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Painstaking, dot-point summary – bond issuance doesn’t lower inflation risk

I will finish this week with a painstaking, dot-point summary of some key elements of Modern Monetary Theory (MMT) to show clearly why bond-issuance which might accompany a budget deficit doesn’t lower the inflation risk of the deficit spending – not now, not tomorrow, nor at some mythical “long-run” point in time. All the inflation risk is on the spending (aggregate demand) side. The monetary arrangements that might or might not accompany the spending decisions of government do not add or subtract from the inflation risk. Mainstream theory thinks they do. That theory is demonstrably false. I will also cover several related myths that seem to have cropped up over the last week – both in the international media and among the comments made on this blog. It seems that we need some baby steps. So with my fire-suit (always) on I hope you all enjoy it. Some of the critics might like to read this news item before they start.

1. Governments need to fund spending myth

A sovereign government that issues its own currency can never be revenue constrained in that currency as an intrinsic fact. It makes no sense to say that government spending is being “financed” by the users of that currency (the non-government sector). The users ultimately depend on the government spending to acquire the currency.

Governments can introduce all sorts of institutional machinery to curtail their fiscal freedom – such as special accounts which bond-issue revenue is placed and from which they spend – and make it look as if they are being funded by proceeds from taxation and debt-issuance. But they are just ideological layers that carried over from the fixed exchange rate/convertible currency system and have no intrinsic meaning in a fiat monetary system.

2. The household and sovereign government analogy myth

Thus the mainstream economics starting point – the analogy between the household and the sovereign government – which claims that any excess in government spending over taxation receipts has to be “financed” in two ways: (a) by borrowing from the public; and/or (b) by “printing money” misses the point that the household uses the currency and the government issues it. The government budget is not a big household budget. Household have to finance all spending prior to spending. The household cannot spend first. The government has to spend first and does not to finance such expenditure – in the normal use of term as applied to a household.

3. The government budget constraint myth

Mainstream economists erroneously build on the household analogy and claim that just like a household the government is bound by the so-called government budget constraint (GBC). The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:

gbc

This says that the Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.

The mainstream economist considers this to be an ex ante (before the fact) financial constraint that the government is bound by. They also erroneously claim that “money creation” results from the government asking the central bank to buy treasury bonds in return for printing “money” which the government then spends.

In normal times, this “debt monetisation” is not a viable option for a central bank. I explain that in these blogs – Deficit spending 101 – Part 1Deficit spending 101 – Part 2Deficit spending 101 – Part 3.

The mainstream claims that if governments increase the money growth rate the extra spending will cause accelerating inflation because there will be “too much money chasing too few goods”! So they claim that governments should only issue debt to “fund” deficits because that reduces the inflation risk.

Lurking behind this view is the Quantity Theory of Money which is an accounting statement linking the outstanding stock of money to the nominal level of GDP. This accounting identity is usually written as MV = PY where M is the stock of “money”, V is the velocity of circulation (or the times that M turns over per period), P is the price level and Y is real GDP. The relationship just says that total spending (MV) has to be equal to nominal GDP (real GDP times the price level) as a matter of national accounting.

If you assume full capacity utilisation is always maintained and V is constant then any change in M must directly impact on P. So if M accelerates – under these assumptions – so will P (that is, inflation).

Once you assume away all the interesting things about the economy (that is, the business cycle – by assuming full employment always) then it is trivial that if M rises so will P. But if Y is below full employment then extra spending can clearly stimulate the real side of the economy without increasing prices. The vast array of evidence over many years supports the notion that increases in aggregate spending when the economy is below full employment stimulate real output and only if aggregate demand is pushed beyond the real capacity of the economy do price pressures build (excluding supply-induced inflationary episodes).

4. The money multiplier myth

The mainstream then link the monetary base (bank reserves and currency on issue) to the stock of money via the money multiplier – another major flaw in their reasoning. Please read my blog – Money multiplier and other myths “> – for more discussion on this point.

The money multiplier model says that: M = m x MB. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the RRR = 0.10). The alleged linkages are (assuming banks are required to hold 10 per cent of all deposits as reserves):

  • A person deposits say $100 in a bank.
  • To make money, the bank then loans the remaining $90 to a customer.
  • They spend the money and the recipient of the funds deposits it with their bank.
  • That bank then lends 0.9 times $90 = $81 (keeping 0.10 in reserve as required).
  • And so on until the loans become so small that they dissolve to zero …

The problem is that this stylised mainstream text-book model isn’t even close to how things actually operate in the banking sector. The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share.

These loans are made independent of their reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds.

Reserve balances are not initially required to “finance” bank balance sheet expansion. A bank’s ability to expand its balance sheet via lending is not constrained by the quantity of reserves it holds or any fractional reserve requirements. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

6. What about open market operations? These are allegedly how the central bank increases or decreases the money supply. The mainstream argue that if the central bank wants to increase the money supply it would purchase bonds in the markets.

But this would just add reserves to the banking system. In the real world, the banks will try to lend those reserves out because they don’t want to be stuck with under performing deposits and competition in the overnight markets will drive the interest rate down. Clearly, if the central bank wants to maintain control over a positive overnight interest rate it has to then drain the excess reserves which would require it offer the banks an interest-bearing asset commensurate with the overnight rate. That is, it would have to sell bonds in an open market operation. The reverse is true if it tried to reduce the money supply by selling bonds. This drains reserves from the cash system and would probably leave some banks short of required reserves. Given the only remedy for an overall shortage of reserves is intervention from the central bank the attempt to decrease the money supply fails.

It is clear that the central bank then is unable to control the volume of money in the system although it can control the price through its monetary policy settings. The monetary base does not drive the money supply. In fact, the reverse is true. Bank reserves at any point in time will be determined by the loans that the banks make independent of their reserve positions.

5. The “free lunch – pay for it later” inflation myth

We know that the Quantity Theory of Money is inapplicable to economies which are constrained by deficient demand (defined as demand below the full employment level). When nominal demand increases in such an economy firms respond by increasing real output (and employment) rather than prices. There is an extensive literature supporting that statement. So when governments expand deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases.

Some mainstream economists call this the “free lunch” period which eventually has to be paid for courtesy of the so-called “long-run budget constraint”. They claim that when aggregate demand reaches real output capacity the “free lunch” for budget deficits run out and they are forced to (finally) obey the long-run budget constraint because at that point taxes have to be increased to curtail aggregate demand to prevent inflation. This amounts to raising “taxes to pay for past, present or future government spending”.

This is of-course an absurd construction of events. The only constraints on nominal government spending are real. The government can purchase whatever is for sale in the currency it issues whenever it chooses. Its past fiscal position is irrelevant to that capacity. Please note: that doesn’t mean it can spend infinite amounts without any problems. The statement is that it can – that is, the intrinsic capacity of a fiat-issuing government.

So, please recite the next sentence several times – noting it is not a general jargon-ridden statement but a clear, concise, definitive fact – there is a real constraint on all spending (public and private).

The government could keep driving nominal demand with ever increasing deficits beyond the full capacity point if it wanted to. Hyperinflation would eventually result. If government aims to promote public purpose via full employment and high real income growth then you would question the sanity of a government that pushed deficit growth beyond the full employment point.

