Category Archives: L. Randall Wray

Central Bank Sterilization

Posted on August 25, 2009 by | Comments Off on Central Bank Sterilization
By L. Randall Wray [via CFEPS]

There is a great deal of confusion over international “flows” of currency, reserves, and finance, much of which results from failure to distinguish between a floating versus a fixed exchange rate. For example, it is often claimed that the US needs “foreign savings” in order to “finance” its persistent trade deficit that results from “profligate US consumers” who are said to be “living beyond their means”. Such a statement makes no sense for a sovereign nation operating on a flexible exchange rate. In a nation like the US, when viewed from the vantage point of the economy as a whole, a trade deficit results when the rest of the world (ROW) wishes to net save in the form of dollar assets. The ROW exports to the US reflect the “cost” imposed on citizens of the ROW to obtain the “benefit” of accumulating dollar denominated assets. From the perspective of America as a whole, the “net benefit” of the trade deficit consists of the net imports that are enjoyed. In contrast to the conventional view, it is more revealing to think of the US trade deficit as “financing” the net dollar saving of the ROW—rather than thinking of the ROW as “financing” the US trade deficit. If and when the ROW decides it has a sufficient stock of dollar assets, the US trade deficit will disappear.


It is sometimes argued that when the US experiences a capital account surplus, the dollars “flowing in” will increase private bank reserves and hence can lead to an expansion of private loan-and-deposit-making activity through the “money multiplier”. However, if the Fed “sterilizes” this inflow through open market sales, the expansionary benefits are dissipated. Hence, if the central bank can be persuaded to avoid this sterilization, the US can enjoy the stimulative effects.

Previous analysis should make it clear that sterilization is not a discretionary activity. First it is necessary to understand that a trade deficit mostly shifts ownership of dollar deposits from a domestic account holder to a nonresident account holder. Often, reserves do not even shift banks as deposits are transferred from an account at a US branch to an account at a foreign branch of the same bank. Even if reserves are shifted, this merely means that the Fed debits the accounts of one bank and credits the accounts of another. These operations will be tallied as a deficit on current account and a surplus on capital account. If treasury or central bank actions result in excess reserve holdings (by the foreign branch or bank), the holder will seek earning dollar-denominated assets—perhaps US sovereign debt. US bond dealers or US banks can exchange sovereign debt for reserve deposits at the Fed. If the net result of these operations is to create excess dollar reserves, there will be downward pressure in the US overnight interbank lending rate. From the analysis above, it will be obvious that this is relieved by central bank open market sales to drain the excess reserves. This “sterilization” is not discretionary if the central bank wishes to maintain a positive overnight rate target. Conversely, if the net impact of international operations is to result in a deficit dollar reserve position, the Fed will engage in an open market purchase to inject reserves and thereby relieve upward pressure that threatens to move the overnight rate above target.

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‘Monetization’ of Budget Deficits

Posted on August 25, 2009 by | 9 comments
By L. Randall Wray [via CFEPS]

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

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


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

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

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

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Posted in L. Randall Wray, Monetary policy, Taxes, The Federal Government Deficit, The National Debt, Uncategorized

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Job Guarantee

Posted on August 23, 2009 by | 11 comments
By L. Randal Wray

A job guarantee program is one in which government promises to make a job available to any qualifying individual who is ready and willing to work. Qualifications required of participants could include age range (i.e. teens), gender, family status (i.e. heads of households), family income (i.e. below poverty line), educational attainment (i.e. high school dropouts), residency (i.e. rural), and so on. The most general program would provide a universal job guarantee, sometimes also called an employer of last resort (ELR) program in which government promises to provide a job to anyone legally entitled to work.

Many job guarantee supporters see employment not only as an economic condition but also as a right. Wray and Forstater (2004) justify the right to work as a fundamental prerequisite for social justice in any society in which income from work is an important determinant of access to resources. Harvey (1989) and Burgess and Mitchell (1998) argue for the right to work on the basis that it is a fundamental human (or natural) right. Such treatments find support in modern legal proclamations such as the United Nations Universal Declaration of Human Rights or the US Employment Act of 1946 and the Full Employment Act of 1978. Amartya Sen (1999) supports the right to work on the basis that the economic and social costs of unemployment are staggering with far-reaching consequences beyond the single dimension of a loss of income (see also Rawls 1971). William Vickrey (2004) identified unemployment with “cruel vandalism”,outlining the social and economic inequities of unemployment and devising strategies for its solution. A key proposition of such arguments is that no capitalist society has ever managed to operate at anything approaching true, full, employment on a consistent basis. Further, the burden of joblessness is borne unequally, concentrated among groups that already face other disadvantages: racial and ethnic minorities, immigrants, younger and older individuals, women, people with disabilities, and those with lower educational attainment. For these reasons, government should and must play a role in providing jobs to achieve social justice.

There are different versions of the job guarantee program. Harvey’s (1989) proposal seeks to provide a public sector job to anyone unable to find work, with the pay approximating a ‘market wage,’ whereby more highly skilled workers would receive higher pay. Argentina’s Jefes program (examined below) targets heads of households only and offers a uniform basic payment for what is essentially half-time work. In Hyman Minsky’s (1965) proposal, developed further at The Center for Full Employment and Price Stability, University of Missouri-Kansas City and independently at The Centre of Full Employment and Equity, University of Newcastle, Australia, the federal government provides funding for a job creation program that offers a uniform hourly wage with a package of benefits. (Wray 1998; Burgess and Mitchell 1998) The program could provide for part-time and seasonal work, as well as for other flexible working conditions as desired by the workers. The package of benefits would be subject to congressional approval, but could include health care, childcare, payment of social security taxes, and usual vacations and sick leave. The wage would also be set by congress and fixed until congress approved a rate increase—much as the minimum wage is currently legislated. The perceived advantage of the uniform basic wage is that it would limit competition with other employers as workers could be attracted out of the ELR program by paying a wage slightly above the program wage.

Proponents of a universal job guarantee program operated by the federal government argue that no other means exists to ensure that everyone who wants to work will be able to obtain a job. Benefits include poverty reduction, amelioration of many social ills associated with chronic unemployment (health problems, spousal abuse and family break-up, drug abuse, crime), and enhanced skills due to training on the job. Forstater (1999) has emphasized how ELR can be used to increase economic flexibility and to enhance the environment. The program would improve working conditions in the private sector as employees would have the option of moving into the ELR program. Hence, private sector employers would have to offer a wage and benefit package and working conditions at least as good as those offered by the ELR program. The informal sector would shrink as workers become integrated into formal employment, gaining access to protection provided by labor laws. There would be some reduction of racial or gender discrimination because unfairly treated workers would have the ELR option, however, ELR by itself cannot end discrimination. Still, it has long been recognized that full employment is an important tool in the fight for equality. (Darity 1999) Forstater (1999) has emphasized how ELR can be used to increase economic flexibility and to improve the environment as projects can be directed to mitigate ecological problems.

Finally, some supporters emphasize that an ELR program with a uniform basic wage also helps to promote economic and price stability. ELR will act as an automatic stabilizer as employment in the program grows in recession and shrinks in economic expansion, counteracting private sector employment fluctuations. The federal government budget will become more counter-cyclical because its spending on the ELR program will likewise grow in recession and fall in expansion. Furthermore, the uniform basic wage will reduce both inflationary pressure in a boom and deflationary pressure in a bust. In a boom, private employers can recruit from the ELR pool of workers, paying a mark-up over the ELR wage. The ELR pool acts like a “reserve army” of the employed, dampening wage pressures as private employment grows. In recession, workers down-sized by private employers can work at the ELR wage, which puts a floor to how low wages and income can go.

