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Response to MMP Blog #24: Foreign Holdings of Government Blogs

Posted on November 16, 2011 by | Comments Off on Response to MMP Blog #24: Foreign Holdings of Government Blogs

Thanks for comments. I’ll return to posting the questionsand my responses this week.
Q1: What about the Chinese or others buying US assets withthe dollars they have credited to their accounts.  They could have controlof US corporations which wouldn’t sit well with the US electorate.
A: I recall the exact same “yellow peril” arguments in the1980s when the Japanese were “buying up” Hawaii and NYC. Look, once they buy USassets they are subject to US laws. If we don’t like what they are doing with“their” property, we change the laws. In truth, is it worse to be subject tothe whims of a convicted criminal like Michael Milken engaged in LBOs thatenable him to downsize workers and strip off assets; or to a Japanese orChinese firm that has a long-term interest in producing autos in Georgia? Iguess it is a toss-up. In any case, most of the Chinese “dollars” are safelylocked up at the Fed, either in the form of reserves or US Treasuries. They getno obvious advantage from that ownership except whatever advantages TreasurySecretary Geithner wants to give to them.
Q2: What do you make of the idea that a weaker dollar would be good for oureconomy because it’d make it less attractive to export American jobs andpossibly bring some back? Would the positive effects of this offset thenegative effects of more expensive oil and imports?
A: Estimates of trade benefits of dollar depreciation arealmost certainly overstated. First, many of our trading partners “peg” to thedollar—depreciation has no effect at all on them. Second, those that don’t peg arewilling to take lower profits (hold dollar prices steady) to keep market share(this has been the Japanese strategy). Third, exports are a cost, imports abenefit so trying to maximize a trade surplus is a net cost maximizingstrategy; ergo: just plain dumb. Fourth, forget those old, 19thcentury factory jobs. They ain’t coming back, and good riddance. Today low wageworkers in developing nations will take them; tomorrow they’ll all be done byrobots who don’t mind hard work for zip wages. Alternative: create good payingjobs in good working conditions right here in the good ol’ US of A.
Q3: When foreign central banks purchase U.S. dollars, howdoes the accounting go from their perspective? Do they mark up U.S. dollars onthe asset side of their balance sheets and issued money on the liability side?Does this lead to increase of reserves in the domestic banking system, and theyhave to issue equivalent amount of bonds to accomodate this? So export ledgrowth, with undervalued exchange rate would still lead to increase in publicdebt even when government’s budget was balanced? And if foreign central bankshold foreign money on the asset side of their balance sheets and domesticcurrency on their liability, aren’t they exposed to huge losses if exchangerates change?
A: Not sure I got all of this, but let’s give it a go.Typical case: a country (say, China) exports goods to the US. Its exportersearn dollars but need RMB (to pay workers, buy raw materials, service debt).Their bank credits their deposit account with RMB, central bank of Chinacredits the bank’s reserves in RMB. So the dollar reserves end up at Bank ofChina (asset of Bank of China, liability of Fed). Bank of China says “hey,these suckers earn zero interest; I want Treasuries” so Fed debits theirreserves and credits Bank of China with Treasuries. Impact in the US: some USbank’s reserves are debited, Bank of China’s reserves credited. No change oftotal reserves until Bank of China buys Treasuries. At that point the reservesdisappear, Fed’s liability to China reduced, Treasury’s liability to Chinaincreased. No necessary impact on the dollar/RMB exchange rate since theexports sold and imports bought were voluntary, and China only exported becauseshe wanted dollars (reserves, then Treasuries). The next question always is:but what if China decides to run out of the dollar and dumps Treasuries? Ok, ifthat happened there could be depreciation pressure on the dollar; in which caseChina loses since its dollar assets decline in value relative to RMB.Fortunately, China is not as dumb as those posing the scenario. It will not runout of dollars in part because it does not want dollar depreciation.
Q4: This discussion gets to the heart of another question Ihave regarding the MMT proposition that tax liability is the main reason usersvalue a fiat currency. As there are considerably more dollars held abroad as ahedge against currency runs and also as banking reserves to underpin intltrade, it would seem that foreigners value the dollar and yet have no taxliability to the US government. How does this square with the MMT claim? Thisalso brings to mind another nagging suspicion that MMT focuses too much onnominal values and not on the real value of the supply of goods and servicesthat underpin the currency. My guess is that Chinese sovereign funds will seekdiversification out of dollar reserves by exchanging them fordollar-denominated real assets.  Barron’shad an article this week that suggests the Chinese govt. will also promote intltrading in yuan to compete with the dollar.  I could see how exchangemarkets with competing currency bloc issuers could provide the constraints onpolicy abuse of fiat currency values – a collapsing exchange rate is a highlyvisible market indicator.
A: Ok: 1. At the extreme, if we impose a $2 trillion taxonly on Bill Gates, you can be sure that others will take dollars because poorBill will work hard for us to pay his tax in dollars. This is a red herring. Wedo not need to tax all 6 billion people in the world to ensure a global demandfor dollars. Tax about 300 million relatively wealthy Americans and you can besure dollars will be demanded outside the US. Because Americans want them topay taxes. Ever hear of the “margin”? Here is one place it works. Tax on themargin and you drive a currency. 2. MMT focuses too much on nominal? Hey, MMTis “modern money theory”. Money. So yes, it is focusing on money. Nominal. Wecould focus instead on the aesthetic value of nose jobs. Then we would call itmodern nose jobs theory: MNJT. In any case, like it or not, we live in amonetary economy. Monetary production economy. Capitalist economy. Choose yourterms. Money matters. 3. Barron’s? Give me a break. That is your source ofanalysis? Read more MMP, less Barron’s. More seriously: China will become thebiggest economy in the world within 5 years. Its currency will likely replacethe dollar in 50. Maybe sooner. Don’t hold your breath.
Q5: To what extent do foreign countries other than Chinahold US dollars as a way to protect their own currencies? Even if not directlypegged to the dollar, don’t many hold dollars to support their currencies in fxmarkets? If China suddenly desired to hold fewer dollars and started to dumptheir US bonds, wouldn’t the weakening of the dollar that might result causeall those other countries to buy more dollars to build back adequate reserves?And wouldn’t that demand tend to support the dollar’s value? In effect won’tevery country that uses dollars to protect its own currency automatically actto protect the value of the dollar as well? If the dollar were to be suddenlydevalued for whatever reason, is their any other stable currency that couldplausibly be used instead by countries that now use US dollars to protect theirown? I can’t imagine Euros or Yuan being very attractive …
A: So many questions, so little time. However, much of thisanswered above. Yes, many hold dollars to enable them to manage or peg theircurrencies. Holdings increased after the Asian Tigers’ crisis, when nationscame to realize you need an unassailable reserve if you are going to peg. Chinalearned it well. Does it increase demand for dollars. As Sarah would say, “youbetcha”. Does devaluation lead to capital losses? Yep. Is there any alternativenow? Nope. You can’t get safe euro debts in sufficient quantity. Oh, sure youcan buy the debts of PIIGS. Go ahead, they need your help. Germany is a netexporter and the model of fiscal rectitude, so you can’t get their euro debt.So euro is a no-go. RMB? No way. Ditto. It is a better Germany than Germany is.Japanese Yen? Exporter. As an exporter it creates sufficient domestic saving toabsorb its large government debt. TINA: there is no alternative to the dollar.Today.
Q6: Okay, I’ve been waiting for these posts for some time. Idon’t know how much of the below question you will deal with in next weekspost, so maybe its best if you ignore the parts of the questions that will bedealt with. (1) You mention Japanese domestic saving. Can we just confirm onceand for all that the high rates of domestic saving in Japan are the result oflarge government deficits and little of this ‘leaking’ abroad due to theirrunning current account surpluses? And can we surmise from this that Japanesesavings rates are largely determined BY the government deficits? — hence, it’sthe deficits that ’cause’ the savings and not the savings that ‘allow’ thedeficits. Sorry, I know I’ve been pressing this point for  while on here.But I’d like it ‘in stone’, as it were. (2) In what way does what you say abovetie into the Hudson/Varoufakis ‘dollar hegemony’ argument? I.e. the argumentthat the US occupies a ‘special position’ due to its post-war status thatallows it to have its currency accepted by others to an extent that no othersovereign can? The kicker here would be that, if there is truth to thisargument the US might not like the prospect of currency devaluations not justfrom the perspective of Wall Street, but also for geopolitical and military(read: imperial) reasons.
A: Thanks for the patience! Japanese gov’t deficits +current account surpluses = large domestic savings. By identity. Yes. Yen forYen. Causation goes from spending to income to saving; or from injections toleakages, in the normal Keynesian way. Some in US would like dollardepreciation (exporters); some would like appreciation (tourists, and yourstruly). The US is special. It has more nukes than anyone else and has shown theworld it is willing to use military might. That was not post-war, it was war. That’sreal hegemony, not merely dollar hegemony. Nuclear hegemony will trump currencyhegemony, I think.
Q6a: Question (1a) — well stated! Let me try to summarize– and add a third alternative: Which view is “best”? * Conventionalview — loanable funds: “private savings allow governmentdeficits” * Philip’s suggestion: “government deficits’cause’ private saving”, or alternatively “private saving isdetermined by government deficits” * Keynes/Godley view (heh..as understood by Hugo): Increased private saving constitutes a demand leakage,since private spending decreases. Private saving decisions thereby ‘lead’ thegovernment into deficit. Because if the government does not go into deficit (toaccomodate for the private saving intentions) the economy will slow down (dueto the decreased private spending). So: “private saving behaviour’leads’ government deficits” or alternatively “governmentdeficits ‘allow’ private saving” Philip, is that a reasonable way toformulate your question (1a)? (Question (1b) would then be the question on whyso few foreigners hold Japanese bonds — is it due to Japanese current accountsurpluses?)

