer owns the assets outright. For example, if I have a joint brokerage and checking account at Wells Fargo, and transfer funds from my checking account into the brokerage account to buy a treasury security, the bank's reserves and deposits decrease by the amount transfered, but the bank does not hold the treasury as an asset — I hold it.Wells Fargo cannot use that treasury as part of a repo operation, and it does not appear on Well's balance sheet just as the contents of a customer safety deposit box does not appear. They are only off-balance sheet liabilities in the event of fraud or theft. If you make this distinction between brokerage accounts/safety deposit boxes and deposit accounts, then your model would change. Bond sales reduce bank reserves outright. I guess you can call it "interest rate maintenance", but I think this is misleading. All that matters is the ability of the government to put downward pressure on credit growth, and there are many ways to achieve this, such as dynamically adjusting capital requirements, enforcing reserve requirements that increased with deficits, direct lending limits (say based on customer incomes), charging banks for any non-cash asset held, etc. In fact, government-set interbank rates are a socially harmful device to limit credit growth, just as paying interest on reserves is harmful. In the former case, banks use their low cost of funds to buy up securities in the private markets, or lend to straw borrowers (e.g. SIVs) who buy up real estate or other assets. So banks are earning income just because the government is deficit spending. This is much worse from a fairness point of view than selling bonds in an auction open to everyone. I agree that you do not *need* to sell bonds, but you do need to institute other measures to limit credit growth if bond sales are suspended. Otherwise this will put upward pressure on consumer and/or asset prices, even if this just means that asset prices fall less than they otherwise would. Any compensating measures should not give banks an unfair advantage over non-bank investors, otherwise the public will not support them. We've had enough bank subsidies already, and enough government interference with asset prices.

  9. RSJ . . .thank you1. I WAS making this distinction regarding who owns the Treasury. I always do and I said very clearly that bond sales reduce rbs outright regardless who's buying them. That's the only way you can settle the bond sale with the Tsy, in fact.2. Reserve requirements have NO effect on credit growth. 3. Paying interest on reserves (as opposed to not paying and draining excess via bond sales) has NO effect on credit growth.4. So, not selling bonds has NO effect on credit growth (aside from possible effects of lower interest rates . . . but that can be alleviated by paying interest at the target rate, if desired, though I'm not necessarily advocating that) because reserve balances have NO effect on credit growth.5. Interest payment on reserve balances are NOT a subsidy for banks . . they are a tool to manage the overnight rate while keeping otherwise excess balances circulating. From the Tsy's perspective, it either pays interest on tsy securities, or it sees its revenue from Fed profits reduced by the amount of interest paid to banks. Concerns about non-bank investors can be alleviated by offering overnight or even term investment options at roughly the same rate as paid on rbs.Best,Scott Fullwiler

  10. I don't think points 1-3 are particularly important to our debate Scott, but so that you can judge, I will explain what I was thinking:1. In many countries, central bank independence laws (eg Article 101 of the Maastricht Treaty) would rule out a government overdraft at the central bank, so I am just excluding that consideration for the sake of argument. This is, by the way, why I prefer the term "state" to "government" when including the central bank.2. OK, treasury bills are somewhat more useful than reserves (eg there are more potential holders, can be posted as derivatives margin, etc), and a discount rate is not quite the same as a moneymarket rate, so bills can trade a little below Fed funds, but not much for long. Selling more bills would not make much difference to the state's cost of funding.3. By distributional conflict, I meant that a situation could develop where one sector of society was required to transfer a large fraction of their income to rentier holders of state debt (either bonds or interest-bearing reserves), which could cause internal unrest.Point 4 is key. If the state tries to pay for its purchases in reserves (or currency; the distinction does not matter here because reserves and currency are exchangeable on demand at par) which do not bear interest, once the non-state sector's demand for such financial assets is satiated (which existing central bank policy would suggest occurs at a few percent of GDP), the non-state is going to demand more and more reserves/currency in return for supplying goods and service to the state. The non-state sector cannot "get out" of reserves/currency (ie "dollars") while the state is running a deficit. But the non-state can demand better terms of trade for accepting them, which is inflation by definition. And if you accept that the state deficit should be constrained by the undesirability of inflation, then you need to consider where this constraint would start binding. The small size of the existing stock of base money in relation to normal government expenditure leads me to believe that this constraint would be binding with modest state deficits; perhaps even smaller than the present deficits.The example of Japan is interesting. One, I believe that Japanese are more willing to hold base money than Americans. Two, point 3 may apply (parasite singles, freeters etc). And three, Ricardian equivalence may well be at work. As I mentioned on the WCI blog yesterday, I think that Ricardian equivalence poses a big challenge to MMT. If the non-state sector regards itself as holding the equity of the state, and debits this holding as the state runs deficits, it is not even possible for state deficits to create net financial assets.The country that would least welcome a US trade surplus is…..the US! If countries like China stopped accepting US financial assets in return for real goods, the US would have to accept an abrupt fall in its standard of living, which would be effected, for example, via a rise in the price of oil.

