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MMP Blog #20: Effects of Sovereign Government Budget Deficits on Saving, Reserves and Interest Rates, (continued)

Posted on October 16, 2011 by admin | Comments Off

Complications and private preferences. There are often two objections to the claim that government spending effectively takes place by simultaneously crediting the recipient’s bank account as well as the bank’s reserves: a) it must be more complicated than this; and b) what if the private sector’s spending and portfolio preferences do not match the government’s budget outcome?

The first of these objections has been carefully dealt with in a long series of published articles and working papers (by Bell (a.k.a. Kelton), Bell and Wray, Wray, Fullwiler, and Rezende who look at actual operating procedures in the US, Canada, and Brazil; I’ll provide references later as well as more details). In practice, the treasury cannot directly credit bank accounts when it wants to spend.

Rather, a complex series of steps is required that involve the treasury, the central bank and private banks each time the treasury spends or taxes. The central bank and the treasury develop such procedures to ensure that government is able to spend, that taxpayer payments to treasury do not lead to bounced checks, and—most importantly—that undesired effects on banking system reserves do not occur. While the end result is exactly as described above (treasury spending leads to bank credits, taxes lead to debits, and budget deficits mean net credits to both demand deposits and bank reserves), it is more complicated.

This often generates another question: what if the central bank refused to cooperate with the treasury? The answer is that the central bank would miss its overnight interest rate target (and eventually would endanger the payments system because checks would start bouncing). Readers are referred to the substantial literature surrounding the coordination (more details for the wonky coming up in a later blog). Nonspecialists can be assured that the simple explanation above is sufficient: the conclusion from close analysis is that government deficits do lead to net credits to reserves, and if undesired excess reserves are created they are drained through bond sales to maintain the central bank’s target interest rate.

The operational impact of bond sales is to substitute government bonds for reserves—it is like providing banks with a savings account at the central bank (government bonds) instead of a checking account (central bank reserves). This is done to relieve downward pressure on the overnight interest rate.

With regard to the second objection we first must notice that if the government’s fiscal stance is not consistent with the desired saving of the nongovernment sector, then spending and income adjust until the fiscal outcome and the nongovernment sector’s balance are consistent. For example, if the government tried to run a deficit larger than the desired surplus of the nongovernment sector, then some combination of higher spending by the nongovernment sector (lower nongovernment saving and lower budget deficit), greater tax receipts (thus lower budget deficit and lower saving), or higher nongovernment sector income (so greater desired saving equal to the higher deficit) is produced.

Since tax revenues (and some government spending) are endogenously determined by the performance of the economy, the fiscal stance is at least partially determined endogenously; by the same token, the actual balance achieved by the nongovernment sector is endogenously determined by income and saving propensities. By accounting identity (presented above) it is not possible for the nongovernment’s balance to differ from the government’s balance (with the sign reversed—one has a deficit and the other a surplus); this also means it is impossible for the aggregate saving of the nongovernment sector to be less than (or greater than) the budget deficit.

So, those are the general responses to those objections. I will do a wonky blog later with more details. But next week we look in more detail at the private saving decision.

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Budget Deficits and Saving, Reserves and Interest Rates: Responses to Blog #19

Posted on October 12, 2011 by admin | 1 comment

By L. Randall Wray

This week we began our investigation of effects of sovereign deficits on saving, reserves, and interest rates. As usual I will group responses by topic. I counted nine main topics. I’ll be very brief in presenting the questions (some of which were quite long!!) so please refer back to Blog 19 for the details.

Q1: Wray claims sovereign government can buy anything for sale in its own currency; but why can’t it just go to forex markets, get foreign currency, then buy everything for sale in ALL currencies?

A: Takes at least two to tango. Domestically, government ensures sellers by imposing a tax in its own currency. Hard to do that on foreigners in their own countries—impinges on sovereignty. So, for example, the US cannot force Italians to pay taxes in Italy in dollars. To buy stuff from Italians, our government MIGHT be forced to use euros. (Note, I did have a caveat—foreigners might take dollars, in which case there is no affordability problem.) So let us say Italians don’t want the cheap, risky dollars (Hah!). Yes the US can go to forex markets and trade dollars for euros. Here’s the problem: it is now subject to forex market demand for dollars. It can never run out of dollars, but the exchange rate can move against the US. At the extreme, it could find no takers even at an infinite exchange rate against the dollar. (Zimbabwe! Weimar!) I am not saying this is probable. I am just saying we need to be careful in our claims. Domestically, government can buy anything for sale if it is for sale in terms of its own currency. And it can create that demand by imposing taxes. Externally, all bets are off. If stuff is for sale only in foreign currency, the government of Rwanda might not be able to buy it.

Q2: Inflation. What causes it? Shortage of supply? External shocks? Excess demand? Unions? Can ELR deliver price stability?

A: Ahhhh, the question of the ages. Here is Keynes: “true inflation” only results once the economy exceeds the full employment level of demand. That is a useful definition, but not consistent with empirical measures—that usually rely on a consumer or producer basket, the index price of which can rise long before full employment. Bottlenecks (say, high tech goods and skilled labor) cause prices to rise. “Supply shocks” (a nice euphemism for OPEC conspiring to raise oil prices!) cause key commodities to rise in price—which causes prices to rise across the full range of output. And so on.