A: Always takes two to tango. By construction, modern government budgetaryoutcome is accommodative—taxes fall and spending rises in downturn. Thedownturn, in turn, can be thought of as resulting from inadequate aggregatedemand which leads to a reluctance to spend. That in turn results from apreference for saving and especially in liquid form. Ergo: private sector wantsto net save in government IOUs, so won’t spend, so a deficit results to satisfythe saving desire. To be sure, causation is always complex but that is a roughand ready explanation.

 Q7: Pretty much.Randy has said many times before that government spending = private savingdollar for dollar. I just want to know if he thinks the case of Japan is aconcrete example of this. Its just a very concrete argument to make against the’Japan is because of high savings’ types. “No,” you’d respond,”Their savings are DUE TO high deficits coupled with trade surpluses! Thegovernment bonds just mop this up. Hence the perpetually low interestrates.”
A: Both. Japan has an inadequate safety net in conjunctionwith 2 decades of recession. Perfectly rational to save. That generates lowgrowth and hence budget deficit. However, since the saving cannot occur unlessthe budget deficit occurs (and trade surplus) it makes sense to say thedeficits allow the desired saving to be realized.
Q8: Could the government be compelled to raise taxes, afterissuing so much bonds, paying so much interest, that bond holders becomenervous and suddenly rush to buy actual stuff (mines power plants, whatever)before inflation and currency depreciation occur ? As the US dollar shift awayfrom international reserve currency status, isn’t a harsh inflation to beexpected ? How to deal with it? When governments lended to banks in 2008, werethey compelled to do so because the massive losses demanded reserves to payright away (or go bankrupt) to an amount exceeding what central banks had intheir balance sheet ? Have we figures saying just that ? Otherwise why wouldgovernments act as Lender of Last Resort and humiliating central banks whopretended to be the ultimate guarantee of the monetary system ? (Yep I was theguy sending an e-mail entitled Lender of Penultimate Resort, I hope I”m nottoo pressing 😀 )

A: In a sovereign country, taxes create a demand for thecurrency and they drain income and thus reduce demand, which can be useful ifthere is inflation pressure. Obviously that is not the problem in recent years.So, no, there is no reason to raise taxes after the bail-out. The US dollar isnot shifting away from international reserve status. Have you been watchingEuroland? There will be a huge euro bond sell-off and a run into US Treasuries.Buy them now before Europe gets all of them. Why did the Fed bail-out WallStreet? Because Bob and Hank and Timmy came from Wall Street to save GovernmentSachs. Not sure it is humiliating, but it certainly is a scandal. Worst inhuman history.
Q9: As far as exchange rates go, context matters.Switzerland is actually rather unhappy about the fact that the CHF rose so muchrelative to EUR in the recent crisis, to the point where their central bankdecided to put a limit on how high the CHF can go. They want to protect theirtourism and export industries. Similarly, it seems to me that a depreciation ofthe USD wouldn’t necessarily be bad for the US. At least, I often read UScommentators complain about the perceived de-industrialization of the US comparedto the rest of the world. A falling USD could certainly help make production inthe US more attractive again, couldn’t it?
A: Again, depends on which American you are. Estimates ofpositive trade effects are almost certainly overstated for the US. For acountry like Italy, depreciation could have a nontrivial effect within Europe.Of course, it cannot do that until it leaves the euro and returns to the Lira. Noone is going to peg to an Italian Lira. So depreciation does increase exports.Given that most countries constrain demand, exporting is a lot like payingpeople to dig holes. It provides jobs devoted to waste. Exports mean youproduce things you don’t get to consume. Pure waste—might as well just dig theholes, unless workers prefer making Fiats they don’t get to drive. The US wouldbe far better off if it exported nothing, imported loads of stuff, and operatedat full employment. Not digging holes but rather doing useful and fun stuff.

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MMP Blog #24: What if Foreigners Hold Government Bonds?

Posted on November 13, 2011 by | 1 comment

By L. Randall Wray

Previously, we have shown that government deficits lead to an equivalent amount of nongovernment savings. The nongovernment savings created will be held in claims on government. Normally, the nongovernment sector prefers to hold some of that savings in government IOUs that promise interest, rather than in nonearning IOUs like cash. Further, we have shown that budget deficits create an equivalent amount of reserves. And banks prefer to hold higher-earning assets than reserves that pay almost nothing (until recently, they paid zero in the USA). Hence, both savers as well as banks would rather have government bonds. We, thus, find that in normal times government will offer interest earning bonds in an amount almost equal to its deficits (the difference is made up by bank accumulation of reserves and private sector accumulation of currency).

However, when government deficit spends, some of the claims on government will end up in the hands of foreigners. Does this matter? Yes, according to many. At one extreme we have many commentators worrying that the US government might run deficits, but will find that the Chinese desire to “lend to” the US government is insufficient to absorb bond issues. Others argue that while Japan can run up government debt to GDP ratios equal to 200% of GDP this is only because more than 90% of all that debt is held domestically. The US, it is said, cannot run up debts that great because so much of its “borrowing” is from foreigners—who might “go on strike.” Others worry about ability of the US government (for example) to pay interest to foreigners. And what if foreigners demand more interest? And what about effects on exchange rates? This week, we begin to look at such issues.

Foreign holdings of government debt. Government deficit spending creates equivalent nongovernment savings (dollar for dollar). However, some of the savings created will accumulate in the hands of foreigners, since they can also accumulate the government’s domestic currency-denominated debt.

In addition to actually holding the currency including both cash and reserves (indeed, it is possible that foreigners hold most US dollar-denominated paper currency), they can also hold government bonds. These usually just take the form of an electronic entry on the books of the central bank of the issuing government.Interest is paid on these “bonds” in the same manner, whether they are held by foreigners or by domestic residents—simply through a “keystroke” electronic entry that adds to the nominal value of the “bond” (itself an electronic entry). The foreign holder portfolio preferences will determine whether they hold bonds or reserves—with higher interest on the bonds. As discussed in previous weeks, shifting from reserves to bonds is done electronically, and is much like a transfer from a “checking account” (reserves) to a “savings account” (bonds).