  11. Thanks for the blog. I agree with your first answer : "for a GIVEN deficit, it is not more inflationary to not sell bonds than it is to sell them". But the point I don't understand is how you control the deficit with the proposal. This is the key point. If there is no control of the deficit, we have inflation and the consequences explained by Rebel. I think inflation is good for most people, and a political goal can be to produce inflation maybe, so that money does not accumulate at some places. But the point is to imagine a system which can be controlled. If the state can produce 10% more money this year, and 20% next year, and always more, using the mechanism you describe, there is a pb. Governments will probably monetize the debts because it will not be possible to pay interests otherwise. But we have to imagine how we put limits on this.

  12. won't ever happen, keep dreaming neo-chartians

  13. A bond is a legally binding promise of future (counter-inflationary) taxation. How long do you think holders of dollar-denominated claims will stand idly by while the state "just prints money?"

  14. Thanks for the reply Scott,100% reserve requirements would allow the government to keep banks in a debtor position and therefore would support the overnight rate just as well as bond sales, but without paying banks any interest, or paying interest on bonds. Agreed? And you do not need 100% reserves, but increasing reserve requirements in line with deficit spending would achieve the same thing.The fairness issue is that paying banks interest on reserves supplies them with pure profits simply because the government has expanded the monetary base — agreed? And they are giving nothing up, because we have no effective reserve requirements and all loans reappear as deposits.On the other hand, when a bond is sold to an investor (at auction), the investor must give up the opportunity to invest that money elsewhere, so the interest is compensation for lost opportunity. Unlike a bank, an investor does not get that money back in the form of a new deposit, but is actually giving something up. There is no "floor" underneath this compensation because the bond is sold competitively (and yields will go to zero if there are no better investment alternatives). Moreover, the total income received by investors is unchanged, as the total interest payments delivered from government to investors are offset by the sales proceeds going in the other direction. You have not made anyone richer by selling assets at market prices to investors. You do make banks richer by paying them interest just for holding money — something that they can't help but do.As to leverage, banks can always put their surplus deposits to use with leverage. For example, they can use repos to lever up to the level of the haircut. I.e. on a 10% haircut, banks can convert $10 of surplus deposits into a $100 of treasury holdings. So while it is true that loans create deposits, banks can create their own loans to put deposits into use, at least under the current regime. It is only when yields are so low that it doesn't pay to do this and incur the unwind risk that banks acquire surplus reserves — banks have little need of actual borrowers in the traditional sense, as using deposit funds to play the markets is lucrative enough.While it is true that a treasury bill held by an investor is acceptable as collateral (say for margin credit), non-bank entities do not have the same leverage facilities as banks. They will not get a 10:1 loan on their treasury security. Although this has changed somewhat with the Primary Dealer Credit Facility.

  15. Anon: I haven't read anyone that understands IORs as well as Scott Fullwiler.

  16. For RebelEconomist:“the non-state can demand better terms of trade…which is inflation..“Inflation occurs when there is demand in markets at, or close to, full employment of resources. Where do you see that occurring?Keith Newman

