The central bank must treat financial stability as a public good

I haven’t much time today. I gave a talk at a conference in Melbourne today (as noted in yesterday’s blog). I will edit the audio soon and post the presentation for those who might be interested. In general I made the obvious point – if you want people to reach their potential and participate in the economy there has to be enough jobs and hours on offer. But the blog topic today relates to a speech made by a senior RBA official in Sydney yesterday which has excited some conservatives. In that speech, the RBA indicated that it would always lend to private banks which had high quality assets (in AUD) but might be experiencing a temporary liquidity problem and were unable to meet its reserve obligations. This function is part of the public good responsibilities of the central bank and does not mean that they prop up failed capitalist businesses. The speech made the valid distinction between illiquid firms and insolvent firms. The point of relevance to Modern Monetary Theory (MMT) is that the central bank cannot control the money supply because as part of its commitment to financial stability it must be prepared to provide reserves to the private banking system. That point is in contradistinction to the mainstream macroeconomics which starts by teaching students that the central bank controls the money supply. Overall, the central bank must treat financial stability as a public good and therefore must always guarantee reserves on demand.

Modern Monetary Theory (MMT) considers financial stability to be a public good. The financial system is linked to the real economy via its credit provision role. Both households and business firms benefit from stable access to credit.

An economy’s financial system is stable if its key financial institutions and markets function ‘normally’. To achieve financial stability: (a) the key financial institutions must be stable and engender confidence that they can meet their contractual obligations without interruption or external assistance; and (b) the key markets are stable and support transactions at prices that reflect fundamental forces. There should be no major short-term fluctuations when there have been no change in fundamentals.

So financial stability requires that financial institutions do not face stresses that might impose economic lossses wider than their own customers and counterparties. Financial stability does not mean that financial institutions cannot fail. Clearly private enterprise carries the risk of insolvency and business failure is part and parcel of the ‘normal’ functioning of the financial system.

Financial stability requires levels of price movement volatility that do not cause widespread economic damage. Prices can and should move to reflect changes in economic fundamentals. Financial instability arises when asset prices significantly depart from levels dictated by economic fundamentals and damage the real sector. Collapses brought on by injudicious speculation that do not affect the real sector or that can be insulated from the real sector by appropriate liquidity provisions are not problematic.

The essential requirements of a stable financial system are:

  • Clearly defined property rights.
  • Central bank oversight of the payments system.
  • Capital adequacy standards for financial institutions.
  • Bank depositor protection.
  • An institutional lender-of-last resort when private institutions refuse to lend to solvent borrowers in times of liquidity crisis.
  • An institution to ameliorate coordination failure among private investors/creditors.
  • The provision of exit strategies to insolvent institutions.

Some of these requirements can be provided by private institutions but they fall in the domain of government and its designated agents.

Private goods are traded in markets where buyers and sellers exchange at prices that reflect the margin of their respective interests. At the agreed price, ownership of the good or service transfers from the seller to the buyer. A private good is ‘excludable’ (others cannot enjoy the consumption of it without being party to the transaction) and ‘rival’ (consuming the good or service specific to the transaction, denies other potential consumers its use).

Alternatively, a public good is non-excludable and non-rival in consumption. Private markets fail to provide socially optimal quantities of public goods because there is no private incentive to produce or to purchase them (the free rider problem). To ensure socially optimal provision, public goods must be produced or arranged by collective action or by government.

Financial system stability meets the definition of a public good and is the legitimate responsibility of government.

The RBA recognise this and provide a detailed explanation of their approach to financial stability which includes their efforts:

… to ensure that the payments system is safe and robust. The Payments System Board within the Bank has explicit authority for payments system safety and stability, and has the backing of strong regulatory powers.

The RBA also note that their “mandate to uphold financial stability does not equate to a guarantee of solvency for financial institutions”. But the RBA still has “an important role in the management of crisis situations in co-operation … responsibility for monitoring financial markets, and payment and settlement systems …”

In addition, and linked to maintaining a viable payments system, the RBA “undertakes transactions in financial markets as part of its responsibility for the implementation of monetary policy, the provision of financial services to its clients and the management of its balance sheet”.

In this context, there was an interesting speech given by a senior official at the Reserve Bank of Australia (RBA) in Sydney yesterday (June 28, 2011) – Collateral, Funding and Liquidity.

This speech seems to have excited a few conservatives out there.

First, there are two sides to a balance sheet – the liabilities side and the assets side. The RBA official argued that the global financial crisis:

… brought into sharp relief the liabilities side of a financial institution’s balance sheet, that is, the funding structure.

In that context a number of large financial institutions failed or required massive bailouts because they could not fund themeselves. The RBA official noted however that the funding issues were symptomatic of the quality of their assets.

Yet in the public debate the focus is often on the liability side – and the RBA official singled out the ratings agencies for their recent ratings downgrades of Australian banks. In May, Moody’s downgraded the debt ratings of Australia’s four largest banks and claimed that it was due to their excessive dependency on international lending markets.

After the financial crisis, which restricted the supply and raised the cost of wholesale funds in global capital markets available to Australian banks, the banks shifted towards local deposits. In part, this was aided by the rise of the household saving ratio after a period of dis-saving associated with the credit binge that drove economic growth in the pre-crisis period but eventually burst as the sub-prime markets collapsed.

So a collateral effect of our national government running massive and increasing budget surpluses from 1996 to 2007 (bar one year) was that local banks were under greater pressure to obtain funds from abroad. Please read my blog – The role of bank deposits in Modern Monetary Theory – for more discussion on this point.