Note also that much, or even most, of inflation results from imputation of price increases to things that are not bought or sold at all (“shelter services”—the sheer joy of living in a house one owns). That gets into complicated discussions ( I wrote about it years ago at www.levy.org). So let us put it this way: beyond full employment, raising aggregate demand (or reducing supply) is almost certain to cause inflation. Before that, inflation is possible but not inevitable. Depends on a wide variety of factors—and is not necessarily a bad thing at all in any case. (Shifting the composition of the consumer basket due to changes of tastes can cause the Consumer Price Index to rise. Is that bad? Of course not—consumers changed their tastes.) The focus on inflation has become a phobia in the worst sense of the term. But in any case, yes, the employer of last resort program helps to stabilize prices—as we discuss in weeks to come.

Q3: The Fed sets the overnight rate but what about others? What if markets react against budget deficits, so the bond market vigilantes demand more blood in the form of higher rates?

A: As discussed, the Fed can set the overnight rate, plus the rate on any other financial assets it stands ready to buy and sell. It can peg the 10 year government bond rate, or the 30 year. It actually did that in WWII. But now it usually does not do that; and even under QE it used a backassward method to try to bring down long rates on Treasuries—trying to use quantities rather than prices to hit a price target! Dumb and Dumber. But whoever claimed Bernanke knows what he is doing? (Hint: he doesn’t. But I suspect you did not need the hint.)

Any rates the Fed does not target are set complexly—some more complexly than others. We used to set the saving and demand deposit rates (Remember Regulation Q? No? Ok you are younger than me. I used to get zero on my checking account and 5.25 max on my saving deposit, and I paid banks for the privilege of banking with them. Just you wait—it will be back to the future soon.) We set some loan rates. (Remember NDSL rates that benefitted students? No? Ok, ditto. Imagine 3% interest rates on student loans, with government forgiving half your debt if you became a teacher! Hey, today’s Real Housewives of Wall Street get similar deals! And they don’t even have to go to college. They just have to marry rich guys on Wall St.)

Leaving to the side government-managed interest rates, others are set by a complex of factors: markups and markdowns, credit and liquidity risks, expectations of Fed policy, expected exchange rate movements, and so on. Too complicated to discuss here. Let me just (cryptically) say that while the purchasing power parity theorem as well as the Fisher interest rate equations perform poorly, Keynes’s interest rate parity theorem holds up well. ‘Nuff said.

Bond vigilantes? Don’t sell them the bonds. Sovereign government NEVER needs to sell bonds. Just leave the reserves in the banks instead. Pay them zero or whatever the support rate is. Euthanize the rentier class, don’t bend over backward for the vigilantes. That was Keynes’s recommendation.

Q4: Can the CB manage the level of reserves by paying a support rate?

A: In the old days when the Fed paid zero on reserves, but had a target rate substantially above zero, the supply of reserves was completely nondiscretionary. The Fed accommodated. Now, it can “pump” trillions of reserves into banks and pay them 25 basis points—the support rate—and charge any bank that is short reserves 50bp. The fed funds rate will stay within that band. So, now, a QE-adopting Bernanke Fed can decide banks should hold $100 gazillion of reserves and buy every toxic waste trashy asset banks have—they are happy to give up the waste—and thereby increase reserves “exogenously”.

Why any Fed would want to do that is beyond me. But Bernanke’s Fed wants to do it. It will do QE3, just you wait.

Q5: Barbara argues that balance sheets are false for government.

A: This sounds a lot like my buddies at the American Monetary Institute (AMI) who want to abolish accounting so that the government can create “debt-free” money. Look, accounting is certainly a human device. (Well, Apes have accounting records too—but they are somewhat more straight-forward. So far as we know they have not yet invented subprimes and credit default swaps.) But there is a logic behind it—to some extent you can say we “discovered” rather than “invented” double entry book-keeping. Frankly, I think anyone who thinks that we can change accounting so that we only look at the asset side and ignore the liability side has at least one screw loose. Government has a balance sheet; its IOUs are our assets. Its deficits are our savings. Changing the way we report the balance sheets will not change the reality. (Hey, banks have been cooking their accounting and they are still toast.) More below.

Q6: Deficits create excess reserves only if all else is equal.

A: Yes. But look at the scale. Budget deficits are in the tens and hundreds of billions or even trillions of dollars. Required bank reserves are miniscule by comparison: a few months of budget deficits will completely satisfy all required reserve needs for the next decade. The flow of reserves that result from typical budget deficits will ALWAYS create excess reserves because required reserves grow much more slowly.

Q7: Isn’t the accounting of debits and credits reversed?

A: OK to simplify I use “T accounts” that are presented in every money and banking textbook. Bank loans are on the asset side of the bank’s balance sheet; demand deposits are on the liability side. Reverse that for the borrower. For the wonkier with a bit of business school education behind them, I strongly recommend this article: Ritter, “The flow-of-funds Accounts: A New Approach” (Jnl of Finance, May 1963) which goes through the balance sheet, the financial uses and sources approach, treatment of real and financial, and integration into flow of funds accounts. It sounds like a couple of commentators are confusing a balance sheet with sources and uses.

Q8: What if the budget deficit is too low to satisfy net financial saving desires by the private (and foreign) sectors? And the Fazzari paper is excellent!

A: Yes that happens. In that case, the private (and foreign) sector reduces spending, causing the budget deficit to widen. Now, to be clear, causation is complex. There can be many slips between lip and cup. As private sector spending falls, its income falls (sales fall, people get laid off) and that could either intensify the desire to save, or reduce it as people must dip into saving to avoid starvation.

