Operation Twist, Part Deux?

by Marshall Auerback and Rob Parenteau

Who funds our budget deficit? It is a question taking on increasing significance, given the recent back up on longer-dated bond yields, which has been explained by many as a “buyers’ strike” in response to growing government profligacy. We think this argument displays a seriously lagging understanding of how much modern money has changed since Nixon changed finance forever by closing the Gold window in 1973. Now that we’re off the gold standard, neither our international creditors, nor the so-called “bond market vigilantes”, “fund” anything, contrary to the completely false & misguided scare stories one reads almost daily in the press.

In his usually effective fashion, Bill Mitchell debunks the notion that “the markets” determine our interest rate structure, as opposed to the central banks. Mitchell discusses this in the context of his analysis of a BIS paper, “The Future of Public Debt: Prospects and Implications”, which raises the old canard about a potential “bond market buyers’ strike” as a consequence of rising public debt.” “[T]he debt ratio will explode in the absence of a sufficiently large primary surplus”, argues the author of the BIS paper. 

From which – Mitchell deduces- “the governments [should] either stop allowing the bond markets to determine yields – that is, use their capacity to control the yield curve or, better still, abandon the practice of issuing debt.”

Mitchell then poses the question: “Why will yields spike dangerously so that real interest rates exceed real output growth rates? There is no answer to this question provided.”

There is no answer provided because, as a point of economic logic, Bill’s critique of the BIS is (as usual) unassailable. BUT as any regular observer of the markets can tell you, bonds have begun to rise again over the past few weeks, notably in the US. This might have occurred for the dumbest reasons imaginable (one person foolishly tried to link the rise in US yields to Portugal’s downgrade by the benighted ratings agencies).

On the other hand, one of the great insights of George Soros was the notion that markets could act on incorrect or imperfect information and thereby create a new kind of economic reality. It might well be that very few understand MMT or basic public reserve accounting, but that doesn’t alter the reality that bond yields have risen 20 basis points in the past week or so. And a central bank which is underpinned by a market fundamentalist ideology, coupled with a bunch of “big swinging dicks” in the trading pits is a potentially toxic combination. The Fed follows the price action at the long end of bond market. Long bond investors often try to force Fed’s hand. Around and around they go,dog chasing tail style.
There’s a power dynamic here – who’s really in control: Big Swinging Dick Finanzkapital (BSDF)or policy geeks who understand basic public reserve accounting?
The Fed clearly has a dilemma. It needs to finesse expectations management for BOTH Treasury bond and equity investors. Bond investors need to know they are not going to get screwed by inflation, so they want the fed funds rate renormalized. Equity investors want the “extended period” of ZIRP to last for, well, an extended period. Free money is good for specs.
So what’s a central banker like Bernanke to do?
How about a modern version of “Operation Twist”, which was implemented originally by the Fed in 1961 to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. It was only marginally successful back then.
So why should it work better today?
Well, the Fed has more tools in its policy box, thanks in part to its policy of paying interest on excess reserves (IOER). Scott Fullwiler has an excellent paper on this (“Paying Interest on Reserve Balances: It’s More Significant than You Think”), in which he demonstrates that this change in Fed policy has severed the relationship between the policy rate target and the level of reserves outstanding (if there ever was one – some indications in recent years were that all Fed had to do was announce new fed funds rate target, and primary dealers would take it there, knowing Fed had capacity to change reserves outstanding – all of which meant Fed did not have to change reserves, since they had a credible threat they could, making the textbook story about Fed ops even more outdated and incorrect).
So the Fed can tell everybody that they are renormalizing the fed funds rate and take the IOER up to 100bps. Note, the Fed does not need to remove any reserves to do this – they can just do it administratively. That’s how the IOER works – it severs the link between reserves in the system and the target policy rate, right?
Then, if the bond gods don’t rally Treasuries on the Fed’s efforts to renormalize the policy rate, Mr Bernanke calls up Bill Dudley (President at the NY Fed) and gives him instruction to buy all the 10 year UST on offer until the 10 year UST yield is down to, oh , say 3.5%. It is an open market operation, which the Fed performs all the time. They won’t have to call it QE, but it is in effect the same thing.
Then, every time some big swinging dick bond trader tries to push it above 3.5% by shorting Treasuries, the Fed slams their face into the concrete by having the open market desk buy the hell out of UST until the 10 year yield is back to 3.5%. Burn Fido enough times, yank his chain enough times, and like the Dog Whisperer, he gets it and stops.
No less than one of the leading “bond market vigilantes” has conceded this point. In his October 2003 Fed Focus, PIMCO’s Paul McCulley has acknowledged that “any market induced—foreign or domestic-driven—upward pressure on U. S. intermediate or long-term interest rates would/will be limited by the leash of the Fed’s . . . anchoring of the Fed funds rate . . . . Put differently, there is a limit to how steep the yield curve can get, if the Fed just says no—again and again!—to the tightening path implicit in a steep yield curve”.