Critics argue that a job guarantee would be inflationary, using some version of a Phillips Curve approach according to which lower unemployment necessarily means higher inflation. (Sawyer 2003) Some argue that ELR would reduce the incentive to work, raising private sector costs because of increased shirking, since workers would no longer fear job loss. Workers might be emboldened to ask for greater wage increases. Some argue that an ELR program would be so big that it would be impossible to manage; some fear corruption; others argue that it would be impossible to find useful things for ELR workers to do; still others argue that it would be difficult to discipline ELR workers. It has been argued that a national job guarantee would be too expensive, causing the budget deficit to grow on an unsustainable path; and that higher employment would worsen trade deficits. (Aspromourgous 2000; King 2001; See Mitchell and Wray 2005 for responses to all of these critiques.)

There have been many job creation programs implemented around the world, some of which were narrowly targeted while others were broad-based. The 1930s American New Deal contained several moderately inclusive programs including the Civilian Conservation Corp and the Works Progress Administration. Sweden developed broad based employment programs that virtually guaranteed access to jobs, until government began to retrench in the 1970s. (Ginsburg 1983) In the aftermath of its economic crisis that came with the collapse of its currency board, Argentina created Plan Jefes y Jefas that guaranteed a job for poor heads of households. (Tcherneva and Wray 2005) The program successfully created 2 million new jobs that not only provided employment and income for poor families, but also provided needed services and free goods to poor neighborhoods. More recently, India passed the National Rural Employment Guarantee Act (2005) that commits the government to providing employment in a public works project to any adult living in a rural area. The job must be provided within 15 days of registration, and must provide employment for a minimum of 100 days per year. (Hirway 2006) These real world experiments provide fertile ground for testing the claims on both sides of the job guarantee debate.

References

Aspromourgos, T. “Is an Employer-of-Last-Resort Policy Sustainable? A Review Article.” Review of Political Economy 12, no. 2 (2000): 141-155.

Burgess, J. and Mitchell, W.F. (1998), ‘Unemployment Human Rights and Full Employment Policy in Australia,’ in M. Jones and P. Kreisler (eds.), Globalization, Human Rights and Civil Society, Sydney, Australia: Prospect Press.

Darity, William Jr. “Who loses from Unemployment.” Journal of Economic Issues, 33, no. 2 (June 1999): 491.

Forstater, Mathew. “Full Employment and Economic Flexibility” Economic and Labour Relations Review, Volume 11, 1999.

Ginsburg, Helen (1983), Full Employment and Public Policy: The United States and Sweden, Lexington, MA: Lexington Books.

Harvey, P. (1989), Securing the Right to Employment: Social Welfare Policy and the Unemployed in the United States, Princeton, NJ: Princeton University Press.

Hirway, Indira (2006), “Enhancing Livelihood Security through the National Employment Guarantee Act: Toward effective implementation of the Act”, The Levy Economics Institute Working Paper No. 437, January, www.levy.org.

King, J.E. “The Last Resort? Some Critical Reflections on ELR..” Journal of Economic and Social Policy 5, no. 2 (2001): 72-76.

Minsky, H.P. (1965), ‘The Role of Employment Policy,’ in M.S. Gordon (ed.), Poverty in America, San Francisco, CA: Chandler Publishing Company.

Mitchell, W.F. and Wray, L.R. (2005), ‘In Defense of Employer of Last Resort: a response to Malcolm Sawyer,’ Journal of Economic Issues, 39(1), 235-245.

Rawls, J. (1971), Theory of Justice, Cambridge, MA: Harvard University Press.

Sawyer, M. (2003), ‘Employer of last resort: could it deliver full employment and price stability?,’ Journal of Economic Issues, 37(4), 881-908.

Sen, A. (1999), Development as Freedom, New York, NY: Alfred A. Knopf.

Tcherneva, Pavlina and L. Randall Wray (2005), “Gender and the Job Guarantee: The impact of Argentina’s Jefes program on female heads of poor households”, Center for Full Employment and Price Stability Working Paper No. 50, December, www.cfeps.org.

Vickrey, W.S. (2004), Full Employment and Price Stability, M. Forstater and P.R. Tcherneva (eds.), Cheltenham, UK: Edward Elgar.

Wray, L.R. and Forstater, M. (2004), ‘Full Employment and Economic Justice,’ in D. Champlin and J. Knoedler (eds.), The Institutionalist Tradition in labor Economics, Armonk: NY: M.E. Sharpe.

Wray, L.R. (1998), Understanding Modern Money: the key to full employment and price stability, Cheltenham, UK: Edward Elgar.

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Interest Rate Determination

Posted on August 21, 2009 by | 26 comments
By L. Randall Wray [via CFEPS]

A few years ago, textbooks had traditionally presented monetary policy as a choice between targeting the quantity of money or the interest rate. It was supposed that control of monetary aggregates could be achieved through control over the quantity of reserves, given a relatively stable “money multiplier”. (Brunner 1968; Balbach 1981) This even led to some real world attempts to hit monetary growth targets—particularly in the US and the UK during the early 1980s. However, the results proved to be so dismal that almost all economists have come to the conclusion that at least in practice, it is not possible to hit money targets. (B. Friedman 1988) These real world results appear to have validated the arguments of those like Goodhart (1989) in the UK and Moore (1988) in the US that central banks have no choice but to set an interest rate target and then accommodate the demand for reserves at that target. Hence, if the central bank can indeed hit a reserve target, it does so only through its decision to raise or lower the interest rate to lower or raise the demand for reserves. Thus, the supply of reserves is best thought of as wholly accommodating the demand, but at the central bank’s interest rate target.

Why does the central bank necessarily accommodate the demand for reserves? There are at least four different answers. In the US, banks are required to hold reserves as a ratio against deposits, according to a fairly complex calculation. In the 1980s, the method used was changed from lagged to contemporaneous reserve accounting on the belief that this would tighten central bank control over loan and deposit expansion. As it turns out, however, both methods result in a backward looking reserve requirement: the reserves that must be held today depend to a greater or lesser degree on deposits held in the fairly distant past. As banks cannot go backward in time, there is nothing they can do about historical deposits. Even if a short settlement period is provided to meet reserve requirements, the required portfolio adjustment could be too great—especially when one considers that many bank assets are not liquid. Hence, in practice, the central bank automatically provides an overdraft—the only question is over the “price”, that is, the discount rate charged on reserves. In many nations, such as Canada and Australia, the promise of an overdraft is explicitly given, hence, there can be no question about central bank accommodation.

A second, less satisfying, answer is often given, which is that the central bank must operate as a lender of last resort, meaning that it provides reserves in order to preserve stability of the financial system. The problem with this explanation is that while it is undoubtedly true, it applies to a different time dimension. The central bank accommodates the demand for reserves day-by-day, even hour-by-hour. It would presumably take some time before refusal to accommodate the demand for reserves would be likely to generate the conditions in which bank runs and financial crises begin to occur. Once these occurred, the central bank would surely enter as a lender of last resort, but this is a different matter from the daily “horizontal” accommodation.

