The fiscal theory of monetary expansion

I am tired of theories of monetary expansion that ignore the considerable role of both commercial banks and fiscal authorities in the creation of money. To hear some people talk, you would think that all that is needed is for the central bank to increase base money (M0), and the total amount of money (M3) circulating in the economy will magically increase. So when the economy is on the floor, monetary conditions are tight and commercial banks not lending, inflate M0 by any means available and wait for life to return. This amounts to believing, in the face of considerable evidence to the contrary, that the earth is flat.

In a credit money system, the vast majority of money in circulation is created not by the central bank but by commercial banks. Furthermore, government deficit spending increases the total amount of money circulating in the economy (unless this money expansion is actively neutralised). Therefore the combination of fiscal authorities and commercial banks can create all the money required by the economy. Indeed it can create far too much, potentially triggering inflation. The job of the central bank is not to create money, but firstly to facilitate payments and secondly to limit the creation of money.

To those of you who are firm believers in the supremacy of central banks, this will seem like heresy. So let me explain how this works with the help of a simple example.

Imagine a sovereign country which issues its own fiat currency. The currency floats freely against other currencies. There is an extensive commercial banking system and a central bank which acts as lender of last resort for the private banks. The reserve requirement is zero and reserves are provided on demand to settle payments made by commercial banks. Most people in the country have bank accounts and the majority of transactions take place through banks. At the start of this example, reserves are zero and there is little physical cash, and consequently the central bank's balance sheet is very small. And (incredibly) the fiscal budget is exactly balanced in every period so that legacy debt doesn’t complicate the example. At the start of this example, therefore, the government's fiscal position is zero. It has no money. What little money is in circulation comes mainly from commercial bank lending to the private sector.

So our government puts together its budget for the year. It takes a while for tax receipts to arrive, and in the meantime it needs to pay wages to employees, benefits to recipients, payments to suppliers. We are used to governments funding their deficits by issuing bonds in advance of spending (more on this shortly), but let us assume for a moment that this government chooses not to pre-fund its deficit spending. How would it make these payments?

It would make them through a commercial bank, of course. Whether or not its transaction account at that bank actually contains any money is irrelevant. The government is the most creditworthy borrower in the country and the sole issuer of banking licences (which confer the right to create sovereign money). In the absence of pre-funding, therefore, the commercial bank would allow the government to make these payments by running an overdraft.

As the Bank of England explains, money is created when banks lend:
Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.
An overdraft is simply a bank loan of indeterminate duration. Overdraft financing of government spending therefore results in M3 expanding by the amount of the government's deficit.

This is, of course, monetary financing of the government deficit. It could be inflationary. So having forced a commercial bank to create money to fund its deficit, the government then drains the newly created money, leaving M3 at its original level.

The principal mechanism used to drain money created by government spending is bond issuance. Payments to government by purchasers of new bond issues are intermediated through the government’s commercial bank account, funding its deposit account and eliminating any overdraft. When a loan or overdraft is paid down, money is destroyed (eliminating the money created when the loan was made). Issuing new bonds ex post therefore reduces M3, while ex ante issuance prevents M3 expanding. Term deposits directly with the government (for example through NS&I) have the same effect.

And so do tax revenues. Bonds are redeemed as tax revenues are received. When the government’s spending (including bond interest payments) is entirely “financed” by bonds which are subsequently redeemed from tax revenues, the increase in M3 from government spending is wholly offset by the reduction in M3 from private sector purchases of new bonds, and their redemption from tax revenues is a wash. Regardless of how much the government spends, if it is wholly offset by bond issuance subsequently redeemed by taxation there is no net new money in the economy.

Of course, government spending may be expansionary for other reasons. Government expenditure mostly goes to people on low to middle incomes, who are likely to spend much of it, so increased government spending may raise the velocity of money even if M3 is unaffected. And investment expenditure can generate returns well in excess of the amount invested.

Government borrowing from central banks is inflationary when the absence of an external borrowing constraint enables the government to spend extravagantly and increased velocity arising from this pushes up prices and wages. This effect can be significant, but it would equally apply if government was borrowing from a captive commercial bank backed by unlimited central bank liquidity support. Prohibiting central bank financing but not commercial bank financing of government deficits is therefore absurd. Admittedly, if commercial banks are unwilling to fund the government deficit, the government can force the central bank to print physical currency and deliver it by a variety of mechanisms: helicopter drops, jars in the ground, brown envelopes, wheelbarrows…..But frankly, with a modern banking system, any government that had to resort to physical cash would already be in very deep trouble. After all, if it is so untrustworthy that domestic banks won’t lend to it, its days are numbered anyway.

Commercial bank lending to government is not really subject to central bank control. Central banks limit commercial bank lending to the private sector by controlling both the price of lending and its availability.  But as long as central banks are willing to supply reserves, and governments are willing to pay interest on their overdrafts, commercial banks will always create money for their governments. Central banks can discourage or prevent commercial banks lending to the private sector - but they can't stop commercial banks supporting their own government.After all, the central bank itself is beholden to its own government. The independence of central banks is entirely fictional.

But what about QE? If government bond issuance drains money, then surely a central bank purchasing bonds must create it.

Indeed it does. If a central bank - or a commercial bank, for that matter - buys all the bonds issued by a government in a budgetary cycle, M3 increases by the amount of the government's deficit exactly as if bonds had not been issued. So QE should be inflationary - and not because of magical multiplier effects arising from increased bank reserves, as flat-earthers monetarists think. Unless the central bank issues more physical cash, inflation comes from rising M3, not M0.

But there is little evidence that QE has much effect on consumer prices, although it does have a significant positive effect on asset prices. This seems to be because the distribution of the M3 increase arising from QE is very different from that arising from the original government spending. 

QE returns money to those who bought bonds, increasing bank reserves (M0) in the process. But increasing bank reserves does not force banks to lend. Returning money to the rich does not encourage them to distribute it more widely in the economy. Swapping one safe asset for another does not encourage the fearful to stop hoarding and spend money. And although QE might reduce yields on government bonds, this wouldn’t make any difference to monetary conditions: making it cheaper for governments to neutralise money growth doesn’t enhance money growth. Weakening the currency might help exporters but it wouldn’t improve domestic demand - indeed it might depress it still further by raising the price of imports.

It seems likely that because of its unfortunate distributional effects, QE simply cannot adequately replicate the velocity effects of direct government spending. Where the money goes matters even more than how much is created.The opportunity cost of relying on QE instead of fiscal stimulus after a severe negative demand shock, when fiscal multipliers are very large, is therefore considerable. And so is the harm done by premature fiscal consolidation undertaken in the belief that monetary policy will offset the negative effects. As I have shown here, it is painfully evident that QE does not fully offset the contractionary effects of fiscal consolidation.

So far, we have been talking about a currency-issuing sovereign with its own central bank. The Eurozone is more complex. But essentially, the same mechanism works there too. Spending in Euros by member state governments via Eurozone banks increases M3. Bond issuance by member state governments drains that increase, as does taxation. Central bank funding of government deficits is outlawed by Article 123 of the Lisbon Treaty, but commercial bank funding is not, so in theory there is nothing to prevent a Eurozone government forcing its banks to lend to it.

In fact they already do. But it's not a happy arrangement - and that is because rather than bank loans or overdrafts, governments have forced banks to buy bonds, exposing those banks to the risk of heavy losses if the market price of those bonds collapses. Since M3 rises when commercial banks buy bonds, these purchases have increased Eurozone M3. I hate to think what it would be without them. But this unfortunate arrangement is known as the sovereign-bank "doom loop", and so far no solution to it has been found. 

So why not replace those bonds with bank loans? Indeed why not end bond issuance completely, and fund government borrowing requirements entirely from bank lending, as Richard Werner of Southampton University has suggested? Hallelujah, we have a solution to the Eurozone crisis. Let all governments borrow directly from their banks to reflate their economies.

If only it were that simple. Eurozone member states have tied themselves into a treaty which requires them to balance their budgets over the business cycle and limit variation to 3% of GDP. To enforce compliance with these rules, the ECB has several times threatened to withdraw liquidity support from banks. Banks denied liquidity support cannot facilitate government spending. So even if Eurozone governments ended bond issuance tomorrow and funded their borrowing requirements entirely from bank lending, there would still be significant restriction of money growth due to ECB-enforced fiscal consolidation. And because the ECB, like all central banks, lacks the power to force commercial banks to lend, it cannot adequately offset this fiscal consolidation.

The only institutions that can create the money used for economic transactions in the real economy are commercial banks, and the only authority that can compel commercial banks to lend is the fiscal authority. Faux monetary expansion by central banks is no substitute for the real expansion caused by government deficit spending via commercial banks. So when the economy is on the floor, monetary conditions are tight and banks not lending to the private sector, unchain the fiscal authority - and stop worrying about deficits.

Related reading:

Printing clever weird stuff - Principles & Interest

Comments

  1. This comment has been removed by the author.

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  2. An interesting post. Thanks.

    I take a different, government centered, approach in my post cryptically entitled "The MV=PQ pathway to the MGB Monetary Base" found at

    http://mechanicalmoney.blogspot.com/2014/12/the-mvpq-path-to-mgb-monetary-base.html

    My base assumption is that any money received from government can be safely assumed to be genuine government issued money. Whether government first gets the money from banks, private borrowing or the printing press makes no difference to the people paid by government. Government money is always good.

    With that base assumption, the only question is how to measure how much money has been issued and how an increase of money supply might occur. Banks, I conclude, only have the illusion of creating money.

    Yes, banks create deposits with loans but the error here is to count bank deposits in an effort to learn how much government money might exist. An inventory of bank deposits would include both government created money and bank loan created money.

    There is certainly no agreement among economist on how fiat money is created! Thanks for your post and thoughts.

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    1. You can't tell the difference between "government created" and "bank created" money. They are to all intents and purposes the same thing. A dollar created by a bank and a dollar created by a government are identical and are equally honoured by government. Your quest to separate them is fruitless, I fear. Money is fungible.

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    2. Of course you are correct about both sources of money being fungible.