  17. RSJ,100% reserve requirement is meaningless!

  18. Keith,The issue is not about inflation now, but whether monetary financing of state deficits would lead to inflation in the longer term. At the moment, the state is already effectively "printing" money, because the government is issuing more bonds to finance its deficit and the Fed is buying similar bonds with reserves for monetary policy reasons, yet there are no unequivocal signs of inflation. The absence of inflation so far is partly because the demand for reserves is elevated by financial stress, and partly because even in a normal recession, monetary stimulus is supposed to work by acting first only on flexible price items in constrained supply – eg products – to generate demand for the sticky price items in surplus – eg labour. Inflation would not be expected to pick up until the precautionary demand for reserves is satiated and the underemployed resources are being utilised. But at that point, unless inflation is to be allowed to accelerate, monetary financing of state deficits must cease, and furthermore, if the precautionary demand for reserves falls or economic activity rises above potential, at least some of the past monetary financing must be reversed – ie the state must sell bonds to withdraw excess reserves. My contention is that, if the state does not sell bonds or (equivalently) does not raise the interest paid on reserves, because zero-interest reserves are considered an appropriate way to routinely finance a government deficit, inflation will inevitably accelerate when the slump ends.No doubt many would say that the priority should be to escape the slump, and any fallout can be dealt with later, but I would disagree. It seems to me that the problems of the US are mainly real (ie real consumption exceeding real income) rather than nominal, and that, while there is a good case for temporary monetary expansion to accommodate the precautionary demand for reserves and to smooth the slowdown as the economy adjusts after the bust, sustaining this expansion as a way of financing government deficits would, by establishing inflation, just add another problem to America's fundamentally unsolved real challenges.

  19. Ramanan,On the contrary, I suspect that a 100% reserve requirement is not at all meaningless. If I understand correctly what it means (ie one dollar in a reserve deposit at the central bank for every dollar taken in deposits), a 100% reserve requirement would mean that the state would largely monopolise the provision of transactions money, with the banks being forced to lend all transactions balances to the government at zero interest. As I suggested in a comment on the previous post by L.R.Wray, nationalising the provision of current accounts would increase the potential for the state to fund itself through non-interest-bearing reserves. While relegating the banks to mere fund collecting agents for the state might be appealing to many nowadays, it should be remembered that, at present, assuming that the banking system is competitive, the public gets transactions services relatively cheaply, either by being paid interest (as is the case in the UK) or given other benefits on current accounts or in the form of cheaper loans. If a 100% reserve requirement was imposed, the banks would have to charge (more) for providing transactions services, so the cost of government debt would be effectively passed on to the holders of current accounts.

  20. By the way, Scott makes a few quite dogmatic statements about banking that I would question – I am not necessarily saying that I disagree with them, but I would like to see some clarification, such as what other things are being assumed equal. The statements that struck me were:(1) In the main post, "banks do not use reserve balances or deposits to make loans, as loans CREATE deposits". I agree that loans create deposits, but can the reverse really be ruled out?(2) In his reply to RSJ on Nov 23 at 19.29, "reserve requirements have NO effect on credit growth". It seems hard to believe that requiring that a certain proportion of any deposit be placed in a non-interest-bearing account does not discourage balance sheet expansion, and with it, credit.(3) Also in his reply to RSJ on Nov 23 at 19.29, "paying interest on reserves has NO effect on credit growth". And if the compulsory deposit is interest-bearing, does that not reduce the disincentive referred to above?I would be grateful if Scott would expand on these points.

  21. Ellen Brown recently posted an article relevant to this discussion http://www.webofdebt.com/articles/lesson_japanese.phpOne side benefit of monetary reform like Ellen proposes in her book Web of Debt as well as Stephen Zarlenga's American Monetary Act @ http://www.monetary.org and Richard C. Cook's Credit As a Public Utility @ http://www.richardccook.com is the possiblility of doing away with Federal taxation for revenue. They may however be a need for taxation for regulation and stabilization to keep the money supply in tune with real economy.Since most people already think that the government creates all the money(when all they actually create now is interest-free coins) and that banks loan out money they already have (100% reserves) it would not be big conceptual leap to make these improvements.Henry Simon, creator of the 100% Reserve Solution (the Chicago Plan) in the 30s wrote "The mistake…lies in fearing money and trusting debt. Money itself is highly amenable to democratic, legislative control, for no Community wants a markedly appreciating or depreciating currency…"