Consider this example. Assume the economy is currently at full employment and private spending (including net exports) is 90 per cent of GDP and public net spending (deficit) is 10 per cent of GDP. Now if potential output (that is, the real output constraint) is growing at say 4 per cent per annum, both private spending and public spending can growing at 4 per cent per annum without pushing the economy beyond the inflation barrier (although at near full capacity there might be some individual sector bottlenecks).

If non-government saving is equal to 10 per cent of GDP then the budget deficit would have to remain at 10 per cent of GDP continuously to support aggregate demand growing at 4 per cent per annum and full employment being sustained.

If, say private sector spending grew at say 5 per cent per annum (with all other parameters unchanged) then the economy would quickly hit the inflation barrier. In that situation, to prevent inflation the government would have to cut its own spending and/or increase taxes to cut the spending of the private sector to bring total nominal aggregate demand growth back to 4 per cent per annum.

The increased taxes are not “paying back” previous deficits nor are they funding anything. They are just maintaining aggregate demand growth in line with real output potential.

The point is that deficits are flows and exhaust each year as does the national income that is created. Every “new” year, the spending flows add to demand which drives income and output (and employment). No government has to pay back last year’s deficit.

The other point is that the inflation risk of government deficits (and all spending) is in terms of the impact on aggregate demand. Inflation is the result of excessive nominal demand (relative to real output capacity – the supply capacity of the economy). Whether the government sells bonds or not is totally irrelevant in this regard. Which leads us to the …

6. Governments choose between printing money and debt issuance to fund deficits myth

Within the government budget constraint literature – once the QTM is used to dissuade governments from “printing money” – the attention turns to taxation and debt issuance.

The mainstream claim that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. As we will see government spending is performed in the same way irrespective of the accompanying monetary operations.

But the mainstream rank the three so-called funding options in terms of their expansionary impact and their inflation risk. Countless chapters on fiscal policy in mainstream macroeconomic text books go through this analysis and mislead their students as a consequence.

So printing money is most expansionary (because it is alleged it not only increases spending but also reduces interest rates – so thwarting their crowding out analysis). Bond sales are less expansionary because they forces up interest rates which crowd out some private spending. The extreme mainstream view is that the interest rate effect totally swamps the government spending stimulus and there is no gain in output.

But all these claims are without foundation in a fiat monetary system and if you gain an understanding of the banking operations that occur when governments spend and issue debt you will see why.

I know some people claim that MMT cuts debate short by saying it is just a matter of understanding banking operations or something like that. Given we have written millions of words over the last few decades minutely describing these operations I fail to comprehend the attack. It just resonates that the critics cannot come to terms with the detail. You will find very little in mainstream macroeconomics textbooks or related literature describing in detail what happens when a government spends, for example.

The mainstream economists construe that governments have a choice when they run deficits – either sell bonds or “print money”. That choice doesn’t transcend the textbook world I am afraid. In the real monetary system – the one we all live in – governments do not spend in that sort of choice-constrained framework.

Government spending is just a process of electronic entries into bank accounts. Millions of transactions every day. Once all these transactions are accounted for (and non-government people and firms have deposited their receipts etc) the manifestation in the banking system is an increase in reserves.

So government spending results in the Treasury credited the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. But at this stage, M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. In other words, budget deficits increase net financial assets in the non-government sector.

If that spending pushes the economy beyond the inflation barrier then the government has to curb public spending growth or private spending growth (by increased taxation). There are other tools (price controls) but we won’t consider them here.

7. The bonds are less inflationary myth

So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

Reflect back on Item 6 and realise that when there are excess reserves in the cash system as a result of deficits there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities).

Accordingly, the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, reduces the money supply.

However, the reality is that:

  • Building bank reserves does not increase the ability of the banks to lend.
  • Banks do not lend bank reserves
  • The money multiplier process does not describe the way in which banks make loans.
  • Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

Think about it like this:

(a) if there were no bonds issued the bank reserves would rise in level. This doesn’t alter the capacity of the private sector to spend nor the bank’s ability to lend.

(b) if instead bonds are issued the level of bank reserves fall and the level of public debt rises. This just amounts to the central bank doing some accounting entries to swap the private “saving” from “reserve accounts” to “outstanding loan accounts”. This has no impact on the government spending or the inflation impact of the government spending.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

Other related blogs include – Why history matters and The complacent students sit and listen to some of that.

8. What if the private sector spend more myth

This myth goes like this. The private sector will distrust a government that doesn’t issue debt and so will seek to hold their accumulated wealth in real assets to hedge against inflation. As a result they will desert the currency.

First, how do these people pay taxes? They have to have the issued currency to pay taxes. They cannot present a gold bar or a piece or real estate or any other asset to the government to relinquish their tax obligations. Yes some might go off-shore but not everyone can do that.

Second, the reserves that governments drain when they issue debt reflect prior public spending. The government just borrows back their own spending to ensure the central bank can manage its liquidity aims.

Third, bonds are highly liquid and holding them doesn’t constrain private spending capacity.

Fourth, if the non-government entities (firms and people) so decide to spend all the “money” that results from government spending – that is, not leave any in accumulated financial assets – then nominal spending growth will increase and the government has two choices. It can decide that more private spending relative to public net spending is good (in the mix of final goods and services) and cut back its own discretionary net spending. The actual budget deficit will shrink anyway because of the automatic stabilisers.

Alternatively, it might consider the current (non-inflationary) public command over real resources is desirable and so it will seek to curb the private spending via taxation.

There is no inevitable descent into hyperinflation.

Musical relief

After a week of reading nonsensical mainstream economics literature and realising (via some of the commentators here) that people still want to defend it – my Friday musical interlude is the great Bo Diddley from 1955 – soothing us with his vibrato. Beautiful.

Conclusion

Here is an assignment for all those who still want to defend mainstream macroeconomics.

Please present a detailed analysis – including a thorough explication of the monetary operations of the Bank of Japan over the last 20 years or so – to explain why Japan has not experienced sky-rocketing interest rates and hyperinflation.

As a secondary assignment please explain why interest rates and inflation are not rising rapidly in the US at present with particular attention to the spiralling of bank reserves and the almost zero demand for private credit.

When you have done that please send it to me and I will highlight it in a blog post. But it will need to be at least 6 thousand words so we avoid statements like “bond issuance reduces inflation risk” and “printing money is hyperinflationary” and “it is just a matter of time” and “Japan is culturally different”. We have heard all those statements before.

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow – even harder than last week!

That is enough for today!

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    This Post Has 205 Comments
    1. Bill:

      Might I just suggest that in this paragraph,

      “But this would just add reserves to the banking system. In the real world, the banks will try to lend those reserves out because they don’t want to be stuck with under performing deposits and competition in the overnight markets will drive the interest rate down”

      You add ” the banks will try to lend those reserves out to each other“.

      The critical difference between lending to other banks versus lending to us regular slobs seems to be the main stumbling block for some.

      Also, when previewing, paragraph breaks (or double line breaks) don’t seem to appear, so the comments look very messy.

    2. Bill,

      “Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.”

      Shouldn’t it be “reduces the money supply.”

    3. Grigory,

      I think the critical difference is payments that use up bank reserves (primary bond issues, taxation, x-bank lending) and those for which private bank demand deposits are acceptable as payment.