      The source of money becomes important when bank loans exceed the money available from the government issued supply. The source of original money for the first loan is important to bank stability.

      Please think of a bank loan of money that came from government. Government seldom recalls money it has issued. Money stably issued is safe to loan.

      On the other hand, money that represents a bank loan deposit is expected to be repaid and retired. With repeated lending of bank deposits, several people can lay claim to a single underlying base money unit. A bank run occurs when all claimants want to lay hands on the base unit at the same time.

      In the USA, the total of accumulated government debt is roughly the same as the monetary measure M2. This reflects the need to limit bank lending to little more than equal the amount of government based money needed to preserve bank stability.

      It is easy to know how much government issued money is in existence and how much bank money is in existence. Look at the loan documents to learn each amount. In the USA, the FED publishes the data.

      The Mxx measures reported by central banks are active monetary measures the CB uses to monitor and control interest rates and lending activity.

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    3. Roger,

      Be very careful what you ask for. The monetary tightening arising from the sudden imposition of 100% reserve banking (which is actually what you are proposing, though you may not have realised that) would be a severe negative shock to the economy. I can't for the life of me see why the worries of the holders of money that their deposits might not be quite safe justify knocking the economy into another black hole. Apart from anything else, clobbering the economy in the interests of making money "safe" is the worst possible thing you can do to the holders of money.

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    4. Frances,

      I had not thought about the situation as a version of 100% reserve banking but you are correct.

      Interesting, it seems to me that the USA has followed this policy for the last 40 years or more. A chart included in the post at

      http://mechanicalmoney.blogspot.com/2014/12/the-mvpq-path-to-mgb-monetary-base.html

      is offered in support of this claim.

      Your post has provoked some informative discussion. Congratulations and thanks.

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    5. Frances,

      "You can't tell the difference between "government created" and "bank created" money."

      Yes you can. Government created money is government issued physical currency + deposits at the central bank. Commercial banks create commercial bank deposits. The two are clearly different things.

      "They are to all intents and purposes the same thing." No, they are not. To a bank customer, a bank deposit might be as good as currency if the deposit is fully guaranteed via government-backed deposit insurance. But that does not actually make the deposit the same thing as government money.

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    6. Phlippe,

      Bank-created and government-created money are fully fungible. Since banks guarantee to convert bank money to government money at par, as far as customers are concerned they are indistinguishable. In a modern monetary economy where the vast majority of money in circulation is bank-created, it is not remotely credible to assert that bank-created money is different from government money - especially if the bank concerned is owned by the state (RBS?). Banks are licensed to create money on behalf of the state.

      This has nothing to do with whether or not the state guarantees bank liabilities. If you lend £100 in physical cash to your next door neighbour, and he loses the lot at the local betting shop, the government does not reimburse you even though it is government-created money that you have lost. A bank deposit is a loan to a bank. Even if the government doesn't reimburse you in the event of losses, that doesn't mean the money isn't real. "Let the lender beware".

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    7. A commercial bank deposit is a loan to a commercial bank, whereas government money is not. Banks can default on loans, hence a basic difference.

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    8. You're still confusing the deposit (loan to the bank) with the thing deposited (money).

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    9. No, I'm not confusing them. I'm saying they are different, whereas you have said that bank deposits and base money are the same.

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    10. Not bank deposits and base money - bank deposits and currency. To all intents and purposes, as far as the average Joe is concerned, these days bank deposits and currency are the same thing. Bank reserves are completely different - the average Joe never sees them and probably doesn't know they exist. See my brief discussion with JKH about this towards the end of this comments stream.

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    11. bank deposits and currency are only the same thing, in the eyes of the public, up to the deposit insurance limit, which is £85,000 in the UK I think.

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    12. No, you are confusing money and bank liabilities again. The owner of a deposit in excess of £85k knows her funds are at risk, because she has lent them to the bank with no insurance cover, but she still sees them as cash.

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    13. In fact the public generally thinks ALL money put aside as "savings" should be 100% safe - including investments in pension funds and ISAs. Hence the continuing calls for compensation by Equitable Life pension investors.

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    14. "The owner of a deposit in excess of £85k knows her funds are at risk, because she has lent them to the bank with no insurance cover, but she still sees them as cash"

      Bank deposits under £85,000 are not supposed to be at risk because they are insured, and that insurance is guaranteed by the government. So they are effectively the same thing as cash or base money as far as the public is concerned. Above that amount, bank deposits are not the same thing as cash.

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    15. "you are confusing money and bank liabilities again"

      I don't know why you think I'm doing that. Bank deposits are a form of money, but not the same form of money as currency or central bank deposits.

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    16. Yes, so you keep saying. I am asking you to abandon your preconceptions and look at how the system actually works - including people's expectations, which do matter. I can buy you a drink just as easily with a card transaction (bank-created money) as I can with currency (base money). The retailer and I are completely indifferent as to which form of money is used. In practice, no-one cares whether it is base or bank money. Currency is far more like bank money than it is like bank reserves. The fact that reserves can be held in the form of physical currency is irrelevant. Reserves - whether electronic or physical - are not money "in circulation". Physical currency in my pocket is money "in circulation", and so is my bank account. That to my mind is a far more useful distinction than this artificial base versus bank money.

      I'm aware that bank deposits above £85k are not insured. But that has nothing to do with the money itself. If I put £100k of used notes in my garden shed it would not be covered by my house insurance, but it would still be money.

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    17. Money is fungible but how it's created is critical for modern societies to understand since it can be created with or without an automatic drain or reflux. If we regard a prime role of money to be the enabling of the contracting of obligations between individuals and organisations to supply the goods and services we all need then optimising its quantity, distribution and value within an economy and between economies is crucial.

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  3. "Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. " I don't know why we're still pretending these are loans. This is money creation, pure and simple. Let's abandon all notion that there's any 'loan' involved here. Fraud maybe, on the part of the bank, but no loan. Let's not forget either this money creation can't take place without a signature from a member of the public, something which is often overlooked. It takes two to perform this particular tango, both a bank and a signatory.

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    2. Yes the term loan is semantically awkward. Monetization would be a more appropriate term although that word itself is popularly used for a variety of things nowadays, not just "create money or currency". The bank monetizes the customer's IOU. You could say, from a different approach, that a bank lends its financial credibility, as its assets outweigh its liabilities. In that way it "lends" the use of its capital. Capital as in assets minus liabilities.

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  4. > Frances

    I have never heard of governments having overdrafts with commercial banks , is this part of the post hypothetical.

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    1. Are you sure about that? What about an open line od credit of say NHS in a commercial bank?

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    2. Good example, BTO. You won't find "government" overdrafts as such at commercial banks, but you will find overdraft facilities for schools, local authorities, hospitals, GP practices - all of which are public sector bodies and therefore "government". I'd be willing to bet that government departments such as DWP also have "working capital" lines of credit (which are overdrafts, really) with commercial banks. As usual, when macro ignores micro, it gets it wrong.

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    3. Thanks Frances,

      In continental Europe where sovereign money creation was outsourced to private banks we have bigger examples than schools, hospitals etc. :)

      Again, in Poland - ZUS which is an equivalent of American Social Security or forgive me if I am wrong British NHS keeps a permanent , open line of credit with commercial banks. This is a huge institution constituting a big chunk of the public expenditures.

      I could write something about the recently scrapped pension system "reform" called OFE that by default had been keepeing ZUS/public budget in a multibillion PLN overdraft position with the commercial banks. They had to let it go because there was no way to reconcile this scam with Maastricht related constraints.

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    4. One more thing regarding QE. Interest payments on bonds kept by private sector constitutes its income and moving these cash flows to CB via QE removes this part of purchasing power from the econmoy. This is a pure deflationary mechanism :)

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    5. So really it is hypothetical as the treasury doesn't have overdrafts with commercial banks. There’s no reason for increasing M3 by this hypothetical method anyway as if you want to increase the amount of deposits in the custody of the general population by deficit spending then you advocate bond financed deficit spending . The rest is monetary policy, if the BoE doesn’t want the selling of Bonds to disrupt the investment markets or interest rates then there is QE and OMO.

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    6. Dinero,

      I did not mention the treasury. I said government. And by that I meant ALL of government. Government does not need to "finance" deficit spending with bond issuance: bond issuance ensures that deficit spending does not cause money supply growth. But if what you need is money supply growth, issuing bonds to "finance" the government deficit then using central bank tricks to restore the money drained by the bond issues is sheer insanity.

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    7. Whether or not you want money supply growth is a monetary observation. If you want to put deposits in the custody of spenders that is a political observation. There is no need to complicate it, by blurring the lines between the two. There is no point in increasing M3 for the sake of it. As you observed putting M3 in the hands of savers will not have the consequence desired.
      GP practices are private bodies, health trusts can go bankrupt, Schools of the academy type are also private concerns I suspect, so the "government" bodies you and BTO have mentioned are off balance sheet , those overdrafts are not what constitutes the deficit. First we need to define how the deficit is calculated and defined.

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    8. ZUS liabilities to OFEs had been going into deficit calculation this is , as I mentioned before, the only reason they were terminated ( OFEs ) .

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    9. I would be surprised if the UK public sector was borrowing, or had the facility to borrow, anything more than peanuts from the commercial banks, as it is more expensive than borrowing from the government (IIRC, the UK used to have lenders like the Public Works Loan Board and the National Loans Fund doing this). But I don't see anything that in principle would stop any part of government from borrowing more from commercial banks.

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    10. By the way, the idea that the government should expand broad money by borrowing from commercial banks was being promoted by Tim Congdon years ago. The trouble with the 1980s focus on broad money was that it is not clear that expanding broad money has any more effect on economic activity and inflation than expanding base money by QE.

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    11. Tim,

      I don't think pure "quantity of money" effects really work, whether you are targeting base or broad money. The relationship between the quantity of money and economic activity in my view is not linear. This is where I depart from Richard Werner's thesis. In my view the distribution of money matters more than the total quantity, and the price of money controls its distribution. And banks can't always expand their productive lending.