In terms of the mad assessments that the ratings agencies are making at present, the RBA official said:

In my view, the pendulum has swung too far in focusing on liabilities. Such a swing is evident in the proposed change to Standard & Poor’s ratings methodology for the global banking system. The proposed new methodology shifts the assessment of financial strength of an institution markedly towards funding and away from asset quality. Asset quality should still be paramount and should be given a far larger weight than liabilities in assessing financial strength, along with the extent of leverage (capital).

All banking regulation should focus on the asset side of the balance sheet which relates to the “quality and value of its assets”. The liability side should not be the focus of regulators. The risk of bank insolvency can only really be assessed once we understand their capital structure and the assets that are supported.

The RBA official then said that with the financial crisis, banks were forced into what he called a “funding-driven world” because “(t)hey can no longer assume that the funding will be readily forthcoming at a given price”.

In this context, the “structure and maturity profile of liabilities” which essentially relates to the probability that bank liabilites “mature at a faster pace than assets” is worthy of analysis. Banks engage in a sequence of debt rollovers to keep their “funding” needs satisfied while holding longer-dated assets.

Clearly, the capacity to attract funds is related to the quality of the asset portfolio that the banks hold.

The Speech then entered headline territory and clearly excited some commentators.

The RBA official said:

If a bank is experiencing a problem of illiquidity, the state of its asset portfolio is even more paramount. This relates to one of the fundamental tenets of central banking, most famously associated with Walter Bagehot. Writing in Lombard Street in 1873, Bagehot states that central banks should lend freely (ie, liberally) at a high rate to solvent but illiquid banks that have good collateral.

So the central banks should be prepared to lend to private banks if they have strong assets even if their liabilities side is problematic. In assessing the desirability of lending to banks the central bank distinguishes between “illiquity” and “solvency”. A bank that is temporarily illiquid (that is, cannot raise funds in the private capital markets) may not be insolvent given their asset structure. The distinction relates to the matching difficulties embodied in the maturity transformation process that banks engage in noted above.

That is, liabilities are generally of shorter maturity to assets.

In this context, the RBA official said in relation to short-term liquidity issues that:

… it behoves the central bank to look through those uncertainties to the underlying asset quality of the institution under question, and be prepared to lend secured against quality assets if the situation warrants.

When the “systemic uncertainty” increases (so banks will not even lend to each other in the interbank market) then the central bank has to ensure that financial stability is maintained and so they stand ready to provide whatever liquidity is required.

Operationally, the RBA lends to banks as a last resort at a rate “which is a small spread (normally less than 10 basis points) to the cash rate”. The cash rate is the current policy target rate.

The central bank operations aim to manage the liquidity in the banking system such that short-term interest rates match the official targets which define the current monetary policy stance. In achieving this aim the central bank may: (a) Intervene into the interbank money market (for example, the Federal funds market in the US) to manage the daily supply of and demand for funds; (b) buy certain financial assets at discounted rates from commercial banks; and (c) impose penal lending rates on banks who require urgent funds.

In practice, most of the liquidity management is achieved through (a). That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non- government sectors.

Money markets are where commercial banks (and other intermediaries) trade short-term financial instruments between themselves in order to meet reserve requirements or otherwise gain funds for commercial purposes. From the perspective of MMT, all these transactions are horizontal and net to zero.

Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly. In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank. Prior to the crisis many countries (such as Australia) maintained a default return on surplus reserve accounts (for example, the Reserve Bank of Australia paid a default return equal to 25 basis points less than the overnight rate on surplus reserve accounts).

Other countries like the US and Japan did not offer a return on reserves which means persistent excess liquidity will drive the short-term interest rate to zero unless the government sells bonds (or raises taxes). As we will show presently, the support rate becomes the interest-rate floor for the economy. After the crisis emerged most central banks began to pay a return on reserves.

The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability. It is this spread that the central bank manages in its daily operations.

In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period. At the end of each day commercial banks have to appraise the status of their reserve accounts. Those that are in deficit can borrow the required funds from the central bank at the discount rate. Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing. Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate. When the system is in surplus overall this competition would drive the rate down to the support rate.

The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.

The central bank seeks to minimise the fluctuations in the interbank rate from its target policy rate. To achieve that aim the central bank supplies funds to the banks to ensure that the demand and supply of overnight funds is consistent with the current policy rate.

The central bank thus provides marginal lending facilities to the banks which are used to lend money at the discount rate to commercial banks (the central bank as lender of the last resort).

In this context the RBA official said:

Emergency liquidity provision would clearly need to be a higher rate than this, otherwise institutions would avail themselves of this source of liquidity even in normal times. That is, the central bank should be a last resort, not a first resort.

Within the Reserve Bank’s operating framework, a reasonable benchmark would be the rate charged on the standing overnight facility, which is 25 basis points above the cash rate. This facility is called upon at various times throughout the year, generally as a result of small unexpected technical hitches in the money market. For example, over the past financial year, it was utilised on two occasions, with a total of $363 million drawn, and for a term of no more than one day.

He also noted that when there is a crisis, the central bank will provide the funds at a rate lower than the “market rate” for obvious reasons. So:

… the rate is penal relative to the normal cost of liquidity provision but not necessarily relative to the stressed market price of funding, a distinction which is often overlooked in such discussions.

The central bank also may discount the “value of the collateral it is lending against” for its own protection in the event of a sudden collapse in asset values.

