Category Archives: Monetary policy

“Fixing the Economy”

Posted on December 31, 2009 by | 7 comments

By Warren Mosler*

I was asked by a reporter to state how I’d fix the economy in 500 words and replied:

Fixing the Economy

1. A full ‘payroll tax holiday’ where the US Treasury makes all FICA payments for us (15.3%). This will restore ’spending power’ allowing households to make their mortgage payments, which ‘fixes the banks’ from the ‘bottom up.’ It also helps keep prices down as competitive pressures will cause many businesses to lower prices due to the tax savings even as sales increase.

2. A $500 per capita Federal distribution to all the States to sustain employment in essential services, service debt, and reduce the need for State tax hikes. This can be repeated at perhaps 6 month intervals until GDP surpasses previous high levels at which point state revenues that depend on GDP are restored.

3. A Federally funded $8/hr job for anyone willing and able to work that includes healthcare. The economy will improve rapidly with my first two proposals and the private sector far more readily hires people already working vs people idle and unemployed.
In 2001 Argentina, population 34 million, implemented this proposal, putting to work 2 million people who had never held a ‘real’ job. Within 2 years 750,000 were employed by the private sector.

4. Returning banking to public purpose. The following are disruptive and do not serve no public purpose:

a. No secondary market transactions
b. No proprietary trading
c. No lending vs financial assets
d. No business activities beyond approved lending and providing banking accounts and related services.
e. No contracting in LIBOR, only fed funds.
f.  No subsidiaries of any kind.
g. No offshore lending.
h. No contracting in credit default insurance.

5. Federal Reserve- The liability side of banking is not the place for market discipline. The Fed should lend in the fed funds market to all member banks to ensure permanent liquidity. Demanding collateral from banks is disruptive and redundant, as the FDIC already regulates and supervises all bank assets.

6. The Treasury should issue nothing longer than 3 month bills. Longer term securities serve to keep long term rates higher than otherwise.

7. FDIC

a. Remove the $250,000 cap on deposit insurance. Liquidity is no longer an issue when fed funds are available from the Fed.
b. Don’t tax the good banks for losses by bad banks. All that does is raise interest rates.

8. The Treasury should directly fund the housing agencies to eliminate hedging needs and directly target mortgage rates at desired levels.

9. Homeowners being foreclosed should have the option to stay in their homes at fair market rents with ownership going to the government at the lower of the mortgage balance or fair market value of the home.

10. Remove the ’self imposed constraints’ that are disruptive to operations and serve no public purpose.

a. Treasury debt ceiling- Congress already voted for the spending and taxes
b. Allow Treasury ‘overdrafts’ at the Fed. This is left over from the gold standard days and is currently inapplicable.

11. Federal taxes function to regulate aggregate demand, not to raise revenue per se, and therefore should be increased only to cool down an overheating economy, and not to ‘pay for’ anything.

*First published on Moslereconomics.com

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Fed Offers New CD; Chairman Bernanke is still confused

Posted on December 30, 2009 by | 7 comments

By L. Randall Wray

As reported in the NYT yesterday, the Fed has decided to offer banks an interest-paying CD. So far, so good. However, the argument offered by the Fed to justify this “innovation” is that it needs to start mopping up reserves in order to prevent inflation:

The Federal Reserve on Monday proposed allowing banks to park their reserves at the central bank, a move aimed at weaning the economy off extraordinary infusions of cash and curbing inflation. The Fed would create the equivalent of a certificate of deposit that pays interest to banks for keeping some of their reserves — which are currently estimated at more than $1 trillion — for up to one year. That would help offset some of the $2.2 trillion the central bank has fanned out into the economy during the financial crisis. It also would allow the Fed to quickly entice banks to take more money out of circulation in case inflation emerged as a serious threat in the near future. The proposal was the latest sign the Fed is intensifying its efforts to scale back the vast amounts of money it pumped into the economy at the height of the crisis.