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    12. What would the point of creating broad money, more deposits, by the Gov borrowing from commercial banks directly and oppening deposit accounts. As we know banks dont use deposits for clearing. All that would happen is that on day one the Gov would have a deposit then on day two it would spend it and the recipient would then have a deposit and the original bank would have clear that with reserves obtained by swapping the Gilt with the BoE, which it may as well have done on day one by buying bonds from the Treasury which then create deposits in commercial banks when the Treasury spends. Overall its the same process, with an extra step where the Government temporarilly has a deposit in a commercial bank account.

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  5. Money's always someone's liability.

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    1. That’s certainly true of money issued by commercial banks: the holder of such money can demand any time that their holding of commercial bank “funny money” be converted to central bank money. In fact people do that when the withdraw physical cash from ATMs. On the other hand, in what sense is central bank issued money a LIABILITY of the CB? As far as domestic holders of CB money are concerned, the CB is not obliged to convert that money to anything. I.e. such money is irredeemable. So it’s not really a liability. Moreover, the state can simply confiscate such money from private sector entities in the form of extra tax. The word “liability” does not normally refer to a debt owed by A to B which A can nullify whenever A chooses. So it’s debatable as what extent base money is a liability of the CB / state.

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    2. In practice it is the same liability as a commercial bank deposit is for a commercial bank as its assets have to back its liabilities in the same way as a commercial bank.

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    3. @Ralph Musgrave: It is a liability of the central bank in the sense that the CB must pay interest on it to the commercial banks. In normal times this interest is just the Fed Funds rate. Nowadays, it is "interest on excess reserves". The ECB, on the other hand, "pays" negative interest on excess reserves. But, ultimately, it doesn't matter. If these central banks intend to tighten policy at some point (and supposedly they will), then they will have to pay interest on all bank reserves.

      Since the assets of the Fed and the ECB are not risk-free in the same way that bank reserves are, they might find themselves in a negative equity position. How are they going to pay interest on trillions of dollars of reserves if they don't have any liquid capital? I guess they could create the money to do so, but this raises the amount of reserves on which the CB must pay interest even further. Wonder who would win this race, the dog or the tail!

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    4. Dinero,

      Nope. Suppose the state had no assets at all. What of it? Assuming the state’s money really is some sort of liability, it could meet that liability out of tax. But in reality, it doesn’t even need do the latter. To illustrate, if you let the state QE £X of Gilts that you own, you then become the holder of £X of base money. Pray tell me what the state then owes you: £X worth of gold?

      Jenkins,

      The Fed Funds Rate is the rate commercial banks charge each other when borrowing / lending reserves to each other. It’s not a liability of the Fed, as I understand it. It’s true the Fed about three years ago decided to start paying a small amount of interest on reserves (for reasons which baffle me).

      As to what would happen if a central bank was short of assets or money needed to pay interest of the latter sort, central banks and treasuries are effectively part of the same government machine. CB profits / losses have been remitted to the treasury at the end of every year for decades. So if the CB was short of money, it could just tell the treasury to screw some extra money from taxpayers and give it to the CB.

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    6. The assets of the CB are not the assets of the state in the first instance. They are the assets on the assets side of its T account like a commercial bank, for the CB that is mainly Government bonds but also gold. If you sell gilts to the BoE you don't get base money you get a deposit in your bank. If you are not acknowledging a fundamental fact that money is a conduit between real transactions and a record of those real transactions outstanding therefore you can then entertain this notion that it can be made out of thin air without a reference to human action, liability or asset.
      CBs pay interest on required reserves which really nullifies your idea that they are not a liability as unfunded interest payments would create more liabilities add infinitum. I don't see why you call bank money "funny money" Bank deposits are the predonimnant form of money and participation in the BoE reserve scheme is voluntary , there are no reserve requirements mandated in the UK.

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    7. The bank doesn't have to present you with a gold piece on demand but it does have a liabilaty that the debtors in aggregate provide something for you to buy that gives your deposit value.

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    8. Whether they pay interest or not (and Ralph is correct about Fed funds being paid by commercial banks rather than the Fed), reserves are a kind of liability of the central bank to the rest of the economy generally as long as there is an inflation target. That is because the inflation target commits the central bank to redeem the reserves if their value drops because the rest of the economy is trying to get rid of them.

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    9. Jenkins, Ralph and Tim

      Prior to 2008 reserve holdings at the Fed in excess of the reserve requirement were not remunerated at all. Now they are remunerated at the IOER rate, which currently stands at 25 basis points. The Fed Funds rate is a market rate determined by financial institutions themselves (not just banks). For the last six years it has occupied a corridor between the IOER rate and zero. I explain why in this post from nearly two years ago: http://coppolacomment.blogspot.co.uk/2013/02/floors-and-ceilings.html

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  6. "Designing Regional Currencies
    1. 1 RC = 1 euro/dollar.
    I.e., they use the accounting function of the dominant currency. This comes in handy for two reasons.
    First, it allows price transparency. If the RC is allowed to ‘float’ it means small transactions in shops involve calculations which may change per day. Your bread will cost $2/3RC one day and $2/2,5RC the next.
    It is also minimizes complications for the firm’s bookkeeping: they don’t need a second ledger and can just add up their income in RC with their dollar/euro income and pay taxes in dollar/euro over the total.

    2. People can buy them with a discount, usually for around 95 cents.
    It can vary from RC to RC: some will offer them for 90 cents, others for 97. But let’s stick with 95 cents here. This means buyers of the RC pay 95 cents for 1 dollar/euro of purchasing power. This gives a useful incentive to people to pay with the RC.
    Businesses can sell their RCs back to its supplier for the same price: they get 95 cents back for 1 RC. This amounts to a small loss. They accepted the RC at face value (1 RC = 1 dollar/euro). But of course this invites them to try and spend the RC themselves, instead of converting back to dollar/euro and in effect taking the RC out of circulation.

    3. Euro/dollar backing allows convertibility……
    Because the RC is sold for dollar/euro, with a discount, there is always 95 cents for every RC in circulation. This is how convertibility is created.

    4. …but it destroys interest free credit.
    There can never be more RCs in circulation than the issuing organization has dollar/euro in the bank as backing. No RCs therefore can be lent out, not interest free, anyway.
    This is the key limitation of this system. The Chiemgauer, which is the largest RC in Germany, circulating in and around Rosenheim, near Munchen, is a good example. They are successful, see turnover grow with 100% per annum. They cooperate with an Anthroposophical bank (GLS Bank), allowing them to offer bankaccounts in Chiemgauer. But they can’t offer interest free credit in Chiemgauer. In fact, they are one of the very few offering credit at all, but at a fairly steep price of 7%.

    5. Demurrage
    Still, RCs can be successful in dampening the interest drain to the plutocracy, because they do bring down capital costs. Not by interest free credit, but by making better use of available money by letting it circulate quicker.
    A dollar/euro may go round 8 to 10 times a year, facilitating a total of 8 to 10 dollar/euro worth of trade.
    Demurrage is a penalty on holding cash: typically about 12% per year. A demurrage will facilitate a massive increase in velocity of circulation. The famous Wörgl experiment saw its units circulate up to 130 times during the 13 months it was in operation.
    This means that with the same amount of cash op to 13 times more trade can be financed, in effect slashing capital costs by more than 90%."
    Anthony Migcheals.

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    1. Anthony Migcheals ( never heard of him before ) is piggybacking on Silvio Gessel's ideas written around a century ago. Lots of stuff Keynes wrote comes from Gessel as well .

      "The natural economic order" written by him in 1920 should be easily obtainable free online if not I will send the coppy to anyone interested. Good read.

      Depreciating money, utopian anarchism, local currencies etc. but why can't we just target full employment coupled with say 2-4 % CPI ?

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    2. I know nothing about the man other then what I have read and from this I believe he is involved in some practical local scheme of mutual credit.
      He freely admits he has been on a steep learning curve since he became politicalized in the aftermath of the series of gulf wars post cold war much like the rest of us.

      Getting on to real energy flows this can point to the underlining motive of these money games.
      The IEA energy electricity stats for the period Jan to sep is pointing to some very strange data artifacts.
      Both the UK and France is showing the biggest decline of electricity of 5 and a half and 6 and a half % respectively.
      This is a massive decline.
      Other typical euro countries are all in a decline phase of in the range of 1 to 3 % including Greece and Spain.

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    3. If we regard both the UK and France as the centre of the extreme usury experiment known as the European union this data begins to make sense even if at first it appears to confirm a depression in the UK and France.
      Both countries but especially the uk remain in extreme goods deficit as that is where the money is.
      Other euro vassals are forced to export real wealth to the core in exchange for tokens to pay interest causing a total collapse of both local and national exchange in Greek land
      The nature of the consumption in the periphery is therefore not about the person - its a conduit type of affair.
      We are seeing a collapse of electricity demand in the UK and France simply because very little production to supply local demand is needed.
      However The colonies must toil in the sweatshop burning the midnight oil.

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  7. Current economic activity in cork is very expansionary and therefore resource intensive but with little to no critical mass , this is the classic symptom of a over scaled banking system.
    The goods produced and consumed
    can never be used effectively.

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  8. http://economic-incentives.blogspot.ie/2014/12/increased-traffic-points-to-economic.html

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  9. Great post Frances.

    My only quibble would be that, in the current situation, I think we're over-concerned with inflation. Of course an increase in money supply is *potentially* inflationary. But where the supply of goods and labour is not scarce, the danger of inflation is much reduced.

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    1. Yes, I completely agree. But those who grew up in the 1970s are perhaps unhealthily concerned with inflation, and they are the ones currently determining policy.

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    2. I'm not sure that it's to do with the 70s - I think it's a political decision. Prioritising low inflation over low unemployment is effectively prioritising today's money over tomorrow's - which is something that the rich rather like.

      Taken to extremes, we see the two "dry" members of the MPC who are prepared to raise interest rates to suppress even a threat of wage increases, when they have already been suppressed for many years.