In summarising, the RBA official said:

Finally, to link back to the arguments I made earlier, I will talk briefly about concerns surrounding the extent to which Australian banks rely on foreign funding. If a liquidity issue were to arise around this funding, it is of critical importance that the foreign-currency denominated funding is fully hedged into Australian dollars, which indeed it is. This means that the liquidity issue is in Australian dollars rather than in foreign currency … The Reserve Bank can meet a temporary liquidity shortfall by lending Australian dollars against the stressed bank’s assets denominated in Australian dollars. The vast bulk of the Australian banking system’s assets are denominated in Australian dollars.

In other words, the central bank ultimately guarantees that the reserves required to facilitate the payments system will be made available to the private banks. That capacity will typically not be drawn upon because there are penalties and collateral discounts applying.

As noted above, the RBA speech generated a reaction in the financial press today with one commentator accusing the central bank of behaving illegally.

In the right-wing Business Spectator article (June 29, 2011) – The RBA’s liquidity spin doesn’t wash – (written by Christopher Joye) we read that:

First, Debelle acknowledges that the RBA’s liquidity services represent a direct subsidy from taxpayers to the banking system …

Debelle was the RBA official (who by the way I taught at one time).

Once you read a conservative talk about taxpayers funding anything you know the commentator does not understand the operations of the monetary system. Please read my blog – Taxpayers do not fund anything – for more discussion on this point.

But the claim by the Joye related to point made by the RBA official that I noted above – that the lending rate attached to emergency lending by the RBA “is still likely to be less than the market rate, as otherwise there would be no need for recourse to the central bank. Thus the rate is penal relative to the normal cost of liquidity provision but not necessarily relative to the stressed market price of funding.”

That just tells me that the central bank takes it responsibility for maintaining stability in the financial system seriously and is recognises that in times of stress the normal prices (rates) do not apply. Its charter is to ensure the payments system continues to function. As long as the asset side of the bank is sufficient to ensure solvency then the central bank’s operations maintain the “public good”.

The other point is that the central bank can make these loans by simply altering balances in the banking system. It can do that independent of the state of tax revenue at any time that it chooses. There is no relation between the RBA lending and treasury tax revenue.

Joye further claims that “lender of last resort” facilities mean that the central bank is providing funds to:

… banks that cannot fund themselves in the private markets – which Debelle fails to observe meets the legal definition of insolvency – the central bank performs a very odd social function indeed. In short, the central bank lifts itself above the ordinary operations of the Corporations Act and decides, in its unilateral judgement, which banks are insolvent and which banks are having what is euphemistically known as a “liquidity”, as opposed to “solvency”, crisis. I have written about this many times before. Under Australian law, there is no distinction: if you cannot meet your current liabilities, you are trading insolvent. Period.

The legal framework may not be a good guide to how we should consider the public good of financial stability. Banks are particular institutions especially in a highly oligopolistic sector (as in Australia). If a small corner store operating in a relatively competitive environment goes broke some losses occur. Creditors lose, employees lose and consumers lose their local (and typically liked) supplier. But the contagion effects will be small. There is no “public good” element in such a business failure. The damaged entities are typically the business’s customers and suppliers. There may be a some extraneous collateral damage but it will be relatively small.

But as noted above, financial institutions are central to the functioning of the credit system which, in turn, impacts on the wider real economy. If a bank fails the consequences are likely to be significant.

Further, banks engage in “maturity transformation” – lending to us over long periods to buy homes, as an example but raising funds at shorter maturities. Other businesses also face this situation but on an attenuated basis.

So it is legitimate for the central bank to distinguish between illiquidity (a temporary problem) and insolvency (a failure of assets plus capital to cover liabilities). The first problem can be easily overcome by the lender of last resort facility. The latter suggests bankruptcy.

Joye’s take on the “maturity transformation” problem facing banks (the conversion of “short-term savings into long-term loans”) is suggestive of a:

… fundamental business flaw: if we ever demand those savings back, the bank may not be able to repay us. Hence the need for ‘central banks’, which have been established in developed countries around the world to furnish public sector liquidity support to failing private banks.

The point he is making seems like a non-point. Central banks were created to maintain financial stability in a unified currency system. All sorts of strange events (like us all withdrawing our savings) might occur but do not because the institutional structure with the central bank at the apex (with all the currency capacities according to it because it is part of the consolidated government sector) creates confidence.

I also noted Joye trying to claim authorship of a concept – that financial stability (including the provision of liquidity) is a public good. He says:

As a final point, Debelle makes the case that “the central bank’s provision of liquidity can be regarded as a ‘public good'” referencing a 2008 paper by two RBA economists. This seems symptomatic of an RBA tendency of avoiding appropriate referencing of third-party work if that material does not originate from within its central banking orbit.

The policy concept of liquidity as a public good was first outlined formally in Australia in a Melbourne Business School paper published by Professor Joshua Gans and myself in early 2008. Fortunately, this paper was referenced by the two RBA economists that Debelle footnotes.

I note that Warren Mosler and myself wrote a public submission in 2002 which was part of the Review of the Commonwealth Government Securities Market conducted by the Commonwealth Treasury.

You can read our academic paper which was also the submission to this review – HERE. In that paper (which I drew upon earlier in this blog) you will read a detailed account of the public good concept. Joye did not reference that paper in his 2008 paper. So if he takes exception to the selective referencing by the RBA official he should reflect on the saying “the pot calling the kettle black.”

And we were not the originators of the concept of financial stability as a public good. We just put it into a MMT framework.