There is a common belief that it makes a great deal of difference whether these electronic entries on the books of the central bank are owned by domestic residents versus foreigners. The reasoning is that domestic residents are far less likely to desire to shift to assets denominated in other currencies.

Let us presume that for some reason, foreign holders of a government’s debt decide to shift to debt denominated in some other currency. In that case, they either let the bond mature (refusing to roll over into another instrument) or they sell it. The fear is that this could have interest rate and exchange rate effects—as debt matures government might have to issue new debt at a higher interest rate,and selling pressure could cause the exchange rate to depreciate. Let us look at these two possibilities separately.
                a) Interest rate pressure. Let us presume that sizable amounts of a government’s bonds are held externally, by foreigners. Assume foreigners decide they would rather hold reserves than bonds—perhaps because they are not happy with the low interest rate paid on bonds. Can they pressure the government to raise the interest rate it pays on bonds?

A shift of portfolio preferences by foreigners against this government’s bonds reduces foreign purchases. It would appear that only higher interest rates promised by the government could restore foreign demand.

However,recall from previous discussions that bonds are sold to offer an interest-earning alternative to reserves that pay little or no interest. Foreigners and domestic residents buy government bonds when they are more attractive than reserves. Refusing to “roll over” maturing bonds simply means that banks taken globally will have more reserves (credits at the issuing government’s central bank) and less bonds. Selling bonds that have not yet matured simply shifts reserves about—from the buyer to the seller.

Neither of these activities will force the hand of the issuing government—there is no pressure on it to offer higher interest rates to try to find buyers of its bonds.

From the perspective of government, it is perfectly sensible to let banks hold more reserves while issuing fewer bonds. Or it could offer higher interest rates to sell more bonds (even though there is no need to do so); but this just means that keystrokes are used to credit more interest to the bond holders.

Government can always “afford” larger keystrokes, but markets cannot force the government’s hand because it can simply stop selling bonds and, thereby, let markets accumulate reserves instead.

                b) Exchange rate pressure. The more important issue concerns the case where foreigners decide they do not want to hold either reserves or bonds denominated in some currency.

When foreign holders decide to sell off the government’s bonds, they must find willing buyers. Assume they wish to switch currencies, so they must find holders of other currency-denominated reserve credits willing to exchange these for the bonds offered for sale. It is possible that the potential buyers will purchase bonds only at a lower exchange rate (measured as the value of the currency of the government bonds that are offered for sale relative to the currency desired by the sellers).

For this reason, it is true that foreign sales of a government’s debt can affect the exchange rate. However, so long as a government is willing to let its exchange rate “float” it need not react to prevent a depreciation.

We conclude that shifting portfolio preferences of foreign holders can indeed lead to a currency depreciation. But so long as the currency is floating, the government does not have to take further action if this happens.

Current accounts and foreign accumulation of claims. Just how do foreigners get hold of reserves and bonds denominated in a government’s domestic currency?

As we have shown in previous weeks, our macroeconomic sectoral balance ensures that if the domestic private sector balance is zero, then a government budget deficit equals a current account deficit. That current account deficit will lead to foreign net accumulation of financial assets in the form of the government’s debt. This is why, for example, the US government is running deficits and issuing government debt that is accumulated in China and elsewhere.

Of course,in the case of the US, for many years (during the Clinton and Bush, jr. presidencies) the domestic private sector was also running budget deficits—so foreigners also accumulated net claims on American households and firms. The US current account deficit guarantees—by accounting identity—that dollar claims will be accumulated by foreigners.

After the crisis, the US domestic sector balanced its budget and actually started to run a surplus. However, the current account deficit remained. The US government budget deficit grew—by identity it was equal to the current account deficit plus the private sector surplus. Given that the US government became the only net source of new dollar-denominated financial assets (the US private sector was running a surplus), foreigners must—by accounting identity—have accumulated US government debt.

Some fear—as discussed earlier—that suddenly the Chinese might decide to stop accumulating US government debt. But it must be recognized that we cannot simply change one piece of the accounting identity, and we cannot ignore the stock-flow consistency that follows from it.

For the rest of the world to stop accumulating dollar-denominated assets, it must also stop running current account surpluses against the US. Hence, the other side of a Chinese decision to stop accumulating dollars must be a decision to stop net exporting to the US. It could happen—but the chances are remote.

Further,trying to run a current account surplus against the US while avoiding the accumulation of dollar-denominated assets would require that the Chinese off-load the dollars they earn by exporting to the US—trading them for other currencies. That, of course, requires that they find buyers willing to take the dollars.

This could—as feared by many commentators—lead to a depreciation of the value of the dollar. That, in turn would expose the Chinese to a possible devaluation of the value of their US dollar holdings—reserves plus Treasuries that total over $2trillion.

Depreciation of the dollar  would also increase the dollar cost of their exports, imperilling their ability to continue to export to the US. For these reasons, a sudden run by China out of the dollar is quite unlikely. A slow transition into other currencies is a possibility—and more likely if China can find alternative markets for its exports.

Next week, we will look to the frequent claim that the US is “special”—while it might be able to run persistent government deficits and trade deficits, other countries cannot.

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Blog #23: Sovereign Debt Limits: Response to Comments

Posted on November 10, 2011 by | 2 comments

Thanks for comments and apologies for being late. I justreturned from Rio. And lest you think I was just tanning on the beach, I wasactually indoors at a conference—underground, no less.

Rather than repeating the questions, let me justsummarize six key issues raised.

  1. Weneed to tie ourselves to the masthead of budget limits to keep politicians fromspending too much. For better or worse we have a budgeting process throughwhich Congress decides how much to allocate to programs, then submits the planto the President. Once approved, this authorizes spending. That is the“democratic” process through which our elected representatives decide whichprograms are worthy of funding—and at what levels. Much of the spending is“open-ended” in the sense that it is contingent (unemployment benefits paidwill depend on economic performance, for example). I do not see how adding aconstraint beyond this is either necessary or consistent with democraticcontrol and accountability. Certainly I do not support many or even most of theprograms Congress and the President decide to fund. I can vote to throw thebums out. If I’m rich enough, I can try to buy them off with campaigncontributions. By its very nature a debt limit is arbitrary and inconsistentwith the budgeting process. In the past, it never mattered—the budget trumpedthe limit and Congress routinely raised the limit. Now the politics of aminority is trying to subvert the budgeting process. In truth, the biggerdanger is the new super-duper hand-picked for ignorance deficit committee thatis authorized to ignore Congress’s will as expressed in the budget and to slashand burn programs in a thoroughly undemocratic manner.

  2. Publicgoods provision is always less efficient than private goods provision; andproduction of public goods crowds-out private goods and hence must reduceoverall efficiency. This is faith-based economics of the worst sort. It hasabsolutely no evidence to support it and defies any logic. Outside of communistor socialist societies, I truthfully cannot see any legitimate use for the hazyterm “efficiency” in economics. Unlike communist societies, capitalistsocieties never operate near to full capacity (with World Wars the onlypossible exception) and hence it is never a simple matter of taking resourcesaway from private use to support public use. And in any case, one cannotimagine any private production without first having in place publicprovisioning.

  3. Abloated government is a drag on growth and causes inflation. Could be true.However, everywhere I look in the West (that is to say, among developednations) the problem is government that is far too small to succeed in thetasks at hand. Too much privatization, too many idle resources, inadequateprovision of essential public services.

  4. Whohas the authority to issue “warrants” or “platinum coins”? As discussed above,Congress and the President first work out a budget. That authorizes Treasuryspending. We can come up with all sorts of procedures to allow Treasury toaccomplish that task. A relatively primitive but effective one would be for itto simply print up Treasury notes and spend. Or it can directly keystrokeentries into the deposit accounts of recipients—but that requires that Treasurycan also keystroke reserves onto bank balance sheets. Since we divide the tasksbetween Treasury and Fed, having banks “bank at the Fed”, it must be the Fedthat keystrokes the reserves. There is no fundamental reason for this—bankscould have accounts at the Treasury used for clearing and then the Treasurywould keystroke the reserves. But we don’t do it that way. So we could have theFed act as the Treasury’s bank, accepting a Treasury IOU and keystroking bankreserves. But we don’t do that either—we say that although the Fed is theTreasury’s bank, it is prohibited from directly accepting a Treasury IOU. Andhence we created complex procedures that involve private banks, the Fed and theTreasury to accomplish the same thing.