    4. As a late comer to the MMT debate, I have probably been one of those causing a degree of frustrating annoyance to MMT-literate persons. At the same time, I hope you will note that I wrote at the outset “I find myself generally in agreement with MMT and its prescriptions”. I then suggested that I thought these prescriptions were approximately equal to “soft Keynesian” economics which would also, I think, accept net budget deficits over the full cycle (especially with a view to maintaining full employment).

      In questioning aspects of MMT to enhance my own understanding, I drew support from those who thought I supported the opposite view. This is not the case. A quirk of mine is that I often become more questioning and more combative, the closer I come to accepting a new (to me) theory or view. I want to test the argument in full and be convinced there are no holes in it before I finally accept it. After, reading the above Painstaking Post most of my concerns and misconceptions are laid to rest.

      This does raise the issue of empiricism and genuine education versus dogma and propaganda. Most persons absorb the dominant illogical or alogical dogmas concerning political economy without effort, without conscious recognition and without critical review. If I, as a layperson and autodidact in economics, at least recognise the problem and then begin to ponder how much time I ought to invest in becoming more literate in political economy… what answer will I come up with? The simple answer is a lot of time if I want to gain a genuine understanding. As minimum I suspect I should read;

      (1) Adam Smith – Wealth of Nations (Done, but a while ago and I skipped the postscript critique of Mercantilism so I should read it again.)
      (2) Karl Marx – Das Kapital Vols 1 to 3 (Read Vol 1 as an undergraduate many years ago. It was not related to my course. Okay I will have to go back and read Vols 1 to 3 in theor entirety)
      (3) Ricardo – (Should I read Ricardo?)
      (4) Keynes – (Yes I should read his magnum opus)
      (5) Hayek – (Perhaps even though I konow will hate it and disagree all the way through but must do it on the prociple of learning some opposing points of view)
      (6) The top MMT theorist (Who is this?)
      (7) Hyman Minsky and his follower Steve Keen.

      This is a minmum reading list. I’ll do my best but I doubt I will get through all of it. How many laypersons are going to do that? And what’s the alternative?

    5. Dear Bill
      Suppose that the government sells a bond for 1,000 to Peter. It now has 1,000 and issues a cheque for the same amount to a pensioner. It seems to me that all what happened is that the money went from Peter’s account to the pensioner’s account. Total deposits remain the same. I don’t understand why the money supply shrinks when the government sells bonds if the revenues from the bond sale are used to finance government expenditures.

      Regards. James

    6. Any Money Market/Fixed Income trader understands this perfectly. You re absolutelly right. G7 Governments (ex euro ones, of course) should drop the sacrosanctum status of the debt profile. Long term debt should be used to set long term risk free interest rates, nothing else. It is absolutelly ridiculous that the market is worried about the funding capacity of these countries. Regards, and thanks for the post

    7. james,

      I am not an economist but let me take a shot at your question. When the CB or
      Treasury issues bonds it is to maintain a target interest rate. That usually entails keeping the money supply at a constant rate. If the government spent and never drained the reserves the interest rate would fall to zero. So, we can infer from this that they do not sell bonds to finance spending. It is for the former. Remember, the money to buy bonds and pay taxes come from spending, not the other way around.

    8. This is a very long blog, so I will react first on the “The government budget constraint myth”. Let’s assume that government is in this position: it has outstanding debt of 100 units representing 100% of the current GDP. These bonds earn 5% nominal interest. Let us say that economy uses 100 money units as monetary base. It suffers from lack of aggregate demand which needs additional 10% spending injection. Now consider the following two scenarios:

      1. Government prints money and increases spending directly by 10%. It issues exactly 10 monetary units, economy gets to full employment and everything starts to sort out. At the end of the year it pays interest on bonds by printing additional money, increasing the total monetary base to 110 + 100 x 0,05 = 115. Debt remains at 100 nominal units.

      2. Government buys back some of its bonds so that it increases the monetary base by 10 points. For simplicity, let’s assume that it decreases outstanding debt to 90 – but it does not matter as it is also valid if it decreases the debt even by 1 unit. New cash in economy starts chasing goods, increases demand and restores economy to full employment. At the end of the year government also prints additional money to pay interest as in scenario 1. The monetary base in economy is 110 + 90 x 0,05 = 114,5. Debt remains at 90 nominal units. Also future inflation expectation are lower then in scenario 1, because government decreased its debt burden meaning it needs to print less money to oblige its debt in the future.

      And now quiz question – which economy experiences higher price level? There is no free lunch here. Government spending by direct money creation will be reflected in increased future inflation.

      PS: of course the dynamics is completely different, in liquidity trap, when bonds are equal to cash. In this economy, if government buys back bonds the money will just sit on accounts of former bondholders doing nothing for stimulation of aggregate demand. This is the dreaded liquidity trap and prescription for resolution of this situation are the same as MMTers would suggest – just create the money where it will be used (fiscal stimulus). But this is border case, in most occasions it suffices to induce private sector to increase spending by offering enough cash in the system in exchange for bonds. This way you lower overall inflation level and expectations in the future.

    9. JV,

      “New cash in economy starts chasing goods”

      That’s your implication. If the government buys bonds it is immediately spent, and if it is in bonds it isn’t spent.

      There is no evidence for that assumption.

    10. “Accordingly, the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.”

      But the CB will quickly run out of bonds if none are issued to fund spending. It can pay IOR, but this is also
      “cheating” in some sense, as its equivalent to funding via overnight T-bills. I’d also need to be convinced that
      funding entirely by IOR wouldn’t make the system more unstable.

    11. Neil: I don’t understand you. Do you suggest that there is no difference in impact that bonds and high powered have on price level? It in other words, that private sector somehow uses bonds for spending?

      If this is so, then I recommend this article from Scott Sumner: http://www.themoneyillusion.com/?p=10116

      As you see in his article, the price level in both Canada an Australia depends on monetary base. NGDP in both Countries is around 30 times of the monetary base. However combined government liabilities (monetary base + bonds) are 5-10 times higher in Canada then in Australia. Clearly what matters for price level is high powered money, not bonds. That means “financing” debt by money issuance IS actually more inflationary than by issuing bonds. I know that this may not fit your model, but these are data from reality. So if reality does not agree with the model, I know on which side I am. Do you, Neil?

    12. I would add another comment to my previous one. There, we ended up with 2 different solutions for insuficient AD. Now, what if government overdid it and now it faces elevated inflation pressures. Let’s suppose that the nominal increase of expenditure by 10% resulted in 5% increase of real output, but the rest is inflationary. What could a government do?

      1). Monetary base is 115, debt is 100. Real output grew from 100 to 105, 10 units of the money in circulation did not find corresponding output and it now threatens the economy by elevated inflation risk. So government can now increase taxes to destroy this exceeding 10 monetary units so that everything is OK again. It is true that part of this tax increase will be covered due to the growth of the economy itself. But it is unlikely that it will be sufficient and it is possible that government will need to increase tax rates to get things in order.

      So what do we have now? Economy at full employment, debt at 100 nominal units, monetary base of 105 – the rest was absorbed by taxes. That means increased tax rate. Economy is in full employment equilibrium again.

      2) Government may issue bonds again. It will issue bonds for 10 monetary units – the same bonds it bought back a year ago. Inflation presure subsided.

      So what do we have now? Economy at full employment, debt back from 90 to 100 nominal units, monetary base of 104,5 No new taxes.