And Steve Fazzari was my teacher, so how can I argue against his paper!

Q9: Provide more details on the process of setting interest rates in the current institutional environment.

A: Well, ignoring QE, we now have a Fed that sets the support rate (paid on reserves) and charges a higher rate to lend reserves; the market rate (fed funds rate) fluxes between the two. The best work on all this is by Scott Fullwiler. I’ll provide a bit more in later blogs—but it gets wonky.

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MMP Blog #19: Effects of Sovereign Government Budget Deficits on Saving, Reserves and Interest Rates

Posted on October 9, 2011 by admin | 1 comment

By L. Randall Wray

Last week we began to analyse fiscal and monetary policy formation by a government that issues its own currency. We went through a list of false statements about sovereign government spending, and offered a list of general statements that do apply. Let us now begin to examine in more detail the government’s budget and impacts on the nongovernment sector. This week we will look at the relation between budget deficits and saving, and the effects of budget deficits on bank reserves and interest rates.

Budget deficits and saving. Recall from earlier discussions in the Primer that it is the deficit spending of one sector that generates the surplus (or saving) of the other; this is because the entities of the deficit sector can in some sense decide to spend more than their incomes, while the surplus entities can decide to spend less than their incomes only if those incomes are actually generated. In Keynesian terms this is simply another version of the twin statements that “spending generates income” and “investment generates saving”. Here, however, the statement is that the government sector’s deficit spending generates the nongovernment sector’s surplus (or saving).

Obviously, this reverses the orthodox causal sequence because the government’s deficit “finances” the nongovernment’s saving in the sense that the deficit spending by government provides the income that allows the nongovernment sector to run a surplus. Looking to the stocks, it is the government’s issue of IOUs that allows the nongovernment to accumulate financial claims on government.

While this seems mysterious, the financial processes are not hard to understand. Government spends (purchasing goods and services or making “transfer” payments such as social security and welfare) by crediting bank accounts of recipients; this also leads to a credit to their bank’s reserves at the central bank. Government taxes by debiting taxpayer accounts (and the central bank debits reserves of their banks).

Deficits over a period (say, a year) mean that more bank accounts have been credited than debited. The nongovernment sector realizes its surplus initially in the form of these net credits to bank accounts.

All of this analysis is reversed in the case of a government surplus: the government surplus means the nongovernment sector runs a deficit, with net debits of bank accounts (and of reserves). The destruction (net debiting) of nongovernment sector net financial assets of course equals the government’s budget surplus.

Effects of budget deficits on reserves and interest rates. Budget deficits initially increase bank reserves by the same amount. This is because treasury spending leads to a simultaneous credit to the bank deposit account of the recipient and to that bank’s reserve account at the central bank.

Let us first examine a system like the one that existed in the US until recently, in which the central bank does not pay interest on reserves. Deficit spending that creates bank reserves will (eventually) lead to excess reserves—banks will hold more reserves than desired. Their immediate response will be to offer to lend reserves in the overnight interbank lending market (called the fed funds market in the US).

If the banking system as a whole has excess reserves, the offers to lend reserves will not be met at the going overnight interbank lending rate (often called the bank rate, but in the US this is called the fed funds rate). Hence the banks with excess reserve positions will offer to lend at ever-lower interest rates. This drives the actual “market” rate below the central bank’s target rate for overnight funds.

Once the rate has fallen sufficiently far away from the target, the central bank will intervene to remove the excess reserves. Since the demand for reserves is fairly interest inelastic, lowering the offered lending rate will not increase the quantity of reserves demand by very much. In other words, it is difficult to eliminate a position of system-wide excess reserves by lowering the overnight rate. Instead, the central bank must remove them.

The way that it does this is by selling from its stock of treasury bonds. That is called an open market sale (OMS). An OMS leads to a substitution of bonds for excess reserves: the central bank’s liabilities (reserves) are debited, and the purchasing bank’s reserves are also debited. At the same time, the central bank’s holding of treasuries is debited and the bank’s assets are increased by the amount of treasuries purchased.

Since the bank’s reserves decline by the same amount that its holdings of treasuries are increased, this is effectively just a substitution of assets. However, it now holds a claim on the treasury (bonds) instead of a claim on the central bank (reserves); and the central bank holds fewer assets (bonds) but owes fewer liabilities (reserves). The bank is happy because it now receives interest on the bonds.

It is easy to see that the same process would be triggered even if the central bank paid interest on reserves—as is now done in the US. Once banks have accumulated all the reserves they want, they will try to substitute for higher-earning treasuries. They will not push the overnight rate below the central bank’s “support rate” (what it pays on reserves)—since no bank would lend to another at a rate below what it can receive from the central bank. Instead banks with undesired reserves will immediately go into the treasuries market to seek a higher return.

The impact, then, will be to push rates on treasuries down. In this second case, the central bank need not do anything—it does not need to sell bonds since it maintains its overnight interest rate by paying interest on reserves.

In practice, a central bank that adopts this second procedure usually pays a slightly lower rate on reserves than it charges to lend reserves. As discussed earlier, in the US the central bank lends “at the discount window” and at the “discount rate”. It might charge 25 basis points (0.25 percentage points) more on its lending than it pays on reserves. For example, it might charge 2% on loans and pay 1.75% on reserves. The “market” interest rate on interbank lending will remain approximately within that band since a bank needing reserves has the option of borrowing at the central bank at 2%, while a bank having extra reserves can earn 1.75% simply by holding them at the central bank.

