Corbynomics 101—It’s the Deficit, Stupid!

By Scott Fullwiler

As anyone who’s followed the discussion has seen, the proposal from the newly-elected leader of the British Labor Party, Jeremy Corbyn, to implement “People’s Quantitative Easing” or PQE, has created a lot of controversy (Richard Murphy’s blog is a good place to see the PQE defense against these arguments).  The basics of the proposal are that the government would create a public bank for financing infrastructure (National Investment Bank, or NIB), which the Bank of England (BoE) would then lend to directly in order to fund.  The NIB would then carry out infrastructure projects to jumpstart the economy, create public capital, and create jobs.

The proposal obviously counters the austerity mantras going around in British politics (not to mention most other places), though Corbyn himself has paid lip service to balancing the budget, as well.  The controversy, beyond the typical concerns with greater government spending of austerians, are fairly predictable for anyone who has taken a standard macroeconomics course (usually with a textbook written by someone who didn’t see the financial crisis coming)—

  • first, the often heard QE = “printing money” = massive inflation argument is pervasive here with regard to PQE, as well;
  • second, there are substantial concerns being voiced that “forcing” the BoE to finance the NIB will undermine the “independence” of the central bank and monetary policy;
  • third, PQE gives the government free reign to spend by eliminating the need to fund its deficits in the financial markets.

So, here I want to look at the accounting and some basic operational realities of this proposal in order to understand how PQE does or does not do what the naysayers say it will.

For PQE, consider a NIB that is essentially an arm of the government carrying out its spending, so we can include it as part of the government simply spending from the government’s account at the central bank, while its purchases of infrastructure show up as government assets.

Here’s what it looks like if (Step 1) the BoE gives the government an overdraft, and (Step 2) the government spends (I’ll show below that there’s more to it than this, operationally, but just bear with me for now):

Table 1: Steps 1 and 2 of PQE

Table 1: Steps 1 and 2 of PQE

In Step 1, the loan from the BoE to the government shows up on both the government’s and the BoE’s balance sheets (obviously).  In Step 2, the spending on infrastructure creates reserve balances, injected into the spending recipient’s bank’s reserve account, and a deposit is credited by the bank to the recipient that also raises the recipient’s net worth.  (Of course, if the government is purchasing infrastructure, the spending won’t directly raise net worth of the builder itself, but when all is said and done, as a matter of double-entry accounting, the non-government sector’s financial net worth will have increased by the same amount as the government’s deficit increase as a result of the spending (e.g., wage income of employees of the builder, profits of the builder’s suppliers, and so on).)

Note, though, that in Step 2, the BoE has created reserve balances that are also assets for banks.  In the UK, reserve requirements are 0, so the demand for reserve balances will be very low and also highly inelastic (it’s not much different where reserve requirements are greater than zero, but it is a little different).  Thus, if PQE is of any size of macroeconomic significance, it will shift the quantity of reserve balances beyond the demand as in Figure 1 and thus push the interbank rate to zero or near zero.  In other words, left on its own, PQE creates a zero overnight rate, or ZIRP (Zero Interest Rate Policy).

Figure 1: PQE, Reserve Balances, and the Interbank Rate

Figure 1: PQE, Reserve Balances, and the Interbank Rate

To avoid ZIRP and set a positive interest rate target, the BoE could pay interest on reserve balances (IOR) and set its interest rate target effectively equal to IOR, as shown in Figure 2.

Figure 2: PQE with IOR

Figure 2: PQE with IOR

This is a basic point of QE, and now PQE, that I have yet to see neoclassical economists acknowledge.  It cannot be any other way.  Think of any market if you’re not familiar with interbank markets—now, shift the supply curve so far that it is now completely to the right of the entire demand curve.  What happens?  The price falls to zero, unless you put in a price floor.  This is Economics 101.  With QE you get ZIRP or IOR = the target rate if you don’t like ZIRP and want the target rate above zero.

This is very significant.  As I explained in more detail here, neoclassicals argue that paying IOR at the target rate stops QE from being inflationary, since in their view banks have the opportunity to earn IOR rather than make loans.  They also argue that ZIRP stops QE from being inflationary, such as with Krugman’s version of the liquidity trap where “base money” (i.e., reserve balances) and Tbills both earn 0% and thus become perfect substitutes and more “money” is essentially the same thing as more Tbills (which isn’t the same thing as Keynes’s liquidity trap, but that’s a whole separate story).

From Figures 1 and 2, though, IOR = target rate or ZIRP are the ONLY TWO POSSIBLE OUTCOMES OF RISING RESERVE BALANCES AS A RESULT OF QE.  Logically, then, neoclassicals own views on QE must conclude that the increase in reserve balances from QE is not inflationary.

So, continuing with the logic of the neoclassical argument, an increase in excess reserve balances that results from PQE must be accompanied by ZIRP or IOR = target rate, and from their own positions on the latter the rise in reserve balances themselves CANNOT BE INFLATIONARY.  So, the first of the key arguments against PQE being made by neoclassicals and heard often in the financial press—that PQE will be inflationary because it raises the “money supply”—is inconsistent with the views held by these very same people.

Now, PQE could be inflationary if the additional spending on infrastructure pushes the economy beyond full employment, or creates bottlenecks in some key resource markets.  Or, from the neoclassical perspective, ZIRP or even interest rate target = IOR could be inflationary if it results in the interbank rate being less than what they view is consistent with the natural rate of interest.  Regardless, from the perspective of the neoclassicals own model the increase in reserve balances that PQE creates is not in and of itself inflationary.

In other words, from a basic consideration of accounting and simple supply and demand in the interbank market, the first objection to PQE—that it is inherently inflationary—is incorrect.