The third explanation is that the central bank accommodates reserve demand in order to ensure an orderly payments system. This might be seen as being closely related to the lender of last resort argument, but I think it can be more plausibly applied to the time frame over which accommodation takes place. Par clearing among banks, and more importantly par clearing with the government, requires that banks have access to reserves for clearing. (Note that deposit insurance ultimately makes the government responsible for check clearing, in any event.)

The final argument is that because the demand for reserves is highly inelastic, and because the private sector cannot increase the supply, the overnight interest rate would be highly unstable without central bank accommodation. Hence, relative stability of overnight rates requires “horizontal” accommodation by the central bank. In practice, empirical evidence of relatively stable overnight interest rates over even very short periods of time supports the belief that the central bank is accommodating horizontally.

We can conclude that the overnight rate is exogenously administered by the central bank. Short-term sovereign debt is a very good substitute asset for overnight reserve lending, hence, its interest rate will closely track the overnight interbank rate. Longer-term sovereign rates will depend on expectations of future short term rates, largely determined by expectations of future monetary policy targets. Thus, we can take those to be mostly controlled by the central bank as well, as it could announce targets far into future and thereby affect the spectrum of rates on sovereign debt.

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Pumping Liquidity to Fight Deflation

Posted on August 20, 2009 by | 1 comment

By L. Randall Wray [via CFEPS]

In recent years there have been numerous calls on the central banks to “pump” liquidity into the system to fight deflationary pressures, first in Japan and more recently in the US. (Bernanke 2003) Years ago, Friedman (1969) had joked about helicopters dropping bags of money as a way to increase the money supply. If this practice were adopted, it probably would be an effective means of reversing deflationary pressures—if a sufficient number of bags were dropped. There are two problems with suc h a policy recommendation, however. First, of course, no central bank would even consider such a policy. Second, and more importantly, this would not really be a monetary policy operation, but rather a fiscal policy operation akin to welfare spending. In practice, central banks are more-or- less limited to providing reserves at the discount window or in open market operations. In both cases, the central bank increases its liabilities (reserves)and gains an asset (mostly sovereign debt or private bank liabilities, although the central bank could also buy gold, foreign currencies, and other private assets). Helicopter money drops are quite different because they increase private sector wealth; in contrast central bank operations do not (except to the extent that adoption of a lower interest rate target increases prices of financial assets).

From the previous section, it should be clear that the central bank cannot choose to increase reserves beyond the level desired/required by the banking system if it wishes to maintain positive overnight rates. If private banks have all the reserves they need/want,then they will not borrow more from the central bank. Open market purchases would simply result in excess reserve holdings; banks with excessive reserves would offer them in the overnight market, causing the interbank interest rate to decline. Once the overnight rate reached the bottom of the central bank’s target range, an open market sale would be triggered to drain excess reserves. This would return the overnight rate to the target, and the central bank would find that it had drained an amount of reserves more-or-less equivalent to the reserves it had “pumped” into the system to fight deflation. Fortunately,no central bank with a positive overnight interest rate target would be so foolish as to follow the advice that they ought to “pump liquidity” to fight deflation.

Japan presents a somewhat different case, because it operates with a zero overnight rate target. This is maintained by keeping some excess reserves in the banking system. The Bank of Japan can always add more excess reserves to the system since it is satisfied with a zero rate. However, from the perspective of banks, all that “pumping liquidity” into the system means is that they hold more non-earning reserves and fewer low-earning sovereign bills and bonds. There is no reason to believe that this helps to fight deflation, and Japan’s long experience with zero overnight rates even in the presence of deflation provides empirical evidence that even where “pumping liquidity” is possible, it has no discernible positive impact. (The US had a similar experience with discount rates at 1% during the Great Depression.) And, to repeat, “pumping liquidity” is not even a policy option for any nation that operates with positive overnight rates.

Can the central bank do anything about deflation? As the overnight interest rate is a policy variable, the central bank is free to adjust the target to fight deflation. However, both theory and empirical evidence provide ambiguous advice, at best. It is commonly believed that a lower interest rate target will stimulate private borrowing and spending—although many years of zero rates in Japan with chronic deflation provide counter evidence. There is little empirical evidence in support of the common belief that low rates stimulate investment. This could be for a variety of reasons: the central bank can lower the overnight rate, but the relevant longer-term rates are more difficult to reduce; most evidence suggests that investment is interest- inelastic; and in a downturn, the expected returns to investment fall farther and faster than market interest rates can be brought down.

Evidence is more conclusive regarding effects of low rates on housing and consumer durables; indeed, recent lower mortgage rates in the US have undoubtedly spurred a refinancing boom that fueled spending on home remodeling and consumer purchases.

Still, this effect must run its course once all the potentially refinanceable mortgages are turned-over. Further, it must be remembered that for every payment of interest there is an interest receipt. Lower rates reduce interest income. It is generally assumed that debtors have higher spending propensities than creditors, hence, the net effect is presumed to be positive. As populations age, it is probable that a greater proportion of the “rentier” class is retired and at least somewhat dependent upon interest income. This could reverse those marginal propensities.

More importantly, if national government debt is a large proportion of outstanding debt, and if the government debt to GDP ratio is sufficiently high, the net effect of interest rate reductions could well be deflationary. This is because the reduction of interest income provided by government could reduce private spending more than lower rates stimulated private sector borrowing. In sum, the central bank can lower overnight rate targets to fight deflation, but it is not clear that this will have a significant effect.

Read the full article here.

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Let’s Create a Real Job Czar for the Jobless

Posted on August 20, 2009 by | 1 comment

By L. Randal Wray [via CFEPS]

For an example of what can be done, we can look to the recent experience of Argentina. As everyone knows, Argentina had been the darling of the Washington Consensus and of the IMF structural adjustment approach. It opened its economy, freed its markets, privatized government operations, downsized government, adopted fiscal and monetary austerity, and—importantly—adopted a currency board based on the dollar. It did everything “right”, but the IMF/Washington Consensus approach was fundamentally flawed and put Argentina into an inherently unsustainable situation. When world financial markets began to doubt the nation’s ability to maintain the currency board arrangement, there was a run on the domestic currency. The IMF/Washington Consensus recommended more austerity—which caused unemployment and poverty to explode. Social unrest eventually led to rioting in the streets. Argentina wisely abandoned the dollar, floated the currency, defaulted on some of the debt, and rejected the IMF/Washington Consensus.


The rioting stopped when the government implemented a job creation program designed to provide a social safety net for poor households with children. The program evolved through several stages, with the final phase beginning in April 2002 with the implementation of the Jefes de Hogar (Heads of Household) program that provides a payment of 150 pesos per month to a head of household for a minimum of 4 hours of work daily. Participants work in community services and small construction or maintenance activities, or are directed to training programs (including finishing basic education). The household must contain children under age 18, persons with handicaps, or a pregnant woman. Households are generally limited to one participant in the Jefes program.

The program’s total spending is currently equal to about 1% of GDP, with nearly 2 million participants (about 1.7 million in Jefes and 300,000 in PEL). This is out of a population of only 37 million, or more than 5% of the population. However, it should be noted that the US spends 1% of GDP on social assistance, while France and the UK spend 3-4% of GDP on such programs. Given a national poverty rate above 50%, and with 9.6 million indigents and a child poverty rate approaching 75%, Argentina’s spending is small relative to needs.