What happens if the 10 year bond breaks out of the 3.5% to 4% range significantly even with no changes in expectations regarding the Fed? Could that happen, or is there some arbitrage mechanism that brings it back? Of course, there will always be smart bond traders (such as our friend, Warren Mosler), who will understand the potential arbitrage opportunity at hand and react accordingly, but a signal from the Fed that it desires a certain rate level or term structure for rates will facilitate the process.

Operation Twist, Part Deux, then? It strikes us as the optimal way to finesse the expectations management dilemma.

It seems to us that we are now approaching a very critical juncture in terms of potentially settling the debate between those who think that central banks establish the rate structure (as most readers of this blog believe) versus those who believe that this is done by the markets (such as the usual band of deficit hawks, and the writer of the BIS report critiqued by Bill Mitchell). Of course, like most MMT adherents, we feel that the whole debate would become less relevant if the US Treasury responded to today’s environment through sensible proactive fiscal expenditure, but it’s hard to sustain political support for that amidst sock puppet politicians who dole out goodies to their corporate contributors, and an Administration which genuinely believes we’re “running out of money”.

That places an unnecessarily large burden on the Fed, hardly an appealing prospect, given Mr Bernanke’s own neo-classical economics framework. Keynes himself was quite explicit about the importance of investor portfolio preferences in determining interest rates specifically. Indeed, Ch. 12 of “The General Theory” is all about the beauty contest aspect of asset price determination in the face of fundamental uncertainty and asset markets organized to optimize liquidity for existing holders. Does the Fed understand this? It may well not happen, but no question an aggressive move to counter short term portfolio preference shifts on the part of private investors could do much to resolve this “who determines rates” question once and for all.

There’s a power dimension here. Does the Fed really want to be led around by the nose by the very same people who created today’s economic disaster?

11 responses to “Operation Twist, Part Deux?

  1. Excellent post, but a slight correction: Nixon closed the gold window on August 15, 1971, not in 1973.

  2. Actually, 1971 and 1973 are both correct. Here is the history.The announcement that became known as "the Nixon shock" was made on August 15, 1971. It took some time for that policy to broadly take effect, since it ended Bretton Woods without officially replacing it. It wasn't formalized until 1973, after George Shultz had replaced John Connally at Treasury. By 1976, the international monetary system had fully completed the switch to a non-convertible flexible rate regime. The US stopped making international payments in gold as of August 15, 1971, upon Nixon's announcement. This is the date the gold bugs and inflationists cite as the last vestige of the gold era after FDR move against public convertibility and private holding of gold. When Nixon acted on Connally's advice in "closing the gold window." gold was only used in finance for international settlement. Incidentally, when I took a course in finance in the summer of 1961, I got to witness the gnomes actually moving the gold bricks among the vaults deep under the FRBNY in accordance with the settlement manifest.Wikipedia: "To stabilize the economy and combat runaway inflation, on August 15, 1971, President Nixon imposed a 90-day wage and price freeze, a 10 percent import surcharge, and, most importantly, “closed the gold window”, ending convertibility between US dollars and gold. The President and fifteen advisors made that decision without consulting the members of the international monetary system, so the international community informally named it the Nixon shock. Given the importance of the announcement — and its impact upon foreign currencies — presidential advisors recalled that they spent more time deciding when to publicly announce the controversial plan, than they spent creating the plan.[2] He was advised that the practical decision was to make an announcement before the stock markets opened on Monday (and just when Asian markets also were opening trading for the day). On August 15, 1971, that speech and the price-control plans proved very popular and raised the public's spirit. The President was credited with finally rescuing the American public from price-gougers, and from a foreign-caused exchange crisis. [2][3]"http://en.wikipedia.org/wiki/Nixon_ShockHenry C. K. Liu: "Having served as secretary of labor in 1968 and head of the Office of Management and Budget in 1970, George Shultz was appointed treasury secretary by Nixon in 1973. During his tenure, Shultz reversed the NEP begun under Connally by lifting price controls domestically and shifted his attention to the international arena to deal with a renewed dollar crisis that broke out in February 1973. Shultz organized an international monetary conference in Paris in 1973 to formalize the 1971 US decision to close the gold window and the abolition of the fixed-exchange-rate system, which had actually begun to collapse in 1971, causing all key currencies since to float. However, cross-border flows of funds continued to be restricted to keep contagious financial instability at bay." http://www.atimes.com/atimes/Global_Economy/HF17Dj01.html