    Now I went through all that simply as an introductionto the warrant and platinum coins proposals. Treasury has the authority toissue platinum coins in any denomination, so could for example make largepayments for military weapons by stamping large denomination platinum coins. Itwould thereby skip the Fed and private banks. And since coins (and reserves andFederal Reserve notes) don’t count as government debt for purposes of the debtlimit this also allows the Treasury to avoid increasing debt as it spendsplatinum coins. Similarly we could create some new IOU we call a warrant thatis made acceptable (for example) in tax payment. It would be a Treasury IOU butwould not be counted among the bills and bonds that total to the governmentdebt. Like currency it would be “redeemed” in tax payment, hence demanded bythose with taxes due. So it is just another finesse to get around arbitrarylimits or procedures put on Treasury spending.

  5. TotalFed commitments (so far) to bailout Wall Street: $29 trillion. That figureresults from a close study by two UMKC PhD students who will soon be releasingtheir study.

  6. Whatabout Italy (etc)? Do they face market imposed debt limits (rather than simplytying their shoes together voluntarily)? Yes. Go to my GLF blog today.They are now more like US states, users not issuers of the currency.

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MMP Blog #23: The Debate About Debt Limits (US Case)

Posted on November 7, 2011 by | 4 comments
By L. Randall Wray

This week we will look at a “special case”, and one that preoccupied Washington recently.As we know, governments spend by keystrokes that they can never run out of–asovereign government that issues its own currency through keystrokes can neverface a financial constraint. However, it can choose to “tie its hands behindits back” by imposing rules and procedures that limit its keystrokes. It could,for example, simply impose a limit of “100 keystrokes per year”. It couldrequire the Treasury Secretary to climb Mount Everest or to seek approval fromterrestrial or extra-terrestrial gods before he is allowed to enter akeystroke. It could require a solar eclipse or similar “miracle” beforegovernment is allowed to credit a balance sheet.

We shouldnot be fooled by such self-imposed constraints. We should be able to seethrough them to understand that since they are imposed by government on itself,they can be removed. Unfortunately, virtually all economists and policymakerscome to see such self-imposed constraints as “natural”, something to neverviolate. Today we will look at the US “debt limit” that consumed policy makersin the US last summer—and will likely be visited again.

Before weproceed, let me acknowledge that I’ve promised our wonky readers some balancesheets and a detailed treatment of internal operating procedures used by theFed and Treasury to get around the self-imposed constraints. I have notforgotten. That is a matter for a later post.

In theUnited States Congress establishes a federal government debt limit. When theoutstanding quantity of federal government debt approaches that limit Congressmust approve expansion of the limit. Note that this debt limit is establishedby policy, not by markets—that is, Congressional action is required byCongress’s own rules, and not by market pressure. Hence, it is not a questionof whether the US government could sell more bonds, or even over the interestrate it would pay on the debt it sells.

In the aftermath of the Global FinancialCollapse of 2007, the US budget deficit increased (mostly due to loss of taxrevenue, as discussed in a previous blog). Predictably, the amount of debtoutstanding grew to the limit, and so each year Congress has had to increasethe limit.

This blogwill look at current procedures to see if there is an alternative to increasingthe limit—while allowing the Treasury to continue to spend. We examined most ofthe details of the operating procedures in a previous blog; in this blog weextend that understanding to come up with an alternative procedure. We will usethe distinction between High Powered Money (Federal Reserve Notes, Reserves,and Treasury Coins) and Treasury Debt (bills and bonds)—only Treasury Debt isincluded in the debt limits, although we know that all of these are governmentIOUs.

So let ussee how we can untie Uncle Sam’s purse strings while living with current debtlimits. It is actually a relatively easy thing to do, requiring only a modestchange of procedure.

First weneed to review how things usually work. Congress (with the President’ssignature) approves a budget that authorizes spending. Treasury then eithercuts a check or directly credits a recipient’s bank account. While the USConstitution vests in Congress the power to create money, in practice theTreasury uses the US central bank, the Fed, to handle its payments. Currentprocedure is for the Treasury to hold deposits in its account at the Fed forthe purposes of making payments. Hence, when it cuts a check or credits aprivate bank account, the Treasury’s deposit at the Fed is debited.

TheTreasury tries to maintain a deposit of $5 billion at the close of each day.Taxes paid to the Treasury are first held in deposit accounts it has withspecial private banks. When it wants to replenish its deposit at the Fed,Treasury moves deposits from these banks. Obviously there are twocomplications: first, tax receipts bunch around tax due dates; and, second, theTreasury normally runs an annual budget deficit—more than a trillion Dollars in2011. That means Treasury’s account at the Fed is frequently short.

To obtain deposits, the Treasury sells bonds(of various maturities). The easiest thing to do would be to sell them directlyto the Fed, which would credit the Treasury’s demand deposit at the Fed, offseton the Fed’s balance sheet by the Treasury’s debt. Effectively, that is whatany bank does—it makes a loan to you by holding your IOU while crediting yourdemand deposit so that you can spend.

But currentprocedures prohibit the Fed from buying treasuries from the Treasury (with somesmall exceptions); instead it must buy treasuries from anyone except theTreasury. That is a strange prohibition to put on a sovereign issuer of thecurrency, if you think about it, but it has a long history that we will notexplore in this box. It is believed that this prevents the Fed from simply“printing money” to “finance” budget deficits so large as to cause highinflation–as if Congressional budget authority (and threatened Presidentialveto) is not enough to constrain federal government spending sufficiently thatit does not take the US down the path toward hyperinflation.

So,instead, the Treasury sells the Treasuries (bills and bonds) to private banks,which create deposits for the Treasury that it can then move over to itsdeposit at the Fed. And then the Fed buys treasuries from the private banks toreplenish the reserves they lose when the Treasury moves the deposits. Got that?The Fed ends up with the treasuries, and the Treasury ends up with the demanddeposits in its account at the Fed—which is what it wanted all along, but isprohibited from doing directly. The Treasury then cuts the checks and makes itspayments. Deposits are credited to accounts at private banks, whichsimultaneously are credited with reserves by the Fed.

In normaltimes banks would find themselves with more reserves than desired so offer themin the overnight Fed Funds market. This tends to push the Fed Funds rate belowthe Fed’s target, triggering an open market sale of treasuries to drain theexcess reserves. The treasuries go back off the Fed’s balance sheet and intothe banking sector. (With the Global Financial Crisis, the Fed changedoperating procedure somewhat—it began to pay interest on reserves, and adopted“Quantitative Easing” that purposely leaves excess reserves in the bankingsystem. That is a topic for another blog.)

And that iswhere the debt gridlock problem bites. Treasuries held by banks, households,firms, and foreigners are counted as government debt (and nongovernment wealththrough accounting identities!) and thus subject to the imposed debt ceiling.Bank reserves, by contrast, are not counted as government debt. (One solution isto just stop the open market sales of treasuries in order to leave the reservesin the banking system. That is essentially what Bernanke’s Quantitative Easing2 does: the Fed is buying hundreds of billions of treasuries to inject reservesback into banks—the reserves that were drained by selling the treasuries tobanks in the first place.) So we are getting treasuries back onto the Fed’sbalance sheet, and yet gridlock remains because there are still too manyTreasuries off the Fed’s balance sheet.