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    3. Count me in! I grew up in the 1970s, and I am concerned with easy money, if not yet inflation. If not the inflation itself, the easy solution mentality of that time was a disaster. If you want prosperity, you have to produce things of value, and live off them or the proceeds of selling them. This is where the Germans get it right, and why I hope they successfully resist the QEezers.

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  10. We live within a economic world where the primary motive of the bankers in the city is energy capture and concentration.
    The current amount of energy needed to waste so the guys in London can capture the surplus is immense.
    We get this empty buses / street filled with cars scene everywhere we look.

    This drive toward concentration is nothing new under the sun.
    The troika came to Dingle in the later part of the 1500s..........the objective was the capture of energy (food for human and animal labour)was the oil of the day

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  11. Frances says “The only institutions that can create the money used for economic transactions in the real economy are commercial banks…”. Actually there is nothing to stop the state creating and spending as much of its own money as it likes – even to the extent of causing hyperinflation, as Robert Mugabe demonstrated.

    Where central bank and treasury are combined, that would be done by simply by having the state print and spend. In contrast, where CB and treasury are separate, it’s done by having the treasury borrow and spend, with the CB immediately QEing he relevant bonds (more or less what we’ve done over the last two or three years). But the two come to the same thing.

    Of course, having created and spent £X of that state created money into the economy, commercial banks assets and liabilities rise by the same amount (£X). (That’s assets in the form of reserves at the CB, and liabilities in the form of amounts owed to customers / depositors.) But that’s just a technicality: it arises from the fact that very few entities are allowed to have accounts at the CB. I.e. commercial banks act as agents for you and me at the CB.

    So in effect, there’s no limit to the amount of state created money that can be created and spent into the economy. And taking that even further, there’s no big technical difficulty in banning money creation by commercial banks altogether.

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    1. Ralph,

      Let's play some thought experiment please:

      Actually there is nothing to stop person X from eating as much of its own food as it likes – even to the extent of causing severe obesity, as some unfortunate examples demonstrate.

      Does it mean that we should hire a cop for each fridge lest people get overweight ?

      People can get killed jumping from the height of, second floor. Do we ban second floors?

      I can go on and on . Reductio ad absurdum can be performed on anything .



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    2. BTO,

      I’m completely baffled as to what your point is. You seem to think I’m saying that because the state can create and spend any amount of money it likes, that therefore we have to take strange measures of some sort to stop it doing so. I actually said nothing of the sort.

      I was simply disagreeing with Frances’s claim that only private banks can “create the money used for economic transactions”. In fact the state can create such money just as easily and in any quantity it likes.

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    3. No, Ralph, it can't. In a Western monetary economy where the vast majority of money is bank deposits, the state cannot create the money it needs without the cooperation of banks. The central bank can create physical currency, but how many state employees are paid in cash these days? They want their wages paid by BACS like everyone else's. Government pays private sector agents through commercial banks. Even a cheque has to be drawn on a commercial bank - and who do you think creates the deposit entries to settle it? Government authorises the creation of money, and commercial banks create it on behalf of government (apart from physical currency).

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    4. @Ralph

      This exactly how I misunderstood you. Please ignore my comment.

      Regarding your opinion exchange with Frances. Government might decide to open its own commercial bank 😄

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    5. Frances,

      This is a bit semantic, but I don’t agree with your claim that “..the state cannot create the money it needs without the cooperation of banks.” In the case of QE, the BoE produces money from thin air and sends cheques or makes BACS payments to bond holders, who in turn deposit the money at their commercial bank, which in turn gets the BoE to credit the commercial bank’s account at the BoE.

      That constitutes “money creation” by the BoE doesn’t it? I agree that that money cannot CIRCULATE in the economy without the cooperation of commercial banks, but that’s only because of a technicality: because we have a rule that severely limits the number of people / entities that have accounts at the BoE. If, as argued by William Hummel, everyone had an account at the central bank then the cooperation of commercial banks wouldn’t be essential.

      Put another way, when the BoE creates money and dishes it out, commercial banks act as agents for recipients of that money. But in that scenario, those commercial banks don’t actually CREATE the money.

      In contrast, I quite agree that most money is created when commercial banks grant loans. That money is certainly created by commercial banks.

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    6. Ralph, that isn't how QE is done. The process for LSAP from non-banks is as follows:

      1. Commercial banks buy bonds from non-banks, creating money as they do so
      2. Commercial banks exchange bonds for newly created reserves at the central bank.

      But even if the central bank DID buy bonds directly by BACS or issuing cheques, those payments would still be intermediated through commercial banks, since non-banks do not have accounts at the central bank. Reserves - the liabilities of central banks - are assets on commercial bank balance sheets, therefore commercial banks would have to create the associated deposits. However you look at it, commercial banks create money when the central bank buys assets from non-banks.

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  12. "This is, of course, monetary financing of the government deficit. It could be inflationary. "

    You are repeating here a monetarist talking point that is a myth. http://neweconomicperspectives.org/2009/11/what-if-government-just-prints-money.html

    Any spending, public or private, could be inflationary, it doesn't matter how you finance it: by having a private bank print a deposit out of thin air, or the government print a bond out of thin air or the government print currency out of thin air.

    "government deficit spending increases the total amount of money circulating in the economy (unless this money expansion is actively neutralised)"

    You cannot neutralize government spending unless by taxing. Financial assets are increased by deficits and with the CB guarding liquidity it doesn't matter if these new assets are bonds or currency - the CB must accommodate the private sector if it wants to flip between them. Monetary policy cannot neutralize the new assets that the deficit spending injected, it can only change their composition.

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    1. You're an MMT-er, aren't you?

      Point 1 re inflation: in your anxiety to prove me wrong, you have completely missed the point.

      In Western monetary economies, ALL money that is capable of causing inflation is actually created by commercial banks, since the amount of physical cash in circulation is declining. It does not matter whether the commercial bank created the money in the course of lending to the private sector or lending to the public sector. What matters is where the money goes. If it goes into consumer spending, it will tend to raise consumer prices (ceteris paribus). If it goes into asset purchases, it will tend to raise asset prices.

      This, by the way, is why QE is not "inflationary" in the normal sense of the word. It goes into asset purchases almost exclusively, raising asset prices substantially (you might regard this as asset price inflation) but making little difference to consumer prices.

      Point 2: I am not talking about financial assets, I am talking about money. MMT does not distinguish between the two, but I do.

      When bonds are issued, money is withdrawn from circulation and replaced with a financial asset that is much less liquid. You just try paying for your shopping with government bonds. Go on, try it.

      Technically, government bonds are a future claim on money - so money is temporarily withdrawn from circulation with a promise that it will be restored later on.

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    2. It seems to me that there is a second option: A repeated, nearly equal, annual injection of new money can become the expected flow of money. Because it is expected, it does not cause inflation but instead, becomes part of the steady state.

      An example based on individual borrowing will illustrate: An individual can borrow $1000 additional each year and spend the extra money to live more luxuriously. He or she can do this so long as the lending source will allow. Each successive annual borrowing will only perpetuate the initial increase that was initiated with the first borrowing. A reversion to the original base spending will only occur when the annual new additional loan is denied.

      This is an example of repeated injections of new money that will not be expected to cause inflation.

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    3. Here are four references explaining how in practice a sovereign government creates money for deficit spending by the simple expedient of pressing buttons on a computer keyboard:-

      http://neweconomicperspectives.org/2010/11/yes-deficit-spending-adds-to-private.html

      http://heteconomist.com/exercising-currency-sovereignty-under-self-imposed-constraints/

      Pages 98 to 109 "Modern Money Theory" L. Randall Wray.

      https://www.youtube.com/watch?v=odPfHY4ekHA

      From 8:00 minute mark.




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    4. I looked at the video on the link that you have in your comment , At 8:00 minute mark Bernanke says "to lend to a bank" . The words are "to lend to a bank" . That is not creating money by pressing buttons on a keyboard as you say, that is conventional T account book keeping. The Fed now has an asset which is the loan agreement with the bank. It is a conventional loan process.

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    5. In your anxiety to prove me wrong you have completely missed the point. Whether the deficit is "monetarlity financed" of bond financed has no impact on the purchasing power and since prices.

      pt2. If you distinguish between assets and money, it is your mistake, and MMT has it right. It is exactly the monetarist affliction. In a world where the private sector can swap between "money" and "non-money" it doesn't make sense to distinguish. So operations that increase M3 and decrease bond holdings by exact same amount are not to be gotten excited about.

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    6. Point 1: no, it is you who has missed the point. "Monetary financing" by the central bank, bond issuance and term deposits all have the same effect - they REDUCE money in circulation. The only form of "monetary financing" that actually increases money in circulation is commercial bank lending to government. If monetary financing by commercial banks is not sterilised by bond issuance, central bank monetisation or term deposits, it can be inflationary.

      Point 2: When I have an app on my phone that instantaneously allows me to draw on my holdings of government debt to pay for my coffee in Starbucks, I will accept that financial assets and money are indistinguishable. Until then you can live in your monetary fantasy world, and I will continue to live in the real world where money and financial assets are not fully fungible.

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    7. Like monetarists, you miss the fact that money doesn't spend itself, so if someone ends up with more money and same wealth, they are unlikely to spend more. Plus we live in a world with central banks: bond holdings are not a constraint you are doomed to live with - you sell it on the market and the CB defending the rate is the buyer of last resort.

      On the monetary financing: study the accounting, go through Fullwiler's examples. The burden of proof is on you here, because your theory violates accounting. Even in your world where deposits spend themselves whether banks buy bonds or they issue overdrafts - deposits are the same.

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    8. Actually, if someone has more money and the same wealth AND they have not fulfilled all their personal wants, they are likely to spend more, ceteris paribus. Hence the average propensity to spend of the poor is positive, whereas the average propensity to spend of the rich is zero - as you said. In effect, you have assumed that everyone is rich. It is reasonable to assume that the poor have little or no wealth, but that is not what you said.

      But this post is a discussion of monetary effects only, not the effect on demand of raising M3, which I have not specifically addressed in this post. I said increasing M3 COULD be inflationary. I did not say it definitely would. Changes in the money supply don't have a linear effect on demand. I am no monetarist.