According to the World Bank’s reviews, the program has been highly successful in achieving a number of goals. First, program spending is well-targeted to the intended population—poor households with children. Second, the program has provided needed services and small infrastructure projects in poor communities, with most projects successfully completed and operating. Third, the program has increased income of poor households. While there have been some problems associated with implementation and supervision of the program cases involving mismanagement or corruption appear to have been relatively rare. Still, there are reports of favoritism, and home country researchers have made serious critiques of program design. However, surveys show that program participants are overwhelmingly happy with the program.

On November 3, 2003, the Mayor of Istanbul, Turkey, announced his intention to create a similar program to fight the growing unemployment problem in that city. Unemployment imposes severe costs on society—both economic costs in terms of foregone output, but also intolerable social costs in terms of rising crime and disintegrating families and communities. The Mayor recognized that no other social program brings so many benefits as those that accompany a job creation program. It will be interesting to follow the developments in Turkey as a “heads of household” job creation program is implemented.

Any sovereign nation that issues its own floating rate currency can “afford” full employment. (Indeed, one might rightly question whether nations can truly “afford” unemployment.) This is because such a government spends by crediting bank accounts, and taxes by debiting them. There can be no question about the solvency of such a nation—even if a deficit results. Japan’s sovereign deficit reaches 8% of GDP; Turkey’s sovereign deficit exceeds 25% of GDP. But so long as these nations maintain floating exchange rates, they can always spend and “service” debt by crediting bank accounts. Hence, if there are unemployed resources, including labor, the sovereign government can put them to work.

The big fear, of course, is that full employment will necessarily generate inflation. If full employment is achieved by “pump priming”, that is, by trying to raise aggregate demand through tax cuts or general government spending, it can in some circumstances generate inflation. However, if full employment is generated through a job creation program designed like Argentina’s Jefes program, it cannot be inflationary. This is because such a program sets a fixed basic wage and then hires all who are ready and willing to work at that wage. This operates like a commodities buffer stock program that sets a floor price—it prevents prices from falling through the floor, but does not push up prices. If the private sector expands, workers are hired out of the labor “buffer stock”; when the private sector down-sizes, workers flow into the “buffer stock”. Hence, the Jefes-type program also provides a strong counter-cyclical stabilizing force. It should be noted that government spending on the program will also be strongly counter-cyclical.

A real Job Czar would be put in charge of a job creation program that would achieve full employment without generating inflationary pressures. Once full employment is achieved, then the pressures to use protectionist measures to fight imports will be diminished. Further, the wage-and-price stabilizing features of a buffer stock approach would reduce reliance on fiscal and monetary austerity to fight inflation.

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The Endogenous Money Approach

Posted on August 17, 2009 by | 3 comments
By L. Randall Wray [via CFEPS]

In Neoclassical theory, money is really added as an after thought to a model that is based on a barter paradigm. In the long run, at least, money is neutral, playing no role except to determine unimportant nominal prices. Money is taken to be an exogenous variable-whose quantity is determined either by the supply of a scarce commodity (for example, gold), or by the government in the case of a “fiat” money. In the money and banking textbooks, the central bank controls the money supply through its provision of required reserves, to which a deposit multiplier is applied to determine the quantity of privately-supplied bank deposits.

The evolving Post Keynesian endogenous approach to money offers a clear alternative to the orthodox, neoclassical approach. With regard to monetary theory, early Post Keynesian work emphasized the role played by uncertainty and was generally most concerned with money hoards held to reduce “disquietude”, rather than with money “on the wing” (the relation between money and spending). However, Post Keynesians always recognized the important role played by money in the “monetary theory of production” that Keynes adopted from Marx. Circuit theory, mostly developed in France, provided a nice counterpoint to early Post Keynesian preoccupation with money hoards, focusing on the role money plays in financing spending. The next major development came in the 1970s, with Basil Moore’s horizontalism (somewhat anticipated by Kaldor), which emphasized that central banks cannot control bank reserves in a discretionary manner. Reserves must be “horizontal”, supplied on demand at the overnight bank rate (or fed funds rate) administered by the central bank. This also turns the textbook deposit multiplier on its head as causation must run from loans to deposits and then to reserves.

This led directly to development of the “endogenous money” approach that was already apparent in the Circuit literature. When the demand for loans increases, banks normally make more loans and create more banking deposits, without worrying about the quantity of reserves on hand. Privately created credit money can thus be thought of as a horizontal “leveraging” of reserves (or, better, High Powered Money), although there is no fixed leverage ratio. In recent years, some Post Keynesians have returned to Keynes’s Treatise and the State Theory of Money advanced by Knapp and adopted by Keynes therein. Rather than imagining a barter economy that discovers a lubricating medium of exchange, this neo-Chartalist approach emphasizes the role played by the state in designating the unit of account, and in naming exactly what thing answers to that description. Taxes (or any other monetary obligations imposed by authorities) then generate a demand for that money thing. In this way, Post Keynesians need not fall into the “free market” approach of orthodoxy, which imagines some pre-existing monetized utopia free from the evil hands of government. The neo-Chartalist approach also leads quite nicely to Abba Lerner’s functional finance approach, which refuses to make a fine separation of fiscal from monetary policy. Money, government spending, and taxes are thus intricately interrelated. This approach rejects Mundell’s “optimal currency area” as well as the monetary approach to the balance of payments. It is not possible to separate fiscal policy from currency sovereignty-which explains why the “one nation, one currency” rule is so rarely violated, and when it is violated it typically leads to disaster (as in the current case of Argentina, and-perhaps-in the future case of the European Union!).

Like Keynes, Post Keynesians have long emphasized that unemployment in capitalist economies has to do with the fact that these are monetary economies. Keynes had argued that the “fetish” for liquidity (the desire to hoard) causes unemployment because it keeps the relevant interest rates at too high a level to permit sufficient investment to raise aggregate demand to the full employment level. While it would appear that monetary policy could eliminate unemployment either by reducing overnight interest rates, or by expanding the quantity of reserves, neither avenue will actually work. When liquidity preference is high, there may be no rate of interest that will induce investment in illiquid capital-and even if the overnight interest rate falls, this does not mean that the long term rate will. Further, as the horizontalists make clear, the central bank cannot simply increase reserves in a discretionary manner as this would only result in excess reserve holdings and push the overnight interest rate to zero without actually increasing the money supply. Indeed, when liquidity preference is high, the demand for, as well as the supply of, loans collapses. Hence, there is no way for the central bank to simply “increase the supply of money” to raise aggregate demand. This is why those who adopt the endogenous money approach reject ISLM-type analysis in which the authorities can eliminate recession simply by expanding the money supply and shifting the LM curve out.