(This isn’t a topic for this post, but from the endogenous money perspective that I hold along with other MMTers, Post Keynesians, and an increasing number of authors in central bank research departments, both arguments by neoclassicals (IOR= target rate and ZIRP stop the rise in reserve balances from QE from being inflationary) are wrong.)

Let’s now consider central bank independence and PQE.  What does “independence” mean here?  I’m going to define it as (1) the central bank’s ability to set the interest rate target where it chooses as a result of its own ability to consult its preferred strategic response to the state of the economy (such as Taylor’s Rule), (2) its ability to manage the quantity of reserve balances circulating as it sees fit, (3) its ability to carry out non-traditional monetary operations (e.g., purchases of longer-term Treasuries or mortgages) in order to manage longer-term interest rates as it sees fit.

Now, as an aside, those that understand central bank operations—as detailed in the literatures on endogenous money and numerous publications by central banks—will know that there are cases in which even the most independent central bank can do (1) but not (2) or (3), such as in the pre-2008 method of central bank operations.  But this is the central bank’s own choice of how to carry out its operations.  It is now well known that setting IOR = target rate is operationally required for (2) to work (if it desires an excess supply of reserve balances and a target rate above zero).  Thus, to simultaneously carry out (1), (2), and (3) as the Fed has done since late 2008, the operational requirement is IOR = target rate.  However, even with IOR < target rate—as many central banks normally practice—it is possible to carry out (1) and (3) simultaneously as the operations for (3) would have to be sterilized with offsetting operations as in the US during early to mid-2008 or during Operation Twist.

At any rate, to sum up, under traditional, pre-2008 operations (1) and (3) are possible (assuming (3) is sterilized).  If IOR = target rate, then all three are possible.  The question is how or whether PQE changes this.

From Figure 2 above, clearly the BoE could set IOR = target rate and thus be able to still carry out (1), (2), and (3).  For (1), it can simply adjust IOR up or down in order to move the target rate, since IOR = target rate.  For (2), it can target any quantity of reserve balances along the flat portion of the demand curve (if it supplies less than as in normal times it will have to accept a rising interbank rate as given by the demand curve—discussed below).  For (3), like the Fed now with IOR = target rate, it can carry out non-traditional operations to reduce longer term interest rates.  All of this is possible as long as IOR = target rate, with or without PQE.

But what about the scenario in which the BoE wants fewer reserve balances to circulate than PQE has created?  As Table 1 shows, PQE creates reserve balances, but the BoE might want a smaller balance sheet than PQE effects.  In (2) above, the BoE can create more balances if it wants as long as IOR = target rate, but what about if it wants fewer balances circulating?

Consider Table 2, in which now there is a Step 3 showing the BoE carrying out reverse repurchase agreements (RRPs) to non-banks such as dealers as the Fed is now doing.  RRPs can drain the reserve balances—all or just some portion, as desired by the BoE—that have been created by PQE.  Indeed, if the BoE wants to return to the pre-2008 method of operations, it can actively use RRPs to set its balance sheet size comparable to that period (allowing for growth in the demand for currency since then, of course) provided it is willing to raise the rate it offers on RRPs to coincide with the more inelastic portion of the demand for reserve balances as the quantity circulating is reduced.  Just as easily, the BoE could instead allow banks to trade in their reserve balances created by PQE for time deposits instead of RRPs as many other central banks have done for years.

Table 2: PQE with RRPs by the BoE to Drain Excess Reserve Balances

Table 2: PQE with RRPs by the BoE to Drain Excess Reserve Balances

Another essentially equivalent option for the BoE would be to sell assets off of its balance sheet.  Table 3 shows, for example, the BoE selling Tbills to dealers in Step 3 instead of RRPs.

Table 3: PQE with Tbill Sales to Drain Excess Reserve Balances

Table 3: PQE with Tbill Sales to Drain Excess Reserve Balances

There is one additional aspect of central bank independence that I have left out that could be potentially affected by PQE.  Note that as a result of PQE the BoE will have to either pay IOR on the additional reserve balances created or pay interest on its RRPs or time deposits to drain them—in other words, there is no such thing as PQE creating “money” unaccompanied by ZIRP, IOR = target rate, or the BoE draining the reserve balances via RRP or something similar.

The payment of IOR reduces the BoE’s profits, and potentially its equity if the BoE ends up with negative profits, which could have political repercussions even though it shouldn’t (as the monopoly creator of reserve balances, the BoE can never be “bankrupt,” though politicians don’t always allow for this reality).  In this case, what should happen is that the BoE be allowed to charge at least about as much interest on the loan it provides to the Treasury as it pays on its reserve balances, RRPs, or time deposits.  This has no effect on the government’s budget if—as is common practice—the central bank returns its profits to the government, but can eliminate political concerns with the BoE’s equity position that might affect its independence.

So, aside from the matter of charging interest on the loan from the BoE to the government to avoid a fall in the BoE’s equity, the second objection to PQE is also incorrect.

Now, for the third objection, the question is whether PQE is reducing or even eliminating the ability of markets or even central banks to provide “oversight” over the actions of the government.  I’ll leave aside the counter argument here that it is at the very least questionable whether we want markets or central banks to do that in the first place since I am only addressing the objections to PQE in this post.  As Bill Mitchell explained, this is quite different from QE as central banks have been doing it the past several years.  Traditional QE is not actually a helicopter drop.  Rather, helicopter drops are fiscal operations, since government deficits raise the net worth of the non-government sector.  Traditional QE is an asset swap that, like all other monetary policy operations, does not alter the net worth of the private sector.