This blog has published a number of pieces explaining why there is no need to worry about the trillions of dollars of reserves and cash created by the Fed to deal with the run to liquidity set-off by this crisis (see here and here). As and when banks decide they do not want to hold reserves, they will retire their loans at the discount window and will begin to purchase higher-earning assets. As this pushes up asset prices (reducing interest rates), the Fed will begin to unwind its balance sheet—selling the assets it purchased during the crisis. Retiring discount window loans plus purchases of assets from the Fed will eliminate undesired reserve holdings. It is all automatic and nothing to worry about or to plan for. And it will not set off a round of inflation. The old “money multiplier” view according to which excess reserves cause banks to lend, which induces spending, which causes inflation, was abandoned by all serious monetary theorists long ago. Chairman Bernanke ought to abandon it, too.

However, there is nothing wrong with offering longer-maturity CDs to replace overnight reserve deposits held by banks at the Fed. Banks are content to hold deposits at the Fed—safe assets that earn a little interest. They are hoping to play the yield curve to get some positive earnings in order to rebuild capital. If they can issue liabilities at an even lower interest rate so that earnings on deposits at the Fed cover interest and other costs of financing their positions in assets, this strategy might work. That is what they did in the early 1990s, allowing banks that were insolvent to work their way back to profitability. The Fed could even lend to banks at 25 basis points (0.25% interest) so that they could buy the CDs, then pay them, say, 100 or 200 basis points (1% or 2% interest) on their longer maturity CDs. The net interest earned could tide them over until it becomes appropriate for them to resume lending to households and firms.

Finally, note that these new CDs are equivalent to Treasuries: government debt that pays interest. However, no one has castigated the Fed for proposing to bankrupt our grandchildren by running up debt. Apparently, this is because economists and policymakers recognize that the Fed is just substituting one kind of liability (reserves) for another kind of liability (CDs). But that is exactly what a sale of a Treasury bond does: it substitutes one government liability (Fed reserves) for another government liability (Treasury bonds). Operationally, it all amounts to the same thing. Once this is recognized, the Treasury can stop issuing debt, we can all stop worrying about our grandchildren, and our nation can get on with ramping up fiscal policy to get out of this economic crisis.

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A New Maestro?

Posted on December 25, 2009 by | 8 comments

By L. Randall Wray

Ok, the media is a poor judge of the performance of the Chairman of the Board of Governors. It seems like only yesterday that it anointed “maestro” status to Chairman Greenspan, right before all hell broke loose and he had to admit that his whole approach to financial markets had been dangerously wrong-headed. Now Chairman Bernanke is awarded with a magazine’s choice as “man of the year”—purportedly for saving capitalism as we know it. More importantly, the Senate is trying to decide whether he deserves reappointment. Usually these votes are little more than a rubber-stamping. Yet, something seems amiss this time around as the Senate Banking Committee voted 16 to 7 for approval—with significant opposition to reappointment. To some extent this is probably a vote of no-confidence for the Administration’s approach to dealing with the financial mess created by three decades of complete mismanagement of the banking system by a succession of Fed and Treasury officials. And, in truth, it would make more sense to fire Timmy Geithner and Larry Summers—who have done far more harm to the economy than has Ben Bernanke.

Let us suppose for a moment that Bernanke had done everything exactly right. Would he deserve accolades? In truth, the job of a Fed Chairman is pretty darn simple. So far as monetary management goes, he has one tool—the overnight interest rate target that is set in meetings of the Federal Open Market Committee. The Chairman has tremendous influence at these meetings, as we know from the transcripts that are released with a 5 year lag. While tremendous significance is believed to surround changes to the Fed’s target rate, in truth the overnight rate has little influence over the economy. As conventional thinking goes, the Fed raises rates in an inflation and lowers them in a recession. When the crisis hit, the Fed should have lowered rates, and did so. By itself, this should have had no impact; and by all accounts it had no impact. Should anyone receive man of the year designation for doing something that any Fed Chairman would have done, and which everyone agrees has virtually no impact?