Conclusion

A well functioning monetary system requires the central bank to ensure there are sufficient reserves in the system to guarantee the payments system. When drawn upon by the private banks these funds come from nowhere given the status of the government as a monopoly issuer of the currency. The central bank is part of the consolidated government in a fiat currency system.

As I finish typing this blog, the Greek government is about to vote on further austerity. I hope their proposals are defeated and they lose power and a new government forms which recognises the obvious – that they must exit the EMU to move forward.

That is enough for today!

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    25 Responses to The central bank must treat financial stability as a public good

    1. I think Joye’s concerns about maturity transformation (MT) are more than a “non-problem”. I think the basic problem with MT is thus. MT essentially equals “borrow short and lend long”, which is an inherently risky activity: the problems can get severe when short term interest rates rise or short term money becomes unavailable. This is essentially what brought Northern Rock down.

      I’ve no objection to people engaging in risky activities. If they lose everything – tough. If they make a million, well done them. But what is government doing guaranteeing the deposits of people who place money in banks which engage in MT? It’s not the job of government or taxpayers to subsidise ANY commercial activity.

      This is where the strength of narrow banking or full reserve banking lies. They separate the risky commercial activities from institutions which take small household deposits. The latter should not be allowed to do anything risky. Thus they cannot afford to pay depositors much interest or any interest at all. But that’s hard cheese. People cannot ask to have the benefits of taking risks (i.e. getting a nice rate of interest) without actually being exposed to the relevant risks.

    2. keynesproblem says:

      My first time. I was actually referred to your blog site from another blogger’s list of good blogs: Fictional Reserve Barking in Canada. They seem to have numerous adherents to MMT up there. For your info and to his credit, I include the address:
      http://fictionalbarking.blogspot.com/2011/06/pimcos-bill-gross-government-must-take.html

      My biggest hurdle is trying to appreciate why it is so difficult for policymakers to see that deficits are not a problem. The problem is as harassing in Canada as in the rest of the world. One has to assume that these people are acting in good faith.

      It should interest your readers that a recent conference on Post Keynesianism organized by the University of Ottawa, in Ottawa Canada, listed members of the Bank of Canada among its audience. I guess that is a great start.

    3. Neil Wilson says:

      “But what is government doing guaranteeing the deposits of people who place money in banks which engage in MT?”

      It reduces the cost of money, which is beneficial overall

    4. Aidan says:

      The point of relevance to Modern Monetary Theory (MMT) is that the central bank cannot control the money supply because as part of its commitment to financial stability it must be prepared to provide reserves to the private banking system.

      That looks like a point of irrelevance to me, because it only applies over a very short timescale. Over a more relevant timescale you have already explained how they can and do control it.

      What’s a much bigger concern at the moment in Australia is the effects of their use of interest rates to control it, as the carry trade has made the Aussie dollar artificially high.

    5. NameBack says:

      Sorry for the off-topic nature of this comment, but I’m having a hard time understanding something as I slog through back-issues of this blog, specifically around private bank lending and constraints (I got onto this after reading about how QE/excess reserves does not induce lending and realizing I needed to read more to understand this).

      Specifically, the picture I seem to be getting from reading all the entries on how banks lend and what constrains them is that there’s nothing stopping two theoretical banks from lending to each other in a circle pretty much infinitely — the only thing that prevents this in the real world is confidence, essentially.

      But I don’t see how this can be accurate. I feel like somewhere along the line I’m misinterpreting something. What is it that stops banks from simply giving each other as much money as they could possibly want?

    6. Neil, I agree that that government guarantees reduce the cost of money – for borrowers. Problem is that there is a price: paid by taxpayers. And the price paid by taxpayers over the last two years has been astronomic.

      It’s a widely accepted principle that it’s not the job of taxpayers to subsidise anything commercial or risky. So to repeat the point I made above, I don’t think government should underwrite maturity transformation.

      Implementing that idea represents a big challenge to the conventional wisdom, and there would be political problems implementing it. But that is just a measure of how far banks and depositors have invegaled their way into the public purse and helped themselves to its contents.

      Also low interest rates are not an unmixed blessing. Low interest rates lead to irresponsible borrowing: NINJA mortgages, asset price bubbles, Greece, etc. Personally I’d like to see interest rates determined by market forces with government keeping out of it as far as possible.

    7. Burk says:

      Thanks for your work, Bill ..
      I was intrigued by your mention of..
      “Clearly defined property rights.”
      … in the context of huge banking losses. Property rights generally imply that creditors have all the rights until their debtors go bankrupt. But in a situation like the US housing bubble, there might be a reason to stop short of large-scale bankruptcy and ask for creditor sacrifice in some systematic way, dropping principal amounts in some mass re-valuation of the market. This would clearly be outside of the normal property rights regime. Someday, this might make an interesting topic for commentary.

    8. Meursault says:

      I am at the Economic and Social Outlook Conference in Melbourne today. You’d love it here Bill. Within the first hour we got Ricardian equivalence, the need for sovereign wealth funds, and conflation of Greek and US debt risks.

    9. Neil Wilson says:

      “there’s nothing stopping two theoretical banks from lending to each other in a circle pretty much infinitely”

      It’s more exciting than that. Short of regulation any bank can create an infinite amount of money at will.

      What limits a bank’s creation of money in the market is willing and able borrowers who will borrow the money at the interest rate on offer. So in boom times there is lots of money created and in bust times hardly any. It’s all down to the lending bank’s ability to assess the default risk posed by customers.

      The only way to control that whipsaw effect is to regulate the banks so that it hits another government imposed limit before it runs out of borrowers. And you do that by imposing a loan to equity ratio on the banks. Once it hits that it can’t lend any more money without raising more equity funding.