      So what is the story? Government had a free lucn (sort of) It was eaten – as it should be – when the demand was insufficient. But ultimately part of the lunch that was not free had to be paid either by increased taxes or seignorage (tolerated inflation).

    13. Bill:

      Firstly, thank you for this wonderful and free blog.

      A question. You wrote regarding banking operations that when the system is short of reserves “the bank will sell bonds back to the central bank or borrow outright through the device called the ‘discount window’. There is typically a penalty for using this source of funds.”

      When a commercial bank borrows outright from the central bank is the money supply increased? Only to be decreased if and when the credit is paid back to the central bank?

    14. Dear Bill,

      I have just two questions for you.

      1. Do budget deficits at the state and local government levels increase net financial assets in the non-government sector?
      2. Do budget deficits of EMU countries increase net financial assets in the non-government sector?

      Thank for your attention.

      José

    15. JV:

      The 2 Scenarios have unstated assumptions regarding private sector savings preferences. Assuming that government bonds are the only saving vehicle, the question is whether interest payments are saved or spent.

      It is not a given that if the private sector has saved 100 in government bonds what they will do with their interest payments.

      Also, if interest is spent, it does not make sense that the government would spend 10, when only 5 would be needed with the additional 5 of interest. You can’t have a period where there is no interest paid if we assume a bond balance of 100 and an interest rate of 5%.

      Lets assume the government knows how much additional total spending is needed (10). The question is whether the private sector wants to save or spent.

      Scenario 1a – If interest is spent, then the government should spend an additional 5, plus the 5 from interest payments providing the 10 additional needed. Total circulation would be 110, bonds/savings would remain at 100.

      Scenario 1b – If interest is saved, then the government should spend an additional 10, with the 5 from interest payments being used to buy more government bonds. Total circulation would be 110, bonds/savings would be 105.

      Scenario 2a – If interest is spent, then the government should buy 5 bonds, plus the 5 of interest payments providing the 10 additional needed. Total circulation would be 110, bonds/savings 95.

      Scenario 2b – If interest is saved, then this is an oddball scenario – we are constrained in this scenario with no government direct spending, so the government would buy bonds, which means that the private sector does not want to save, but spend. But we just said that the private sector wants to save interest. Anyway …

      The government would buy 10 bonds, then with the 5 from interest payments, the government would turnaround and sell 5 of bonds to the private sector. Total circulation 110, bonds/savings 95. Same result as in 2A.

      Anyway, in all Scenarios, the spending is equivalent to aggregate demand needed, the difference is in net financial assets of the private sector, which reflects different savings preferences implied by your assumptions. The closest to “equilibrium” is 1A, where the government directly spends the amount needed, less the interest payments to the private sector providing the remaining spending.

    16. Bill,

      When you have done that please send it to me and I will highlight it in a blog post. But it will need to be at least 6 thousand words so we avoid statements like “bond issuance reduces inflation risk” and “printing money is hyperinflationary” and “it is just a matter of time” and “Japan is culturally different”. We have heard all those statements before.

      Completely agreed. When I read statements like those I have learned to skip that post and move on to the next in my reading list. I read so much that I need to find a way to keep the number of time-wasting posts down. So in that vein, I have come up with my own decent macroeconomic filter

      Thanks for another great post! (and another *great* video)

    17. Thank you for your patience, Professor Bill! Your writing is helpful for those of us who learned mainstream macro economics.

    18. Hi Professor Mitchell,

      I’m trying to get my head around these ideas; please pardon my partial comprehension
      (or is it my total incomprehension?).

      If aggregate spending (and thus GDP) grows at 4% over the long term, but the public
      deficit is 10% of GDP over the long term, this would seem to imply that the total reserves (or
      the total debt issued to drain them) must grow faster than GDP. The new reserves created
      each year are 2.5 times the growth in GDP.

      It appears to me that over time, this would imply that the total reserves, or the debt issued
      to drain them, would asymptote to 250% of GDP, but would be stable at that level.

      If that were stable, this non-economist imagines that it would not be a bad
      thing if the consequence were full employment.

      Perhaps I’m starting to understand this.

    19. Pebird: thanks for your response. It is indeed refreshing, that someone is willing to go through the pain to address what are my main objections directly.

      First, please be aware that I am assuming “normal” recession, not a liquidity trap.

      Now, you are perfectly right that it indeed depends on private sector savings preferences. Based on that, different sizes of stimulus/bond purchases will be needed to stimulate AD. You are also right, that government spending has a feature that it is guaranteed impact on AD.

      But it also bears opportunity costs. Under normal circumstances, injection of money via standard monetary policy stimulates private spending (consumption and investment), or in other words it discourages savings. So increase of real output is driven by private sector, while government sector maintains its ordinary path. So this discussion boils down to practical issues – such as how effective is the government spending, how flexible the policy is, if the projects may be finished in time to actually have impact at the time they are needed.

      And last, your scenario 2b is exactly what is called liquidity trap. This is a scenario when direct government spending is required in order for economy to get going again.

      But I would like to point on yet another important point. If you compare the 2 scenarios (direct government stimulus vs bond purchase) – in case it is overdone – that means it stimulates AD too much, you see that stimulation via money printing is either more inflationary, or it adds to more debt, or it directly increase taxes. I do not deny that when there is insufficient demand that there is no free lunch for government. It is. But this lunch may be eaten in terms of decreased debt burden/decreased inflation instead of government spending.

    20. Having been brought up on textbooks and newspaper articles written by mainstream economists, I wonder how MMT can find an audience – if even the most eminent of policy makers and economists (Summers, Krugman, etc.) – even those not in thrall to neoliberal doctrine can’t grasp the fundamentals, what hope is there for the rest of us?

      I’m just about bright enough to grasp the gist of the MMT position, but would hardly be able to hold my own in a debate with an orthodox economist. The media, including most of the internet is awash with junk economics, with government deficits holding centre stage. How on earth will it be possible to make a dent on such a fortress – particularly when it defends the self-interest of the most economically and politically powerful?

      I feel like I’ve just swallowed the red pill.

    21. “It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

      Think about it like this:

      (a) if there were no bonds issued the bank reserves would rise in level. This doesn’t alter the capacity of the private sector to spend nor the bank’s ability to lend.

      (b) if instead bonds are issued the level of bank reserves fall and the level of public debt rises. This just amounts to the central bank doing some accounting entries to swap the private “saving” from “reserve accounts” to “outstanding loan accounts”. This has no impact on the government spending or the inflation impact of the government spending.”

      I’d rather think about it this way. Apple saves $100 for one year in a checking account. The gov’t deficit spends $100 with no bond attached. At one year and one day, there could be $200 in circulation of medium of exchange. I assumed the fed funds rate went to zero and no other reactions to that. That is somewhat unrealistic, but trying to keep it simple.

      Apple saves $100 for one year in a checking account. The gov’t deficit spends $100 with a bond attached. Apple buys the bond. At one year and one day, there could be $100 in circulation of medium of exchange. I assumed both interest payments and principal payments on the gov’t bond to pay it off (no rollover risk). I ignored the interest payment transfer between borrower and lender.

      Notice the $200 vs. $100 in circulation of medium of exchange.