That’s enough for today—just about over my 1000 word target! Send your comments and questions.

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Fiscal and Monetary Policy in a Sovereign Nation: Responses to Blog #18

Posted on October 6, 2011 by admin | Comments Off

By L. Randall Wray

Thanks for comments. Let me provide a dozen responses, by topic.

Q: What about interest on reserves?

A: Chairman Bernanke moved to pay interest on reserves a couple of years ago, joining other countries (like Canada) that do so. Does that make any difference? Yes and no. First it simplifies operations and renders Treasury bond sales superfluous. Since the purpose of bond sales is to provide an interest-earning alternative to non-interest paying reserves, once you pay interest on reserves that is effectively the same thing as a bond. Ergo, you can stop selling bonds.

Now, why do you sell bonds when reserves don’t pay interest? Because excess reserves in the system drive overnight rates below the central bank’s target. It then sells bonds to offer the alternative.

But the easiest way to hit a target interest rate is to charge—say—50 basis points (100 bp = one percentage point) on loans at the discount window then to pay 25 bp on reserves held at the central bank. The overnight market rate on interbank lending (fed funds in the US) cannot deviate from the 25 to 50 bp range. (These are the ceilings and floors—you can do the same thing with sheep wool: government pays $25 to buy wool and sells at $50 so wool never rises above $50 nor falls below $25). The narrower that range, the smaller the flux of overnight rates.

Now as we know the US (and Canada) still sells bonds. This mostly has to do with the maturity structure: reserves are close substitutes for very short term bonds (ie: 30 day bills), and the central bank normally stays at the very short end.

Not that Treasuries understand any of this: when rates on 30 year maturity bonds are low, they issue lots of those thinking they’ll save on interest payments. But any Central bank with a floating rate can set the overnight rate anywhere it wants, and then just pay interest on reserves—no need to ever issue long maturity debt. Call your Treasury official and explain this. Stop issuing bonds = never run up against debt limits = never have kindergarten level debates in congress about debt limits.

Q2: In real terms, do government deficits take away “real saving”?

A: At full employment, government deficits move resources away from other uses to the public purpose. That might be good; it might be bad. With fewer resources available for private use, private investment might be lower. In that sense, “private real saving” is less. Fewer shopping malls, more schools and museums. Less investment in producing social life-altering underarm sprays, and more investment in bridges that do not collapse into rivers. I don’t know which to choose. But I’ve been flying a lot, avoiding bridges but sitting next to passengers who could use the spray.

Judge that for yourself. In nominal terms, however, government deficits create equivalent private savings—dollar for dollar. (Full disclosure, some can leak out to imports from Mars, etc.)

Q3: How does the central bank (CB) affect interest rates? Using open market operations (OMO)? Does it use the fed funds rate or discount rate? Is the 10 year bond rate set by the CB or by the market?

A: From above, we know CBs target overnight interest rates, and can use the ceilings and floors approach: lend at the discount window at 50bp and pay 25bp on reserve balances. In which case the “market rate” will flux between the two. Is this done through OMO? Not really. If the CB announces it will move its target rate from the range of 25-50bp to 50-75bp it does not need to engage in any OMO. All it does is to increase its rate paid on reserves to 50, and increase its discount rate charged to 75. And then “presto-change-o” market rates move. So you can see it uses both the fed funds rate (target) and the discount rate (rate charged), as well as the “support rate” paid on reserves.

What about longer maturities like the 10 year? It could do the same in that maturity—offer to buy at an interest rate equivalent of 200 bp and to sell at 150bp and you can bet your bottom dollar that the 10 year will trade in that range. But normally central banks do not do that. (QE tried a backassward way to do it: using quantity rather than price to try to get long rates down. Didn’t work—but who says Bernanke knows what he’s doing?)

Q4: What is endogenous vs exogenous?

A: It is somewhat arbitrary; and these terms are used in different senses (for the truly wonky: statistical, theoretical, or control senses). To keep it simple, most people use these to refer to the policy sense: does the government control the variable? For example, does the CB control the “money supply” or the “interest rate”. Well, it clearly cannot control the money supply—however measured except in the sense that it can do a Bernanke and fill banks full of excess reserves (that cannot get out). But it clearly can set overnight interest rates—all of them do—so that is called “exogenous” control of interest rates.

Q5: If the deficit gets bigger and bigger, doesn’t it have to get repaid later out of savings?

A: No. The US government debt was only “repaid” once in our nation’s history: 1837. That will never happen again. Bet on it.

Q6: In a fixed exchange rate system does govt really “choose” to spend less (or raise its interest rate target) to protect currency?

A: Yes. In the sense that it can “choose” not to do so, and then deal with the consequences. You can “choose” not to drive on the right (or left) side of the road. You might not enjoy the outcome. I’ve done it. You probably have, too. You might even “choose” to drive above the speed limit, too. There are consequences, and we all deal with them.

Q7: Does it matter if govt spends money into existence for interest payments rather than wages (as in ELR program)?

A: Yes. It can also spend money into existence to support fat cat Wall Street fraudsters. Good idea? Maybe not. Will it run out of funds? No.