Better to replace the FOMC with a rule that the overnight rate will be kept at zero from now on, a directive that the NYFed would implement. That would provide a lot more stability to the financial sector—and would go some way toward J.M. Keynes’s “euthanasia of the functionless rentier class”. But that is a story for another day.

In a crisis, the other thing the Fed does is to “provide liquidity”—that is, it lends reserves to prevent bank runs. This has been widely accepted policy since the 1840s and there is no central bank anywhere in the world that would not act as a lender of last resort in the sort of situation Bernanke faced. In fact, Bernanke was a bit slow to the gate on this, and never seemed to fully understand what he was doing. While he should have lent reserves without limit, to all comers, and against any kind of collateral, he played around with a variety of limited auctions, let a major financial institution fail due to lack of access to the Fed’s lending, and demanded good collateral for far too long. If anything, the Fed’s slow learning curve contributed to the crisis. Man of the year? I think not.

Finally, the Fed is supposed to be a regulator of financial institutions—through the thick and thin of the business cycle. Let us suppose a counterfactual: what if Bernanke had been a competent regulator from the time of his appointment? In truth, he consistently and persistently opposed any regulation that might have prevented this crisis, but in that he only followed his predecessor. And most of the damage had been done, with Greenspan at the helm since 1987 and with most of the important deregulation already accomplished by 2000. Clearly Bernanke deserves a grade of D- as a regulator (Timmy proudly earned an F when he testified before Congress that in all his years at the helm of the NY Fed he had never acted as a regulator!). So, he is certainly no worse than a Rubin or a Paulson and by 2005 when he was appointed he would not have had sufficient time or influence to overcome all the damage that had already been done. But a Man of the Year might have at least sounded a warning—rather than continually claiming even through summer 2007 that all was fine and dandy.

Bernanke will win reappointment. He has probably learned a bit as a result of this crisis so he will be a better head in his second term than he was in his first. Much is made of his scholarship that focused on the Great Depression. It is indeed a great advance over the work of Milton Friedman, who claimed the Fed caused the crisis by reducing the money supply. Bernanke also blamed the Fed for the initiation of the crisis, but the prolonged depression resulted because of the failure of financial institutions—which disrupted the relation between banks and their customers. When the bank of a farmer or entrepreneur failed, they were unable to borrow to finance operations—which collapsed production and employment. This is probably why Bernanke wants to prop up Wall Street institutions at all costs, to get “credit flowing again”. What he does not understand is that Wall Street banking has evolved—these are not lenders. They are speculators that serve no useful public purpose. If Bernanke were ever to figure that out, and would start to close down these predators, then he might deserve to be called Maestro.

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Why Bernanke Must Go

Posted on December 20, 2009 by | 7 comments

By Marshall Auerback

There are any number of reasons why Ben Bernanke should not be reconfirmed, notwithstanding the vote in his favor by the Senate committee last week.

1. Let’s start by using some criteria laid out by Bernanke himself. When first nominated as chairman of the Federal Reserve, Mr. Bernanke promised a greater degree of transparency than his predecessor, but has completely stonewalled anybody seeking to obtain clarification of the events surrounding the credit crisis and more specifically, the role of the Federal Reserve. Any information disclosed would have facilitated a proper assessment of Bernanke’s job performance (which is probably one of the reasons the Fed chairman doesn’t want it released) and, more importantly, would have created a foundation for useful forensic work to prevent recurrences going forward.

Understanding what the decision-making was prior to and during the crisis is key to evaluating Bernanke’s performance and to improving performance in general. Post mortems are standard in sports and medicine. Why not here? And, more importantly, why does Bernanke continue to oppose it? Even the Swiss National Bank has provided a higher level of disclosure and transparency on the banking crisis to its public than has hitherto been agreed by the Bernanke Fed.