    22. “First, how do these people pay taxes? They have to have the issued currency to pay taxes. They cannot present a gold bar or a piece or real estate or any other asset to the government to relinquish their tax obligations. Yes some might go off-shore but not everyone can do that.”

      First, I would say issued medium of exchange to pay taxes.

      Second, you are ignoring the rich’s budget who have extremely high real earnings and/or real earnings growth. They make say $1 million, spend say $200,000, pay taxes of $200,000, and save $600,000. They can take their $600,000 and invest in “hard assets” to drive up their price with no increase in “final demand”. If producers realize this, they won’t respond to higher prices by expanding.

    23. It seems to me that the key propositions of MMT are empirically testable. If I understand the broad gist of MMT correctly, then proposition 1 of MMT is likely to be:

      Net Financial Assets of National Economy in Year ( X+1) = Net Financial Assets of National Economy in Year X + Budget Deficit in Year X + the Capital Account in Year X.

      Is this formulation correct? Can anyone paste links to long data series for OECD (but non-EU) countries illustrating the direct realtionships and inverse relationships implied by this formula or the relevant corrected formula? Naturally, to be valid, the net financial assets of the national economy would have to have been collected and computed from data independent of the terms in the right hand side of the equation. Is this possible? Forgive my ignorance of the nuts and bolts of national accounts and finance.

    24. JV:

      I guess the point I was trying to make was that if the saving desire is the driving factor, then the government has no choice between spending and bonds – the private sector makes the decision on inflation (by excess spending), not the government.

      Also, we need to separate consumption from asset pricing.

      If we agree that net financial assets (NFA) represent the value of real assets in the economy, and assume that in all Scenarios we end up with more real assets than before, then the Scenarios clearly have different impacts on asset prices.

      If due to our stimulus, the country ends up with more real assets than prior to stimulus, we should expect NFA greater than when we started. It would appear that Scenario 1B, where government spends to increase output and interest payments are used to save (e.g., reflect the increased quantity of real assets), would have the most stable impact on consumption and asset prices.

      In both Scenario 2 versions, where the private sector sells bonds back to the government for spending, we end up with less NFA to represent more real assets, e.g., asset deflation. Which seems to me to be a less stable situation.

    25. I want also to revive a more philosophical question I asked earlier. I can understand if Bill Mitchell is too busy to answer a new and noisy contributor but I hope that an accredited and knowledgeable student of Bill’s or of MMT can address my questions (this one and the one above). The spirit of my questions is that while I consider myself close to MMT on many issues of political economy (I am likely a “lay” post-Keynesian of some sort), I am troubled by the apparant “formalist” nature of MMT. I posted earlier on other threads about this issue.

      Essentially, I asked, “Is MMT in some respects just a formal system, internally consistent because it is constructed to be that way?” I also wrote subsequesntly, “”It has occurred to me, since writing the above, that MMT is a formal system because it describes a formal system. If this is true then it fully rehabilitates MMT.” Perhaps, I went too far in saying “fully” but you get my drift.

      My naive concerns that MMT is simply a formalist system seem to be reflected by some of the more thoughtful critics.

      Murphy – “it’s bad economics to confuse accounting identities with behavioral laws […] economics is not accounting.”

      I do find however that Murphy’s Robinson Crusoe critique of MMT is totally deficient and indeed entirely tangential to the premises and substantive theory of MMT (so far as I understand them).

      New Keynesian, Brad DeLong, has suggested MMT is not a theory but rather a tautology. Again, this seems to point at a concern that setting up a formalist system of accounting identities to describe finance does not describe the real economy.

      Can anyone answer my questions?

      On a lighter note (or perhaps a sombre note), can anyone imagine a reporter trying to raise public debate about government deficits above the current lamentable level?

      Reporter: “Candidate X, can you tell us whether you follow Keynesian, Post-Keynesian, Austrian, MMT or some other economic theory over the issue of government deficits?”

      Candidate X: “Say what?” (Pauses to play up to laughter from sycophant bystanders.) “Look seriously, everyone knows that deficits are a bad thing. Government finances are just like your household finances. If you are in too much debt it’s a bad thing. It has to be paid back. Government deficits are just money printing and that creates severe inflation. Everyone with any common sense knows that.”

      The rhetorical appeal to common prejudice and simplistic (fallacious) rubrics is coupled with inclusive congratulation for everyone who agrees with the politician; they have common sense like him and “everyone knows” that common sense trumps effete intellectualism.

    26. pebird: Honestly, you lost me here. I do not know what you mean by “Net financial assets represent the value of real assets in the economy”. I believe that in MMT by net financial assets it is meant cash, bank reserves and bonds. Now real assets are things like houses, machines, land, comodities etc. These assets were accumulated over decades. While their value can be expressed let’s say in currency – you may say “this antique I endowed from my granny could have value of $1000” I do not see any meaning this may have for our discussion.

      In scenario 1, and in scenario 2 we ended with the same amount of NFA. The only difference is that in scenario 1 government had to increase taxes to destroy cash (and thus lowering NFA of private sector) while in scenario 2 it only swapped bond for cash and vice versa. (in truth part of the monetary base was printed in both cases – just enough to accommodate real output growth).

    27. @ Ikonoclast: “This is a minimum reading list. I’ll do my best but I doubt I will get through all of it. How many laypersons are going to do that? And what’s the alternative?”

      1) Enjoy being alive!
      2) Enjoy being alive!
      3) Enjoy being alive!
      3) Practice the usual mental discipline –

      Instead of ranging over a wide field, start off with some aspect such as central banking operations, gather up all of the MMT links from the academicians pertaining to the subject and read thoroughly. Once understood compare with non-MMT views that you think may be relevant; then make up your own mind. Then expand to the next aspect: like methodically clearing weeds from a pond – students tend to reverse this process in their enthusiasm. In meditation its called aspiration >> concentration >> meditation >> contemplation >> illumination >> inspiration. People often focus on the content, but its the processes of the mind being employed as a tool (in order to understand the content) that underlies everything.

      @ Ikonoclast “New Keynesian, Brad DeLong, has suggested MMT is not a theory but rather a tautology. Again, this seems to point at a concern that setting up a formalist system of accounting identities to describe finance does not describe the real economy.”

      My take is the skin of the earth, its resources and human beings are real: dynamic human values mediate. All wealth comes from the earth and goes back to the earth – it’s hard to understand why human beings get so excited about ‘dirt’ (other than for essential living). The monetary system is just a plugin – it could be anything – it too reflects human nature. “It is in the minds of men that wars begin …” [UN Charter]

      MMT is just a bunch of concepts: but having said that, they offer a far more realistic description of the current monetary system on planet earth than any other (in my limited interested bystander understanding). It took people a long time to work out where the rain came from!

      What inspires me the most about people like the MMT academicians that you meet around the blogs and their conceptual edifice – is their humanity! There are billions of concepts in the world; but not so many that minister intelligently to the (monetary) needs of the human species.

      It might be in the ‘minds of men the wars begin’ but it is in the ‘hearts of men’ that what it means to be a human being is actually felt. Whether theory, tautology or voodoo, where the concepts lead to is important – there is much in mainstream economic thought that is deadly!

      Cheers …
      jrbarch

    28. JV:

      Yes, NFA is total cash and other financial instruments, net of private debt. There is no private debt in these Scenarios (my assumption).