Q8: Use GDP income measure rather than GDP expenditure measure.

A: Well, by identity they are identical. But, yes, it does matter that the wage share in the US has dropped toward third world status (about 50% of national income; vs 25% in Mexico). And so for consumption to grow Americans had to borrow heavily. Bad idea.

Q9: MMT has an unwarranted fixation on nominal vs real.

A: Give me a break, Neil. I guess you slept all through last week (see Blog 17). If anyone suffers from a fixation it is our Austrian brethren who are so fixated on “real” that they cannot understand that we live in a monetary economy.

Thanks, Eric and Calgacus.

Q10: Can the CB compel banks to support higher reserve levels; can the CB control interest rates without issuing reserves?

A: CB can raise required reserve ratios, and banks (magically!) will hold more! That acts like a tax on banks, increasing their cost of doing business as reserves pay very little, ie 25 bp. Banks are less profitable. Not sure why we want that. In the Canadian system, bank holdings are right about zero—since the Bank of Canada requires zero and operates with a ceiling and floor interest rate as described above. Nice system. Sometimes those Canadians surprise you with how clever they can be! So, yes, they hit their interest rate targets even as banks essentially hold no reserves. But they do use them for clearing—which is all that matters.

Q11: How are government bonds issued?

A: By Treasury, to special banks, that use reserves to buy them. The CB supplies the reserves the banks need. We’ll do more of this later.

Q12: I go to a bank and it creates a loan; does it create money out of thin air? Is this disreputable?

A: Yes. And No. It takes your IOU, and creates its own IOU (your demand deposit). Out of a keystroke to a computer tape. Sounds a bit sexy but not at all pornographic. It is the bank’s IOU. It gets your IOU (“loan”) and goes into debt (demand deposit). It does not “get something for nothing”. If it eventually earns profits on the deal, that is a reward for “underwriting”: determining that you are no scumbag deadbeat borrower who will default.

I think that’s the nicest thing I’ve ever said about a banker. Made her sound almost like Jimmy Stewart. On that note I should stop.

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MMP Blog #18: Fiscal and Monetary Policy Operations in a Nation that Issues its Own Currency

Posted on October 2, 2011 by admin | 22 comments

By L. Randall Wray

This week we will begin to examine our next topic: government spending, taxing, interest rate setting, and bond issue. We will examine fiscal and monetary policy formation by a government that issues its own currency. We will bear in mind that the exchange rate regime chosen does have implications for the operation of domestic policy. We will distinguish between operational procedures and constraints that apply to all currency-issuing governments and those that apply only to governments that allow their currency to float. Over the previous 17 (!) weeks we have touched on much of this, but now it is time to get down to “brass tacks” to look at some of the nitty-gritty. As always, we are trying to stay true to the purposes of a “Primer”—a fairly general analysis that can be applied to all nations that issue their own currency. We will note where the results only apply to specific exchange rate regimes. And we will get into some of the procedures adopted that effectively “tie shoelaces together”—self-imposed constraints. This week we will provide a quick overview of general principles.

Statements that do not apply to a currency-issuer. Let us begin with some common beliefs that actually are false—that is to say, the following statements do NOT apply to a currency-issuing government.

Governments have a budget constraint (like households and firms) and have to raise funds through taxing or borrowing

Budget deficits are evil, a burden on the economy except under some circumstances

Government deficits drive interest rates up, crowd out the private sector…and necessarily lead to inflation

Government deficits leave debt for future generations: government needs to cut spending or tax more today to diminish this burden

Government deficits take away savings that could be used for investment

We need savings to finance investment and the government’s deficit

Higher government deficits today imply higher taxes tomorrow, to pay interest and principle on the debt that results from deficits

While these statements are consistent with the conventional wisdom, and while they are more-or-less accurate if applied to the case of a government that does not issue its own currency, they do not apply to a currency issuer.

Principles that apply to a currency issuer. Let us replace these false statements with propositions that are true of any currency issuing government, even one that operates with a fixed exchange rate regime

The government names a unit of account and issues a currency denominated in that unit;

the government ensures a demand for its currency by imposing a tax liability that can be fulfilled by payment of its currency;

government spends by crediting bank reserves and taxes by debiting bank reserves;

in this manner, banks act as intermediaries between government and the nongovernment sector, crediting depositor’s accounts as government spends and debiting them when taxes are paid;

government deficits mean net credits to banking system reserves and also to nongovernment deposits at banks;

the central bank sets the overnight interest rate target; it adds/drains reserves as needed to hit its target rate;

the overnight interest rate target is “exogenous”, set by the central bank; the quantity of reserves is “endogenous” determined by the needs and desires of private banks; and the “deposit multiplier” is simply an ex post ratio of reserves to deposits—it is best to think of deposits as expanding endogenously as they “leverage” reserves, but with no predetermined leverage ratio;

the treasury cooperates with the central bank, providing new bond issues to drain excess reserves, or retiring bonds when banks are short of reserves;

for this reason, bond sales are not a borrowing operation used by the sovereign government, instead they are a “reserve maintenance” tool that helps the central bank to hit interest rate targets;

the treasury can always “afford” anything for sale in its own currency, although government always imposes constraints on its spending; and

lending by the central bank is not constrained except through constraints imposed by government (including operational constraints adopted by the central bank itself).