Furthermore, unlike orthodox economists, Post Keynesians reject a simple NAIRU or Phillips Curve trade-off according to which some unemployment must be accepted as “natural” or as the cost of fighting inflation. Earlier, some Post Keynesians had argued for “incomes policy” as an alternative way of fighting inflation, however, that rarely proved to be politically feasible. Lately, at least some Post Keynesians have argued that not only is the inflation-unemployment “trade-off” unnecessary, but that full employment can be a complement to enhanced price stability. This is accomplished through creation of a “buffer stock” of labor, according to which the government offers to hire anyone ready, willing, and able to work at some pre-announced and fixed wage. The size of the buffer stock moves counter-cyclically, such that government spending on the program will act as an “automatic stabilizer”. At the same time, the fixed wage and benefit package helps to moderate fluctuation of “market” wages. Finally, it is emphasized that the “functional finance” approach to money and fiscal policy advanced by Lerner explains why any nation that operates with a sovereign currency will be able to “afford” full employment. In this way, it is recognized that while unemployment exists only in monetary economies, unemployment does not have to be tolerated even in monetary economies. When aggregate demand is low, fiscal policy-not monetary policy-can raise demand and provide the needed jobs. The problem is not that money is “neutral”, but that when demand is low, the private sector will not create money endogenously, hence, the government must expand the supply of HPM through fiscal policy. If a deficit results, this will increase reserves held by the banking system, which must be drained through sale of government bonds in order to prevent a situation of excess reserve holdings from pushing overnight interest rates to zero. Therefore, bond sales by the treasury are seen as an “interest rate maintenance operation” and not as a “borrowing” operation. Indeed, no sovereign issuer of the currency needs to borrow its own currency from its population in order to spend.

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FOR FURTHER READING

Brunner, Karl. 1968. “The Role of Money and Monetary Policy”, Federal Reserve Bank of St. Louis Review, vol 50, no. 7, July, p. 9.

Cook, R.M. 1958. “Speculation on the Origins of Coinage”, Historia, 7, pp. 257-62.

Davidson, Paul. Money and the Real World, London, Macmillan, 1978.

Deleplace, Ghislain and Edward J. Nell, editors. Money in Motion: the Post Keynesian and Circulation Approaches, New York, St. Martin’s Press, Inc., 1996.

Dow, Alexander and Schiela C. Dow 1989. “Endogenous Money Creation and Idle Balances”, in Pheby, John, ed, New Directions in Post Keynesian Economics, Aldershot, Edward Elgar, p. 147.

Friedman, Milton. 1969. The Optimal Quantity of Money and Other Essays, Aldine, Chicago.

Grierson, Philip (1979), Dark Age Numismatics, Variorum Reprints, London.

—–. 1977. The Origins of Money, London: Athlone Press.

Hahn, F. 1983. Money and Inflation, Cambridge, MA: MIT Press.

Innes, A. M. 1913, “What is Money?“, Banking Law Journal, May p. 377-408.

Kaldor, N. The Scourge of Monetarism, London, Oxford University Press, 1985.

Keynes, John Maynard. The General Theory, New York, Harcourt-Brace-Jovanovich, 1964.

—–. A Treatise on Money: Volume 1: The Pure Theory of Money, New York, Harcourt-Brace-Jovanovich, 1976 [1930].

Knapp, Georg Friedrich. The State Theory of Money, Clifton, Augustus M. Kelley 1973 [1924].

Lerner, Abba P. “Money as a Creature of the State”, American Economic Review, vol. 37, no. 2, May 1947, pp. 312-317.

Marx, Karl. Capital, Volume III, Chicago, Charles H. Kerr and Company, 1909.

Moore, Basil. Horizontalists and Verticalists: The Macroeconomics of Credit Money, Cambridge, Cambridge University Press, 1988.

Mosler, Warren, Soft Currency Economics, third edition, 1995.

Parguez, Alain.1996. “Beyond Scarcity: A Reappraisal of the Theory of the Monetary Circuit”, in E. nell and G. Deleplace (eds) Money in Motion: The Post-Keynesian and Circulation Approaches, London: Macmillan.

Rousseas, Stephen. Post Keynesian Monetary Economics, Armonk, New York, M.E. Sharpe, 1986.

Wray, L. Randall. Understanding Modern Money: The Key to Full Employment and Price Stability, Edward Elgar: Cheltenham, 1998.

—–. Money and Credit in Capitalist Economies: The Endogenous Money Approach, Aldershot, Edward Elgar, 1990.

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Financial Instability

Posted on August 15, 2009 by | 1 comment
By L. Randall Wray [via CFEPS]

Economists have long been concerned with the economic fluctuations that occur more-or-less regularly in all capitalist economies. (Sherman 1991; Wolfson 1994) To be sure, there are different kinds of economic fluctuations—ranging from the Kitchin cycle (tied to inventory swings and lasting on average 39 months) to the Juglar cycle (lasting about seven or eight years and linked to investment in plant and equipment) to the Kuznets cycle of twenty years (associated with demographic changes) and finally to the Kondratieff long wave cycles attributed to major innovations (electrification, the automobile). (Kindleberger 1989) Financial factors might play only a small role in some of these fluctuations. Generally, economists studying financial instability have tended to focus on periodic financial crises that frequently coincide with the peak of the common business cycle, although financial crises (especially in recent years) can occur at other times during the cycle. Furthermore, an economy might be financially unstable but manage to avoid a financial crisis. It is best to think of financial instability as a tendency rather than as a specific event, although the typical financial crisis might be the result of unstable financial processes generated over the course of a business cycle expansion. In this essay, we will be concerned primarily with economic instability that has at its roots a financial cause, with less interest in either economic fluctuation that is largely independent of finance or in isolated financial crises that do not spill over to the economy as a whole.


A variety of explanations of the causes of financial instability have been offered. One possible cause could be a speculative “mania” in which a large number of investors develop unrealistic expectations of profits to be made, borrowing heavily to finance purchases of assets and driving their prices to absurd levels. Eventually, the mania ends, prices collapse, and bankruptcies follow. (Kindleberger 1989) The tulip mania of 1634, the South Sea bubble in 1719, or the Dot-com boom of the late 1990s might be cited as examples of speculative manias. Speculative booms often develop, and are fueled by, fraudulent schemes. Recent examples of financial crises in which fraud played a large role include the collapse of the Albanian national pension system (1990s) as well as the American Savings and Loan fiasco (1980s). (Mayer 1990) Other explanations have tended to focus on a sudden interruption of the supply of money or credit that prevents borrowing and forces spending to decline, precipitating a cyclical downturn. The modern monetarist approach attributes financial instability and crises to policy errors by central banks. According to monetarist doctrine, when the central bank supplies too many reserves, the money supply expands too quickly, fueling a spending boom. If the central bank then over-reacts to the inflation this is believed to generate, it reduces the money supply and causes spending to collapse. (Friedman 1982) Others advance a “credit crunch” thesis according to which lenders (mostly banks) suddenly reduce the supply of loans to borrowers—either because the lenders reach some sort of institutional constraint or because the central bank adopts restrictive monetary policy (as in the monetarist story). (Wojnilower 1980; Wolfson 1994) Finally, one could add exchange rate instability and foreign indebtedness as a precipitating cause of economic instability, especially in developing nations since the breakup of the Bretton Woods system. (Huerta 1998)

Other analyses have identified processes inherent to the operation of capitalist economies. (Magdoff and Sweezy 1987) In other words, rather than looking to fundamentally irrational manias or to “exogenous shocks” emanating from monetary authorities, these approaches attribute causation to internal or endogenous factors. Karl Marx had claimed that the “anarchy of production” that is an inevitable characteristic of an unplanned economy in which decisions are made by numerous individuals in pursuit of profit is subject to “disproportionalities” of production such that some of the produced goods cannot be sold at a price high enough to realize expected profits. Key to his explanation was the recognition that production always begins with money, some of which is borrowed, used to purchase labor and the instruments of production in order to produce commodities for sale. If, however, some of the commodities cannot be sold at a sufficiently high price, loans cannot be repaid and bankruptcies occur. Creditors then may also be forced into bankruptcy when their debtors default because the creditors, themselves, will have outstanding debts they cannot service. In this way, a snowball of defaults spreads throughout the economy generating a panic as holders of financial assets begin to worry about the soundness of their investments. Rather than waiting for debtors to default, holders of financial assets attempt to “liquidate” (sell) assets to obtain cash and other safer assets. This high demand for “liquidity” (cash and marketable assets expected to hold nominal value) causes prices of all less liquid assets to collapse, and at the same time generates reluctance to spend as all try to hoard money. Thus, the financial crisis occurs in conjunction with a collapse of aggregate demand. (Sherman 1991; Marx 1990, 1991, 1992)