      However, there is a widespread belief among policymakers - whether justified or not - that unsterilised deficit spending is inflationary, and that is the principal driver of sterilisation actions. Beliefs often have more effect on policy than logic.

      No, my theory does not violate accounting. You have assumed that the buyers of government bonds are banks. If a bank buys government bonds - whether newly issued or on the secondary market - M3 rises since the bank creates money when it spends: therefore bank purchases of new bonds don't sterilise the money effect of deficit spending. In effect, the bank is lending to government. But if non-banks buy newly issued bonds, M3 falls (unless they fund their purchase with new bank credit, of course). Go through the accounting yourself and work it out.

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    9. Roger,

      You haven't thought about where the money goes when it is spent. It isn't destroyed - it goes to the suppliers of the goods and services that individual is consuming. One individual borrowing to fund a luxurious lifestyle in this manner wouldn't make any difference to inflation, but if everyone borrowed repeatedly to spend in this manner, it would raise consumer prices and/or asset prices.

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    10. It is, I think, a shame that people get so dogmatic about these points. It seems most likely to me that bonds are not a perfect substitute for base money, so that bonds and money should not just be lumped together as Net Financial Assets, but a relatively close substitute, so QE might be expected to produce a weak increase in purchasing power. Come to think of it, this probably reflects an increase in private sector wealth anyway, since the central bank has to pay up a bit to persuade the holders of treasury bonds to sell them (a fact that may be hidden if the central bank does its accounting on a historic cost basis).

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    11. Dinero. To argue that the purchase of toxic mortgage bonds represents obtaining sound assets is stretching the truth! Indeed they were the trigger for the financial crisis because they were not created by transparent market processes to determine true value. You also need to read the web references I also provided because what is at issue here in this article and the comments is understanding a primary purpose of human beings using money which is that it enables us as a species to contract obligations with each other to provide the goods and services we all need. If there is insufficient of it actively circulating on a broadly distributed basis this cuts down the ability of all to obtain the goods and services they need. It is erroneous to believe that the supply of this money is primarily driven by banks loans simply because interest on the loans plus reserves have to be obtained from somewhere to grow an economy and that somewhere can only be a sovereign government. Ponzi lending by private banks to create the interest on interest on interest is clearly not going to work.

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    12. Its not striclty true that interest has to be created have to fund interest payents. As long as Bank share holders spend the interst it can then re-circulate in the economy to repay further interest payments. Up untill the very last one perhaps.

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    13. Dinero. But you can hardly rely on this to regulate an economy (in terms of having adequate money circulating in an economy without over-bidding resources) especially since money management increasingly seems to be focused on making money on money by way of asset inflation rather than investment in the real economy of producing goods and services. Also you neglect the creation of reserves by private banks.

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    14. Schofield,

      Private banks don't create reserves. But they can force central banks to do so.

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    15. I used the term generically to refer to private banks loss absorbing capacity.

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    16. Ah. Then you are referring to capital reserves (equity), whereas we have been talking about cash reserves (asset).

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    17. Yes because I'm asking Dinero to consider where this equity can come from given that accounting for the domestic private sector as a whole one set of entities profits come out of another set of entities "pockets" and therefore net to zero.

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    18. This comment has been removed by the author.

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    19. > Schofield
      The equity comes from the capitilastion of the re-circulating loan repayments. A loan of £100 can be settled with £1 if it keeps re-circulating. Equity means more is owed than is lent, a greater amount owed than is lent can be settled as long as the loaned amount keeps recirculating.

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    20. Dinero, this is wrong.

      Equity is the difference between assets & liabilities on the bank's balance sheet. Deposits are liabilities, loans are assets. So the bank's equity actually means it owes LESS than it has lent. In practice banks also have cash reserves, which are their own deposits at the central bank and sit on the ASSET side of their balance sheets. So total assets = loans + reserves, total liabilities = deposits, equity (also known as capital) = assets - liabilities.

      Banks can increase their equity by replacing deposits with shares (debt for equity swap) - this is the famous "bail-in". Or they can issue more shares (a rights issue). Or they can increase their equity organically by retaining profits on their balance sheets instead of dishing them out in dividends and bonuses. Lending itself does not increase equity, but the interest earnings on lending may do.

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    21. It is not wrong.

      When I typed more is owed than is lent I am refering to the banks borrowing customer owing more than is lent to them by the bank. Therefore the bank has equity across the sum of its balance sheet.

      This situation can occur from loan arangement fees.

      Eg a borrower borrows £100 000 and an arrangement fee of £1000 is levied. And so they owe £100 000 and they have borrowed £99 000.
      So the bank has equity immediately of 1%.

      Equity is generated endogenousely in the loan process. Or more conventionally the Equity comes from the capitilised loan repayments.

      Now Lets get to the point - Schofield asks where can this equity come from , he wants to know how can this balancing sum be repaid as it was never issued in the original loan process
      - as I replied it can be repaid as a single currency unit can re -circulate and clear accounting multiples of currency units as it does so.

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    22. Dinero. As I said before do the maths. Try working out the increasing compound interest on loan after loan to pay the original loan compound interest eventually a point is reached where a loan has to be taken out with no principal but simply to pay the accumulated interest. Even Bernie Madoff couldn't fool a prudent and honest banker over such a loan request! In consequence the question has to be asked where can the money come from to pay loan interest in aggregate for the domestic private sector without attracting a further interest penalty. There are only two possible sources.

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    23. > Schofield

      Here is the maths for you

      January the private sector borrows £100 billion with 10% interest due. Next january they pay £10 Billion interest which is payed to the bank employees and shareholders which is then spent with the private sector, and so the private sector has these deposits back in their custody because it has been re-circulated. at the end of year two the private has this money to pay the interest due for year two. You are thinking of bank T accounts , principle , and interest as if they were piles of something physical. They are not. They are accounting records of monies due. They don't need to be settled with stocks , they can be settled with flows. A single currency unit can re -circulate many times and clear accounting entries of multiples of currency units as it does so

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    24. Dinero. You are ignoring the following drains or destruction of money; repayment of loans which cancels money out, taxation on loan money creation and the desire to save including the making of money on money which also takes money out of active circulation. You also ignore the effect of recessions which can selectively destroy the value of money sometimes below the point when bankers and/or politicians first began inflating the value. So for example "big ticket" items like many American homes have not fully recovered their 2006 peak value but when it comes to replacing their cars they find that car prices have continued to rise.

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    25. Dinero. Of course, you need to add to my list of drains as explained above that if a bank wishes to grow it also needs to consider the retention of profits for its equity ratio.

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  13. Is there any point in settings targets for M0/M1/M2/M3 money growth? Suppose that M3 grew in the US by 15% in the last year. Does that tell me anything about GDP growth, unemployment, inflation or any other fundamental economic variable? I don't think so, but maybe I'm wrong?

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    1. NGDP growth is positively correlated with M3 growth which in turn lags M3 lending growth, as we would expect in an economy where the money supply is largely created through bank lending. Other variables not so much since they depend on other factors - for example, NGDP at 5% could be made up of RGDP 1% and inflation 4% or vice versa.

      The Fed doesn't produce M3 figures any more, and M2 is not so well correlated with NGDP because of the amount of activity that goes on outside the regulated banking system.

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  14. You write that government deficit spending increases the total amount of money circulating in the economy, but that's not correct is it ? the deficit is calculated in the budget, as the spending is decided and the tax revenue estimated and the deficit spending is pre funded by bond sales as the year goes along is it not. The deficit is announced in the budget prior to the year in which that the deficit occurs.

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    1. Yes, Dinero, it is correct. Please separate spending and funding. Governments may choose to pre-fund their spending, just as banks may choose to pre-fund their lending - but they don't have to, and if they choose not to then government spending increases the amount of money in circulation in exactly the same way as bank lending does and for exactly the same reason.

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    2. Deficit spending does not increase the total amount of money in the economy. There is a "Ways and Means " overdraft facilaty at the Bank of England. But it has not been used since 2009. And even when it was used, it was for small amounts , nothing at all comparable to the amounts involved in deficit spending.

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    3. Dinero, you are still confusing spending and funding. Consequently you have missed the WHOLE POINT OF THIS POST. Please read it again.

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    4. I have read it thoroughly. The title of the post is "the fiscal theory of money expansion" and we have assertained that deficit spending does not create money expansion so that point is clear. Deficit spending does not create money expansion. Congratulations on your recent Pierra article by the way. The observations that an increase in M decraeses V in the MV=PY equation is a very good observation.

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    5. Dinero.

      You have misunderstood the post. Deficit spending that is not sterilised by bond issuance DOES expand broad money. That's why in the last two comments I have insisted that you separate spending and funding. You assume that governments have to fund their spending by bond issuance.But they have no such obligation. If they do not fund by issuing bonds, then government spending expands M3 through the commercial bank lending mechanism as I explained in the post. So your statement that "deficit spending does not create money expansion" is wrong. "Deficit spending funded by bond issuance does not create money expansion" would be correct, but that wasn't what you said.

      Referring back to your original comment, you said that the deficit was pre-announced. But the budgeted deficit and the actual deficit are rarely if ever the same, because both tax revenues and spending are subject to economic uncertainty. The fact that government pre-announces a budget deficit does not mean that it will necessarily end up with one at all, let alone one the size of that announced.

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    6. But the amount of purchases of Gilts by commercial banks is small. Moslty it is non banks buying deficit issued Gilts.

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    7. The two methods of commercial bank funding in the post is bond buying and overdrafts. Firstly The amount of purchases of Gilts by commercial banks is small and and secondly In the comments you clarified that you would not in fact find Government overdrafts. So in conlclusion , in the reality of the common practice by which government deficit spending is funded , deficit spending does not create money expansion. Which is an important distinction to make because promoting deficit spending to acheive that would not have that effect on its own.

      However if you want to replace the term "expansion of " with an "increase in circulation of" then that would make sense.