    10. Neil Wilson says:

      “Problem is that there is a price: paid by taxpayers. And the price paid by taxpayers over the last two years has been astronomic.”

      Only because the central bank’s resolution procedure for insolvent institutions under its control was faulty.

      If the banks had been properly nationalised, the shareholders and bank investors wiped out and the insolvent banks resolved properly via a well known procedure then there would have been very little impact other than a rise in the cost of money. And we only get a rise in the cost of money because the capital regulations were faulty in the first place allowing the cost of money to get too low.

      MT is like nuclear power. It’s cheap as long as you get the containment design right.

    11. Fed Up says:

      “Modern Monetary Theory (MMT) considers financial stability to be a public good. The financial system is linked to the real economy via its credit provision role. Both households and business firms benefit from stable access to credit.”

      This is where I disagree. Try a basically all currency economy with no private debt and no gov’t debt. I believe the economy will get more financial stability when the amount of medium of exchange does not fall because of debt repayment and/or debt defaults.

    12. Fed Up says:

      Neil Wilson said: “And we only get a rise in the cost of money because the capital regulations were faulty in the first place allowing the cost of money to get too low.”

      By cost of money, do you really mean the cost of a demand deposit (medium of exchange) from a loan (debt)?

      What if geekspeak needed more demand deposits to prevent price deflation from cheap labor and positive productivity growth?

      That brings me to my next point/question.

      I believe the way the system is set up now, the only way to create NEW medium of exchange is from the demand deposits from a loan (meaning debt and has to be borrowed into existence). Maybe someone can verify that.

    13. Senexx says:

      @Meursault

      There’s constantly calls for a sovereign wealth fund in Australia based on the Mining booms, I was even listening to Bernard Keane from Crikey on Canberra Radio yesterday (across the net I’m not in the ACT) and he even called for it. He did note the economic “hard heads” in Treasury are against it but also thinks it is inevitable.

      And it is easy to see why we should be against it when we read Bill’s blogs Norway and the Sectoral Balances and The Futures Fund Scandal. So maybe there are actually some public servants in the Treasury Department that actually get MMT and understand stock-flow consistency & the sectoral balances.

    14. Will Richardson says:

      On strike today in the UK.

      The quality of debate could be worse but it’s still pretty ignorant, talk of taxpayers funding and not enough focus on the pensions for MPs, Senior Civil Servants and top Businessmen, how the rich see increasing wealth and incomes whilst the rest of us see one in nearly two centuries declines in living standards.

    15. Mike says:

      Bill you said the RBA guy was a former student. While I don’t expect you to tell us if he was a good student, did he leave you tutoring understanding MMT? If so does he subscribe to this now?

    16. bill says:

      Dear Mike (at 2011/06/30 at 18:39)

      I don’t think it would be appropriate for me to comment on any of my former students.

      best wishes
      bill

    17. Some Guy says:

      Fed Up: Try a basically all currency economy with no private debt and no gov’t debt. Strictly speaking, that is not a monetary economy at all. Currency is government debt. What you mean by a “just currency” economy is like an ancient or some medieval ones. The closest modern example would be a command economy. A “just currency” economy is almost the same as a “just government debt, some interest bearing” economy, especially if the rate is low. And in turn, if some private debt is added, but relatively not much, we don’t change things much. Minsky is the one to read here. Arthur Shipman’s blog, The New Arthurian Economics is a fun place to read about such things.

      You are right, lots of liquid government debt/currency, high government debt/GDP, government debt/private debt ratios makes for financial stability, as long as the government’s taxation power is real, and there are no real world shocks, as in the USA post WWII.
      *
      But no private debt?: No bar tabs? Surely you jest. IIRC, a significant fraction of the ancient Sumerian records represented debts owed to the beer women of Ur etc. Alas, work is the curse of the drinking class, but in the future, like the past, the ancient wisdom of the JG will provide ziggurats for us to build to pay off our debts to these angels.
      *
      the only way to create NEW medium of exchange is from the demand deposits from a loan (meaning debt and has to be borrowed into existence) Your terminology is confused. Demand deposits are not “created from” a loan. They are just created, the only way any form of money has ever been created, by someone printing an IOU on paper or on silver or on electrons, usually with some culture hero’s mug emblazoned on it. Demand deposits are generally created by banks only in exchange for a borrower’s IOU. The loan is the borrower’s debt. The bank monetizes it – buys it with a smaller amount of current bank debt/bank deposits/bank checks/banknotes, which modern governments put their full faith and credit behind in various ways, and make into negotiable, circulating money.
      *
      Sometimes governments just mail checks to their citizens, just for being there, as valentines to show their love. Governments are the only ones with the size and muscle to do this regularly and have their credit still be good, their love be requited. For their muscle means they sometimes send tax letters demanding you send them valentines in the form of dollars/valentines (which originally came from them), to prove your love for them.
      *
      In either case, government payment/spending or taxation/sales vs bank account crediting / acceptance of a loan note or balance drawdown/ loan repayment are just cases of the same thing, the efflux and reflux of credit. The loans being good and repayable (and repaid) are equivalent to the government injecting money into the economy and maintaining its value by effective exercise of its power of taxation.
      *
      So government deficit spending, whether pretend-“financed” by printing bond-money or not, is a case of new “medium of exchange”, which can be traded for demand deposits, being created in existing systems without a private loan. But since “medium of exchange” – better to just say “money” – is just a particular type of debt, that which becomes a medium of exchange, the idea of it being created without being “borrowed into existence”, without being somebody’s debt, is a contradiction in terms, once they are correctly defined. And this is true in any monetary system that deserves the name.