2. The Fed chairman claims unique expertise on the grounds of his scholarship of the Great Depression. Few have actually challenged him on the basis of these academic credentials, yet Bernanke holds these out as if they are manifest proof of his appropriateness for the position as head of the Federal Reserve. Ironically, even though Bernanke drew heavily on the work of both Milton Friedman and Anna Schwartz for his own scholarship of the period, Ms Schwartz herself has been enormously critical of the Fed’s conduct both pre-crisis and in seeing providing liquidity as the primary solution. She also warned explicitly against drawing comparisons between the gold standard era Depression and now. Additionally, Bernanke’s reading of the Depression (which is pretty conventional, that the Fed blew it by not providing more liquidity) ascribed little significance to fiscal policy, which has led Bernanke toward wrongheaded “solutions” such as “quantitative easing” and an alphabet soup of lending facilities, none of which did anything to enhance aggregate demand. Consistent with that, the Fed chairman been on the wrong side of fiscal policy, urging the Congress to balance the budget, at least longer term, which suggests that he learned nothing of the fiscal successes of the New Deal.
3. Bernanke’s consistent advocacy of “quantitative easing” perpetuates the silly notion that the Fed has had something to do with the economic “recovery” (a line which Time Magazine had readily embraced in its selection of the Fed Chairman as “Person of the Year”). He has ascribed little importance to the existence of the automatic stabilizers and indeed has persistently fed the misguided notion that the Federal government had limited fiscal resources.

The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment. But as Bill Mitchell as pointed out, quantitative easing merely involves the central bank buying longer dated higher yielding bonds in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts: “[QE] is based on the erroneous belief that the banks need reserves before they can lend and that quantitative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates.” In the real world, the creation of a loan and (concurrently) a deposit by a bank are in no way constrained by the quantity of reserves. Instead, the terms set by the central bank for acquiring reserves (which then also affects the rates banks borrow at in money markets) affect a bank’s profit margin on a newly created loan. Thus, expanding its balance sheet can create a potential short position in reserves, and thus the profitability of newly created loans, not the bank’s ability to create the loan.
Banks, then, lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. Even the BIS recognizes this. Unfortunately our Federal Reserve chairman either does not know this (in which case his ignorance disqualifies him for another term in office) or he deliberately misrepresents the actual benefits of QE (duplicity being another good ground for disqualification for a 2nd term). The current incoherence of our economic policy making could diminish if we had a Fed chairman who understood the importance of fiscal policy, rather than one who downplays its significance. Which leads to point 4 below.

4. The Fed chairman continues to demonstrate a tremendous conceptual confusion at the heart of the current crisis, particularly in regard to the banking sector. He actively supported TARP on the grounds that repairing the banks balance sheets would somehow “unblock” credit flows and thereby enhance economic activity. The whole notion of repairing bank balance sheet is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. This will never happen as long as this apologist for Wall Street remains head of the Fed. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by, amongst others, the Federal Reserve Chairman.
For all of these reasons, Bernanke must go.

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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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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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Keynes’s Relevance and Krugman’s Economics

Posted on August 18, 2009 by | 3 comments

By Felipe C. Rezende

It is true that Krugman considered himself a saltwater economist. But he is closer to Post Keynesian economics than he imagined. In his post “The greatness of Keynes …” he wrote: “The key to Keynes’s contribution was his realization that liquidity preference — the desire of individuals to hold liquid monetary assets — can lead to situations in which effective demand isn’t enough to employ all the economy’s resources.”

That is precisely what Post Keynesian economists have been arguing since Keynes’s revolution. Given uncertainty in the Knightian sense, it is the existence of money and the organization of production around money that cause unemployment of labor and productive resources. This is so because money is special in a capitalist economy, it affects economic decisions both in the short-run and in the long-run. According to Keynes (1936), money has special properties such as almost zero elasticity of production, almost zero elasticity of substitution and low carrying costs. See Krugman’s introduction to the new edition of Keynes’s General Theory, Wray (2007) and Davidson (2006) for further details.