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    8. Dinero,

      This is a theoretical post - hence "fiscal THEORY of monetary expansion". How the flows are distorted in practice by the beliefs and behaviours of those currently charge of government deficit spending is not the point. So no, I will not change what I have said, since it is correct. Deficit spending without bond issuance creates money.

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    9. Oh its a theoretical post. I did ask if it was hypothetical in comment 6th January.

      Now you clarify its a theoretical post. So ok, no problem. Thanks.

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  15. I'm confused by your statement 'Since M3 rises when commercial banks buy bonds, ..." when the rest of your post is based on the fact that bond sales reduce M3. Why in one case does M3 go up, and in the other go down?

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    1. I perhaps should have said "bond sales to non-banks reduce M3". A bank buying government bonds has the same monetary effect as a bank lending to government, because banks create money when they buy securities as well as when they lend directly. Consequently purchases of new bond issues by banks does not sterilise M3 growth from government deficit spending. And when banks buy government bonds on the secondary market, M3 rises. The Bank of England explains all of this in the paper I've linked to in the post.

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    2. banks do not create money when they buy Govt securities. As banks can only buy Govt securities with Govt currency which the banks do not create.

      The impact on the non-base monetary aggregates of banks buying Govt securities is zero.

      Chase buys $1M in TSY securities:

      Chase:
      +$1M securities (assets)
      -$1M reserves (assets)

      TGA:
      +$1M in reserves (assets)
      +$1M in securities (liabilities)

      All the balances balance. No bank liabilities are created (bank loans)

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    3. Your accounting is incorrect. If banks buy government securities, the accounting is exactly the same as it is for loans. Reserves only settle the movement of funds.

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    4. Just to clarify: what you have left out is the payment to the customer who sells the bonds. This may be the government or a private sector agent. Reserves are not customer funds.

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    5. Frances-

      "A bank buying government bonds has the same monetary effect as a bank lending to government, because banks create money when they buy securities as well as when they lend directly. "

      These are exactly your words. You are specifically talking about when banks are buying the TSY bonds. Not when non-banks are buying the bonds through banks as intermediaries. In the bank buying the bonds example, the accounting is exactly as I described. Its not a complicated accounting entry. If you wish to refute the accounting, please feel free to provide the T-accounts proving you are right.

      This is the nice part about accounting, like math, its objective, its not an opinion.

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    6. "Reserves are not customer funds."

      Exactly, banks cannot buy T-bonds with their own IOUs, they must buy them with their assets (reserves). And when banks buy T-bonds themselves with their reserves, their liabilities do not change.

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    7. Your accounting is still wrong. You have left out the payment of MONEY (not reserves) to the seller of the bonds. That money is created by the commercial bank. The movement of reserves settles the payment, that is all.

      And yes, I am specifically talking about banks buying bonds, not non-banks buying bonds using banks as intermediaries.

      And no, I am not going to provide the accounting. It is shown in detail in the Bank of England paper, the link for which is in my post. I suggest you study it - carefully. It discusses the effect of bank purchases of sovereign bonds on the money supply in some detail.

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    8. Think of it like this. When a bank makes a loan, it buys a non-tradeable credit security from the customer and pays for it with its own IOUs. When it buys tradeable credit securities IT DOES EXACTLY THE SAME. The accounting entries are identical. If the customer from whom it buys the securities has an account at that bank, the bank places newly created money to the value of the securities in that account and there is no movement of reserves. If the customer from whom it buys the securities has an account at a different bank, the bank transfers reserves to the value of the securities to the receiving bank, which is a transfer from one reserve account to another at the central bank. The receiving bank then credits the customer account with newly created money. Either way, money is created - it's just a question of which bank creates it. The accounting for a purchase of securities is thus no different from a loan.


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    9. I've read the paper a number of times and no where does it talk about the impact of banks buying the bonds themselves.

      "You have left out the payment of MONEY (not reserves) to the seller of the bonds."

      There is no payment of bank IOUs to the Fed when the banks sell TSY bonds to the Fed.
      The banks exchange reserves for T-bonds, bank IOUs are not affected.

      Sorry but this is an objective fact.

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    10. The only time there would be an increase in bank IOUs would be when banks buy T-bonds from the TSY and if the banks in turn credit TT&L accounts (checking accounts TSY has at private banks).

      I honestly do not know enough about the precise operations and how widespread the use of TT&L accounts is for the TSY.

      But when the transactions only affect the banks reserve positions at the Fed and the Treasury General Account at the Fed. No bank IOUs are created.

      So I guess we both could be right depending on the circumstances.

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    11. The US's broker-dealer arrangement for primary bond issuance is unique in the world and the banks involved really should be considered as part of the government for the purposes of bond issuance. The accounting is abnormal since it is really only a transfer payment between government and quasi-government organisations. What you have done is treated a special case as a general example.

      I don't know how you managed to miss the Bank of England authors' discussion of bank purchases & sales of sovereign bonds. I can only think you were looking for something equivalent to the US broker-dealer arrangement and didn't find it. But that is because the UK's debt issuance procedure is different. Primary auctions are open to non-banks as well as banks and the accounting is as I described. The accounting is also as I described for secondary market purchases, which actually are by far the largest proportion of government bond transactions.

      The relevant paragraphs in the Bank of England paper are these:

      "Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy. But they are far from the
      only ways. Deposit creation or destruction will also occur any time the banking sector (including the central bank) buys or sells existing assets from or to consumers, or, more often, from companies or the government.

      "Banks buying and selling government bonds is one particularly important way in which the purchase or sale of existing assets by banks creates and destroys money. Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw currency in large
      amounts. (1) When banks purchase government bonds from the non-bank private sector they credit the sellers with bank deposits. (2)

      Delete
    12. In fact the accounting as you have described it - banks pay Fed for bonds issued by Treasury, Fed reimburses Treasury with proceeds of bond sales - would be illegal in Europe, since it is a form of central bank financing of government. It would contravene Article 123 of the Lisbon Treaty.

      The Bank of England used to have a similar arrangement (it was the cash manager for HMT) but that has now been ended: there is a separate Debt Management Office (DMO) which handles the issuance and redemption of government bonds, and the HMT's Ways & Means account at the Bank of England is now only used for emergencies (last time it was used was in 2008 after the Lehman crisis). The residual balance in that account is gradually being paid off.

      Delete
    13. Thank's for the clarifications. Nice post btw.

      But if the bank buys a Treasury bond DIRECTLY from the government at auction (i.e. not from a non-bank entity), isn't that purchase settled in central bank money only, rather than with bank credit? Especially since the government may not even have an account at the bank that is purchasing the bond.

      Delete
    14. @Auburn Parks, You are hooked up on the idea that government bond purchases need to be paid for in reserves. This need not be the case. Such a transaction is just an exchange of assets, which need not involve the central bank at all, and the government could pay its counterparty with any asset mutually satisfactory to them and the bond seller - say, used fighter aircraft.

      Delete
    15. Yes indeed. In fact intergovernmental loans are often paid for in kind. Venezuela, for example, is paying China in oil.

      Delete
    16. Although treasury is free to swap its paper for anything it is offered, in practice in the UK the DMO is selling gilts for reserves to replenish the National Loans Fund buffer, which must be put to 0 at the close of each period. In net terms those reserves have already been created by procuring debits on the Consolidated Fund, where the resulting balance was then carried over into the NLF. All RDEL goes like this and also CDEL (though watch Ed Balls on this one). That's why the automatic stabiser works, if V falls and we don't hit tax lines (credits to the CF) then the money is saved and presented to the DMO. That's why George cannot control the deficit and the more he tries to cut, the bigger it gets. The deficit is endogenous, because in practice gilts are swapped for balances in sterling current accounts, which we call reserves.

      Delete
    17. The quote from the BoE paper reads "When banks purchase government bonds from the non-bank private sector they credit the sellers with bank deposits." Key words, " private sector". It does not say that is the case when the commercial bank buys directly from the government issuing new bonds. In that case the government does not receive a deposit , its receives a transfer of an amount of pre existing reservers transfered to its account. Its true that reserves are used for clearing but the fact is when the borrower is the government the clearing takes place immediately as the government does not use bank deposits , it does use BoE deposits of course.

      Delete
    18. However when the Treasury spends it, the recipient would then have a commercial bank deposit , so by that route the borrowing by the process of commercial banks buying bonds, when it occurs, and subsequent spending does create deposits.

      Delete
    19. Dinero, that is a Memorandum pre-funded account model. Settlement takes place via legal arrangements that track participants' central bank liquidity positions and payments occur via a liquidity bridge at the end of the cycle (UK & Germany). Or via another variant called the autonomous central bank money model (Finland), where participants use their own RTGS accounts to pre-fund their settlement account at the SSS, which is located at the NCB.

      We also have something called an Integrated model (France, Sweden) where everything takes place within the NCB, although the information processing is in the hands of the SSS.

      Finally, there is the Interfaced model, where the settlement accounts are the same as participants' RTGS account at the NCB (Spain, Greece, Italy, Netherlands, Portugal).

      So at least when there is (government debt) ISSUANCE, there's central bank money settlement in the first instance as well.

      Delete
    20. Dinero,

      If the government funds itself by issuing bonds, which are bought by commercial banks that pay for them with pre-existing reserves, the subsequent transfer of those reserves to the government's account at the central bank is effectively a drain of base money M0. I've explained this here (there is a minor error regarding use of reserve accounts, so read the comments as well): http://coppolacomment.blogspot.co.uk/2013/01/central-banks-safe-assets-and-that.html

      Delete
    21. Frances,

      Thank you for one of the clearest posts on these issues. I wonder why all this has been swathed in misinformation by the press and politicians until quite recently.

      Referring to the BoE paper. "Banks often buy and hold government bonds as part of their portfolio of liquid assets that can be sold on quickly for central bank money if, for example, depositors want to withdraw currency in large amounts."

      - Does this imply that a bond can always be sold to another commercial bank for reserves at the Central Bank? Clearly (I think) if the bond was sold in the market, then it would be paid for through a deposit account, shrinking the balance sheet and providing no extra reserves.