    18. Jeff65 says:

      Ralph,

      Regarding “full reserve banking”: what do reserves have to do with maturity transformation?

    19. Fed Up says:

      Some Guy’s post said: “Fed Up: Try a basically all currency economy with no private debt and no gov’t debt. Strictly speaking, that is not a monetary economy at all. Currency is government debt.”

      Why would currency with no bond/loan/IOU attached be considered gov’t debt? By debt (gov’t or private), I mean it has an interest rate attached, repayment terms attached, and brings something from the future to the present.

      And, “A “just currency” economy is almost the same as a “just government debt, some interest bearing” economy, especially if the rate is low. And in turn, if some private debt is added, but relatively not much, we don’t change things much.”

      Yes, it can change “things” especially with more and more debt looking at it from a budget and time perspective of the major economic entities.

      And, You are right, lots of liquid government debt/currency, high government debt/GDP, government debt/private debt ratios makes for financial stability, as long as the government’s taxation power is real, and there are no real world shocks, as in the USA post WWII.”

      No, that’s not what I’m saying. However, is going from mostly supply constrained to mostly demand constrained considered a “real world shock”?

      And, “But no private debt?: No bar tabs? Surely you jest.

      No. I am not.

      And, “the only way to create NEW medium of exchange is from the demand deposits from a loan (meaning debt and has to be borrowed into existence) Your terminology is confused. Demand deposits are not “created from” a loan. They are just created, the only way any form of money has ever been created, by someone printing an IOU on paper or on silver or on electrons, usually with some culture hero’s mug emblazoned on it. Demand deposits are generally created by banks only in exchange for a borrower’s IOU. The loan is the borrower’s debt. The bank monetizes it – buys it with a smaller amount of current bank debt/bank deposits/bank checks/banknotes, which modern governments put their full faith and credit behind in various ways, and make into negotiable, circulating money.”

      I don’t see the difference between this “the only way to create NEW medium of exchange is from the demand deposits from a loan (meaning debt and has to be borrowed into existence)” and this “Demand deposits are generally created by banks only in exchange for a borrower’s IOU. The loan is the borrower’s debt.”

      I suggest looking at my, JKH’s, and Adam (ak)’s comments at this post:

      http://bilbo.economicoutlook.net/blog/?p=15038

      Start at JKH says:
      Tuesday, June 28, 2011 at 21:00

      I assumed a 10-month mortgage and that the bank held onto to it (kept it on its budget/balance sheet).

      It seems to me the demand deposit(s) can circulate as medium of exchange.

      Also, go to a bank and ask for a new demand deposit with no bond/loan/IOU attached. They’ll say no. Go the fed and ask for new currency with no bond/loan/IOU attached. They’ll say no.
      “Sometimes governments just mail checks to their citizens, just for being there, as valentines to show their love. Governments are the only ones with the size and muscle to do this regularly and have their credit still be good, their love be requited. For their muscle means they sometimes send tax letters demanding you send them valentines in the form of dollars/valentines (which originally came from them), to prove your love for them.”

      Assume gov’t budget already in deficit. Gov’t sends me a check and sells a bond (debt). Later they tax me. That should be called forcing me into debt and then using the tax as interest payments (and possibly principal payments) on the debt. I don’t want to go into debt or make interest payments nor should I be forced to.

      What this is really about is if an economy needs more medium of exchange, how should that be done and whether it should be currency/demand deposits with no loan/bond/IOU attached or with a loan/bond/IOU attached (making it debt). If it is debt, then there is an interest rate attached, repayment terms attached, and brings something from the future to the present.

    20. Kostas Kalevras says:

      @Ralph Musgrave

      Government guarantees public savings (deposits). A bank’s profits come from the interest paid on loans (minus the interest paid on deposits). A bank may face a liquidity problem and start losing money because of higher rates on it’s own borrowing from the financial markets. It’s liquidity problems can be settled through injections from the central bank. It’s loses will just start eating on it’s capital. If things go like that for a while then it comes to a point where it’s capital to assets ratio is too low. At that point it’s shareholders will have to make an injection or face bankruptcy. If they settle for the latter the government/central bank will take over the bank with shareholders and managers taking all the loses. It’s employees will probably keep their jobs and it’s depositors will not lose anything because of government deposits guarantee.

      The big problem is just that things did not go that way in 2008.

    21. Mike says:

      Fair enough Bill but it would be nice, comforting actually, to know that someone senior there understands how things work — particularly when so many other demonstrate that they don’t!

    22. Some Guy says:

      Fed Up: IMHO you are making things more complicated than they really are. As I mentioned above and Wray mentioned elsewhere – “medium of exchange” is NOT how to start thinking about money. It “draws your attention to all the wrong things”. Just plain “money” or “currency” is a much better word.

      Why would currency with no bond/loan/IOU attached be considered gov’t debt?
      Look at a dictionary under “debt”. Currency, and all forms of money fit the definition. The trivial idea that “all money is debt” is the heart of MMT. Mitchell-Innes’s two papers are a great place to absorb this, as are many of Wray’s papers. Was just having a conversation about this with Rodger Mitchell & others here .

      By debt (gov’t or private), I mean it has an interest rate attached, repayment terms attached, and brings something from the future to the present. This is not the usual definition of “debt”. Especially the third. Only time machines really bring things from the future to the present. Any form of money, any form of debt incorporates “futurity”. Why would anyone hold money otherwise? Money, including currency, is always for something to be consumed in the future, always “brings something from the future to the present” the way you mean.