  22. That's funny, Ramanan — why did the banks lobby so hard to lift these requirements and find loopholes in them? Why all the sweep accounts? It is because the banks do not want to hold any assets that are not earning a return. But this is exactly what we want — we must create a system in which banks hold large reserves that do not earn a return if we are to expand base money however we want, and still keep credit growth under control. This requires some differentiation between bank liabilities and which assets those liabilities can back.If we had not been floating 7 Trillion in debt, then we would have 7 Trillion in reserves that would now be accumulating interest payments. At 4%, this is 280 Billion a year of bank profits, going directly into bank capital. If Capital requirements are 12:1, this would enable 3.4 Trillion a year of bank balance sheet expansion, which the government is obligated to back via guarantees on deposits and automatic overdraft provisions. In other words, the lending power of the banks is growing at a rate of .04*12 = 48% a year in this system. As long as that is the case, the vertical sector is crowded out by the horizontal sector. This is the exact opposite relationship that we should have with banks. The real issue here is to use the benefits of non-convertibility for *both* the horizontal and vertical sector. It does not "cost" a bank more to hold 7 Trillion rather than 1 Trillion of reserves — they are just numbers in a computer — and we need to establish a system in which banks are required to hold more and more reserves, while at the same time being able to impose whatever cost of funds we want, *and* to keep the growth of bank capital in check. In a fiat world, there is no reason to allow banks to lend out deposits on a 1-1 for basis. Ideally, the private sector should contribute only bank capital and the government sector should supply the loanable funds. What we have now is a hybrid system in which the government supplies some of the loanable funds, and the private sector supplies the rest, together with bank capital. The net result is more positive feedbacks together with banks earning risk free returns as they mint profits during booms and are recapitalized by government during busts. In such a system, the public will be loathe to remove the checks on government — so there is a real battle between the horizontal and vertical system. Only by removing some of these positive feedbacks and regaining control of both bank capital and bank cost of funds under any deficit policy will the public accept a change to the Fed-Treasury relationship. Paying banks money does not shift the power balance towards the government.

  23. Sorry for the delay responding, RSJ (and I'll get to the others as time allows . . . apologies).1. Regarding 100% reserves, like Ramanan, I’m very skeptical that they will be able to constrain anything. Certainly under current operating procedures, they wouldn’t have any effect aside from the usual “tax effect” of RR, as the Fed provides reserves at stated rates. A much more constrained regime that required banks to only hold Tsy’s on the asset side would be different, but then you’ve just moved the endogenous creation of loans and their corresponding liabilities outside the banking system. The question there becomes who provides these latter institutions with overdrafts as they settle payments daily. If either banks or the Fed do, then you haven’t changed much, aside from regulatory structure. If nobody does, then you’ve set yourself up for a payments crisis at some point in the near future.2. Regarding the fairness issue, certainly it is viewed that way politically and in the financial press. But reserves are the lowest possible source of interest returns for banks, whereas the rate structure of their liability side hasn’t necessarily changed (and may have worsened, depending on the portfolio preferences of depositors . . . the creation of the reserve balances was accompanied by deposits initially). For instance, it’s very doubtful that a bank could be highly profitable while holding only interest earning rbs on its asset side. The choice in reality is probably between a regime with very few reserve balances and interest payment below the target rate (i.e., the cb drains all or most of the excess to hit the overnight target) or a regime with a large qty of balances and interest pmt at the target. From the bank’s perspective, it’s hard to say the latter is much more profitable than the former, if it is at all.3. The investor in a Tsy is making a choice between the risk/return profile of Tsy’s vs. that of all other potential investments. Aside from unusual circumstances (rush to safety, etc.), the “floor” is set by the cb’s target. The difference between rbs earning interest and an investor buying a Tsy is maturity (and maturity premia, of course), as Tsy’s are simply time deposits at the cb while reserve balances are overnight accounts at the cb. And both earn interest on their investment.4. VERY good points on leverage, repos, and banks. Further support for my view that it is bond sales that are more inflationary than cFullwilerreating non-interest bearing reserve balances or currency, and an interesting and relevant distinction b/n bond purchases by banks and non-banks.Best,Scott

  24. Regarding the queries by Rebel:(1) In the main post, "banks do not use reserve balances or deposits to make loans, as loans CREATE deposits". I agree that loans create deposits, but can the reverse really be ruled out?SCOTT: I am referring to loans, as in mortgages, commercial loans, etc. Yes, certaintly, a bank can receive a reserve inflow from payments to its depositors, and the bank can choose to sell these reserves in the fed funds market. I am fully aware of that. But additional deposits don't improve the bank's OPERATIONAL ability to create any of these loans, to basic customers, money markets, or whatever.(2) In his reply to RSJ on Nov 23 at 19.29, "reserve requirements have NO effect on credit growth". It seems hard to believe that requiring that a certain proportion of any deposit be placed in a non-interest-bearing account does not discourage balance sheet expansion, and with it, credit.SCOTT: See my previous post. It's the difference between operational ability to lend and an increase in costs on quantity supplied. RR don't affect the former, but can affect the latter. I've always acknowledged this by saying RR or the need to otherwise acquire reserves affects the PROFITABILITY of the loan; apologies for any confusion.(3) Also in his reply to RSJ on Nov 23 at 19.29, "paying interest on reserves has NO effect on credit growth". And if the compulsory deposit is interest-bearing, does that not reduce the disincentive referred to above?SCOTT: Same as my answer to the previous question.Best,Scott Fullwiler