      There was no increase in taxes in any of the Scenarios (again, as I calculated them).

      I didn’t assume the government overspent in Scenario 1, because they didn’t over buy bonds in Scenario 2.

      In the way that I calculated, all four scenarios ended up with 110 in circulation. But there was a difference in how much was saved (bonds):

      Scenario 1A/1B 100/105
      Scenario 2A/2B 95/95

      So in Scenario 1 there is higher NFA – which there better be since in Scenario 1 the government net spends (adds more NFA) and in Scenario 2 it does not.

      To keep things simple, lets assume no new physical assets are created, just more income and spending and real output with the same assets. So additional output is entirely consumption goods, no additional assets are created. Which makes sense, since we said initially that there was excess capacity in the economy.

      So, in both Scenarios 1 and 2 you have a more productive economy (the same assets generating higher income) but in Scenario 2 those assets are worth less than when they were less productive. That seems odd to me.

    29. Bill,
      Again, yeoman’s work here.
      A great, concise score on how money works.
      And with a great potential to spread your message.

      You might imagine my response is to ask that you consider the exact same purpose and function of government monetary operations, within a full-reserve banking system, as outlined by Fisher, Simons, Knight, Douglas and others.
      The potential for inflationary effects from changes in high-powered money does not exist.
      There is no high-powered money.
      There is no issue of whether reserve requirements play any role in endogenous money.
      The debt-management requirement to manage rates and other monetary relations would disappear.
      There were a lot of great American economists who were the most progressive of the time that backed the full-reserve banking system
      It has many benefits.
      For those who may be skeptical, this is not some Austrian prank.

    30. J.V. Dubois,

      You made an assumption that increasing the (unsterilised) government deficit by 10 units over a year period leads to the same effects on aggregate demand as increasing the monetary base at the beginning of the period by the same amount. Then you want to prove that it is smarter to use monetary policy instead of fiscal one.

      “1. Government prints money and increases spending directly by 10%. It issues exactly 10 monetary units, economy gets to full employment and everything starts to sort out.

      2. Government buys back some of its bonds so that it increases the monetary base by 10 points. For simplicity, let’s assume that it decreases outstanding debt to 90 – but it does not matter as it is also valid if it decreases the debt even by 1 unit. New cash in economy starts chasing goods, increases demand and restores economy to full employment.”

      I don’t want to get into a discussion who and why thinks that increasing the monetary base will work that way.

      The assumption you made that the effects of these 2 alternative policies would be similar is clearly wrong regardless whether the economy is in a “liquidity trap” (if one exists) or not. It is wrong because it has not been empirically shown that increasing the monetary base leads to a significant expansion of the demand.

      I found a paper clearly not written from the post-Keynesian or MMT positions providing meta-analysis of the statistical results from multiple countries. The conclusions found in that paper should settle this dispute. Your analysis which follows the initial assumption about the impact of expansion of M0 on aggregate demand is based on an invalid assumption.

      Bernd Hayo ZEI University of Bonn
      Money-Output Granger Causality Revisited: An Empirical Analysis of EU Countries
      Paper provided by ZEI – Center for European Integration Studies, University of Bonn in its series ZEI Working Papers with number B 08-1998.

      “In this paper, the evidence collected in the large literature on testing for Granger-causality from
      money to output is revisited. Using a broad data base of 14 EU-countries plus Canada, the US
      and Japan, and quarterly data from the mid 60s to the mid 90s, a number of hypotheses from
      this literature is evaluated. It is found that very few general conclusions can be sustained.”

      “The seminal contribution to this topic is Sims (1972). Based on his early study we can
      formulate the following hypothesis:
      H1: In a model with only two variables, money Granger-causes output.
      In a later study, Sims (1980) analysed the question in a vector autoregression (VAR)
      employing additional variables (prices and interest rates). He found:
      H2: The statistical significance of the effect of money on output will be lower when including
      other variables in a multivariate test.

      Conclusion
      The preceding discussion in section three has made pretty clear that general hypotheses based
      upon Granger-causality tests are not very robust with respect to different variables, time
      periods or countries. However, there appears to be a Granger-causality effect present in many
      of the economies under investigation. This effect will be much more pronounced when
      allowing for a number of asymmetric influences. But more general statements about money-
      output causality cannot really be supported. All the other substantial findings are more or less
      connected with specific countries, like the reverse causality results for Canada and the US, the
      existence of significant two-way causalities in Austria and Spain, and the statistically
      insignificant effects for Germany. One important lesson to draw from this conclusion is that
      concentrating research on one country, here the US, does not help very much in assessing
      general questions connected with Granger-causality. For instance, the specific claim made by
      Davis and Tanner (1997) that money still causes economic activity when appropriately
      adjusting the time period is likely to be correct only in the context of the US economy.
      Looking at the attempt of grouping countries according to the results of the causality tests
      presented in the preceding section does not improve the situation very much. Even though it is
      possible to extract a small number of country groups displaying similar behaviour, it is not
      always clear why they actually show that behaviour. Many of the countries in the grouping
      conform to a priori expectations, while others do not display obvious similarities. On the other
      hand, the main reason for employing exploratory data analysis is to uncover relationships
      which are not obvious. In any case, the result of the country clustering should make us careful
      with respect to simple generalisations, like North versus South, or core versus periphery.
      …”

    31. If my assets are earning 10% interest, I’m much less inclined to part with them to purchase more of my favorite vice than if they are earning no interest. And, of course, my purchase of said vice bids up its price, especially if said vice is in short supply.

      So, let’s scale up the interest sensitivity of my vice seeking to the private sector’s demand for goods and services in general. If their wealth is earning interest, they’ll be less inclined to liquidate it to bid up the prices of their favorite alternatives to saving.

      So, when the government sells interest-bearing assets to the private sector, it seeks to increase the degree to which the private sector prefers to save rather than consume, thereby reducing the demand for goods and services, thereby reducing inflation.

      What am I missing?

    32. In response to Ikonoclast’s comment:

      New Keynesian, Brad DeLong, has suggested MMT is not a theory but rather a tautology. Again, this seems to point at a concern that setting up a formalist system of accounting identities to describe finance does not describe the real economy.

      Much the same could be claimed about all of mathematics — it’s all proven from very simple laws of logic. That makes in no less correct and no less relevant.

    33. mpr,

      There are a lot of Treasuries outstanding! It’s a Fractional Reserve banking system. They only need enough reserves to clear transactions between the banks. Transactions between accounts within a single bank clear without the use of reserves.

    34. Ikonoclast.

      Economics as we know it all stated with Ricardo (In the English language at least).

      Anything before that, including Smith is of little value to anyone bar an historian of economic thought.

    35. jrbarch says “What inspires me the most about people like the MMT academicians that you meet around the blogs and their conceptual edifice – is their humanity! There are billions of concepts in the world; but not so many that minister intelligently to the (monetary) needs of the human species.”

      I say – Here! Here! Well said.

    36. Ok, after frustrating battle with MMT tautologies and word games (government does not need to be financed), I came up to what seems to be a substance of MMT. If you want to continue arguing benefits of your theories, please focus on these instead of endless circles about banking operations, financing of government etc.
      .
      1) [standard] Monetary policy is ineffective in stimulating aggregate demand. [I think, that the purpose of large part of MMT cannon about how banking sector operates aims to prove just this]

      2) Because of 1, desired savings of private sector does not depend on real interest rate. It is fixed, and government may only satisfy this desire by spending. It is assumed, that private sector just absorbs whatever amount of Net Financial Assets government creates during such spending spree. If government spends too much (pushing aggregate demand over aggregate supply) it may indeed create inflation, but private sector will absorb that too because there exists a threat of taxation in the future.