Some of the elements of Marx’s analysis were adopted by Irving Fisher in his “debt deflation” theory of the Great Depression, as well as by John Maynard Keynes in his General Theory. While Fisher devised a theory of special conditions in which markets would not be equilibrating, in Keynes’s theory these were general conditions operating in monetary economies. Briefly, Fisher attributed the severity of the Great Depression to the collapse of asset prices and the ensuing financial crisis that resulted from an avalanche of defaults. (Fisher 1933; also Galbraith 1972) Adopting Marx’s notion that capitalist production begins with money on the expectation of ending with more money later, Keynes developed a general theory of the determination of equilibrium output and employment that explicitly incorporated expectations. (Keynes 1964) He concluded there are no automatic, self-righting forces operating in capitalist economies that would move them toward full employment of resources. Indeed, he described destabilizing “whirlwinds” of optimism and pessimism, in striking contrast to the Smithian notion of an “invisible hand” that would guide markets toward stable equilibrium. Also, like Marx, Keynes identified what he called the “fetish” for liquidity as a primary destabilizing force that erects barriers to the achievement of full employment. Most relevantly, rising liquidity preference lowers the demand for capital assets, which leads to lower production of investment goods and thus falling income and employment through the multiplier effect.

Hyman Minsky, arguably the foremost twentieth century theorist on the topic of financial instability, extended Keynes’s analysis with two primary contributions. (Minsky 1975, 1986) First, Minsky developed what he labeled “a financial theory of investment and an investment theory of the cycle”, attempting to join the approaches of those who emphasized financial factors and those who emphasized real factors as causes of the cycle by noting that the two are joined in a firm’s balance sheet. (Papadimitriou and Wray 1998) As in Keynes’s approach, fluctuations of investment drive the business cycle. However, Minsky explicitly examined investment finance in a modern capitalist economy, arguing that each economic unit takes positions in assets (including, but not restricted to, real physical assets) that are expected to generate income flows by issuing liabilities that commit the unit to debt service payment flows. Because the future income flows cannot be known with certainty (while the schedule of debt payments is more-or-less known), each economic unit operates with margins of safety, collateral, net worth, and a portfolio of safe, liquid assets to be drawn upon if the future should turn out to be worse than expected. The margins of safety, in turn, are established by custom, experience, and rough rules of thumb. If things go at least as well as expected, these margins of safety will prove in retrospect to have been larger than what was required, leading to revisions of operating rules. Thus, a “run of good times” in which income flows are more than ample to meet contracted payment commitments will lead to reductions of margins of safety. Minsky developed a classification scheme for balance sheet positions that adopted increasingly smaller margins of safety: hedge (expected income flows sufficient to meet principal and interest payments), speculative (near-term expected income flows only sufficient to pay interest), and Ponzi (expected income flows not even sufficient to pay interest, hence, funds would have to be borrowed merely to pay interest).

This leads directly to Minsky’s second contribution, the financial instability hypothesis. Over time, the economy naturally evolves from one with a “robust” financial structure in which hedge positions dominate, toward a “fragile” financial structure dominated by speculative and even Ponzi positions. This transition occurs over the course of an expansion as increasingly risky positions are validated by the booming economy that renders the built-in margins of error superfluous—encouraging adoption of riskier positions. Eventually, either financing costs rise or income comes in below expectations, leading to defaults on payment commitments. As in the Marx-Fisher analyses, bankruptcies snowball through the economy. This reduces spending and raises planned margins of safety. The recession proceeds until balance sheets are “simplified” through defaults and conservative financial practices that reduce debt leverage ratios.

Central to Minsky’s exposition is his recognition that development of the “big bank” (central bank) and the “big government” (government spending large relative to GDP) helps to moderate cyclical fluctuation. The central bank helps to attenuate defaults and bankruptcies by acting as a lender of last resort; countercyclical budget deficits and surpluses help to stabilize income flows. The problem, according to Minsky, is that successful stabilization through the big bank and the big government creates moral hazard problems because economic units will build into their expectations the supposition that intervention will prevent “it” (another great depression) from happening again. Thus, risk-taking is rewarded and systemic fragility grows through time, increasing the frequency and severity of financial crises even as depression is avoided. While there may be no ultimate solution, Minsky believed that informed and evolving regulation and supervision of financial markets is a necessary complement to big bank and big government intervention. Like Keynes, Minsky dismissed the belief that reliance upon an invisible hand would eliminate financial instability, indeed, he was convinced that an unregulated, small government capitalist economy would be prone to great depressions and the sort of debt deflation process analyzed by Irving Fisher.

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REFERENCES

Fisher, I. (1933), ‘The Debt-Deflation Theory of Great Depressions’, Econometrica, 1, October: pp. 337-57.

Friedman, M. (1982), Capitalism and Freedom, Chicago and London: The University of Chicago Press.

Galbraith, J. (1972), The Great Crash, Boston: Houghton-Mifflin.

Keynes, J. (1964), The General Theory of Employment, Interest, and Money, New York and London: Harcourt Brace Jovanovich.

Kindleberger, C. (1989) Manias, Panics, and Crashes: A history of financial crises, New York: Basic Books, Inc.

Huerta, A. (1998), La Globalizacion, Causa de la Crisis Asiatica Y Mexicana, Mexico: Editorial Diana.

Magdoff, H. and P. Sweezy. (1987) Stagnation and the Financial Explosion, New york: Monthly Review Press.

Marx, K. (1990), Capital: Volume 1, London: Penguin Classics.

—–. (1991), Capital: Volume 3, London: Penguin Classics.

—–. (1992), Capital: Volume 2, London: Penguin Classics.

Mayer, M. (1990), The Greatest-Ever Bank Robbery: the collapse of the savings and loan industry, New York: Charles Scribner’s Sons.

Minsky, H. (1975), John Maynard Keynes, New York: Columbia University Press.

—–. (1986), Stabilizing an Unstable Economy, New Haven and London; Yale University Press.

Papadimitriou, D. and L.R. Wray (1998), ‘The Economic Contributions of Hyman Minsky: varieties of capitalism and institutional reform‘, Review of Political Economy 10, No. 2, pp. 199-225.

Sherman, H. (1991), The Business Cycle: Growth and crisis under capitalism, Princeton, New Jersey: Princeton University Press.

Wojnilower, A. (1980), ‘The Central Role of Credit Crunches in Recent Financial History’, Brookings Papers on #Economic Activity, No. 2: 277-326.

Wolfson, M. (1994), Financial Crises: Understanding the postwar U.S. experience, Armonk, New York and London: M.E. Sharpe.

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A Primer on Government Surpluses

Posted on August 15, 2009 by | 6 comments
What is a federal government surplus?