As Bill explains, though, because PQE involves government deficit spending, PQE is in fact, as Stephanie Kelton termed it, Overt Monetary Financing of Government (OMFG).  Some refer to this as “public control of the money supply,” but that’s not really true (depending on how one defines the “money supply”) as the BoE can still control the quantity of reserve balances outstanding as discussed above and shown in Tables 2 and 3.  On the other hand, if the BoE does this, it nonetheless doesn’t stop the fact that with PQE the government has spent without having to go to markets or the central bank itself.

But does this matter in the sense of being much different from “plain vanilla deficits” (PVD) the government might run in the absence of PQE?

Instead of PQE, Table 4 shows a standard PVD run by the government to finance infrastructure spending.  In this case, the government will issue Tbills to replenish its account at the central bank before it undertakes the infrastructure spending.  In Step 1, the government sells a Tbill to a bond dealer.  In Step 2, there is spending on infrastructure.

Table 4: Plain Vanilla Deficit to “Finance” Infrastructure Spending

Table 4: Plain Vanilla Deficit to “Finance” Infrastructure Spending

(Of course, from the MMT perspective, there is nothing “plain vanilla” about this, since it is the government that is requiring itself to sell the Tbills before it spends.  This is nothing more than a self-imposed constraint—OMFG would be more in line with “plain vanilla” if this were better understood.  A currency-issuing government never needs to finance its spending in financial markets, and as discussed above OMFGs like PQE do not raise additional risks of inflation.  Nonetheless, this post is written to address critics of PQE, so I will stick with the more common definitions.)

There are two important things to understand from Table 4 relative to the previous tables.  First, all four tables show that PQE or PVDs raises the net worth of the non-financial private sector.  From the neoclassical perspective, none of these scenarios are more inflationary than any other assuming the central bank’s target rate is the same in all four—there is IOR = target rate in Table 1 and sterilization of the spending in Tables 2, 3, and 4 via Tbill sales or RRPs.  The impact in all four on aggregate demand is thus simply the infrastructure spending itself.

Second, for a currency-issuing government like the UK’s operating under flexible exchange rates, the debt service in all four scenarios is essentially the same.  In Table 4, the debt service on PVD is the Tbill rate, which will arbitrage quite closely with the BoE’s target rate.  In Table 1, the government’s debt service is a bit more complicated—recall that in most cases central banks transfer their profits to the national government.  This means that paying IOR = target rate on the OMFG that results from PQE (are you keeping up with all the acronyms?) reduces the BoE’s profits returned to the government by the total IOR paid on the OMFG.  But this reduction in profits sent to the government in Table 1 will be about the same as the amount of debt service paid by the government in Table 4, so the effect on the government’s budget from debt service (either by the government or by the BoE on IOR) either way is essentially the same.

In Tables 2 and 3, the effect is basically the same again—in Table 2, the RRPs earn a money market rate similar to the BoE’s target rate, while in Table 3 the Tbill now circulating is just like the Tbill issued in Table 4.

So, the fact that the government has to issue Tbills in financial markets in the case of PVD is not materially different from OMFG in PQE, because it is not operationally possible to do OMFG without IOR = target rate, RRPs at roughly the target rate, or sterilizing OMFG by selling financial assets like Tbills held by the BoE.  The government’s Tbill rate will arbitrage with these rates since it is just as risk-free to the private sector as is the central bank’s liability earning IOR = target rate (note that the central bank is a legal agency for sovereign currency issuing governments, so the government’s debt can’t be any more risky than one of its agencies’).  The BoE’s interest rate policy effectively sets the interest rate on the national debt; it doesn’t control whether or not the government can issue the debt and it does not decide whether or not or how much overall the government can spend.  And this is all true whether or not there is PQE, OMFG, or PVD.

The issuance of Tbills in PVD doesn’t “crowd out” financing in financial markets.  Yes, there is a dealer that has spent a deposit to purchase the Tbill in Table 3, but dealers are backstopped in repo markets by the BoE and also by banks (themselves backstopped by the BoE).  So, the funds for purchasing Tbills is created out of thin air at the margin, not prior savings.  All of this is not even to mention that the reserve balances required by the banking system to settle the dealers’ purchases of Tbills with the government are created by a sale of previously issued government debt (either outright or in a repo) from the BoE.  In short, those that argue that PVD somehow constrains the government or the financial system overall more than OMFG does are wrong.

So, in the end, all three arguments against PQE are incorrect.

  • Is PQE inherently inflationary?   PQE is only as inflationary as the spending itself.
  • Does PQE limit central bank “independence?   The BoE’s ability to set rates is not affected, and if it sets IOR = target rate, it can target the quantity of reserve balances and/or carry out non-traditional operations like QE, etc., just as without PQE.
  • Does PQE encourage profligate government spending?   A monetarily sovereign government spends and taxes as it chooses through the political process (i.e., Parliament/Congress, Prime Minister/President) laid out in the nation’s laws, and this is so whether it deficit spends via PVDs or OMFGs via PQE.  The central bank for such a government sets an interest rate policy that effectively determines the interest rate on the national debt; again, this is so whether government deficits are of the PVD or OMFG variety.

In other words, PQE via OMFG changes very little, if anything, operationally.  That is, PQE is not significantly different from PVD once we consider accounting and operational realities.  The key is thus not that PQE or OMFG creates “money” directly relative to PVD, but that PVD, PQE, and OMFG all directly create spending and net worth for the private sector—this is what fiscal policy in any of these forms brings to macroeconomic policy that monetary policy alone via interest rate changes or QE operations cannot.