      I don’t see the difference between this “the only way to create NEW medium of exchange is from the demand deposits from a loan (meaning debt and has to be borrowed into existence)” and this “Demand deposits are generally created by banks only in exchange for a borrower’s IOU. The loan is the borrower’s debt.”

      The difference is that the loan note held by the bank, and the borrower’s demand deposit are independent things, two debts which are created independently and then exchanged. One is not “created from” another. If you barter a chicken for a duck, did you create the duck from the chicken?

      It seems to me the demand deposit(s) can circulate as medium of exchange. Yes – that is what (modern) banking is. A “private” entity’s debts, the bank’s demand deposits, are backed by the government, which says the bank’s debt- its banknotes or deposits – are as good as government debt – currency, state money for almost all purposes. This makes bank deposits into money – debt which is transferable, debt which becomes a medium of exchange.

      Also, go to a bank and ask for a new demand deposit with no bond/loan/IOU attached. They’ll say no. Go the fed and ask for new currency with no bond/loan/IOU attached. They’ll say no. The point is not whether they DO it, but whether they COULD do it. Banks need to make a profit, so they don’t do this. They could, maybe as a advertising promotion to be their millionth customer. The government does it all the time. It mails out government checks all the time, creates ” NEW medium of exchange” which is NOT “from the demand deposits from a loan (meaning debt and has to be borrowed into existence)” . Anyone would be happy if there were a bond “attached” to his government check. He’d remove the staple and have more money!

      Governments don’t “attach” bond/loans/IOUs to their currency (which IS just a government bond/loan/IOU in the first place!). What could “attach” mean? Selling bonds is a comparatively unimportant and unnecessary sideshow that should be ignored at first. Think of bonds as dollar bills and dollar bills as bonds. It’s like thinking that if the government prints ones & sends them out in the mail and hundreds, which are only available at banks that trade them for 100 ones that the hundreds somehow “back” the ones, or the ones are issued with hundreds “attached”.

      Abba Lerner was as always particularly clear on these kind of points. When people talk about governments deficit-spending, he noted that they usually conflate the “borrowing” & spending into one operation in their mind – borrowingandspending, when they are two completely independent ones. Many MMTers propose “no bonds” so no pretend-“borrowing”, just spending and taxing.
      Assume gov’t budget already in deficit. Gov’t sends me a check This is already putting the government in debt. A government check is a government debt.

      and sells a bond (debt).
      This is just the government doing the not-very-economically-important favor to those who hold government debt= cash=tax credits of exchanging them for a little bit more government debt, dollar bills with a date in the future, a deferred tax credit, at a discount – the inverse of the interest rate. It is not borrowing. The government is already in debt to the currency holder. The holder is just swapping one government financial asset for another. Trading a bond for a dollar is no more “borrowing” or “going into debt” than exchanging two fives for a ten is.

      Later they tax me. That should be called forcing me into debt and then using the tax as interest payments (and possibly principal payments) on the debt. I don’t want to go into debt or make interest payments nor should I be forced to. The taxation is where the government is forcing you into debt. That is what taxation IS. “I don’t want to go into debt” = “I don’t want to be taxed” Who does? The government spending is the “real taxation” as Mosler says – the real transfer of goods and services from private to public, but it is entirely voluntary. The “borrowing”/ bond sale is a comparatively meaningless sideshow. Unless you pay your taxes late, YOU don’t make interest payments. The GOVERNMENT makes interest payments to you when you hold a bond. These expressions are dangerously confused – it verges on the confused, backwards, mainstream media idea of the “National Debt” as something the citizens OWE, rather than OWN.

    23. Tom Hickey says:

      @ Fed UP, Some Guy

      Good response, Some Guy. I would simply add that bond issuance to offset spending creates an incentive (interest payment) not to spend what the government has just spent into the economy. This incentive not to consume or invest but rather to save then creates the need for a larger deficit (and more tys issuance) to offset the demand leakage to saving, resulting in a self-augmenting cycle. The top of the town are the principal savers and so deficits flow to them in the form of tsys as a subsidized parking place for savings.

    24. Neil Wilson says:

      I would also suggest (although it is only a thought experiment that seems to fit the evidence) that the interest incentive contributes to the exchange rate being higher than it otherwise would be.

      Which then favours imports over domestic production. Where a country is a net importer you appear to get a trend developing where this incentive effectively subsides foreign consumption over domestic – causing domestic production to atrophy.

      Again it appears that it can only be countered by making sure that deficit spending is sufficient to plug the leak *and* that deficit spending is without an interest subsidy.

      Under current financial arrangements with insufficient deficit spending, export led countries seem to ‘win’.

    25. Fed Up says:

      Some Guy’s post said:

      “Fed Up: IMHO you are making things more complicated than they really are. As I mentioned above and Wray mentioned elsewhere – “medium of exchange” is NOT how to start thinking about money. It “draws your attention to all the wrong things”. Just plain “money” or “currency” is a much better word.”

      No, medium of exchange is correct because both currency and demand deposits are medium of exchange. There are too many definitions of “money”, and “currency” and demand deposits are different but can be similar.

      And, “Why would currency with no bond/loan/IOU attached be considered gov’t debt?
      Look at a dictionary under “debt”. Currency, and all forms of money fit the definition. The trivial idea that “all money is debt” is the heart of MMT. Mitchell-Innes’s two papers are a great place to absorb this, as are many of Wray’s papers. Was just having a conversation about this with Rodger Mitchell & others here .”