Here is aproposal to change procedures in a way that eliminates the need to raise debtlimits. When Uncle Sam needs to spend and finds his cupboard bare, he canreplenish his demand deposit at the Fed by issuing a nonmarketable “warrant” tobe held by the Fed as an asset. With the full faith and credit of Uncle Samstanding behind it, the warrant is a risk-free asset to balance the Fed’saccounts. The warrant is just an internal IOU—from one branch of government toanother—really not anything more than internal record keeping. If desired,Congress can mandate a low, fixed interest rate to be earned by the Fed on itsholdings of these warrants (to be deducted against the excess profits itnormally turns over to the Treasury at the end of each year). In return, the Fedwould credit the Treasury’s deposit account to enable government to spend. Whenthe Treasury spends, its account is debited, and the private bank that receivesa deposit would have its reserves at the Fed credited.

From theFed’s perspective it ends up with the Treasury’s warrant as an asset and bankreserves as its liability. The Treasury is able to spend as authorized byCongress, and its deficit is matched by warrants issued to the Fed. Congresswould mandate that these warrants would be excluded from debt limits since theyare nothing but a record of one branch of government (the Fed) owning claims onanother branch (the Treasury). The Fed’s asset is matched by the Treasury’swarrant—so they net out.
AndCongress would not need to increase the debt limit when a crisis hits thatresults in growing budget deficits.

Thisproposal just shows how silly it is to tie the Treasury’s hands behind its backthrough imposing debt limits. We already require that a budget is approvedbefore Treasury can spend. That constraint is necessary to imposeaccountability over the Treasury. But once a budget is approved, why on earthwould we want to prevent the Treasury from keystroking the necessary balancesheet entries in accordance with Congress’s approved spending?

Thebudgeting procedure should take into account projections of the evolution ofmacroeconomic variables like GDP, unemployment, and inflation. It should try toensure that government keystroking will not be excessive, stoking inflation. Itis certainly possibly that Congress might guess wrong—and might want to reviseits spending plan in light of developments. Or, it can build in automaticstabilizers to lower spending or raise taxes if inflation is fuelled. But itmakes no sense to approve a spending path and then to arbitrarily refuse tokeystroke spending simply because an arbitrary debt limit is reached.

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Responses to Blog #22: Bonds, Reserves and Savings

Posted on November 4, 2011 by | 1 comment

Sorry am traveling, so the Blog has had a bit of a vacation.Must be brief today:
Q1: What about Ellen Brown?

A: I like the idea of public banking. Not a topic for today.Do not completely agree with her view of Fed.

Q2: What encourages a bank to lend money?

A: Most important: a profit opportunity to lend to aborrower likely to service her debt. Hint: has nothing to do with reserves.

Q3: At what point does borrowing at discount window push updiscount rate?

A: Never. This is not about quantity, it is about price.Central bank sets the rate at the discount window, so rate rises only whencentral bank decides to increase it.

Q4: Why does Japan have low bond rates?

A: Because BofJapan wants low rates. Set the overnight rateat zero, keep it there for a generation, and just like magic markets price in azero cost of overnight funds! You could just as well have asked why the USA hadnear zero bond rates throughout WWII in spite of budget deficits that would causea Greek to blush.

Q5: Many say rest of world funds the US trade and budgetdeficits.

A: And they be wrong. Dazed and confused. Where did everydollar the Chinese have come from?

Q6: Convince Bill Gross and we win the lottery.

A: Right. Note how well PIMCO did before Paul left PIMCO,and how poorly it is doing now. Paul and his rabbit understood MMT (more orless).

Q7: Isn’t treasury mandated to sell bonds equal to itsdeficit and to have funds in its account at the central bank before cuttingchecks?

A: Yes, true of many treasuries around the world. Goodexample of a government willing to tie its hands behind its back. Topic forlater blog. It is a specific case, not the general case. But, yes important butwe will see it makes no difference.

Q8: Banks create deposits out of thin air?

A: Yes when they make loans.

Q9: Deposit multiplier story: banks lend their excessreserves and through the magic of a multiplier money is created by a multiple.

A: Pure textbook fantasy. No, doesn’t work that way.

Q10: What would happen if reserves were discretionary?

A: Central bank has given up interest ratetarget, lets checks bounce, and bank checks don’t clear at par, so paymentssystem breaks down.

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MMP Blog #22: Reserves, Governement Bond Sales, and Savings

Posted on October 31, 2011 by | 3 comments
By L. Randall Wray

Last week, we showed that government deficits lead to an equivalent amount of nongovernment savings. The nongovernment savings created will be held in claims on government. Normally, the nongovernment sector prefers to hold that much of that savings in government IOUs that promise interest, rather than in nonearning IOUs like cash. This week, we will look at this in more detail.

Bond sales provide an interest-earning alternative to reserves. We can say that short term treasury bonds are an interest earning alternative to bank reserves (as discussed earlier reserves at the central bank often do not pay any interest; if they do pay interest, then government bonds are a higher-earning substitute). When they are sold either by the central bank (open market operations) or by the treasury (new issues market), the effect is the same: reserves are exchanged for treasuries. This is to allow the central bank to hit its overnight interest rate target, thus, whether the bond sales are by the central bank or the treasury this should be thought of as a monetary policy operation.

Reserves are nondiscretionary from the point of view of the government. (In the literature, this is called the “accommodationist” or “horizontalist” position.) If the banking system has excess reserves, the overnight interbank lending rate falls below the target (so long as that is above any support rate paid on reserves), triggering bond sales; if the banking system is short, the market rate rises above target, triggering bond purchases.  The only thing that is added here is the recognition that no distinction should be made between the central bank and the treasury on this score: the effect of bond sales/purchases is the same.

There is a surprising result, however. Since a government budget deficit leads to net credits to bank deposits and to bank reserves, it will likely generate an excess reserve position for banks. If nothing is done, banks will bid down the overnight rate. In other words, the initial impact of a budget deficit is to lower (not raise) interest rates. Bonds are then sold by the central bank and the treasury to offer an interest-earning alternative to excess reserves. This is to prevent the interest rate from falling below target. If the central bank pays a support rate on reserves (pays interest on reserve deposits held by banks), then budget deficits tend to lead banks gaining reserves to bid up prices on treasuries (as they try to substitute into higher interest bonds instead of reserves)—lowering their interest rates. This is precisely the opposite of what many believe: budget deficits push interest rates down (not up), all else equal.

Central bank accommodates demand for reserves. Also following from this perspective is the recognition that the central bank cannot “pump liquidity” into the system if that is defined as providing reserves in excess of banking system desires. The central bank cannot encourage/discourage bank lending by providing/denying reserves. Rather, it accommodates the banking system,providing the amount of reserves desired. Only the interest rate target is discretionary, not the quantity of reserves.

If the central bank “pumps” excess reserves into the banking system and leaves them there, the overnight interest rate will fall toward zero (or toward the central bank’s support rate if it pays interest on reserves). This is what happened in Japan for more than a decade after its financial crisis; and what happened in the US when the Fed adopted “quantitative easing” in the aftermath of the financial crisis that began in 2007. In the US, so long as the Fed pays a small positive interest rate on reserves (for example, 25 basis points), then the “market” (fed funds rate) will remain close to that rate if there are excess reserves.

Central banks now operate with an explicit interest rate target, although many of them allow the overnight rate to deviate within a band—and intervene when the market rate deviates from the target by more than the central bank is willing to tolerate. In other words, modern central banks operate with a price rule(target interest rate), not a quantity rule (reserves or monetary aggregates).

In the financial crisis, bank demand for excess reserves grew considerably, and the US Fed learned to accommodate that demand. While some commentators were perplexed that Fed “pumping” of “liquidity” (the creation of massive excess reserves through quantitative easing) has not encouraged bank lending, it has always been true that bank lending decisions are not restrained by (or even linked to) the quantity of reserves held.

Banks lend to credit-worthy borrowers, creating deposits and holding the IOUs of the borrowers. If banks then need (or want) reserves, they go to the overnight interbank market or the central bank’s discount window to obtain them. If the system as a whole is short, upward pressure on the overnight rate signals to the central bank that it needs to supply reserves.