While PQE does not change the nature of fiscal policy, it does change the framing of the debate about fiscal policy, or attempts to do so, to show that the government doesn’t have to finance itself, ever.  If it works, it would be a tremendous improvement on the more standard discussions we see regarding fiscal policy.  Unfortunately, the economics establishment’s understanding of monetary operations is so poor that we are inundated by objections to PQE based on the more standard framing shown here to be incorrect

There are two final things worth pointing out regarding the MMT view on PQE.  First, MMTer Randy Wray wrote a paper in 2001 calling for essentially a PQE-like program in the US.  Second, Warren Mosler has noted that simply having the government guarantee debt issued by the NIB would perhaps be a more politically palatable solution that would be essentially identical—the national government would decide how much the NIB could borrow/spend and the NIB would then be able to borrow at effectively the same rate the government issues its debt, itself based on the central bank’s target rate.  As such, government guaranteed debt of the NIB would be effectively the same thing as PVD, which as shown above is not different in a macroeconomically significant way from OMFG via PQE.

29 Responses to Corbynomics 101—It’s the Deficit, Stupid!

  1. Two things strike me about the analysis in this post: it is very, very complicated, and it assumes that the accounting method of the current economic/financial system is a natural law. Interest rates? Borrowing? Come on, this is MMT!

    Economists, including some I have read here, have harped forever that the principal difference between a government and a family is that the family does not have an unlimited supply of money. They say that this is why governments cannot be run as families, economically speaking. But under MMT, at least my father’s version of it, there is an unlimited supply of money, so government can be run like a family. Money can be spent for good causes–non-inflationary causes that improve the lives of the family members and that also build a better future for all. Political considerations vanish. Money is spent as needed. It is not borrowed, it is activated from the great money supply in the Treasury Department’s computers.

    We humans are part of the universe. We obey the laws of the universe. The things we build and do are also part of the universe, and one of the things that we do, universally, is trade. We are geniuses at creating goods and services that have value and are suitable for trade. Money is a tool that enables us to practice the universal art of trade on a vast scale. It is a way of describing and managing our trading activity. It is a way of describing a natural part of the universe. It is a form of mathematics. Like arithmetic, algebra, trigonometry, plane geometry, differential calculus, integral calculus, general relativity, and all the rest, it is a method for describing the physical world. Money is not an invention, it is a discovery—just as all forms of mathematics are discoveries.

    We humans are bound to the crazy, irrational idea that money is a physical thing, like an ounce of gold, a silver coin, or a hundred-dollar bill. This mistaken belief has held us back for centuries, for millennia. But money is none of those physical things. It is simply an idea, a mathematical concept, an accepted way to facilitate human commerce. It does not exist in the physical world. And this is a very, very good thing. This means that money is well-suited to be managed by computers—they are great for storing bits and bytes that can be used to represent money and can be converted to many useful things. And they can do an enormous amount of work, or processing, of the kind that is needed to provide the financial capabilities that a modern civilization requires—computers are great at doing math.

    One thing to keep in mind about computers is that when a task is difficult for humans it is usually easy for computers, and when it is easy for humans it is usually difficult for computers. So handling trillions of financial transactions each day, and maintaining control of billions and billions of personal and business checking and savings accounts is a snap for computers. Money and computers were made for each other. This happy synergy between computers and money makes democrato-capitalism easy to implement and administer. So, we will be able to press a few computer keys and activate all the money we need to fund our essential functions as individuals and as a society.

    Alexander Hamilton, tyranno-capitalists, our national government officials, virtually all economists, the loudest voices in journalism and the mass news media, most experts in academia, the World Bank, the IMF, the Wall Street Journal, your local banker, and central national banks everywhere are convinced that we have a limited supply of money.

    On the other hand, I stand with my father, my brother Randall, and with Uncle John, Uncle Earl, Uncle Billy Don, Uncle Gail, Uncle Bill, Herman Killebrew and many of their friends. We have all held true to the position that our supply of money is inexhaustible. My defense of our position is to ask all those who say that the money supply is limited to furnish proof of their claim. I have asked this question of many persons over the years, and I have yet to receive an answer. Some cite the debt limit law, but that is not an answer. The debt limit law is merely a reversible law passed by our national Congress, and we know from experience that they are a bunch of bozos—especially when it comes to helping our population financially.

    In other cases, some have said that disaster will strike if we spend, and spend, and spend. They are right. Our unlimited supply of money is so vast that to just turn it loose on society would be like trying to drink from a fire hose—we simply could not handle it. But you and I are rational enough to realize that we should manage our supply of money so that it will help us instead of hurt us. My father and Uncle John solved the fire hose problem more than 60 years ago.

    So, this post is another example, a well-thought-out example, that accepts the framework of the current tyranno-capitalist economic/financial system as a starting point. Interest rates? Borrowing? Balance Sheets? Come on, let’s move into the future.

  2. “In the UK, reserve requirements are 0”

    Technically the large banks have to maintain Cash Ratio Deposits at the BoE – which is an over-complicated scheme to ‘fund’ the Bank of England where they get 0% interest on a minute portion of the reserves, and the interest paid goes to the Bank as a fee.

    But they have to maintain that amount at the BoE.

    http://www.bankofengland.co.uk/statistics/Documents/faq/crds.pdf

    So the reserve requirements are *effectively* zero.

    • Scott Fullwiler

      Thanks, Neil. I researched all of that years ago and knew there was something a bit different about the BoE RR system.

  3. “note that the central bank is a legal agency for sovereign currency issuing governments, so the government’s debt can’t be any more risky than one of its agencies”

    In the case of the UK it is more straightforward than that. The BoE is owned by HM Treasury (i.e. HM Treasury is the beneficial owner of the equity).

    So BoE is a subsidiary of HM Treasury both de facto and de jure.