Some of these statements will seem cryptic at this point. We will clarify further in the following weeks. Here we are setting out the general principles that will be discussed later in order to contrast them with the “conventional wisdom” that likens a government’s budget to a household budget.

Let us be careful to acknowledge that these principles do not imply that government ought to spend without constraint. Nor does the statement that government can “afford” anything for sale in its own currency imply that government should buy everything for sale in its currency. Obviously, if things are for sale only in a foreign currency, then government cannot buy them directly using its own currency.

These principles also do not deny that too much spending by government would be inflationary. Further, there can be exchange rate implications: if government spends too much, or if it sets its interest rate target too low, this might set off pressure to depreciate the currency. This means that the government’s interest-setting policy as well as its budget policy will be mindful of possible impacts on exchange rates and/or inflation rates; in that sense, interest-setting and fiscal policy are “constrained” by government’s desire to control the exchange rate or the inflation rate.

This brings us to the exchange rate regime: while the principles above do apply to governments that peg their exchange rates, they must operate fiscal and monetary policy with a view to maintaining the peg. For this reason, while these governments can “afford” to spend more, they might be choose to spend less to protect their exchange rates. And while government can “exogenously” lower its interest rate target, this might conflict with its exchange rate target. For that reason, it might choose to keep its interest rate target high if it is pegging its exchange rate.

Next week we will begin to examine in more detail the government’s budget when it is the issuer of the currency.

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Real vs. Financial Accounting: Responses to Blog #17

Posted on September 29, 2011 by admin | 4 comments

Ok this week we are detailing the difference between real and financial—both flows and stocks. Let me provide answers on seven points, and (sorry) postpone for a couple of days an answer to the eighth (which I have not had time to go through).

Q1 (Neil): What about a reserve currency? What about insufficient real investment—especially to deal with the extra demand of ELR?

A: All the real and financial accounting applies to any nation, any currency. No difference. But, OK, might be worthwhile to have a blog devoted to the international reserve currency. Will do.

On adopting ELR and capacity. Look, my belief is that capitalists are not (too) stupid. If there is demand, they will try to meet it. There can be bottlenecks, but those are temporary. We do not need to prod them to invest. If there are sales prospects they will add capacity. On ELR (a topic we have not covered yet), we increase employment and probably demand for consumer goods. By Okun’s law, reducing the unemployment rate by one percentage point raises output by three percentage points (GDP). The ratio could be considerably less for ELR. Note that conventional estimates of a universal ELR program are that wages and other costs would be about 1% of GDP, so by Okun’s law, reducing unemployment by 10 percentage points or so the extra output generated would be far more than enough (up to 30 percentage points of GDP, although probably less) to satisfy the demand. But—we’ll do this later.

Q2: (Tom): Doesn’t childcare (etc) increase value added as women (etc) are released to higher value work? And Austrians argue only real assets, not financial assets, constitute “the economy”.

A: Agreed on the first point, but “efficiency” is vastly overrated—see below. The second, Austrian, point might be OK as a prescription, but certainly not as a description of the real world (a point Dave makes, too). This is a “monetary production economy” where satisfying consumer demand (providing “utils”, raising living standards, reproducing labor power—whatever you want to call it) occurs only by coincidence. What matters is monetary profits. All the more important when Wall Street runs the economy.

Q3: (Geerussell): Does government need to tax all activity, including production for own use?

A: No. We need a broad-based tax that is hard to avoid. Cubic foot of dwelling space, or perhaps cubic inches of cranial space, will do it. (Everyone needs shelter and a brain.)That will drive money, allowing government to move resources to the public purpose.

Q4: (Rvm) Does MMT apply to communist society?

A: In theory, socialist society still uses money to motivate production, hence to move resources to public purpose. So, yes, taxes drive money and money motivates labor. From each according to ability to each according to contribution. In communist society, in theory, you no longer need money to motivate activity. From each according to ability to each according to need. No taxes, no money.

Q5: (Dave): Is drop-out hippiedom the future?

A: Well, a lot of people thought that back in 1965. We’re still waiting. Note, I do think that “slow” and “local” food is a good thing, with proper caveats.

Q6: (Forrest) Again, a question on efficiency vs independent food production.

A: Briefly, efficiency is vastly overrated as an overriding goal, and it often (maybe always) conflicts with sustainability. Without getting overly tree-huggy about this, if using a few more workers in agriculture instead of poisonous petrochemicals can help to save the globe, let’s give up some efficiency. It is not like we’ve run out of labor. And if we go a bit wonky, the economic definition of efficiency is only well-defined in a general equilibrium model with continuous full employment. That ain’t our real world. Most of the time we have massive amounts of unemployed resources, so putting them to work increases output without sacrificing any efficiency, no matter how inefficient the production process.

Q7: (Joe & Larry—I sure wish it had been Moe&Larry!): Money is the way to shift real production; money is not real stuff, but moves it.

A: Mostly agreed—from the perspective of government. Government creates a money of account, issues IOUs denominated in it, and imposes a tax to move real resources to the public sector to accomplish the public purpose (as it sees it). Unfortunately, in a capitalist economy, the captains of industry that control a huge portion of production do not see it that way. All they really care about is money.

Q8: (Mattay): Accounting example.

A: Sorry—will try to answer soon.