When the federal government’s revenue exceeds its spending over the course of a year, it is running a budget surplus and outstanding Treasury securities will be reduced by the same amount over the year. In 1999, the federal government’s surplus was $99 billion and it is projected to grow to $142 billion for fiscal year 2000. This means that US taxpayers will pay $142 billion more in taxes this year than the government spends. More concretely, taxpayers will write checks to the Internal Revenue Service in the amount of $1.914 trillion, while the US Treasury will write checks received by Americans in the amount of only $1.772 trillion—a difference of $142 billion. The only way that taxpayers can write checks to the IRS that exceed the amount of checks received from the Treasury is to surrender $142 billion of Treasury securities to the government. In other words, running a surplus necessarily means that the Treasury is reducing nominal wealth of the non-government sector. This is why federal budget surpluses reduce outstanding Treasury debt and non-government sector net nominal worth.


What is the long-term effect of running perpetual government surpluses?

On current projections, the federal government will run surpluses over this decade that will total more than $2.9 trillion, leading to an equivalent reduction of non-government sector net nominal wealth—of $2.9 trillion. This wipes out almost 80% all of the publicly-held US Treasury debt, including that now held by foreigners. No one can accurately predict how the economy will react to such an unprecedented reduction of its nominal wealth—especially when the most liquid assets will be removed from private portfolios. However, throughout our history, the US has experienced exactly six periods of substantial reduction of federal government debt, achieved through persistent budget surpluses, and each of those periods ended in one of our nation’s six depressions. Our last period of substantial surpluses occurred between 1920 and 1930, when Treasury debt was reduced by 36%; the Great Depression began in 1929. For a more recent example, Japan began to run government surpluses in 1987, which reduced non-governmental nominal wealth and generated a deep recession that has already lasted a decade. Note, however, that neither the US in the 1920s nor Japan in the late 1980s came close to draining $2.9 trillion worth of wealth from the economy, even after adjusting for higher prices today.

Doesn’t a budget surplus allow us to save for the future?

Those who believe that a surplus can be “saved” for the future, or “used” to finance tax cuts or spending increases simply do not understand the nature of a surplus. Does anyone really believe that we can “save for the future” by burning $3 trillion worth of private sector wealth? During any period, the government can always choose to spend more (or less), in which case the surplus over the period may be lower (or higher); similarly, it can increase (decrease) taxes and thereby may increase (decrease) the surplus. But, as Gertrude Stein said, “there is no there there”-a surplus exists only as a deduction from private sector income. The negative household saving that some commentators are finally noticing is merely the accountant’s flip-side to the budget surplus. A government surplus necessarily reduces private sector savings and cannot be “saved for the future”.

How do budget surpluses impact non-government sector financial balances?

There is another, less transparent, impact of government surpluses on the non-government sector. At the level of the economy as a whole, when one sector spends more than its income, another necessarily spends less for the simple reason that in the aggregate, total spending equals total income. Let us, then, disaggregate the economy into three sectors to determine the implications of government surpluses for the other sectors. First, we can consolidate all levels of government into a public (or, government) sector, and likewise consolidate households and firms into a domestic, non-government (or, private) sector. For completion, we must add a foreign (“rest-of-the-world”) sector. At the aggregate level, the spending of all three sectors combined must equal the income received by the three sectors. It is clear that if the public sector is spending less than its income—that is, it is running a surplus—this must imply that at least one other sector is spending more than its income (in other words, is running a deficit). Mathematically, the sum of the balances of the three sectors must equal zero. It is convenient for our purposes to write this as:

{Public Sector Surplus} + {Foreign Sector Surplus} = {Private Sector Deficit},

which merely moves the private sector balance to the right-hand-side and reverses the sign (in other words, writes the balance as a deficit rather than a surplus, since a negative surplus is the same thing as a deficit).

Because the US has been running a balance of payments deficit in recent years, this means that the foreign sector is in surplus (the rest-of-the-world receives more US dollars than it spends). A few years ago, our public sector ran a sufficiently large deficit to more than offset the foreign sector surplus, so that our domestic non-government sector was able to run surpluses. However, in the past two years, the US public sector’s balance has turned toward surplus. When combined with our balance of payments deficit (or foreign sector surplus), this means that the domestic private sector’s balance (that is, its savings) has turned sharply negative—toward large and growing deficits. The non-government sector deficit is now approximately equal to 5.5 percent of GDP—far and away the largest private sector deficit the US has seen in the post-war period.

Will the federal government really run surpluses for the next decade?

It is very difficult to take seriously any analyses that begin with the projection that our government will run surpluses for the next decade. Part of our skepticism comes from the inherent difficulty in making projections. More importantly, it is difficult to believe that our economy can continue to grow robustly as the government sucks disposable income and wealth from the private sector by running surpluses. When the economy slows, the surplus will eventually disappear—automatically—as unemployment compensation rises and tax revenue falls due to the slowdown. As the government spends more and taxes less, the surplus will vanish.

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The Federal Reserve: History, Procedures and Policy

Posted on August 13, 2009 by | 2 comments

By L. Randall Wray [via CFEPS]

History of the Fed
The Federal Reserve Act of 1913 created the Fed ‘to furnish an elastic currency, to afford the means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes’. For many years, the guiding principle of the Fed was the ‘Real Bills Doctrine’ under which the Fed ‘rediscounted’ eligible paper (lending reserves to banks) to facilitate trade. During WWI, the Fed purchased Treasury debt as interest-earning assets, although it was not noticed until the 1920s that this added bank reserves, supporting a multiple expansion of deposits–the ‘deposit multiplier’. In 1924 the Fed first attempted to operate countercyclically, loosening policy in recession to increase bank lending. However, bond purchases did not increase reserves because banks retired loans at the discount window–the first of many times that the Fed learned it could not ‘push on a string’: reserves, loans, and the money supply are demand determined and cannot be increased directly through monetary policy. Symmetrically, analysts found that bond sales merely forced banks to the discount window to replace lost reserves. Hence, the Fed could not control bank lending through attempts to control reserves.

Interpretations of the Fed’s policy during the 1930s range from the Monetarist claim that the Fed reduced the money supply, causing the financial crisis and Great Depression, to the more common belief that the Fed’s inaction made things worse. Actually, the Fed intervened immediately, buying $125 million of Treasury securities on the day of the stock market crash– nearly doubling Fed holdings in one day. The New York Fed also opened its discount window to New York banks that were helping correspondent banks. During the early months of the crisis, the Fed continued to meet currency demand and used open market operations to stabilize interest rates. However, by autumn 1931 gold outflows increased, leading the Fed to raise discount rates to protect gold reserves. The money supply (and reserves) was shrinking not because of Fed policy, but because banks could not find worthy borrowers. In truth, there was little that monetary policy could do; recovery would require fiscal stimulus, which finally came with the New Deal and WWII.

WWII generated huge fiscal deficits, and the Fed agreed in 1942 to peg the Treasury bill rate at 3/8 of 1 per cent. The long-term legacy was a large debt stock, enabling the Fed to use bond purchases rather than discount window borrowing to provide reserves. After the war, the Fed was concerned with potential inflation. In 1947 the Treasury agreed to loosen reins on the Fed, which promptly raised interest rates. The Fed continued to lobby for greater freedom to pursue activist monetary policy, resulting in the 1951 Accord, which abandoned the commitment to maintain low government interest costs. Although not announced explicitly, the Fed clearly targeted interest rates for the next three decades to implement countercyclical policy.