  4. What the above does show is that there is systemic inefficiency in the design of the structure as it stands.

    You have the Bank of England able to adjust long term rates via RRPs and you have the Debt Management Office (another subsidiary department of HM Treasury) issuing Gilts to do the same thing.

    In the case of the Funding for Lending Scheme you actually had the Bank of England *borrowing* Treasury Bills from the Debt Management Office that the DMO had created specifically for the task.

    ISTM that the Bank of England should simply be merged with the Debt Management Office, and the bankers turned into Civil Servants. The new DMO would have as much freedom as it does now, but it would be very clear that they report to the elected Chancellor of the Exchequer.

    All those championing Central Bank Independence have a political motive. And that political motive is to stop a government from doing what the people elected it to do. We have seen what central bank independence means in Greece – deliberately crippling an economy against the wishes of the elected government. It means that there is no escape from the One Truth embedded in the central bank design, the Truth believed by the economists that advise it and get paid by it, and the bankers that run it.

    It is a deliberate political move to try and prevent any debate between competing ideas about how an economy should be run.

  5. There is no doubt PQE and other economic strategies to counter austerity will work.

    The challenge is to execute these strategies in the UK political climate.

    The powerful UK financial sector and their associated right wing ideologues are virtually unchallenged in their dominance of the mainstream media broadsheet press, tabloid press and independent broadcasters. The BBC and centrist media outlets (e.g. Guardian) have a strong institutional bias and are steadfastly neoliberal on economic matters.

    The overwhelming message to the population is that deficit reduction is of paramount important. This message is broadcast via loudhailer 24/7. The UK has a long history where perfectly valid economic policy presented by the left wing opposition has been shot down by and superseded by bogus counter arguments. Jim Callaghans labour government was a victim of a campaign based on bogus arguments the pound would be trashed and the UK destroyed economically. This was aided and abetted by George Soros currency attacks and a foolish currency peg.

    The point being…. Austerity arguments are risible, complete and utter hogwash but get huge public support through powerful media messaging. It is not difficult to offer perfectly rational arguments against austerity and propose better economic policy. The challenge is to counter the immense media bullshit machine and get an alternative message through to the population.

  6. Impressively thorough post, Scott.

    Operations and accounting are inextricably linked as the foundation for understanding how money works or how it could work. What did you do to deserve the task of pushing this Sisyphus rock not only uphill, but across the ocean?

    🙂

    There are probably a handful of human beings who will understand the analysis as thoroughly as you’ve described it. The ranks are thinned by those who don’t have the accounting knowledge but wished they did, and by those who without having the accounting knowledge reflexively reject the importance of having it (the latter still including quite a contingent in the mainstream economics profession I imagine.)

    Important themes, perhaps:

    a) The desirability of accounting and operational knowledge
    b) “PQE” as described is a fiscal operation; “regular” QE isn’t
    c) The institutional design of the central bank allows it to do fiscal operations – if it is authorized to do so
    d) When it comes to managing the central bank policy interest rate, there are many ways to skin the cat – but no way of avoiding the operational necessity of doing it one way or another. A policy interest rate of zero in particular is a central bank choice – not the automatic result of an excess reserve configuration. A central bank always has the option of setting a non-zero policy interest rate, regardless of reserve configuration.
    e) Inflation is a function of spending patterns – not of central bank balance sheet structure (including the excess reserve configuration)

    Your description of the nature of central bank independence is interesting. I agree with it. I’ve always thought of this subject as being two tiered – the independence of the central bank to set the policy interest rate and manage its balance sheet under delegated authority; and the ultimate dependence of the central bank on the government’s choice in delegating that authority.

    • Scott Fullwiler

      Hi JKH,

      Thanks for the comments. On independence, I don’t know that I’ve seen it defined “officially,” but it seems to me it’s about letting the CB follow and implement its strategy–I don’t know what else it could mean, but I hedged by giving “my” definition. Good to hear you agree, so I may be on fairly firm ground there.

      Hope you are well!
      Scott

      • It’s pretty clear that ‘central bank independence’ is, for some, a stepping stone onto ‘central bank dominance’ – where the central bank countermands or cripples what a sovereign elected government decides to do by using financial weapons.

        We have seen how that plays out in Greece where the central bank declares banks solvent with one hand (thereby denying depositors access to the insurance funds) while denying liquidity with the other to cripple the payments system. All to bring an elected government to its knees.

        That is a far cry from the finance minister instructing a central bank department to manage the yield curve appropriately for the capital development of the economy.

        For me it is vital that central banks are merged with the debt management offices so that central banks can manage the entire yield curve *and* that they become a department of Treasury. Then it is clear the central bank is an arm of government and answerable to the minister in charge and ultimately to the congress/parliament of the country.

        Central bank autocracy must be avoided at all costs.

        • Scott Fullwiler

          I agree, Neil. But in the piece I was arguing that those in favor of CBI and arguing against PQE don’t realize that PQE doesn’t affect CBI. But, yes, if we opened the discussion to whether or not CBI is a good idea in the first place, I’m with you. I was just taking the critics at face value.

  7. I don’t understand this kind of arguments. As a Keynesian – neither Post-Keynesian nor Neo-Keynesian nor otherwise but simply Keynesian – I belive that inflation is necessary to create jobs even with severe unemployment. For two reasons, the first one being that prices must rise over costs for employers to increase employment. The second one is somehow the other side of the coin, that investment requires savings, and public investment paid with new money makes use of forced savings through inflation. Now, let’s forget about the first reason. Where do savings to finance public investment paid with PQE come from?

    • Scott Fullwiler

      Hi Enrique

      1. I didn’t say PQE wasn’t inflationary ever, I just said if there was inflation it comes from the spending, not the fact that the CB is “funding” the govt.