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MMP Blog #17: Accounting for Real Versus Financial (or Nominal)

Posted on September 25, 2011 by admin | 17 comments

By L. Randall Wray

Last week we took a quick diversion into Euroland, which is crashing as we speak. Obviously, we went much too quickly to really give a good analysis of her problems. I urge readers to look at the front pages of NEP for timely pieces. Since this is a Primer, we want it to be more like a textbook. If Euroland completely disintegrates before next summer, I’ll add another section to do a post mortem on the misguided experiment in separating nations from their currencies. There are only very limited circumstances in which that can work—and Europe is not one of them.

Last week we received a well-thought-out query, which is pasted below in its entirety (although I removed the author’s name to respect privacy). I think the author raises points that are sufficiently important that we should take another unplanned diversion this week. This is the great thing about running the Primer this way as I can see where I’ve failed to adequately explain something. I had thought the distinction between real and financial (nominal) was clear—but obviously it was not.

At this point you might want to skip down to the bottom of this post to read the query. I will summarize the main point later, but I expect that many of you would agree with the author—so go ahead and read it first. Then we’ll get to the response.

Ok, let me try to explain this as clearly as possible.

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PROBLEMS WITH THE DESIGN OF THE EURO: Responses MMP Blog #16

Posted on September 21, 2011 by admin | 3 comments

By L. Randall Wray

Sorry, got to be brief—for an explanation go here:

http://www.economonitor.com/lrwray/2011/09/21/fear-of-flying/

I’ll have to punt a bit on some of the techie details onoperations within the Euroland. Maybe we can come back to them later.

Q1 Anon: Weren’t the design flaws of the euro intentional,that is, what neolibs wanted?

A: Yes, probably true. I’m not an expert on Europeanpolitics. But let me say that there is no evidence that they thought it wouldcome to this—with a likely default by Greece that will escalate into a possibledestruction of the whole project. By contrast, MMTers did!

Q2 Roberta: We’re all artists.

A: ??? I guess so!

Q3 Philip: How do governments borrow from the ECB?

A: Well, technically that is prohibited—the ECB was not tobuy government debt. That was the beauty of the system—governments had to sellto markets, therefore they would be subject to market discipline and would notrun up excessive deficits.

Hey, how’s that working for them so far? Not so good. Youall know the stories. Goldman helped them hide the debts. Markets did notunderstand that these are not sovereign nations—until it was too late. AndFrench and German banks loaded up on high risk Greek debt. The rest is history;or at least will soon be. Market discipline does not work. Ever. Never.

Q4 James: Aren’t euro nations much like US states?

A: First prize! By Jove he’s got it. That’s the problem.They are like US states with no Washington backing them.

Q5: Rvaucbns: What is the endgame for the euro?

A: I urge you to read Dimitri Papadimitriou’s piece over atHuffPost:

http://www.huffingtonpost.com/dimitri-b-papadimitriou/endgame-for-the-euro_b_968623.html

I’m planning to write something up soon.

Q6: Neil: what about lender of last resort in the EMU?

A: By design there was not supposed to be one. Marketdiscipline was supposed to work. Each individual country was supposed to beresponsible for its own banks—but since they were not sovereign they could notdo a Timmy-Benny $29 trillion bail-out. The ECB lends to individual CBs againstcollateral; they’ve had to widen what was acceptable. But it won’t be enough.

Q7: What is SGP

A: Yes it is stability and growth pact

Q8 Joe and Hugo: Are there net financial assets in Euroland?

A: Yes; first there are dollars. In Euros, yes individualnational governments create them but as discussed in the blog they’ve got toworry about clearing across borders since ultimately those are convertible ondemand to ECB euro reserves and the ECB is not supposed to buy government debt.

Q9 Dario: why do markets only “partially” recognize thatdowngrades of sovereign debt do not matter?

A: They do not fully understand, so there is usually a bitof uncertainty surrounding a downgrade. Then they realize the sky did not fall,markets for sovereign debt recover, and rates go back where they were. Unlike adowngrade of Greek debt.

NEXT WEEK: We might take a bit of a diversion because we gota long and interesting comment on the differences between real and financial. Ithink it will be worthwhile to get all that clear.

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MMP Blog #16: The Unusual Case of Euroland: The Non-Sovereign Nature of the Euro and the Problems Raised by the Global Financial Crisis

Posted on September 18, 2011 by admin | 17 comments

By L. Randall Wray

In the next series of blogs we will look in more detail at fiscal and monetary operations of a nation with a sovereign currency. Before we do that, let us briefly examine the case of the Euro. Let me say that we will not address the unfolding crisis across Euroland in detail. The reason is that events are moving too quickly and we do not know where they will lead. This primer in some sense needs to be “timeless”—anything specific that we discuss will quickly become outdated. The fundamental point to be made here is that the Euro arrangement was flawed from the beginning. Crisis was inevitable—as I have been writing since the mid 1990s. There is no way the system as designed could possibly survive a significant financial crisis. And a crisis began in 2007. Due to flaws in the set-up, it was obvious (at least to those who adopted MMT) that the original arrangement was not sustainable. We could not say for sure how the resolution would turn-out, but a fundamental change would be required.

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The Debt Pyramid and Clearing: Responses to MMP Blog #15

Posted on September 15, 2011 by admin | 7 comments

By L. Randall Wray

This week we examine the debt pyramid and clearing of IOUs in the state money of account. Thank you for your questions and comments, and apologies for being late with the response (believe it or not, I lost track of the days of the week—thought I had another 12 hours to get this done).