  3. Marshall,I think investors require a certain real rate of return, and if they don't get it, they will adjust their behavior. Maybe you overlook this when you focus on speculators. The required real return on term Treasuries is simply the price investors charge for delaying spending. Assume that the marginal investor wants a 2% real return from 10yr Treasuries, and inflation expectations are 2.5%. Under your proposal, the Fed says, "tough luck, only 3.5% is on offer." An expected real return of 1.0%. What does the marginal investor do? All else equal, he hits the Fed's bid. That is, if the 10yr is priced "too rich for him", the choice is not only to refrain from buying: he can also sell.So offering a 1.0% real rate on the 10yr could result in the Fed buying up much of the long end of the curve. Where would the money go? Some into spending, and this is arguably inflationary. I think the assumption most interventionists make is that the output gap will "channel" all stimulus into RGDP growth rather than inflation. Maybe. There are other options available, though. Some sovereign may offer that 2% real return, so the money leaves the dollar and flows abroad. Again, just as with rising spending, the resulting devaluation is, all else equal, inflationary. Two inflationary effects of capping real riskless returns below required returns. These of course would raise inflation expectations and further lower expected real returns on offer from the Fed. The yield curve acquires a distinct "crimp" between 7's and 10's, and the Fed has to start vacuuming up 7's, which leads to a crimp between 5's and 7's, and so on. Until velocity is raging as nominal spending rises and dollar devaluation accelerates. I imagine you would argue that higher nominal private spending is exactly what you want to procure. But of course, higher nominal spending is a prerequisite for higher inflation. Again, I think this breaks down into an argument about whether inflation expectations can become unanchored under an output gap. I think you will find that most Latin Americans are quite comfortable with the existence of such a phenomenon, while most Americans treat it as an impossibility. Having spent much time in the former region, I feel the need to point this out.

  4. I'm French and love this blog, hence I correct your "fancy American French" :In French « une part » means a share, part is said « une partie » (yes, it also means a party like in garden party). I stop there the explanation, you likely don't need more. Just wanted so-called "sophisticated" people not to ironically smile at your title.Thank you for this site and all your work.

  5. One benefit of replacing bond sales with IOR is that the interest paid to the Fed for Tsy overdrafts would be much lower than the $300 to $700 billion a year in debt service payments project over the next decade (for both new debt and for old debt that's been rolled over). Of course, even if the interest rate wasn't lower, it wouldn't matter since the Fed forwards its net profits to Tsy anyway.Of course, the downside of stripping out future interest from the CBO's "unsustainable debt" scare charts is that they'd then look less scary. :o)

  6. I can almost hear Thomas Edison and Henry Ford shouting "Yes! Yes! Abandon the practice of issuing debt.""If our nation can issue a dollar bond, it can issue a dollar bill. The element that makes the bond good makes the bill good."… Thomas Edison on government created debt-free money in NYTimes interview. See http://www.prosperityuk.com/prosperity/articles/edison.html

  7. Tom – I remember a professor of mine explaining that the "Nixon shock" announcement actually had two parts: One, they were adjusting the price of gold from the then-current price of $35/ounce up to $38/ounce Second, they were closing the gold window. Thus, Nixon announced that henceforth, $38/ounce was the price at which the U.S. government would not buy gold.You gotta love that Tricky Dick…

  8. I suspect most have never understood the devastation on the US economy caused by the two-tier dollar that was created on January 31 1934 after US citizens were ordered to turn in their gold at $20.67 while foreign holders could get $35. After many gyrations up and down, in 1942-43 the Roosevelt (internal) dollar, the gold-convertible external dollar and the British pound were in approximate parity. By the time the IMF took up regulation aftr Bretton-Woods the internal dollar was only worth 75% of the external dolar which meant that American farmers and producers endured a hidden tariff export tariff of 33% while conversely creating a 25% subsidy for imports entering the US. Selling a $100 product abroad was the same as selling it for $133 at home. This effectively subsidized US corporations that moved abroad by 25% besides the cheap labor advantage. By the time Nixon closed the window the Roosevelt dollar was only worth 41 cents which made the hidden export tariff 144% or the import price subsidy 59%. Any wonder the hustlers from Arkansas took over? The devil was not in the gold window but in the overvalued dollar.

  9. This article at The Pragmatic Capitalist ties in with the concept being discussed here, indirectly. I think many Americans have a warped view of how the market for treasuries really works. This is a pretty good explanation.http://pragcap.com/the-concept-of-vertical-and-horizontal-money-creation

  10. To argue that central banks do not control interest rate structures is absurd..e.g.,what do these idiots think the FOMC does???????????? Gold was nothing more than a fiat currency to convince the public & governments that paper could be swapped for gold in order to protect agianst inflation. After WW2 see how the gold bullion standard evolved into a method to offload U.S. military expendentures/social programs on to Europe & Japan. Finally to the point the plug was pulled on the gold window… especially after the French government persisted in cashing in

  11. Does the Fed really want to be led around by the nose by the very same people who created today’s economic disaster? Simple answers to simple questions:Yes.