      3) There is no difference between bonds and high powered money with regards to price level. MMT considers them only as “Net financial assets” and as such they are interchangable.

      Sorry, but these are some pretty strong implications. I would like to see especially any proof of 1. As I think that it was proven numerous times, that monetary policy is very effective in stimulating AD.

    37. J.V. Dubois:
      ” I would like to see especially any proof of 1.”

      QE policies in USA and over the world. They only propped up asset prices but didn’t increase aggregate demand, only fiscal policy did that. From Japan to USA or UK.

      “Because of 1, desired savings of private sector does not depend on real interest rate.”

      Not only because of 1, but true (or at least partially true). You can see this in prebubble bust and now in many countries like Brazil or China with higher interest rates. IR policies are much impotent at setting aggregate credit expansion levels and savings desire, this has much to do with asset prices and economy momentum (business cycle), hence aggregate demand and expectations.

      “but private sector will absorb that too because there exists a threat of taxation in the future”

      I don’t think MMT says this, inflation can happen and is dangerous, this is stated all over MMT literature as far as I know. Also I think the “we can tax inflation” is a bit naive on reality: you can’t increase or cut taxes (as well as change the tax structure) that easily and it depends on a whole load of political and social factors . Most people is not gonna understand or be interested in monetary system theory just like they don’t do with current mainstream theories, so you can roll out some policy options.

      “There is no difference between bonds and high powered money with regards to price level.”

      This is what this blog is about, I think that MOST times this is true, but there can be again some exceptions product of dysfunctional political system, poor state of the economy and/or social unrest. However this would be even truer if such metrics as public debt/GDP disappeared and bonds where counted as a monetary aggregate, but this would be shocking to much people :D

    38. New Keynesian, Brad DeLong, has suggested MMT is not a theory but rather a tautology.

      That’s bizarre, because as I understand it, you cannot derive causality, or are any implications from tautologies. The way that MMT uses accounting (tautologies) is to restrict the possible number of theories to describe reality ; the accounting provides the framework. Scott Fullwiler has an excellent point on this topic, he said (paraphrasing poorly) that you can have any demand and supply model you want, but if you violate accounting rules then you are not describing reality. Once you have the accounting framework in place you can start talking about the causality, and the implications. For instance, the reason why private Net savings is important is because at its heart MMT is Minskyian — the liability structure of the private sector matters! Every economic unit is essentially the same, issues liabilities upon themselves to obtain assets. What differs is one of degree, some institution’s liabilities are very liquid (e.g. Banks and the State). So to suggest that MMT is a mere tautology is to miss the forest for the trees — you cannot do economic theory with identities alone. You can’t even do theory with tautologies alone.

    39. “1) [standard] Monetary policy is ineffective in stimulating aggregate demand. [I think, that the purpose of large part of MMT cannon about how banking sector operates aims to prove just this]……

      Sorry, but these are some pretty strong implications. I would like to see especially any proof of 1. As I think that it was proven numerous times, that monetary policy is very effective in stimulating AD.”

      The United Kingdom. 2007-2011. Quantitative Easing £200 billion. Growth negative. Unemployment rising.
      Am I missing something?

    40. Leverage:
      ……………………
      “but private sector will absorb that too because there exists a threat of taxation in the future”

      I don’t think MMT says this, inflation can happen and is dangerous, this is stated all over MMT literature as far as I know. Also I think the “we can tax inflation” is a bit naive on reality: you can’t increase or cut taxes (as well as change the tax structure) that easily and it depends on a whole load of political and social factors . Most people is not gonna understand or be interested in monetary system theory just like they don’t do with current mainstream theories, so you can roll out some policy options.
      ……………………
      Ok I agree. But then please admit that government expenditure (in case private AD is sufficient), IS actually “financed” by future taxes. Please can Billy or someone else admit this?

      I say that even direct government expenditures in most cases (economy is not in liquidity trap) is financed by future taxes. Free lunch from insufficient demand can be actually eaten by private sector.

      But then again, I see that core of the MMT is monetary policy denialism. You guys indeed see all the world as if it is in liquidity trap.

    41. J.V. Dubois, monetary policy works only as long as the economy is *co*operating with the central bank. The assumption of *co*operation is critical. Contrary to this fiscal policy works *always* because spending of money does not need any additional assumptions. The only question that remains is the macro-economic efficiency of such spending.

    42. J.V. Dubois,

      Monetary policy is in any advanced country conducted through the banking system. We are not always in a liquidity trap because we are not always under credit contraction. But when the private sector is deleveraging, like right now, and not taking on more debt, then demand falls, unemployment increases and income decreases, taken to the extreme you can fall in a debt-deflation spiral. Then monetary policy is mostly impotent and does not work in this environment because CB don’t lend to the public directly, this is the work of the treasuries through fiscal policy (in fact they are lending tax credits as monopolists of money under current monetary system).

      Given there wouldn’t be changes in current monetary & financial system (which could use a lot of change), monetary policy anyway should be conducted through reserves and capital constrains, and the CB IR should be permanently zero IMO. Banks will always expand supply as long as the expectations are good, that’s monetary police in full effect.

      So spending is not financed throught taxes, neither financially nor economically. Financially is ex-post facto; and economically what finances spending is either output gap in the economy or productivity increases derived of spending. If there isn’t output gap or the spending is misdirected, and there isn’t productivy gain from these spendings, the results will be inflationary (however take in mind, that contrary to neoliberal propaganda, public spending had very limited effect on inflation, if any, in the last decades, because inflation was mostly driven by private credit expansion).

    43. IIUC, the classic argument that bond issuance lowers inflation risk goes as follows:

      Bond issuance increases the supply of interest-bearing assets.
      Increased supply depresses prices of such assets.
      Lower prices mean higher interest yields.
      Higher interests yields diminish the propensity to spend those assets on goods and services..
      Decreased demand implies lower risk of inflation.
      Q.E.D.

      So, what am I missing? Was this argument addressed above?

    44. MMT will be for ever beyond me when the law of the land is reduced to ‘ideology’. Yes of course the law can be ignored. Yes of course a sovereign government can spend any way they want to. But the governments say they are constrained and MMT agrees they are constrained.

    45. wigwam, I love those “classic” arguments. What about such QED: Higher yields lead to higher income from savings, higher propensity to spend from income and therefore higher demand for goods.

    46. Hi Sergei,

      Thanks. That seems to mean that people are spending a smaller percentage of a bigger income stream. Right?

      If so, to settle the matter, we would seem to need a model for the relationship between the propensity to spend and interest yields.

      Wigwam

    47. J.V. Dubois

      Governments do not “finance” their current spending by future taxes.

      The flaws in the IGBC theory have been thoroughly exposed by Scott Fullwiler. You will find this paper on the website of CFEPS or SSRN. I strongly recommend reading that paper as it will hopefully address all the issues you have raised.