      - Why would a bank prefer to hold bonds against possible large withdrawals rather than rely on the interbank and/or Central Bank provided liquidity?

      - What is the limit on buying up assets through the expansion of a bank's balance sheet?

      Regards,

      Richard.

      Delete
  16. "Weakening the currency might help exporters but it wouldn’t improve domestic demand . . . "

    It can increase domestic demand if relatively cheaper domestic goods and services are available?

    ReplyDelete
    Replies
    1. Weakening the currency tends to raise, not lower, the prices of domestic goods and services.

      Delete
    2. Relative to imported goods.

      Delete
    3. I think weaking the currency would increase domestic demand, Frances - by what used to be called "import substitution".

      Delete
    4. Tim

      Import substitution would not increase domestic demand. After all, demand for imports is still domestic demand: all people would be doing is substituting domestically-produced goods for more expensive imports. Import substitution therefore might increase domestic supply. But if domestic supply itself relies on imports of intermediate goods, weakening the currency will raise the price of domestic goods and services.

      Delete
    5. I think you are confusing domestic demand C+I+G with aggregate demand C+I+G+(X-M), Frances. But I should have used the old term "domestic absorption" to avoid confusion.

      Delete
    6. Weakening the currency's external value would not make any difference at all in a closed economy (C+I+G). The domestic equivalent is inflation, which does tend to increase C.

      Delete
  17. Very nice post, Frances. You’ve covered an enormous amount of territory here.

    “Unless the central bank issues more physical cash, inflation comes from rising M3, not M0… the distribution of the M3 increase arising from QE is very different from that arising from the original government spending…QE simply cannot adequately replicate the velocity effects of direct government spending.”

    Important stuff there, IMO.

    Because academic monetary economics tends to reject the importance of banks, it can only fail to see the importance of these kinds of distinctions. But such distinctions are everything when attempting to explain the effect of QE and other things relating to government fiscal and market activity.

    How academic economics can reject the importance of banking and yet even include the word “reserves” in its thought train is beyond me. (Certain high priests of market monetarism who you may know are highly indoctrinated along these lines.) Even if the profession is sincere in any of its post-crisis self-reflection admissions, it really is not qualified to investigate its own shortcomings in this regard, due to this chronic built-in bias. The subject of economics is bigger than the profession. Thankfully there are one or two ex-bankers around to point this out from time to time.

    ReplyDelete
    Replies
    1. P.S.

      I made a point somewhat similar to your M0/M3 distinction here:

      http://jpkoning.blogspot.ca/2015/01/cracks-in-zero-lower-bound.html?showComment=1420544782355#c292169423945448083

      Delete
    2. "How academic economics can reject the importance of banking and yet even include the word “reserves” in its thought train is beyond me."
      According to this 'monetarist' there is "has clear and overwhelming substantiating evidence from all economies at all times." ?


      “Another enigma here is that the alternative view — that in the long run, national income is a function of the quantity of money — has clear and overwhelming substantiating evidence from all economies at all times. Both evidence and standard theory argue that the expansionary open market operations that are the hallmark of quantitative easing, not bank recapitalisation, should have been policy-makers' first priority last autumn. In the next crisis they must accept that money, not bank credit by itself, is the variable, which matters most to macroeconomic outcomes.”

      http://standpointmag.co.uk/node/1577

      Delete
    3. I do so agree, JKH. Academics are so hamstrung by their need to discuss everything in the context of mathematical models, especially ones that usually involve some small tweak of a "standard" one, that they are making little progress in actually understanding the economy. It seems to me that, while there is lots of disagreement about money creation in the blogosphere, at least it is being discussed in terms of balance sheets so that its impact can be traced through the whole system. Although academics may be increasing building money into their models, I doubt whether they are including both money AND its counterparts - ironic considering how much importance they attach to general equilibrium.

      Delete
  18. Frances-

    This is an excellent post. However, there are a few things to take issue with.

    Your assertion that Govt spending that is not offset by T-securities issues is unfounded. In fact, this assertion is directly contradicted by QE.

    Whether or not the Govt issues securities, the same people are receiving the income from the Govt spending, so we can more or less hold this part of our analysis of the securities or no securities deficit spending models constant. The institutions and people that are depositing their funds into securities accounts at the Fed are saving by definition. Which as you describe admirably, is why QE does not cause inflation. It is simply returning to savers their own funds, which they are not likely to spend on consumer goods and services increasing inflation. Which is exactly why deficit spending without issuing securities is not inherently inflationary. The savers are not going to spend their money in either case.

    ReplyDelete
    Replies
    1. Oops.

      First sentence should read:

      Your assertion that Govt spending that is not offset by T-securities issues is inflationary is unfounded

      Delete
    2. Please read what I said again. I did not say it IS inflationary. I said it COULD BE inflationary.

      You have ignored the points I made about the very different distribution of unsterilised govt spending and QE. But this is crucial. The people who buy bonds - and sell them back in QE - are much richer than the people to whom govt deficit spending generally goes, and therefore have a much lower propensity to consume. For this reason, govt deficit spending may be inflationary even if sterilised. And for the same reason, QE is not inflationary. Distributional effects matter.

      Personally I do not think that sterilising the money effect of govt deficit spending makes much difference to its macroeconomic impact, precisely because the distributional effects are so different. What I am describing is the beliefs of policymakers.

      Delete
    3. "The people who buy bonds - and sell them back in QE - are much richer than the people to whom govt deficit spending generally goes, and therefore have a much lower propensity to consume. For this reason, govt deficit spending may be inflationary even if sterilised. And for the same reason, QE is not inflationary. Distributional effects matter."

      Actually Frances, I've ignored nothing. You are simply overlooking the contradiction inherent in your position.

      Deficit spending with or without bond issuance does not change the recipients of the Govt spending and thus will not have a different impact on inflation.

      QE or bond issuance only changes the portfolio balance of savers after the fact and so this also does not have an impact on inflation.

      If QE does not cause higher inflation because the savers have their checking deposits back, then deficit spending without bond issuance will not cause inflation either because those same savers have the same amount of checking deposits.

      This is the contradiction, and this is why bond issuance does not sterilize anything wrt inflation.

      The only potential impact issuing T-bonds has in the asset classes. If the Govt never issued a bond or did QE infinity, there would be $12 Trillion in savings that would have to find some place else to be saved.

      These are fundamentally different issues.

      Delete
    4. But wrt to policymakers, yes they have silly views on the way the monetary system works. They also think that the Govt must actually borrow its own IOUs from the public before the Govt can issue them. Which is of course ridiculous since Govt IOUs can by definition only come from the Govt itself.

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    5. @Auburn Parks "....policymakers....have silly views on the way the monetary system works. They also think that the Govt must actually borrow its own IOUs from the public before the Govt can issue them"

      I must say that MMTers could do better without this kind of arrogance, referring to people like Randall Wray as if their word was infallible. The policymakers typically work at places which are central to the money system, so they are liable to know at least as much about the money system as MMT's leading lights.

      Delete
    6. Tim Young. On the basis of your statement you'd better explain to us all why you consider Wynne Godley's contribution to monetary theory is defective since it forms part of MMT and Godley was a former Deputy Head of the British Treasury Department.

      Delete
  19. Frances
    Your point in the comments above that commercial banks act as defacto state institutions is to my mind key. To be more precise we are talking about the 40 or so organisations who hold Reserve accounts at the BoE and act agents for the govt. It should also be remembered that it was Tony Benn who created Girobank which pioneered the replacement of commercial cheque clearing with electronic real time payments and introduced free banking. Therefore the current monoply enjoyed by private banks in the current account market is not a deep feature of our system but another sorry example of growth in economic rents since the late 70s. Tresury sending bonds to the BoE via the secondary market is simply the earliest example. The old tally sticks are buried under Threadneedle St. You yourself on an earlier blog on the ECB help spot a similar 'Goldman' gig with EIB bonds.

    ReplyDelete
  20. Fiscal policy can be distinguished from monetary policy, fiscal discretion entirely negates the advantage of monetary commitment.

    ReplyDelete
  21. Are bank deposits and central bank money perfect substitutes for each other, imperfect substitutes, or not substitutes at all? Whichever is assumed will lead to different conclusions.

    ReplyDelete
  22. Having commented on the discussion, something I still don't understand from the post itself, Frances is this remark: “I mean it. If a government borrows from the central bank to pay down a commercial bank overdraft, M3 falls”.

    I don't see this. The government obtains reserves from the central bank (in return for some loan asset, marketable or otherwise) and pays them to the bank to reduce its overdraft. The nature of the commercial bank’s assets change, but its liabilities, including M3, are unaffected.

    ReplyDelete
    Replies
    1. If the government overdraft is simply replaced with increased reserves (an asset swap) I would agree with you. But that is not what I am saying. I am suggesting that the overdraft is discharged with no offsetting increase in assets, as happens when a private sector client pays off a loan. The loan asset is discharged by means of a reduction in liabilities.

      Delete
    2. Sorry, I am now totally baffled! What liabilities are reduced? What does the government do with its (reserves I presume) borrowing from the central bank?

      Delete
    3. Thinking about it, you are right about the asset swap and I am wrong about M3. Government paying off commercial bank loans or overdrafts with money created by the central bank is monetisation of public debt, just as if the central bank bought government bonds directly from banks. The balance sheet of the central bank expands, so M0 rises, but M3 remains unchanged.

      Delete
    4. Thanks, Frances. That's what I figured - nice to know that I am not going nuts!

      As I said in my comment to JKH, I do believe that the kind of hydraulic reasoning we are using here, tracing transactions as they propagate through balance sheets, is the most promising way to understand QE, helicopter drops, and how money might affect prices etc. The academics, if they have money in their mathematical models at all, include it as a standalone variable, so they don't even start to analyse these effects. When the BoE talks about fostering unorthodox thinking, this is the kind of approach I want to see, but I suspect that what they will have in mind is just academics who use similar mathematical models but reach unconventional conclusions.