Government deficits and global savings. Many analysts worry that financing of national government deficits requires a continual flow of global savings (in the case of the US, especially Chinese savings to finance the persistent US government deficit); presumably, if these prove insufficient, it is believed,government would have to “print money” to finance its deficits—which is supposed to cause inflation. Worse, at some point in the future, government will find that it cannot service all the debt it has issued so that it will be forced to default.

For the moment, let us separate the issue of foreign savings from domestic savings. The question is whether national government deficits can exceed nongovernment savings in the domestic currency (domestic plus rest of world savings). From our analysis above, we see that this is not possible. First, a government deficit by accounting identity equals the nongovernment’s surplus (or savings). Second, government spending in the domestic currency results in an equal credit to a bank account. Taxes then lead to bank account debits, so that the government deficit exactly equals net credits to bank accounts. As discussed,portfolio balance preferences then determine whether the government (central bank or treasury) will sell bonds to drain reserves. These net credits (equal to the increase of cash, reserves, and bonds) are identically equal to net accumulation of financial assets denominated in the domestic currency and held in the nongovernment sector.

We conclude: since government deficits create an equivalent amount of nongovernment savings it is impossible for the government to face an insufficient supply of savings.

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Budget Deficits and Saving: Responses to Comments on Blog 21

Posted on October 28, 2011 by | Comments Off on Budget Deficits and Saving: Responses to Comments on Blog 21

By L. Randall Wray
Sorry this is late—there were a lot of comments and I amtraveling. Before we begin, a note and plea: we are getting an increasingnumber of emails with comments and questions (sent to NEP email and to mine).Please understand I cannot respond to those—I get hundreds of emails a day andit would consume all of my time to respond individually. That is why I amcollecting comments on the Primer page and responding to all at once. I knowsome people are having trouble posting comments (I do too!) but what I’ve foundis that “three’s a charm”: if you hit “post” three times it inevitably works.Sorry about that.
Some of the comments were quite long and dealt with severalissues. So this week I am posting most of the text, followed by my response.
Iris: So from my point of view, what you obviously neglectis to insert all the additional references to presupposed material, which us,especially with less “previous knowledge of MMT” could help to betterunderstand the matter you’re dealing with. My impression is for example, thatnot only general accounting basics are necessary but also knowledge about thestructural system of inter-firm-, inter-bank- and governmentbanking-institutions’ accounting to private sector. Would it be asked
to much of a favor for you to perhaps offer, at least via footnotes, thesehints too?
A: Well there is always a trade-off. We don’t want to getinto defining the meaning of “the” (as a former President tried to do). I dopresume some knowledge and it is tricky just how much should be assumed and howmuch explained in detail. Sometimes the reader with less background is probablygoing to have to accept some statements without fully understanding all thedetails behind them. I have been leaving out detailed accounting for tworeasons: it is more detail than most will want, and it is hard to produce thesein Word (and I have no idea how hard it is for our techie to post them to theblog). However, since there have been a number of requests, I will devote ablog to “T Accounts”.
Hugo: Ok, “excess deposits” results in increased”demand for profitable savings vehicles”. And if demand for savingsvehicles exceeds supply, the market will adjust. Savers will have to acceptlower yields on their savings. Firms would find it more easy to borrow money.Interest rates for corporate bonds would likely decrease (in thefinancial markets?). But I feel the transmission to an increase in governmentbonds is somewhat weak here? What you are suggesting seems to be: “Excessdeposits seeking profitable savings vehicles”  -> “excessreserves in the interbank lending system” -> “overnight ratemaintenance” -> “bond sales” -> “equilibrium”..?But how does “excess deposits” necessarily lead to “excessreserves” here?
A: Before I get into a response, Guest responded to Hugo,trying to straighten this out:
-Guest:It is a result of double-entry book keeping. Whenever government creditsdeposits of someone in the banking system, it alse credits banks reserves tocreate asset that offsets banks deposit liability.
A: OkI am not sure what an excess deposit would be. When I get my paycheck mydeposit goes up and surely I do not think it is excessive. I then buyconsumption goods and services. I might also make some portfolio decision overwhat is left, allocating some of my accumulated savings to higher earningfinancial assets. Hugo says I might bid up bond prices, on both private andgovernment debt, lowering interest rates on the outstanding stock. Right. He isnot convinced that a government deficit will put downward pressure ongovernment bonds, however, because he does not see how my “excess deposits”creates “excess reserves”. Remember that reserves are on the asset side of thebank’s balance sheet while deposits are on the liability side. When governmentmakes a payment, both sides go up—the bank’s reserves at the Fed are credited,and my demand deposit is credited. Most of those additional reserves will beexcess reserves (details on this are complicated as reserve requirements arecalculated after a lag—let us ignore those details for now). Banks make aportfolio decision: buy something that earns higher interest rate. First theycan lend in the overnight, fed funds, market, pushing that rate down. Next theycan buy a close substitute, treasuries (government bonds), and then diversifyinto other assets. (Note: unless they buy treasuries from the central bank,this shifts reserves about but does not reduce aggregate reserves.) Sincecentral banks target an interest rate (ie: the fed funds rate in the US) theywill react once the interest rate falls below the target. They will begin tobuy treasuries. That eliminates the excess reserves and the downward pressureon interest rates.

-Luigi: “The impact of the deficiton bank reserves has been emphasized by the neo-chartalist school (Bell2001; Wray 1998), but neochartalist writers do not explicitly draw on theconclusion that it supports the complete exogeneity of the long-term rateof interest”. Parguez writes this in 2004, it’s right? How MMT considerlong-term rates of interest?