  25. Anonymous said… Clarification for RSJ, Rebel, and others . . . The point about reserve requirements and credit growth is about banks' operational abilities to create loans/deposits. That is, a bank's operational ability to create a loan is never restricted by how many reserves it holds or must hold against deposits.However, YES, we've ALWAYS acknowledged that reserve requirements can raise costs, as they are effectively a tax. As in any market in which a tax is imposed on the supply side or costs are otherwise increased, this will shift the supply curve up and absent a shift in demand could result in a reduced qty of loans made.BUT, witness Canada, UK, Australia, NZ, Sweden, and so forth, without any RR . . . how do they control credit growth in your view? In other words, are you suggesting these countries cannot control credit growth (RSJ)?This does raise an interesting question, of course, which is whether RR could be manipulated to affect bank costs such that they could be a potential policy lever for controlling credit growth (note that even in this case, though, we are a long ways from the money multiplier model explanation of controlling credit). Some countries do try to do this. A related question is whether there are better (i.e., less disruptive and more effective) ways to do this, which most of my MMT colleagues would argue is the case (and some of these methods are in place already in some countries).Best,Scott Fullwiler

  26. Scott et al: yes reserve reqmts in system in which central bank does not pay interest on reserves acts as a tax and thus increases costs. Presumably this lowers return on assets and equity (unless fully passed along to bank's creditors and debtors). Impact on bank willingness to lend (and borrower willingness to borrow) is hard to assess. I doubt result of all this is significant on growth of loans. In any case, as we know, a lower ROE can actually encourage more leverage, more innovation, moving more stuff off balance sheet, and even faster growth of loans. LRWray

  27. Hi Scott,I think there is some confusion between describing the role of constraints in the current system, and the effectiveness of these constraints in a world without bond sales. You are proposing a world without bond sales, and I am pointing out a flaw and then "fixing" this flaw by suggesting full reserves. I am not saying that full reserves are needed now, or are relevant now. Reserves are small now in comparison to what they would be if no debt was sold. The proposed MMT regime: Remove "Fed Independence" and allow the Treasury to spend unconstrained based on political rather than accounting checks. Stop selling bonds, and instead pay interest on reserves when you want a positive interbank rate. Generally the rate should be zero. Rely on capital requirements and stricter lending standards to control credit growth.My critique:This proposal must address the case when there is a GDP worth of reserves, and assume that inflation is running at 6% and credit is growing too quickly. Real Estate prices are booming — what do you do? You have to be able to have an answer for this situation, rather than just assuming we will stay in a Japan-style stagnation forever, and design a system that fails in any other regime. Either that, or argue that we will never be able to reach this state under the MMT regime, so that we wont need any tools to deal with this.Here is the criticism:1. Capital requirements are ineffective at constraining credit growth if banks have funding costs below that of the private credit markets. In that case, banks will attract plenty of capital. Note that private credit market funding costs will be at the level of expected nominal GDP growth; if banks have funding costs substantially below this level, excess borrowing will keep growing up until a credit crisis occurs. When the bad debt is finally cleared (maybe 30 years later in the case of Japan), excess borrowing will start up again, etc.2. If you accept #1, then you need a way to boost banks' cost of funds. The proposal is to pay interest on reserves. But in this case, the proceeds directly boost bank capital in proportion to the amount of tightening desired, and they force base money to grow as well. This puts private banks in a seignorage position, in which they are earning $1 of government interest payments for every $1 of expected GDP growth. This strategy will fail to constrain lending, long term, and will create a world that no non-banker wants to live in. 3. If you accept #2, you are left with a single line of defense — underwriting standards. You are handing banks a GDP worth of money, ample capital, and then expect them to not lend that money out, but let it shrink with inflation. There is no way that this will happen — there are too many options with straw borrowers, or lending on assets that are price-insensitive. Moreover debt growth boosts incomes as well. So if you stop selling debt, you need some other way to ensure that bank costs of funds are inline with private sector cost of funds. Something that is a real cost to banks, not a benefit payment — or if you prefer, a "tax". My proposal to fix this flaw is to not let banks lend reserves at all. Force the banks to obtain all loanable funds from the government, and to obtain only bank capital from the private sector. This is more robust, cleaner, and easier to enforce. And it works. Put an iron wall between bank lending and the private credit markets. Set the rate charged by the Fed to be positive and stable, "in line" with long term GDP growth expectations.Obviously you still need narrow banking, capital requirements, and strong underwriting. But at least these other constraints have a chance to be effective if banks have appropriate funding costs.