Q: (Douwe): Please explain the “degree of separation from the CB”.

GA: Thanks for the nice comment. See the pyramid below. Obviously this is a simplified picture of the hierarchy. Within government IOUs we include the Treasury and the Fed. Bank IOUs include demand deposits and other liabilities that banks promise to convert to government IOUs.

Nonbank IOUs are issued by firms and households; it is rather arbitrary where we put the dividing line between bank IOUs and IOUs of “other” financial institutions. Perhaps the most useful way is to distinguish between those types that have direct access to the central bank, and those that do not.

That also brings up the point made by RVAUCBNS: what happens if something goes wrong at the bottom of the pyramid (say, in the shadow banks)? Yes, and that is indeed what happened in the global financial crisis (GFC). Typically those lower in the pyramid issue IOUs that are convertible on some conditions to bank IOUs, that in turn are convertible to government (central bank reserve) IOUs. When something goes wrong, the nonbanks turn to banks for finance (lending against the nonbank’s IOUs); the banks in turn go to the CB. But when expectations turn ugly, the banks won’t lend so the nonbanks cannot make good on promises. That led to the liquidity crisis; the Fed eventually decided to lend to everyone, including the Real Housewives of Wall Street (as Matt Taibi demonstrated).

Additionally, the pyramid is useful for thinking about whose IOUs one can use to make payments on one’s own IOUs. You cannot repay your IOU with your own IOU (you’d still owe); only sovereign government can do that (as we discussed, if you present a five pound note to the Queen, she gives you another; she still owes, but so what—you’ll never get anything else out of her even if you go to court). You use someone else’s—what we call a second party or third party IOU (not first, which is yours; second would be using your creditor’s own IOU; third would be using the IOU of someone unrelated). Normally those lower in the pyramid use bank IOUs; banks in turn use government IOUs (CB reserves).

Jim wondered about power in the structure. Certainly! I’d love to be at the top of that pyramid! Even being at the bank level is a nice gig: government would stand behind your IOUs so they’d be as good as government’s. Gee, do you think your IOUs would then be widely accepted? Yes. When government handed a bank charter over to Government Sachs (oh, whoops, Goldman Sachs), suddenly its IOUs were as good as the Fed’s. Led to a huge multi-billion dollar subsidy. On the other hand, that comes with tighter regulations and supervision (at least, it is supposed to do so). Jim also wondered about the “flatness” of the pyramid—a good point. The pyramid is bigger at the bottom for a reason: more IOUs issued at the bottom than at the top. We can think of that as a more sophisticated financial system. And generally that is true—in developed economies government IOUs (including cash) are a smaller portion of the whole. Since the US Dollar is used all over the world to finance illegal activities, there are more of them sloshing about than you’d expect for a highly developed financial system. And now after QE, we’ve got a lot more bank reserves (at the top of the pyramid) than usual.

Q2: (Jeff) What about settlement of Eurodollars?

A: Same story. Ultimate clearing is at the Fed since these “leverage” US Dollars. (Note: there are also private settlement services—I am simplifying. Banks with off-setting claims on one another can use a private settlement system; they only need to go to the central bank for net clearing, as only the CB can create reserves.)

Q3: (Anon) The Fed mandates that primary dealers buy and sell treasuries.

A: Yes. This is part of the operating procedures to ensure the Treasury can get deposits as needed and move them to the Fed to cut checks or credit accounts as needed.

Q4: (Dave) Techie question about complications in Fed lender of last resort operations. Scott Fullwiler answered—and there is no way I can improve on Scott’s paper since he is the numero uno expert. Those who are really wonkie can go to his paper—it is far too complex for this primer.

Q5: (Glenn) Didn’t Chairman Bernanke admit he bailed out the banks with keystrokes? Where does the Fed borrow from and is there a limit? And wouldn’t it be better to spend the money to bail-out Main Street?

A: Yep. Fed “keystroked” trillions of reserves into existence, buying Treasuries and toxic waste MBSs. Calling this “borrowing” is misleading, which is why I do not use that term. Yes, the Fed is indebted, dollar for dollar, for every one of those keystrokes. Reserves are Fed IOUs. So you could call that “borrowing” and the banks with the reserves could be called “lenders” since they are the creditors. But this is nothing like you or me borrowing to buy a car. We are truly limited in how much we can borrow. The Fed has no limit to keystrokes (unless Ron Paul finally gets Congress to put a limit on the Fed—in other words, self-imposed limits are always possible).

The Fed and Treasury spent, lent, and guaranteed $29 trillion to rescue the banksters. Wouldn’t it be better to spend a fraction of that to rescue Main Street and the unemployed? I think so. Probably 99% of Americans would agree. Unfortunately we do not control the Fed and Treasury.

Q6: (Godefroy) What is inside bank assets? (RVAUCBNS) Aren’t there two kinds of money? Government and bank.

A: I think you mean what is on the asset side of a bank balance sheet. Reserves (electronic entries on the liability side of the CB), treasuries, private bonds and securities, loans, and a tiny bit of vault cash.

Two kinds of money: yes, two main categories. Inside money is the money-denominated IOUs of the nongovernment sector. What I called private money things. Outside money is the money-denominated IOUs of the government sector (cash plus reserves; we can also include treasuries since those are just reserves that pay higher interest). Note it is outside money that is at the top of the pyramid.

Thanks, again. Sorry for being a bit late and a bit brief.