      IMO and to see what is really going on, more than one “definition” of debt may be needed.

      And, “By debt (gov’t or private), I mean it has an interest rate attached, repayment terms attached, and brings something from the future to the present.
      This is not the usual definition of “debt”. Especially the third. Only time machines really bring things from the future to the present. Any form of money, any form of debt incorporates “futurity”. Why would anyone hold money otherwise? Money, including currency, is always for something to be consumed in the future, always “brings something from the future to the present” the way you mean.”

      Go ask someone on the street about mortgage or credit card debt and what happens. I believe most people will say they look at the monthly payment (part of the repayment terms) and the interest rate to borrow at. There are also default terms and collateral. IMO, that is the usual definition of debt. Now I suppose there could be more than one definition of debt. Lastly, what if the person is denied the debt? Usually, they can’t spend today, but will at least have to wait until in the future.

      And, “I don’t see the difference between this “the only way to create NEW medium of exchange is from the demand deposits from a loan (meaning debt and has to be borrowed into existence)” and this “Demand deposits are generally created by banks only in exchange for a borrower’s IOU. The loan is the borrower’s debt.”

      The difference is that the loan note held by the bank, and the borrower’s demand deposit are independent things, two debts which are created independently and then exchanged. One is not “created from” another. If you barter a chicken for a duck, did you create the duck from the chicken?”

      I agree they are independent things. I don’t agree they are two debts, but that comes down to definitions again.

      And, “It seems to me the demand deposit(s) can circulate as medium of exchange.
      Yes – that is what (modern) banking is. A “private” entity’s debts, the bank’s demand deposits, are backed by the government, which says the bank’s debt- its banknotes or deposits – are as good as government debt – currency, state money for almost all purposes. This makes bank deposits into money – debt which is transferable, debt which becomes a medium of exchange.”

      I agree that the powers that be want currency and demand deposits to both be medium of exchange. As far as being debt, definitions again.

      And, “Also, go to a bank and ask for a new demand deposit with no bond/loan/IOU attached. They’ll say no. Go the fed and ask for new currency with no bond/loan/IOU attached. They’ll say no.
      The point is not whether they DO it, but whether they COULD do it. Banks need to make a profit, so they don’t do this. They could, maybe as a advertising promotion to be their millionth customer. The government does it all the time. It mails out government checks all the time, creates ” NEW medium of exchange” which is NOT “from the demand deposits from a loan (meaning debt and has to be borrowed into existence)” . Anyone would be happy if there were a bond “attached” to his government check. He’d remove the staple and have more money!”

      I’m not sure they could. It seems to me the gov’t checks are either “paid for” (loosely) with taxes or a bond attached. What I am referring to is when someone gets a gov’t check (demand deposit) and some rich entity gets the gov’t bond.

      And, “Governments don’t “attach” bond/loans/IOUs to their currency (which IS just a government bond/loan/IOU in the first place!). What could “attach” mean? Selling bonds is a comparatively unimportant and unnecessary sideshow that should be ignored at first. Think of bonds as dollar bills and dollar bills as bonds. It’s like thinking that if the government prints ones & sends them out in the mail and hundreds, which are only available at banks that trade them for 100 ones that the hundreds somehow “back” the ones, or the ones are issued with hundreds “attached”.”

      Actually, I believe the gov’t does attach bonds/loans/IOUs to their currency (I mean currency and not demand deposits here). What could “attach” mean? Good question to think about.

      And, “Abba Lerner was as always particularly clear on these kind of points. When people talk about governments deficit-spending, he noted that they usually conflate the “borrowing” & spending into one operation in their mind – borrowingandspending, when they are two completely independent ones. Many MMTers propose “no bonds” so no pretend-”borrowing”, just spending and taxing.

      Assume gov’t budget already in deficit. Gov’t sends me a check.
      This is already putting the government in debt. A government check is a government debt.

      and sells a bond (debt).
      This is just the government doing the not-very-economically-important favor to those who hold government debt= cash=tax credits of exchanging them for a little bit more government debt, dollar bills with a date in the future, a deferred tax credit, at a discount – the inverse of the interest rate. It is not borrowing. The government is already in debt to the currency holder. The holder is just swapping one government financial asset for another. Trading a bond for a dollar is no more “borrowing” or “going into debt” than exchanging two fives for a ten is.”

      Once again, that all depends on definitions. IMO, swapping and going into debt are two different things.

      And, “Later they tax me. That should be called forcing me into debt and then using the tax as interest payments (and possibly principal payments) on the debt. I don’t want to go into debt or make interest payments nor should I be forced to.
      The taxation is where the government is forcing you into debt. That is what taxation IS. “I don’t want to go into debt” = “I don’t want to be taxed” Who does? The government spending is the “real taxation” as Mosler says – the real transfer of goods and services from private to public, but it is entirely voluntary. The “borrowing”/ bond sale is a comparatively meaningless sideshow. Unless you pay your taxes late, YOU don’t make interest payments. The GOVERNMENT makes interest payments to you when you hold a bond. These expressions are dangerously confused – it verges on the confused, backwards, mainstream media idea of the “National Debt” as something the citizens OWE, rather than OWN.”

      IMO, there is a difference between paying taxes to run a balanced budget, meaning no gov’t bonds and having gov’t bonds. Lastly, what happens when the few rich entities own the all of the bonds and everyone else owes the bonds (in other words, wealth/income inequality)?

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