      Delete
  23. Frances,

    "having forced a commercial bank to create money to fund its deficit"

    At what point did the government force the bank to create money to fund its deficit? As far as I can tell from your example it was done voluntarily.

    ReplyDelete
    Replies
    1. You really think that a commercial bank which depends for both its licence and its liquidity on government would refuse that government a credit line?

      Delete
    2. Are you going to shut down the bank if they refuse? Arrest people? Is the government setting the interest rate too? Should the government force anyone to lend to it?

      This is certainly a very strange, not to say troubling, line of argument outside of Venezuela, Iran, or Zimbabwe.

      Delete
    3. If a bank is licensed to create money on behalf of the state, the government does have the right to revoke its licence. How would this differ from broker dealers being compelled to buy a proportion of bonds issued at every primary auction, on pain of losing their privileged status? In the US, the broker-dealer relationship is with the Fed: but in the UK it is with the DMO, which is part of the fiscal authority.

      And governments do set interest rates. You forget that in sovereign currency-issuing countries such as the UK the central bank, which effectively sets the funding costs for banks, is an arm of government.

      And your second paragraph is simply over-dramatic. The banking sector is heavily regulated and controlled in every country in the world, and nowhere more so than in the US, UK and the EU. In the EU, the ECB (which has no direct democratic mandate) dictates fiscal policy to elected governments and enforces it with threats to withdraw liquidity from the banks. This strikes me as far more "troubling" than a fiscal authority revoking the licence of a commercial bank that will not support democratically-mandated deficit spending.

      Delete
    4. You didn't answer the question. Are you going to shut down the banks if they refuse to lend money to your government?

      Governments do not set interest rates on their own borrowing. Ask Greece about this.

      Over-dramatic? You're talking about essentially destroying the credit sector, not "regulating" it. Why on Earth do you suppose capital will submit to theft rather than simply fleeing, as it has everywhere this kind of scheme has ever been tried? Investors don't want to lose their money.

      Delete
    5. ...and you think this going to help credit markets? Really?

      I'm aghast, I thought First World economics was being discussed here. Sorry I stopped by, please carry on without me, this is not a productive use of my time.

      Delete
    6. If you knew any game theory, you would know that banks are not going to stand up to government for exactly the same seasons that markets do not stand up to a credible determined central bank. They may not be shut down, but they can't win.

      A sovereign currency-issuing country with its own central bank can control the interest rates on its own borrowing. The central bank standing ready to purchase government bonds in effect sets a ceiling on yields. Interesting that you mention Greece, not Italy and Spain where the ECB intervened to prevent yields skyrocketing. OMT doesn't support your argument, does it?

      Actually, Greece doesn't pay market rates on the majority of its debt either.

      "Destroying the credit sector?" Seems to me the greatest destroyer of the credit sector is itself. And you are over-dramatising again. Why should a credible government be unable to borrow from domestic banks? Capital flees when the government is a basket case, not when it is credible - and credibility depends on how government spending is directed and, crucially, whether the government can tax its population. This applies regardless of the manner of financing that he government uses.

      The point of this post is that government spending has monetary effects. You've chosen to ignore this completely.

      Delete
  24. I started losing interest at "Therefore the combination of fiscal authorities and commercial banks can create all the money required by the economy." This is sort of like arguing that the Army makes the police irrelevant because the Army already has plenty of guns. CBs and fiscal spending have entirely different jobs, just because they both involve money doesn't make them adequate substitutes.

    "But there is little evidence that QE has much effect on consumer prices" Market monetarists have been arguing for a long while that temporary liquidity injections are not inflationary, because everyone knows the Fed will unwind them. That is not an argument against "the supremacy of central banks," it's an argument against a particular policy of CBs. Better to just target the NGDP trend.

    "So when the economy is on the floor, monetary conditions are tight and banks not lending to the private sector, unchain the fiscal authority - and stop worrying about deficits."

    Again, this is too much like saying "When someone robs a liquor store, send in the tanks-- and stop worrying about the collateral damage." Governments should no more increase spending to increase money supply than they should cut spending to reduce it.

    ReplyDelete
    Replies
    1. I think you are being a little over dramatic. In what weird world is money being created by commercial banks as a consequence of government deficit spending the equivalent of sending in the Army?

      You create a distinction between central bank and fiscal authority that does not exist in reality. Furthermore, you appear to be applying some kind of moral judgement - central bank money creation "good", fiscal authority money creation "bad". I apply no such judgement. Money creation is neutral. I am simply examining the various mechanisms by which money can be created, with a view to encouraging better understanding of what Tim Young calls "hydraulics" and therefore the design of an efficient and effective means of creating AND DISTRIBUTING money in economies where base money is not much used by the general public.

      If you wish to participate in this debate, please put your political prejudices about fiscal versus monetary authorities on hold and discuss the mechanics dispassionately.

      Delete
    2. This comment has been removed by the author.

      Delete
    3. The Army is a bad tool for managing local crime. Fiscal authorities are a bad tool for managing monetary policy.

      OK, so in your reality central bank independence is completely meaningless and the general public doesn't use the monetary base. I think we've moved beyond rational debate, good bye.

      Delete
    4. Central banks are only as independent as politicians allow them to be. The mandate of central banks is set by politicians. This is a no-brainer.

      The declining use of physical cash in the Western world is a matter of fact. The vast majority of transactions are made bank-to-bank: the banks themselves use base money to facilitate those transfers but it is completely transparent to the general public. As far as the general public is concerned, they are transferring the money in their deposit accounts - which is bank-created money. The vast majority of money in circulation in the Western world is bank-created. Again, this is a matter of fact.

      Since fiscal policy has monetary effects, fiscal authorities are involved in monetary policy whether you like it or not. If you regard that as the Army being in control of the police, well tough, that's how it is.

      Delete
  25. Frances,

    Just saw your Pieria piece:

    http://www.pieria.co.uk/articles/getting_things_wrong_federal_reserve_style

    It's one of the best I've seen by you or anybody on this subject.

    For some time now I've wanted to write up something about how conventional monetary economics has made the mistake of conflating bank reserves and currency into an amalgam called "the monetary base" - and that this conceptual porridge is at the heart of a lot of misunderstanding about monetary policy implementation. The (market) monetarists in particular are devoted to "base" analysis. That allows them not to look at the details of banking operations.

    You seem to be on a roll lately and may be in a good position to write something along these lines if you agree with it. It's certainly a take that is consistent with the kind of analysis you do in your Pieria piece.

    One observation on your analysis:

    The smooth M2 trend has definitely been affected/supported by QE, because bond sales into QE have originated almost entirely from non-bank portfolios (cumulative net). In fact, that M2 effect is where the real monetary "action" is in QE. Reserves are relatively useless, but what’s happening on the other side of bank balance sheets reflects a more useful QE-assisted M2 trend. This is all consistent with viewing QE as a fight against bank/M2 deleveraging in the counterfactual, and is not inconsistent with the rest of your analysis.

    I really shouldn’t be dumping praise on you like this – but you’re doing some good stuff here!

    :)

    ReplyDelete
    Replies
    1. Wow, thanks JKH!

      To my mind currency and bank reserves perform entirely different functions in the economy and it's a bit ridiculous to conflate them. The point I was making to Philippe elsewhere on this thread is that in a Western economy where use of physical cash is gradually being replaced with electronic bank-to-bank (or device-to-device) transfers, we should really regard bank deposits and physical currency as to all intents and purposes indistinguishable. When both Starbucks and I are indifferent about whether I pay for my coffee with contactless payment directly from my bank account or physical cash, distinguishing between them is no longer meaningful. Bank reserves, however, (apart from being a black art that the average Joe doesn't understand) have a much more limited function. Thanks for the tip - I really should write about this. Time to split up M0.

      I didn't go into the causes of the apparent normality of M2 growth in the Pieria post, but yes, it's nowhere near as "normal" as it appears. M2 growth due to bank lending pre-crisis has to a considerable extent been replaced by M2 growth due to Fed LSAPs from non-banks. I think this probably explains the fall in M2 velocity.

      Delete
    2. I am surprised that the Fed would expect anything other than crashing velocity of reserves. Essentially they are trading with savers (albeit indirectly via banks), giving them enough money to induce them to part with what is normally a savings product - bonds. Surely it is likely that such counterparties look at reserves, or M2 in the case of a non-bank, as a substitute savings vehicle rather than as a "hot potato".

      Delete
    3. Tim,

      Congratulations. That is the best demolition of the market monetarists' "hot potato" argument in favour of QE that I have seen for quite a while.

      Delete
    4. I don't really get your distinction between currency and bank reserves. Bank reserves includes currency that is held by banks.

      Delete
    5. Tim, the argument seems to be that QE induces 'savers' or portfolio managers to seek out alternatives to government bonds and plain deposits, buying commercial bonds or stocks etc. The people then selling these assets in turn look for something to do with the money they receive in return. At some point someone receiving money for assets actually spends the money on goods, services, employing workers etc, which increases demand in the real economy. The hot potato idea rests on the assumption that money does not get 'stuck' in the financial markets or in personal hoards if the supply of money is large enough.

      Delete
    6. This, from a 'Thatcherite Monetarist'.

      “In short, although the cash injected into the economy by the Bank of England's quantitative easing may in the first instance be held by pension funds, insurance companies and other financial institutions, it soon passes to profitable companies with strong balance sheets and then to marginal businesses with weak balance sheets. And so on. The cash strains throughout the economy are eliminated, asset prices recover, and demand, output and employment all revive.”
      http://www.imr-ltd.com/graphics/recentresearch/article6.pdf

      Delete
    7. Philippe 21:11

      You're right. I'm guilty of unintentional terminological conflation - a mistake I make too often.

      (But different from what I consider to be intended conceptual amalgamation in the case of "the monetary base")

      I mean the distinction to be between reserve deposit balances (used for inter-bank payments made through the bank clearing system) and currency.

      Currency held by banks is inventory for use in their role as distribution agents for currency.

      That is quite a separate purpose from the inter-bank payment function. It is in effect the front end stock of outstanding currency held by the public.

      Delete

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