    • Tax Economic Rents as one way to combat asset bubbles & keep prices in line with cost.

      Yes, I’m a parrot.

  28. There is always a "reserve" requirement of some kind, Scott, even if it only derives from the bank's own desire to avoid a penally expensive overdraft at the central bank. And, if not reserves in the form of a demand deposit at the central bank, banks will also hold alternative liquid assets as a buffer, such as treasury bills, with returns that presumably follow those on reserves (loans) quite closely.

  29. RSJ,"Capital requirements are ineffective at constraining credit growth if banks have funding costs below that of the private credit markets."A requirement of $1 of bank capital for every $1 of bank assets would constrain credit growth. Less absurdly, there must be a point between 0 and 1 capital to asset ratio where ROE will be low enough to curb credit growth."The proposal is to pay interest on reserves."Wouldn't the proposal be to *charge* interest when the banks obtain reserves, either from the CB or each other? In your credit growth scenario, no bank will want to hold excess reserves. The CB can impose a tax on lending by collecting interest from borrowers at the CB discount window. The "seignorage" would flow to the CB and then to the Treasury.Pardon me if my comment misses your point – I'm a MMT neophyte.

  30. Oregon Guy,"Wouldn't the proposal be to *charge* interest when the banks obtain reserves"The MMT folks suggest paying interest on reserves in order to maintain an interbank market support rate. E.g., banks will not loan to each other for less than x% if they can get x% risk-free from the government. My proposal is to charge banks for loanable funds, but the only way you can do this while supporting very large reserves (due to the no-bond sale assumption) is to not allow banks to lend reserves."A requirement of $1 of bank capital for every $1 of bank assets would constrain credit growth."I am not saying that you need $1 of capital to fund $1 of lending, but that banks must obtain all loanable funds from the government, and can only obtain bank capital from the private sector.The role of capital is to enforce underwriting discipline by being in the first loss position for bad loans. In this sense, at the operational level for a specific bank, loan growth is constrained by capital requirements. But the aggregate *amount* of bank capital is itself a function of bank profits with respect to other investment returns. Therefore supplying banks with below-market funding costs, paying banks interest on reserves, and other related measures encourage bank capital formation and subsequent credit-growth. I think this is a key flaw with the Japan fascination. Nominal GDP in Japan is the same as it was in 1992. Basically Japan's GDP never managed to sustainable grow in nominal terms since the bubble burst in 1990. Every upward spurt was greeted with a contraction and deflation, pulling nominal GDP growth back to zero. In this environment, a ZIRP policy does not result in below-market funding costs for banks, and large reserves are irrelevant since they are primarily the result of the private sector de-levering. But this situation of endless forbearance and credit deflation cannot be the normative assumption for MMT policy, and I would like to see how MMT proponents would respond to a situation of a GDP worth of bank reserves/vault cash, elevated inflation, and elevated credit growth. Either that, or a convincing rationale that such a state can never be reached due to other factors.

  31. The asset-liability charts would be clearer if you included the Gov as a third chart.

  32. I didn't read all of this, but Zimbabwe printed money and so did Weimar. It would probably work on a modified basis, limited to maybe 2% of GDP. Also, I believe Fractional Reserve banking should be outlawed if this ever is tried because money expansion would have to be a monopoly. A better idea might be, why don't the government print money and loan it out? Instead of running deficits, lend the money. The interest would become the tax revenue, a tax on income of a different kind. The great secret about economy is that it runs on credit expansion of sound money (sound is subject to opinion, but in general it is where it can be loaned at a profit after depreciation and taxes). All these schemes that produce booms (the 1990's and the 2000s bubbles) are all created by too much credit in one form or another.