A: Sounds OK to me. A central bank CAN target a long termrate (ie 30 year treasury bond) and hit it if it wants, but central banksnormally do not. Instead, they target the short end and when they want thelonger term rates to fall, they make statements like “we expect to hold theovernight rate at a low level for the foreseeable future”. That makes holdersof longer maturity bonds more confident that the short term rate will not risesoon—which would cause capital losses. There are a number of approaches to thedetermination of longer term interest rates: expectations theory, habitattheory, and interest rate parity. As a great philosopher once said “you canlook it up”. But in conclusion, yes, MMT agrees that longer rates are complexlydetermined and are not normally exogenously controlled by central banks.
WH10: “Finally, the fear that government might “printmoney” if the supply of finance proves insufficient is exposed as unwarranted.All government spending generates credits to private bank accounts—which couldbe counted as an increase of the money supply (initially, deposits and reservesgo up by an amount equal to the government’s spending).”That’s only halfthe picture for those concerned.  Peopleperceive govt spending as being counteracted by bond sales, so the money supplyseemingly does not go up.  HOWEVER, is itnot the reality that a significant proportion of bond sales come from bankPrimary Dealers, which ‘spend’ from their reserve accounts, such thateffectively there is a net credit to deposit accounts (as opposed to them beingoffset by purchases of bonds out of deposit accounts)?  In other words, it seems we’re almost always’printing money,’ if this is the case.
A: Minsky said: “anyone can create money (things), theproblem lies in getting it accepted”. Yes, we are almost always “printingmoney” in the sense of issuing IOUs denominated in the state money of account.Get over it. On some conditions, that can cause prices of output or offinancial assets to rise. It all depends. There is no automatic channel thatcauses an increase of “money supply” however defined to lead to “inflation”,however defined. And there is nothing that magical with respect to inflationeffects of government spending as opposed to private spending. If I get an autoloan to buy a car, on some conditions that could push up car prices and hencethe CPI. And we could find that some measure of the money supply also hadincreased. If government strokes some keys to add a vehicle to its fleet ofcars, on some conditions that could push up car prices, the CPI, and somemeasure of the money supply. Yes, it is a possible outcome and if you reallywant to point your finger at the increase of the money supply, I guess you can.I would say that it was the increased purchase of autos that in tight markets(full employment, full capacity utilization) would induce manufacturers toincrease prices. Note that could also happen without any additional loans or“printing money”.
WH10: Was there a time when did the U.S. Govt could spendbefore requiring the Treasury’s account to be marked up?  If we imagine afiat currency starting out, but Fed overdrafts are not allowed and the sameinstitutional restrictions that we have today are in place, then what are theaccounting statements which allow the government to spend without a positiveaccount?  Does this necessitate the existence and willingness of primarydealers that to have their reserve accounts go negative to facilitategovernment spending?  Why are they willing to do this? 
A: Not exactly sure when the US government decided to tieits shoes together by requiring Treasury to have a credit to its account at theFed before making a payment, but it could date to creation of the Fed in 1913. Whatif there were no Fed? Bank clearing could take place on the books of theTreasury, and the Treasury could simply credit them with reserves whenever itmakes a payment. Even simpler, it could just pay with paper notes or coins. Or,in the old days, with tally sticks. These would be the debt of the governmentand the financial assets of the nongovernment, accepted in tax payment.
Dave: I guess I’ve missed something (though I’ve reviewedthe two previous posts): Given that reserve requirements are defined by the Fed(http://www.federalreserve.gov/…how does the non-governmental sector as a whole acquire “excessreserves” i.e. don’t reserves only grow as much as (in proportion to) thesurplus the non-governmental sector accumulates from deficit spending? Or doyou only mean that SOME agents/banks/actors of the non-governmental sectoraccumulate “excess reserves”? Or….?
A: Banks can get reserves from either the central bank orthe treasury. When treasury buys goods and services, bank reserves arecredited. We normally call that government spending. When the central bank buysfinancial assets from banks (ie: buys government bonds, or private debt, or theIOUs of a “borrowing” bank) that also increases bank reserves. But we do notnormally call that “government spending”. Really it is, but it is spending onassets not on goods and services (so does not show up in GDP).
Joe: OK, so we’re starting to get to the answer of”What if people don’t want to buy the bonds?” Perhaps some examplenumbers, accounts etc. would make thing a bit more concrete as ‘portfoliopreference’ is rather vague. Also, the idea the deficit spending comes first,to provide the reserves to purchase the bonds, seems logical(money must existbefore you can buy bonds), but doesn’t the treasury need a positive balance inorder to spend? Bond sales increase the balance, so there’s a very strongillusion that the proceeds from bond sales are recycled into the treasury’saccount (which I believe is the traditional, pre-1971 view).  Did theinterpretation just change in 1971; pre-1971 money from bond sales went intotsy account, post-1971 cash assets are converted to bond assets while new moneyis put into tsy accout? And how can the deficit be mandated to be covered bybonds, if you have to wait for preferences to adjust, there must be some timelag between spending and bond ales?  (sorry, lots of questions, I’mpatient, hopefully it’ll all clear up in the coming weeks)
A: Not sure how numbers would help. In the US, where we tiedthe government’s shoes together, the Treasury first sells bonds to specialbanks that buy them by crediting the Treasury’s deposit account. Treasury movesthe account to the Fed before spending. These bonds will be bought by thespecial banks, so at this point the portfolio preferences of the nongovernmentsector do not matter. Deficit spending will increase bank reservesdollar-for-dollar (cash withdrawals will reduce that a bit). As discussed thebanks will try to buy earning assets such as government bonds. The Fed andTreasury coordinate how many bonds will need to be sold by the two of them tooffer earning assets as alternatives to reserves, to allow the Fed to hit its interestrate target. A complication is that in the Treasury’s new issue market, itpursues “debt management”, offering a range of maturities. Occasionally theTreasury might offer a maturity that does not match “portfolio preferences” ofpotential purchasers.
Hugo: According to Vickrey, private capital in the U.S willhave trouble seeking profitable productive investment. Is government bond salesneeded as savings vehicles for the private sector to prevent assets bubbles?
A: Not sure I follow. To prevent asset bubbles, I’d userules, regulation, and supervision of financial institutions. The problemreally is not one of “excess saving”, so trying to “soak up” saving throughgovernment bond sales will not resolve it. If I want to speculate in Martianocean-front condo futures, I do not need any savings. All I need is a bank.
Kostas: “In reality, the Chinese receive Dollars(reserve credits at the Fed) from their export sales to the US (mostly), thenthey adjust their portfolios as they buy higher earning Dollar assets (mostly,Treasuries)”. It would be nice if you could elaborate on how foreigncentral banks get a hold of dollars in their Fed accounts. My understanding isthat this happens when central banks (of surplus countries) intervene inforeign exchange markets in order to maintain their currency foreign exchangevalue (by offering their currency in exchange for foreign assets). Is there anyother way for Bank of China to acquire US$ reserves?
–Dirk: Of course. The People’s Bank of China can borrow/buydollars from abroad. Not only from the US, but from anybody who holds dollars.In case of buying dollars, the counter-party has to accept yuan (not a problem)and the exchange rate might be changing (indeed a problem).
A: Thanks, Dirk, I think you answered.
Neil: “Recipients of government spending then can holdreceipts in the form of a bank deposit, can withdraw cash, or can use thedeposit to spend on goods, services, or assets.” Can’t they also swap itfor another currency with a willing party at an agreed exchange rate?  So the ‘shifting of pockets’ surely has anexchange effect as well, not just an interest effect. Or do you see currencyexchange as just another asset purchase and that it will effect themacroeconomy in the same way as any other asset price shift?
A: Yes, I can use a dollar deposit to buy foreign stuff,take vacations abroad, or to buy foreign assets. The dollar deposit will beheld by someone else. My spending abroad can affect the exchange rate.
Andy: What effect,if any, does a reduction in bank depositshave on central banks’ day to day operations? For example if repayment ofprivate debt is greater than bank lending and fiscal tightening by governmentsat the same time.
A: Let us say bank deposits decline due to loan repayment. Whenit comes time to calculate reserve requirements (in the US, more than a monthlater), banks will find they have excess reserves relative to what is requiredon their deposits. They will attempt to individually reduce reserves held bypurchasing bonds (etc). That just shifts the reserves about. But it also pushesthe overnight interest rate down. The central bank responds with an open marketsale of treasuries. So it “forces” the hand of the central bank that reacts tothe interest rate decline.
Suspicious: When will we get the MMP  explaining how to credibly regulate a bankingsector ? Banks have always managed to circumvent doctrines, ideologies,regulations, etc. and to wreck havoc the financial system. What’s the purposeof the central bank reserves not being inflationary if banks can loot it viacontrol fraud, and raise prices like in the commodities, and even causehyperinflation if only they were not as greedy as preventing anyone butthemselves to make money on it ?

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MMP BLOG #21: GOVERNMENT BUDGET DEFICITS AND THE “TWO-STEP” PROCESS OF SAVING.

Posted on October 23, 2011 by | 2 comments
By L. Randall Wray
In the previous two weeks we have shown that government budget deficits take the form of net credits to bank reserves at the central bank and as well to the deposit accounts of those who receive net government spending. Normally, this leads to excess reserves that are drained through the offer of government bonds, sold either by the central bank or by the Treasury. Hence, budget deficits normally result in net positive acquisition of Treasuries. But even if they do not, then on government sector ends up with net saving in the form of claims on government.

To put it as simply as possible: government deficit spending creates nongovernment sector saving in the form of domestic currency (cash, reserves, Treasuries). This is because government deficits necessarily mean the government has credited more accounts through its spending than it debited through its taxes.

Remembering the comments on Blog 20 we need to make clear that we are talking about net saving in the domestic currency. The domestic nongovernment sector can also net save in foreign currency assets. And some members of the nongovernment sector can save in the form of claims on other members of the domestic nongovernment sector—but that all nets to zero.

It is now obvious from the previous discussion that the nongovernment savings in the domestic currency cannot pre-exist the budget deficit, so we should not imagine that a government that deficit spends must first approach the nongovernment sector to borrow its savings. Rather, we should recognize that the government spending conceptually comes first–it is accomplished by credits to bank accounts. And finally we recognize that both the resulting budget deficit as well as the nongovernment’s savings of net financial assets (budget surplus)are in this sense residuals and are equal.