In October 1979, Chairman Paul Volcker, announced a major change: the Fed would use the growth rate of M1 as its target, abandoning interest rates. In practice, the Fed calculated total reserves consistent with its money target, then subtracted borrowed reserves to obtain a non-borrowed reserve target to control money growth. However, if the Fed did not provide sufficient non-borrowed reserves, banks would simply turn to the discount window, causing borrowed reserves to rise (and, in turn, cause the Fed to miss its total reserve target). Because required reserves are always calculated with a lag, the Fed could not refuse to provide needed reserves at the discount window. Thus the Fed found reserves could not be controlled. Further, the rate of growth of M1 actually exploded beyond targets in spite of persistently tight monetary policy, demonstrating the Fed could not hit money targets, either. The attempt to target reserves effectively ended in 1982 (after a very deep recession); the attempt to hit M1 growth targets was abandoned in 1986; and the attempt to target growth of broader money aggregates finally came to an official end in 1993.

Current Policy

Since the early 1990s, the Fed has formulated a new operating procedure that is loosely based on the new monetary consensus—the orthodox approach to monetary theory and policy. The Fed’s policy today is based on five key principles:

1. transparency;
2 gradualism;
3. activism;
4. inflation as the only official goal, but the Fed actually targets distribution;
5. neutral rate as the policy instrument to achieve these goals.

Briefly, over the past decade the Fed has increased “transparency”, telegraphing its moves well in advance and announcing interest rate targets. It also follows a course of gradualism–small adjustments of interest rates (usually 25 to 50 basis points) over several years to achieve ultimate targets. Ironically, by telegraphing its intentions long in advance, and by using a series of small interest rate adjustments, the Fed creates expectations of continued rate hikes (or declines) that it feels compelled to make—for otherwise it can jolt markets—even if economic circumstances change.

These developments have occurred during a long-term trend toward policy activism, contrasting markedly with Milton Friedman’s famous call for rules rather than discretion. The policy instrument used by the Fed is something called a “neutral rate” that varies across countries and through time—an interest rate that is supposed to be consistent with stable GDP growth at full capacity. The neutral rate cannot be recognized until achieved, so it cannot be announced in advance—which is somewhat in conflict with the adoption of transparency. In consequence, the Fed must frequently and actively adjust the fed funds rate hoping to find the neutral rate. But, as Friedman long ago warned, an activist policy has just as much chance of destabilizing the economy as it does to stabilize the economy—matters are made worse when activist policy is guided by invisible neutral rates and fickle market expectations that are fueled by the Fed’s own public musings.

Finally, the Fed claims that its chief concern is inflation. Actually the Fed does target asset prices and income shares, and it shows a strong bias against labor and wages. It will allow strong economic growth and even rising prices, so long as employment remains sluggish and wages do not rise. When, however, the Fed fears that wages might rise, it raises interest rates. Further, there is evidence from transcripts of secret Fed deliberations that it does pay attention to asset prices. Indeed, one of the reasons for rate hikes in 1994 was a desire to “prick” the equity market’s “bubble”. It is probable that rate hikes at the beginning of 2000 were designed to slow the growth of stock prices; and rate hikes that began in 2004 may have been geared to slow real estate speculation.

Chairman Greenspan has been credited with masterful management of monetary policy through the Clinton-era “goldilocks” boom of the 1990s, the recession at the end of the decade, and the economic recovery after 2001. Still, critics note a number of missteps: Greenspan said the stock market was “irrationally exuberant” as early as 1994 (six years before it peaked) and various attempts by the Fed to cool it failed; after stocks crashed in 2000, Greenspan denied it is possible to identify asset price bubbles; the Fed frequently forecast inflationary pressures that never arrived; and sometimes (including summer of 2004) appeared to raise rates when labor markets were weak, while in other cases it seemed to wait too long to lower rates in recession.

Central Banking Today

By their own admission, most central banks now operate with an interest rate target. To hit a non-zero target, the Fed adds or drains reserves to ensure that banks have the amount of reserves desired (or required in nations like the US with official reserve requirements). Reserves are added through discount window loans, purchases of government bonds, and purchases of gold, foreign currencies, or private sector financial assets. To drain reserves, the central bank reverses these actions. It is actually quite easy to determine whether the banking system faces excess or deficient reserves: the overnight rate moves away from target, triggering an offsetting reserve add or drain by the central bank. Central banks also supervise banks and other financial institutions, engage in lender of last resort activities (a bank in financial difficulty may not be able to borrow reserves in the private lending market even if aggregate reserves are sufficient), and occasionally adopt credit controls, usually on a temporary basis. We will ignore these types of activities as of secondary interest.

When the operating procedure is laid bare, it is obvious that views about controlling reserves, or sterilization of international capital flows, or central bank “financing” of treasury deficits by “printing money” are incorrect. If international payments flows or domestic fiscal actions create excess reserves, the central bank has no choice but to drain the excess–or the overnight rate falls toward zero. On the other hand, if international payments flows or domestic fiscal actions leave banks with insufficient reserves, overnight rates rise above target. For this reason, the quantity of reserves is never discretionary.

Likewise, the view that a central bank might choose to “print money” to finance a budget deficit is flawed. In practice, modern sovereign governments spend by crediting bank accounts and tax by debiting them. Clearing with the government takes place using reserves, that is, on the accounts of the central bank. Deficits lead to net credits of reserves; if excessive, they are drained through bond sales. These activities are coordinated with the Treasury, which issues new bonds in step (whether before or after is not material) with deficit spending. This is because the central bank would run out of bonds to sell. In countries in which the central bank pays interest on reserves, bond sales are unnecessary because interest-paying reserves serve the same purpose—that is, to ensure the overnight interest rate cannot fall below the target. The important point is that central bank operations are not discretionary, but are required to hit interest rate targets.

In sum, the Fed and other central banks of countries with sovereign currencies have complete policy discretion regarding the overnight interest rate. This does not mean that they do not take into account possible impacts of their target on inflation, unemployment, the trade balance, or the exchange rate. Further, central banks often react to budget deficits by raising the overnight interest rate target. These policy actions are discretionary. But what is not discretionary is the quantity of reserves in a system such as that adopted by the US—where banks do not earn interest on reserves. This is because a shortage causes the interest rate to rise above target; an excess causes it to fall. The Fed is forced to defend its target by intervening—adding or draining reserves. A country like Canada that pays interest on positive reserve holdings (and charges interest on reserve lending) need not drain “excess” reserves—because they are not really excessive. Indeed, there is no real distinction between reserves that pay interest or treasury bills that pay interest—both serve the same purpose of maintaining a positive overnight interest rate, so there is no reason to sell bills to banks to “drain excess reserves” in such countries.

We conclude that central banking policy really boils down to interest rate setting and that calls for controlling reserves or the money supply are misguided. However, it is far from clear that interest rates matter much, especially when transparency and gradualism eliminate the element of surprise. Thus, the view that monetary policy can “fine-tune” the economy is probably in error.

References:

Friedman, Milton. 1969. The Optimal Quantity of Money and Other Essays. Chicago: Aldine.

Wray, L. Randall. Understanding Modern Money: The Key to Full Employment and Price Stability, Edward Elgar Publishing, 1998.

—-. The Fed and the New Monetary Consensus: The Case for Rate Hikes, Part Two Levy Policy Brief No. 80, 2004 December 2004

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