  33. RSJBanks don't lend reserves, they settle payments with reserves. There's no such thing a "loanable funds" in a fiat money system. Banks create loans/deposits simultaneously out of thin air. Reserves and reserve requirements do not operationally constrain this under a fiat money system, though reserve requirements can affect the profitability of lending, and thus may affect the rate banks charge. To constrain lending, you have to enforce capital requirements (and perhaps vary them procyclically, etc.), require banks to hold onto the loans they make instead of selling them, and enforce the list of legal assets banks are allowed to hold. But reserve requirements won't help aside from the indirect affect on profitability.Best,Scott Fullwiler

  34. From Warren Mosler (www.moslereconomics.com)by RSJ Hi Scott,I think there is some confusion between describing the role of constraints in the current system, and the effectiveness of these constraints in a world without bond sales. You are proposing a world without bond sales, and I am pointing out a flaw wm: there isn't one. and then "fixing" this flaw by suggesting full reserves. I am not saying that full reserves are needed now, or are relevant now. Reserves are small now in comparison to what they would be if no debt was sold. The proposed MMT regime: Remove "Fed Independence" and allow the Treasury to spend unconstrained based on political rather than accounting checks. Stop selling bonds, and instead pay interest on reserves when you want a positive interbank rate. Generally the rate should be zero. wm: right. Rely on capital requirements and stricter lending standards to control credit growth.wm: and other things as well, particularly narrowing banking regs. My critique:This proposal must address the case when there is a GDP worth of reserves, and assume that inflation is running at 6% and credit is growing too quickly. Real Estate prices are booming — what do you do? wm: if unemployment is 'too low' a well a tax hike is in order. You have to be able to have an answer for this situation, rather than just assuming we will stay in a Japan-style stagnation forever, and design a system that fails in any other regime. Either that, or argue that we will never be able to reach this state under the MMT regime, so that we wont need any tools to deal with this.wm: the tool is taxation. Here is the criticism:1. Capital requirements are ineffective at constraining credit growth if banks have funding costs below that of the private credit markets. In that case, banks will attract plenty of capital. Note that private credit market funding costs will be at the level of expected nominal GDP growth; if banks have funding costs substantially below this level, excess borrowing will keep growing up until a credit crisis occurs. When the bad debt is finally cleared (maybe 30 years later in the case of Japan), excess borrowing will start up again, etc.wm: i don't completely follow this. Capital requirements limit bank leverage and alter risk adjusted returns for bank investors 2. If you accept #1, then you need a way to boost banks' cost of funds. wm: the banks cost of funds per se is not the problem? The proposal is to pay interest on reserves. But in this case, the proceeds directly boost bank capital in proportion to the amount of tightening desired, and they force base money to grow as well.wm: how does paying interest on reserves boost bank capital?wm: and how do you have a zero rate policy and pay interest on bank reserves? This puts private banks in a seignorage position, in which they are earning $1 of government interest payments for every $1 of expected GDP growth. This strategy will fail to constrain lending, long term, and will create a world that no non-banker wants to live in. wm: Don't see this as a problem given my above comments 3. If you accept #2, you are left with a single line of defense — underwriting standards. wm: plus the 'legal lending list' plus risk weighting of legal assets, etc. etc. etc. You are handing banks a GDP worth of money,wm: banks can fund in unlimited quantities in any case ample capital, and then expect them to not lend that money out, but let it shrink with inflation. There is no way that this will happen — there are too many options with straw borrowers, or lending on assets that are price-insensitive. Moreover debt growth boosts incomes as well. wm: banks will lend to credit worthy borrowers with sufficient incomes to support their debt. wm: incomes are adjusted by fiscal policy

  35. Hi Mannfm1. The point of the post was not necessarily to promote "printing money" (Randy's was, but mostly half seriously). The point was to demonstrate that what the government ALREADY does is essentially the same thing, and in fact it's MORE inflationary if anything than "printing money" would be.2. Fractional reserve banking does not exist under fiat money systems. As Randy explained, reserve requirements can affect the profitability of lending (or the bank's markup over its costs), but not the banks' operational abilities to lend. Fractional reserve banking, in which banks are operationally constrained by reserve requirements or must otherwise limit lending to some multiple of reserves to anticipate customer withdrawals only applies to a gold standard or similar type of system.3. Regarding Zimbabwe, see here: http://bilbo.economicoutlook.net/blog/?p=3773Best,Scott Fullwiler

  36. Scott,Capital requirements cannot constrain lending in aggregate if bank costs of funds are below the private sector's cost of funds. Banks will attract plenty of capital in that case. re: reserves Do you dispute that if banks were required to hold 100% reserves against deposits, then they would be forced to borrow from the CB regardless of the amount of deposits in the system?In that case, do you agree that it would not be necessary to pay banks interest on reserves?