      2. For PQE, the proposal is for the CB to lend to the Treasury by creating balances out of thin air. So there’s no prior savings. I would argue there’s no prior savings when there’s a normal deficit, too, though, but that’s a longer discussion.

    • Enrique Viaña : That kind of “Keynesianism” is the antithesis of Keynes’s economics – so the correct prefix is “anti” rather than “neo”, “post” or “simply”. Inflation is not necessary to create jobs, especially with severe unemployment. Keynes (& Lerner) had strong antipathies to inflation. That prices must rise over costs for employers to hire more is utterly untrue. For more hiring, it is revenues, not prices that must rise over costs, and a rise in quantities sold, coming from more (effective) demand is the usual way in business and the one most integral to Keynes’s economics. Public investment paid with new money making use of forced savings through inflation is monetarism, not Keynes.

      The short and simple and correct answer to the question of where the money comes from to finance any public (or private, even) spending or investment is that it comes from the “printing the money”, money/debt creation. Public spending finances itself. The “financing” is the act of spending and the acceptance of the money. Money is a form of debt. Nobody seems to have any problem with the idea of becoming indebted, or ever seriously asks “where did the debt come from?” But mysteriously, people are mystified about money creation, where money comes from.

  8. Scott, you’ve got the job.
    Can you start as Governor of the Bank of England around May 2020? I’m not asking; I’m begging.

  9. This is a very clear explanation.

    Part of the problem here is that some of the leading advocates of PQE have suggested that it offers interest free funding on the basis of paying a zero rate on reserves, which clearly places a greater restriction on the central bank.

  10. There is one main questions I have.

    Could the Central Bank, rather than paying the IOR = target rate, not just decree that say 0.5% is the official target rate? It would then say that banks could not lend/borrow to each other at less than the official rate. That becomes the rule, the CB just says you cannot undercut that rate. So banks can then lend to each other or borrow from each other, but the minimum rate which they have to pay is 0.5%.

    But if they have additional reserves after that, the Central Bank would not pay them any interest.

    So, there would be an official Central Bank rate (for inter-bank lending of reserves). But there would be no cost to the Central bank, because the Central Bank would not pay that rate (for reserves deposited at the Central Bank).

    The Central Bank is currently subsidising the banking sector by having a policy to pay interest on all the reserves.

    • Scott Fullwiler

      I reject the premise of your argument that this is a subsidy. If you oversupply banks with reserves, what that means is that you didn’t sell treasuries and instead left them with reserves. If you have a positive interest rate target, then you have to pay IOR on these reserves, but that simply replaces the interest you would have paid on the Treasuries, and is actually less than the latter since Treasuries can have higher maturities. The Fed has been returning record profits to the US Treasury due to QE, which has removed interest income paid on Treasuries to the financial sector and replaced it with IOR at 0.25%.

      Also, when you fill banks up with reserves, don’t forget they have liabilities as an offset. So, what you’re saying is that instead of no “subsidy” for banks, you want to “stick it to them” by giving them $trillions of assets that earn nothing. It’s well known that deposits that banks pay 0% on actually cost banks on balance to manage even beyond the fees they charge. So, in your scenario, banks would be holding $trillions and on balance taking a loss on. In fact, even holding reserves earning IOR isn’t profitable for a bank–we know this because otherwise even without IOR they’d hold a bunch of Tbills instead of making loans since that’s about the same thing; but they don’t do that, because the spread on Tbills over their liabilities isn’t high, and on average probably negative.

      Now, if you simply have it in for banks not to recoup some of the losses that IOR ends up leaving them with when reserves are oversupplied, then RRPs is a potential answer, since that would drain bank reserves without the bank necessarily earning anything. For instance, a small business could use the RRP to earn some risk-free interest while its bank’s reserves would be drained. For the financial system overall, there’s no reason to prefer IOR to RRPs, so that might be preferable to you.

      I also don’t know how likely it is to simply decree to the financial system that “there shall be no loans below X%.” It might work, but it might not. And there will be many non-banks and bank depositors unhappy about it as banks would make up for the effective tax on them by pushing it onto their customers.

      Now having said all this, IF banks are not oversupplied with reserves and IOR is paid on them, then, YES, I would agree it is a subsidy. In this case, the rationale for the subsidy would be to make it easier for the central bank to achieve its interest rate target–so it’s a cost/benefit type of analysis, and the academic research has suggested that the small cost of IOR (since there aren’t many reserves circulating in this case for several reasons, including that IOR < target rate) outweighs the benefits to the financial system of achieving the interest rate target more precisely.

      • Thank you, Scott, for this very detailed response.

        SF: “I reject the premise of your argument that this is a subsidy. If you oversupply banks with reserves, what that means is that you didn’t sell treasuries and instead left them with reserves. If you have a positive interest rate target, then you have to pay IOR on these reserves, but that simply replaces the interest you would have paid on the Treasuries, and is actually less than the latter since Treasuries can have higher maturities. The Fed has been returning record profits to the US Treasury due to QE, which has removed interest income paid on Treasuries to the financial sector and replaced it with IOR at 0.25%.”

        First of all, I agree, maybe subsidy is too strong a term, as the target interest rate is not primarily set to increase the banking industry’s profitability. But in setting the interest rate, apparently the Monetary Policy Committee in the UK which is responsible for monetary policy took account of the the profitibality of the banks. Here is Tony Yates (from his longandvariable blog from 15th September) :

        “Indeed, the main reason why MPC decided not to cut rates closer to the zero floor in March 2009, a view it held to until February this year, was that further cuts would eat into bank profits. ”

        Then, you are of course correct, that the net effect of doing QE is saving the government money, as it saves more money on interest rate payments it would have made on the bonds it purchased, than it pays out as the target rate for IOR.