As a sidenote (for now) those who claim that the US government must borrow Dollars from thrifty Chinese don’t understand the most basic accounting. The Chinese do not issue Dollars—the US does. Every Dollar the Chinese “lend” to the US came from the US. In reality, the Chinese receive Dollars (reserve credits at the Fed) from their export sales to the US (mostly), then they adjust their portfolios as they buy higher earning Dollar assets (mostly, Treasuries). The US government never borrows from Chinese to “finance” its budget deficit. Actually, the US current account deficit provides Dollar claims to the Chinese, and the US budget deficit ensures these are in the form of “currency” (broadly defined to include cash,reserves, and Treasuries).

More generally, as J.M. Keynes argued, saving is actually a two-step process: given income, how much will be saved; and then given saving, in what form will it beheld. Thus, many who proffer the second objection—that nongovernment portfolio preferences can deviate from government spending plans–have in mind the portfolio preferences (that is, the second step) of the nongovernment sector.How can we be sure that the budget deficit that generates accumulation of claims on government will be consistent with portfolio preferences, even if the final saving position of the nongovernment sector is consistent with saving desires? The answer is that interest rates (and thus asset prices) adjust to ensure that the nongovernment sector is happy to hold its saving in the existing set of assets. Here we must turn to the role played by government interest-earning debt (“treasuries”, or bills and bonds) to gain an understanding.

For the purposes of this discussion, we can assume that anyone who sold goods and services to government did so voluntarily; we can also assume that any recipient of a government “transfer” payment was happy to receive the deposit. Recipients of government spending then can hold receipts in the form of a bank deposit, can withdraw cash, or can use the deposit to spend on goods, services,or assets.

 In the first case, no further portfolio effects occur. In the second case, bank reserves and deposit liabilities are reduced by the same amount (this can generate further actions if it reduces aggregate banking system reserves below desired or required levels—but those are always accommodated by the central bank to the extent that attempts by banks to adjust reserve holdings cause the targeted interest rate to move away from target). In the third case, the deposits shift to the sellers (of goods,services or assets). Only cash withdrawals or repayment of loans can reduce the quantity of bank deposits—otherwise only the names of the account holders change.

Still,these processes can affect prices—of goods, services, and most importantly of assets. If deposits and reserves created by government deficit spending are greater than desired at the aggregate level, then the “shifting of pockets” bids up prices of goods and services and asset prices, lowering interest rates. Modern central banks operate with an overnight interest rate target.

When excess reserves cause banks to bid the actual overnight rate below the target, this triggers an open market sale of government bonds that drains excess reserves. (As discussed in the response to comments last week, we modify this if the target interest rate is zero; or if the central bank pays a support rate below which excess reserves cannot push market rates.)

So the answer to the second objection about inconsistency of portfolio preferences is really quite simple: asset prices/interest rates adjust to ensure that the nongovernment’s portfolio preferences are aligned with the quantity of reserves and deposits that result from government spending—and if the central bank does not want short-term interest rates to move away from its target, it intervenes in the open market.

It is best to think of the net saving of the nongovernment sector as a consequence of the government’s deficit spending—which creates income and savings. These savings cannot pre-exist the deficits, since the net credits by government create the savings. Hence, the savings do not really “finance” the deficits, but rather the deficits create an equal amount of savings.

Finally,the fear that government might “print money” if the supply of finance proves insufficient is exposed as unwarranted. All government spending generates credits to private bank accounts—which could be counted as an increase of the money supply (initially, deposits and reserves go up by an amount equal to the government’s spending).

However, the portfolio preferences of the nongovernment sector will determine how many of the created reserves will be transformed into bonds, and incremental taxes paid will determine how many of the created reserves and deposits will be destroyed.

Next week: we’ll get more deeply into bond sales by government and impacts of budget deficits on interest rates.

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Budget Deficits and Saving, Reserves and Interest Rates Part 2: Responses to Blog #20

Posted on October 20, 2011 by | Comments Off on Budget Deficits and Saving, Reserves and Interest Rates Part 2: Responses to Blog #20

By L. Randall Wray

Q1:  Andy. What does”wonky” mean? 

A: Think “policy wonk” someone who gets all data-heavy andinto the deep technical details to do policy analysis. So it is used to warnthe reader that only those really interested in details needs to read on.

Q2: Ryan. Let’s assume the economy already works with fullcapacity, and the government would like to maintain it without any furtherinflation or deflation. Does the government now have to make an educated guess(regarding the exogenous part of gov. deficit) what the nongovernment savingdesire might be, so that it (government) fulfills its goal (full employment andprice stability). Kind of trying to hit moving target? And in this regard, isthe ELR governmental program kind of “shoot and forget” mechanism,which automatically, always finds, or helps to find the moving target(nongov.  saving desire)?

A: No, not really. Let us say government puts in place theELR and 20 million show up for work. Before the program was in place, everyonewas worried about the future—paying bills, losing jobs, etc. Net privatefinancial saving desires were, say, $1 trillion. No one wanted to spend. Nowwith 20 million new jobs and the certainty that you can find one reduces thesesaving desires. You go shopping. You feed your family. The private sectorstarts hiring, producing. GDP starts growing. You get recruited out of the ELRprogram into a hiring paying private sector job. You pay more taxes. Federalgovernment spending on ELR falls, its budget deficit falls into line with thelower net financial saving desires. The only planning you need by government isthe “real stuff”—create jobs. Govt does not need to try to hit the net savingdesires—that is done automatically.

Q3:  Paolo. “thisalso means it is impossible for the aggregate saving of the nongovernmentsector to be less than (or greater than) the budget deficit”Take the”greater than” option. What about a nongovt. sector export surplus?Wouldn’t that add net financial assets to the nongovt. sector aggregate savingsabove the amount generated by govt deficits?

A: Yes, Americans might also save in foreign currencydenominated assets—ie UK pounds. Those can come from export surpluses. I was talkingabout domestic currency. But you are correct, in some countries the net savingdesire could largely take the form of foreign currency (ie in places where USDollars are desired).
Q4. Guest. Prof. Wray, On page 7 of “Waiting for the Next Crach: The Minskyan Lessons Wefailed to Learn”(http://www.levyinstitute.org/p…, you said Goldman Sachslet hedge fund manage Henry Paulson design sure-to-fail synthetic CDO’s. Didyou mean John Paulson? If I’m not mistaken, Henry Paulson was Sec of treasuryduring the GFC…   Just checking, causeI’m sure John Paulson wants his credit for being one of the world’s premier**s****s.

A: Yes a helpful editor added the wrong first name. I thinkit is now corrected.
Q5: MamMoth, Dale, Neil, Samuel.  Many questions and comments on exogenous vsendogenous.

A: In economics the distinction between endogand exog is used in three different senses: control, theoretical, andstatistical. Only the econometricians reading this care about the last one soI’ll leave it. In the control sense it means the govt can “control” thevariable: ie control the money supply, control the interest rate, control theprice level. MMT shares with the “endogenous money” or “horizontalist”approaches the view that the CB cannot control the money supply or bankreserves. Instead the CB must accommodate the demand for reserves. HOWEVER thesetheories were formulated back when the interest rate paid on reserves was zerobut the Fed’s target overnight interest rate was nonzero. Excess reserves drovethe market (fed funds) rate below zero so the Fed would have to drain reservesby selling Treasuries. But now the Fed has a near zero interest rate target(like Japan) and so can leave excess reserves in the system and pay 25 basispoints on them and the market rate remains near 25 basis points.  So you could say that with QE the Fed“exogenously” increases bank reserves. There is an asymmetry, though, becausethe Fed can leave banks full of excess reserves but cannot leave them shortreserves—which would drive the market rate above the target. On the other hand,the CB’s target interest rate is clearly exog in the control sense: the Fed canset its target at 25 bp, or raise it at the next meeting to 150 bp. Finally,the control sense and the theoretical sense are related but not identical. Letus say the US had a fixed exchange rate and used the interest rate policy tohit the peg. We can say the interest rate is exogenously controlled (set by theFed) but it is not theoretically exog because the overriding policy is to pegthe exchange rate.

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

By L. Randall Wray

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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