  37. Hi RSJRegarding capital, yes, it's certainly possible to remain within a sustainable growth rate if you're profitable enough. That doesn't mean you can't procyclically vary capital requirements to offset, or any number of things (and fiscal policy, too, of course, which is our preferred, though not exclusive, tool). My views on bank regulation are along the lines of Minsky and Bill Black (he knows a lot more than I do, obviously), and you'll have a hard time convincing me that their respective (and complementary) approaches to financial regulation would be bubble inducing or inflationary. And neither has that much use for adjusting banks' costs of funds.Regarding reserve requirements, yes, if banks are required to hold ANY % of deposits then they will be forced to borrow from the CB, as long as the CB hasn't over supplied already. In Canada, banks borrow from the CB and the RRR is 0%. Regardless of rr or deposits, banks always have to borrow just to settle payments (particularly on an intraday basis in the US), again assuming they aren't kept in substantial oversupply. But borrowing from the CB only affects the cost of funds, and thus the profitability of lending, not the operational ability to lend. Obviously the effect is greater depending on how high rr ratio is set (and how much banks can innovate to offer non-reservable accounts that cut their costs, which they will obviously try to do). And, as Randy noted above, reducing the profitability of loans and "a lower ROE can actually encourage more leverage, more innovation, moving more stuff off balance sheet, and even faster growth of loans."Best,Scott

  38. The first para of Scott Fullwiler’s above article suggests that Wray’s November 2009 suggestion about printing money instead of increasing government debt is “creative”.Hardly. This is pretty well what the UK government – central bank machine spent 2009 doing. That is the entire UK 2009 deficit has been quantitatively eased (about £200bn worth).Granted this involves a theoretical debt: owed by the UK Treasury to the Bank of England. But this is a nonsense. Both institution s are owned by UK citizens. Moreover, the Bank of England is, speaking strictly legally, owned by the UK Treasury.So why did the UK government – central bank machine carry out the above absurd paper chase? One answer, as I understand it, is that European law required it. I.e. E.U. law says governments cannot just print money as per Wray’s suggestion. So the UK government did the next best thing – well, EXACTLY the same thing to be more precise.Second, there are large numbers of influential economic illiterates out there who are happy enough with “government borrowing” and “quantitative easing”, but who don’t like “money printing”. If giving something a different name keeps these idiots happy, then so be it.

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  41. Scott, a somewhat unrelated question.Since most money in the economy is endogenously produced by banks, isn't it potentially inflationary, just like money coming from govt spending? I understand that inside the private sector all money nets to 0, but, if I understand correctly, the banks have almost unlimited capacity to produce new money on their asset side, while on the liability side they just have to potentially loan some money from the Fed for reserves, am I correct? Then the new money they created contributes to aggregate demand without any offsetting money taking away from it, so, it could be inflationary? If I am correct, why are some many people worried about inflationary potential of govt spending but not of bank loans? Or, am I totally off?Thanks in advance!

  42. Peter,Yes, you are correct. Private sector creation of "money" netting to zero in terms of net financial assets for that sector is not the same thing whatsoever as saying the private sector can't create "money." (Many people get confused on this point.) It can, and does, and it can be inflationary, and it can (and just recently did) create asset price bubbles if excessive.Best,Scott Fullwiler

  43. Capital requirements cannot constrain lending in aggregate if bank costs of funds are below the private sector's cost of funds

  44. I have a post on some of the comments here, it is at http://open.salon.com/blog/clintballinger/2012/12/17/post_keynesianism_mmt_100_reserves_project_question_1
    I am working on trying to understand MMT views on Full Reserve Banking there.
    Cheers,
    Clint

  45. Banks create loans/deposits simultaneously out of thin air

    I think you’re misunderstanding fractional reserve banking, commercial bank money isn’t “real money.” Yes, that can be done, but it doesn’t actually create more money that can be spent (in fact it decreases it, because of the reserve). Eventually someone receiving the loan spends the money, and the reserves control that amount.

    That’s why, for instance, the government could not tomorrow say “We’re going to borrow $900T this year in order to build a road from D.C. to Mars.” The money just doesn’t exist to be lent. You could monetize it, but then you end up like Zimbabwe.