        But my view would be that the two are separate actions, quite independent from each other.

        The financial sector (other than banks (we are told)) sold the bonds under QE. That is quite separate from the fact that another part of financial sector (banks only) gets the IOR. So the QE would have happened anyway, and the interest to be paid on reserves is a monetary policy decision not directly related to and independent from the original QE.

        Then the oversupply of reserves is as a side effect of money being deposited in banks following QE, by the bond-holders who sold the bonds, or the investors who sold shares (bought from the proceed of the bond sales). So there is a cash overhang which is now in deposit accounts in the banks. That is a gross oversimplification, but it is mainly asset markets (shares in particular) which were driven up so let us just go with that.

        Now, in the end that money from these asset sales seems to have ended up in straight bank deposits returning 0% interest in the banking sector. That is the liability side. So the banks got stuck with all that extra money. They did not seek it out, but it ended up there.

        On the other side we have for the UK still £315bn of reserves on the balance sheet of the banks (from the original £375bn QE). That is the asset side.

        So IOR costs the BoE about £1.5bn a year at the current rate of 0.5%.

        SF: “Now, if you simply have it in for banks not to recoup some of the losses that IOR ends up leaving them with when reserves are oversupplied, then RRPs is a potential answer, since that would drain bank reserves without the bank necessarily earning anything.”

        It is not really that I have it in for banks, but I am surprised at the actual cost of following this particular monetary policy. I was until a few days ago completely unaware of it, as would probably be 99.9% of the population. But now I know about it, I am just looking at the opportunity costs of using £1.5bn for something else. It would, for example, build five 500 bed hospitals.

        You mentioned RRP, which, of course would work, but which would be as expensive for the Bank of England than the target rate. So the BoE would now still pay 1.5bn a year to support RRP to drain all the reserves. (That again under the assumption that decisions on QE and IOR are independent from each other)

        But there would also be other ways to reduce the reserves.

        First, banks could decide by themselves to do it, if they find holding deposits and reserves under a ZIRP too costly. Banks could reduce their deposit rate until they have negative deposit rate, so that their balance sheet shrinks. (I suppose we would find an increased demand for banknotes as people now put money under their mattresses)

        Alternatively, the government could start taxing deposits until the reserves are drained.

        Negative interest rates on deposits or taxing deposits have of course other implications, but it would certainly allow the government to drain money which sits there for no particular reason.

        But, most of all, these options do not cost the BoE £1.5bn a year, so it is worth considering just for that reason. (Because we rather build 5 hospitals with the money.) In fact, taxing deposits at banks would allow the government to have additional money, for more worthwhile projects. (that should not be the reason for the tax, the tax on deposits should simply, as a monetary policy measure, reduce reserves at the banks)

        SF: “I also don’t know how likely it is to simply decree to the financial system that “there shall be no loans below X%.” It might work, but it might not. And there will be many non-banks and bank depositors unhappy about it as banks would make up for the effective tax on them by pushing it onto their customers.”

        I think it is worth a try.

        Banks would certainly complain. But beyond that we cannot really say what would happen. Maybe they start lending out reserves more easily now, after they stop getting 0.5% interest on them, so it would increase bank lending.

        • Scott Fullwiler

          “But my view would be that the two are separate actions, quite independent from each other.”

          And this is where we disagree. You say you want 5 more hospitals, but with IOR you end up with more govt income than without it since you aren’t issuing gilts (assuming large excess balances). Obviously, you want that + the 5 hospitals (and the government isn’t financially constrained to begin with, so it can do that even with the $1.5 IOR pmt)–I don’t think it’s possible to do without just putting the CB’s target to zero or even below. It’s basic supply and demand—push the supply curve way to the right of the demand curve; the price falls to zero (ZIRP) unless you put in a price support (IOR or equivalent). I don’t think anything you’ve proposed as an alternative is of much use or would work as you think to keep a target rate above zero, large surplus of reserves, and no support payment to somewhere in the financial system all at once.

          I’ll just say, though, that (perhaps like you?) I’m quite alright with ZIRP–there are some arguments as Yates notes about bank profits and how money markets would respond, and I don’t find those to be good reasons to have IOR > 0. Better to change the system of short-term finance in that case than cater to the already bloated financial system.

          I also don’t see any reason for negative rates aimed at removing money that’s “just sitting there.” The net effect is to reduce income of savers, which hurts the economy. If I’m a saver and you cut my interest rate, I might respond by saving MORE. Now, negative rates could encourage borrowing or might even encourage the sort of reductioin in idle balances you mentioned (though I doubt it), of course, but that’s not the best approach to increasing spending in an economy piled high with private debt, IMO and in which the private sector for it’s own good should be saving more (or reducing debt, which shows up as the same thing in national income accounts), not less.

          This is all not to mention how easy it would be to get around this–there’s too much profitability involved for the financial system not to find the work around. It’s not dissimilar to the early 1980s when holding deposits became way more costly given how high rates were on everything else. The net effect was all sorts of financial innovations within a few years to allow earning on balances that could either be spent or easily shifted to accounts that could be used for spending. Just a massive portfolio shift. And trying to move everyone to currency isn’t a good idea–99% of the value of transactions is electronically transmitted. You’re just not going to get the drain into currency you’re looking for, and if you did (which you won’t), the amount is so staggering that it may cost way more than 1.5b to create it all.

        • Scott Fullwiler

          Actually, I’m going to change gears here–I don’t really need to resist your views. We agree on how IOR works w/ and w/o large excess reserves. If there’s a way to enable the CB to adjust its target rate and still meet your criteria, I don’t see why I should have a problem with it as long as it doesn’t impose costs on others of much significance. I don’t know if it’s possible, but if it works and doesn’t have significant side effects, seems alright to me.