As Wray (2007) put it:

In my view, the central proposition of the General Theory can be simply stated as follows: Entrepreneurs produce what they expect to sell, and there is no reason to presume that the sum of these production decisions is consistent with the full-employment level of output, either in the short run or in the long run. Moreover, this proposition holds regardless of market structure—even where competition is perfect and wages are flexible. It holds even if expectations are always fulfilled, and in a stable economic environment. In other words, Keynes did not rely on sticky wages, monopoly power, disappointed expectations, or economic instability to explain unemployment. While each of these conditions could certainly make matters worse, he wanted to explain the possibility of equilibrium with unemployment. (Wray 2007:3)

Krugman also refuted the New Keynesian claim that involuntary unemployment exists due to price and wage stickiness. According to Krugman, “there’s no reason to think that lower wages for all workers — as opposed to lower wages for a particular group of workers — would lead to higher employment.” Keynes explained why flexible wages do not assure full employment and, as Krugman noted, Keynes wrote a whole chapter entitled “changes in money wages” to explain that the cause of unemployment is not due to wages and prices rigidities as New Keynesians wrongly claim. (See for instance here, here, and here)

Wray also pointed out that

“Keynes had addressed stability issues when he argued that if wages were flexible,then market forces set off by unemployment would move the economy further from full employment due to effects on aggregate demand, profits, and expectations. This is why he argued that one condition for stability is a degree of wage stickiness in terms of money. (Incredibly, this argument has been misinterpreted to mean that sticky wages cause unemployment—a point almost directly opposite to Keynes’s conclusion.)” (Wray, 2007:6)

In fact, Krugman observed that flexible wages and prices can make things worse rather than better even if one includes real balance effects. Wage and price flexibility are destabilizing forces which also trigger a Fisher-type debt deflation process.

On Say’s Law, Krugman argued (here and here) that

“If there was one essential element in the work of John Maynard Keynes, it was the demolition of Say’s Law — the assertion that supply necessarily creates demand. Keynes showed that the fact that spending equals income, or equivalently that saving equals investment, does not imply that there’s always enough spending to fully employ the economy’s resources, that there’s always enough investment to make use of the saving the economy would have had it it were at full employment.”

“The understanding that Say’s Law doesn’t work in the short run — that a fall in consumption doesn’t automatically translate into a rise in investment, but can lead to a fall in output and employment instead — is the central insight of Keynes’s General Theory.”

On the Loanable funds model of the interest rate he pointed out (here and here) that:

“One of the key insights in Keynes’s General Theory — actually, THE key insight— was that the loanable funds theory of the interest rate was incomplete. Loanable funds says that the interest rate is determined by the supply of and demand for saving; Keynes pointed out that the supply of saving is endogenous, depending on the level of output. He even illustrated the point with a remarkably ugly diagram.”

Krugman also argued that “saving and investment depend on the level of GDP. Suppose GDP rises; some of this increase in income will be saved, pushing the savings schedule to the right. There may also be a rise in investment demand, but ordinarily we’d expect the savings rise to be larger, so that the interest rate falls”

It means that as income expands, for instance due to government spending, there is a downward pressure on the interest rate. This is the crowding in effect. As he noted government spending “does NOT crowd out private spending”

He then pointed out that what is moving interest rates “it is not deficits. It’s the economy.”

He also has been using a framework that Post Keynesian economists have been using for a long time. See for instance here, here, here, and here. Check also Krugman’s posts here and here.

Krugman, clearly following Minsky (1986), concluded that “government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression.” This is precisely the point that Minsky made in the first chapters of his book “Stabilizing an Unstable Economy”.

The above statements are precisely what Post Keynesian Economists have been arguing for years. They completely refute the basis of the mainstream economics which guide policy both in the U.S. and in the rest of the world. However, there is definitely a convergence of economic thought between Paul Krugman’s economics, Post Keynesian economists and the specialized media (see here and here). Keynes’s and Minsky‘s economics provide the basis for the next generation of economic models.

As Greenspan admitted before the members of the Congressional committee :”I found a flaw in the model that I perceive is the critical functioning structure that defines how the world works. That’s precisely the reason I was shocked….I still do not fully understand why it happened, and obviously to the extent that I figure it happened and why, I shall change my views”.

Shall they?

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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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