  11. Dear Professor F,
    Are you saying that it is OK under most circumstances for currency issuing governments to spend more than they tax and that a PQE offers no technical advantage over allocating the funds through the normal channels?
    A

    • Without speaking for Scott, I would wager that he would argue that it is VITAL for a sovereign government to spend more than it taxes, assuming its economy has a current account deficit. #sectoralbalances

      As for PQE, it is just a set of political balance sheet transactions performed by a consolidated sovereign government to obfuscate finances for the unwitting masses that see institutional distinctions where there are none.

  12. A constructive “mainstream” (SWL?) engagement with MMT on the idea of central bank independence:

    http://mainlymacro.blogspot.ca/2015/09/central-bank-independence-and-mmt.html

    There are certainly different levels of analysis in this debate.

    My impression Scott is that you are asserting that central bank operational independence and monetary policy effectiveness would not be compromised under a hypothetical PQE. This is in response to erroneous claims that PQE would compromise the ability of the central bank to manage monetary policy independently and effectively from that point on, those claims really being argued and steered by a failure to understand monetary operations.

    At the same time, PQE is not really a central bank choice. Notwithstanding the central bank’s ability to continue to set monetary policy effectively at the operational level, PQE would be a decision that would be imposed on the central bank as a strategy to be executed in part by the central bank.

    In addition, MMT’s strategic or structural preference as I understand it would be for treasury/central bank integration of some type. So the imposition of PQE is a type of decision that is more or less consistence with that type of integration. Yet the reason for it in this case is being argued by its proponents in a way that misinterprets the nature of a type of central bank operational independence that exists now.

    I’m not quite sure where SWL is coming from, but it appears to be one of the more constructive engagements of mainstream (?) with MMT that I’ve noticed lately.

    • There is a key political point here.

      The central bank *is* a department of government. It’s job is to adapt the economy to the financial decisions of the elected congress/parliament. Whether it does that simply for capital development, or has an hand in aggregate demand management depends entirely upon the political philosophies of the elected government.

      Any notion that the job of the central bank is to restrict the parliament in what it can do is to be resisted. And that includes the false notion that the private sector is charging an interest based upon what the government is deciding to do/not do. It isn’t.

      The government has first dibs over the real resources in the economy. The private sector can work with what is left, and anything the private sector leaves behind can then be hoovered up by government for additional ‘nice to have’ public works.

    • Scott Fullwiler

      Hi JKH

      “My impression Scott is that you are asserting that central bank operational independence and monetary policy effectiveness would not be compromised under a hypothetical PQE. This is in response to erroneous claims that PQE would compromise the ability of the central bank to manage monetary policy independently and effectively from that point on, those claims really being argued and steered by a failure to understand monetary operations.”

      Yes, this is where I was going.

      “At the same time, PQE is not really a central bank choice. Notwithstanding the central bank’s ability to continue to set monetary policy effectively at the operational level, PQE would be a decision that would be imposed on the central bank as a strategy to be executed in part by the central bank.”

      That’s true, yes. Good point. Operationally and macroeconomically, it’s of no significance, of course. The BoE creates a loan to the govt and earns interest, and then creates reserves and pays interest, so it’s basically a wash. And if it prefers, it does a repo or something to drain the reserves, paying interest. Again, a wash, and no net effect on the size of the BoE’s balance sheet from the PQE in that case–it’s largely traded a bond issued by the Tsy for a loan to the Tsy.

      As we know, overall, it’s just the BoE doing the govt’s traditional “job” of offsetting the deficit spending with a bond sale or interest rate support. It’s probably of significance politically to the BoE that the it is “lending” to the govt, but this doesn’t need to affect the profits negatively and doesn’t affect BoE’s ability to carry out it’s desired strategy, as we’ve agreed. And, of course, the US Fed in the past has had to provide such overdrafts (not in these qty’s, though) and I don’t know that it was viewed as harming the Fed’s independence (perhaps it was, though).

      “In addition, MMT’s strategic or structural preference as I understand it would be for treasury/central bank integration of some type. So the imposition of PQE is a type of decision that is more or less consistence with that type of integration. Yet the reason for it in this case is being argued by its proponents in a way that misinterprets the nature of a type of central bank operational independence that exists now.”

      I personally am not overly wedded to such structural integration as much as integrating hierarchy of authority more explicitly in describing these operations, but that’s a different discussion of course. I think you’re right, though–it’s important to define what CB independence is since the loan from the BoE to the govt could reasonably be interpreted by some as a threat to independence. You’ve just made me very glad I did explicitly define CB independence in this post. 🙂 And I think the definition I gave was consistent with neoclassical literature–that’s what I was shooting for, anyway.

      “I’m not quite sure where SWL is coming from, but it appears to be one of the more constructive engagements of mainstream (?) with MMT that I’ve noticed lately.

      • Scott Fullwiler

        On your last point that I neglected to respond to, I would agree–very honest and constructive engagement from SWL, which is always appreciated.

  13. I was looking for a post like this. I am hoping you can answer some of my questions.

    It seems to me a central bank is a hedge fund with some different, but very important, rules applied to it than a normal hedge fund. Thoughts?

    Does the solvency of a central bank matter?

    My grocery store and I bank at the ***same*** bank. I write a check to the grocery store for groceries. What happens? You can ignore the groceries if you want.

    Assume all of the commercial banks are solvent. Preferences change, and all entities want to hold currency and no demand deposits. What happens?

    Are central bank reserves used to settle payments and to set the fed funds rate and nothing else?

    Thanks!