      Interest Rates and Fiscal Sustainability by Scott T. Fullwiler
      Working Paper No. 53

      “The sustainability of fiscal policy as determined via the orthodox IGBC framework is irrelevant for understanding the workings of a modern money economy. The orthodox framework’s assumption that interest rates are determined in a loanable funds market for interest rate determination and the related assumption of differing inflationary impacts of “monetization” versus the “financing” of deficits are both fundamentally flawed. Instead, the orthodox view that fiscal deficits or international forces might have large effects on interest rates could be appropriate only for a non-sovereign-currency-issuing government operating under fixed exchange rates, not for a modern money regime with flexible exchange rates (Wray, 2006a). Consistent with the monetary nature of interest rates in a modern money regime, rates on Treasuries have followed the stance of monetary policy, not fiscal policy, and have only risen above the rate of GDP growth during times when high interest rate policies were set in place by monetary policy makers. And because interest rates on the national debt in a modern money regime are a matter of monetary policy, it follows that the stance of monetary policy has much to do with whether a given fiscal path is “sustainable” or not.”

    48. Wigwam, thanks your replies to my questions about formalism. You said, “Much the same could be claimed about all of mathematics — it’s all proven from very simple laws of logic. That makes it no less correct and no less relevant.” This is an apt answer. Karl Popper discusses that precise philosophical question about mathematics; namely why does mathematics apply to the real world? I won’t go into his (incomplete) answer here, mainly because I would have to go back to the text to refresh my memory. Suffice it to say, the short answer is that experience shows it works, although the full reasons why might be difficult or impossible to elucidate in philosophical terms.

      The thing that bothers me about capitalist political economy is that people and resources are real and money is not real. At least, money is not real in the sense that people, matter and energy are real. Let us leave aside for the moment the issue that money was developed as a medium of exhange to replace barter. In some respects, one can equate modern money to locks. Locks were invented because people can be dishonest and greedy. Money now serves the same purpose, to lock people out of taking too much or even of taking their fair share. Money also allows a select few to lock up an enormous amount of resources for their own exclusive use. The money system (in my view) is as much a governance system (or part of the governance system if you like) as law, justice and state force. The money system as it operates now is an anti-democratic force.

      So often, the operation of the money system is about protecting money and enhancing “wealth” (meaning minority monied interests) rather than protecting and enhancing the lives of all people. There are enough tasks needing doing in our society and enough overall wealth to fully employ all adults who wish to work. As the British riots show, the social and economic costs costs of not achieving full employment are far higher than achieving it. So why can’t our society achieve it? What are the impediments? The impediments must arise from the power of the monied interests and their influence on public policy. Our society needs more than the public accounting revolution promised by MMT. The power of the plutocrats and corporate capital must be broken.

    49. Ah Bo Diddly has rhythm! Did you see his legs move when he lost it. Smooth.
      As for the post comments as usual the wanker class want to make it all academic sounding.
      Its effing simple. (when I typed wanker spell check asked if I ment Banker lol.)
      If the people you like to call agents don’t want to spend because they are sacred about the near future then it doesn’t matter how much money you offer to lend them at lower and lower interest rates they wont spend. No spending increase = no growth. Non Asian governments have now teamed up to scare the spending right out of their agents. The more scared they are getting the less spending they are doing. Add stupid governments that reduce spending at the same time and we must have a recession. Recession cant be avoided in this set up. So non:Asia is about to have the mother of all downturns. Simple as 1+2.
      Either the agents increase spending or the government increases spending. If neither increases spending its effing obvious what happens eh. Sweet F. A. So inflation aint the problem, ask a Japanese agent for confirmation.
      Cheers Punchy

    50. “There are a lot of Treasuries outstanding! It’s a Fractional Reserve banking system. They only need enough reserves to clear transactions between the banks. Transactions between accounts within a single bank clear without the use of reserves.”

      It sounds like you’re forgetting the scenario. We’re talking about the govt. not issuing any more bonds.
      The quantity of excess reserves which had to be repoed out would eventually exceed the tsy debt held by the Fed.

      Of course in the current system the amount of tsys outstanding is more than sufficient to soak up excess reserves.

    51. Our Friend J.V. Dubois, almost plaintively says:

      But then please admit that government expenditure (in case private AD is sufficient), IS actually “financed” by future taxes. Please can Billy or someone else admit this?

      Well not even under a bright light will I ever admit that when I am discussing a fiat monetary system.

      Get real. Government expenditure in such a system never needs financing. Since when has a policy tool designed to attenuate fluctuations in aggregate demand (in this case, the use of taxes at full employment) been considered to be funding anything. Taxes in this context create the real resource space for spending to be non-inflationary.

      We should use words that have meaning in the way that we share that meaning. In English, the concept I outline in the last paragraph is not referred to as “funding”.

      best wishes
      bill

    52. Ikonoclast said:

      “Our society needs more than the public accounting revolution promised by MMT. The power of the plutocrats and corporate capital must be broken.”

      I agree 100%. MMT might provide the basis for the future texts and so on once the current regime falls. But it will take a completely different kind of attack to bring the ruling ideology to its knees.

    53. Bill,
      Do you think that it wouldnt matter if all of US government debt was in the form of monetaty base (100% of GDP)? And if so why? Because your answers at point 8 are clearly unsatisfactory: “the government has two choices” “It can decide” “cut back its own discretionary net spending.” “Alternatively” ” it will seek to curb the private spending via taxation.”
      In normal times government deficit is equal to few percentages points of GDP so you can not cut spending by e.g. 1o times more.

      And I dont think that your claim: “bonds are highly liquid and holding them doesn’t constrain private spending capacity” is true. Because if you want to spend after selling bonds someone who bought these bonds can not buy other things. So net spending on real assets doesnt change in this case.
      Now, you can of course buy with loan from the bank with bond as collateral. But if a lot of people wanted to do it the value of collaterals and loans would diminish. And besides that banks have to take into account their investment policy and capital ratios so they are constrained in giving loans.
      Also I dont agree with the statement that loans create deposits. It may be true for any particular loan but from the perspective of asset liabillity management it certainly is not. Because banks have to take into accunt if they will be able to replace deposits just created if their clients wanted to withdraw them. So they are constrained by their ability to replace these deposits. Besides that banks are also investors themselves and can spend their reserves on other things (outside of financial markets) so interest rates will not fall to zero. Of course this money has to return to banks but in the meantime inflation is a possibility (maybe even hyperinflation and in this case reserves de facto will not return to the banking sector).

    54. Andrewjudd,
       
      disclaimer: I’m an autodidact MMTer, so any mistakes are my own.

      MMT will be for ever beyond me when the law of the land is reduced to ‘ideology’. Yes of course the law can be ignored. Yes of course a sovereign government can spend any way they want to. But the governments say they are constrained and MMT agrees they are constrained.

       
      Then you’re not understanding that MMT distinguishes between three different types of constraints.
       
      This is best understood if you consider Minsky’s definition of an economic unit: all economic units essentially take positions in assets by issuing liabilities upon themselves, what distinguishes different economic units is a matter of degree. For instance, the state and banking institutions have more marketable liabilties than households and firms, hence their liabilties act as the clearing unit. With that in mind, the constraints are as follows:
       
      1. The financial constraint: If any entity specifies that its liabilties are convertible into another asset — that is, if the entity pegs its liabilities to another asset, say every dollar is equal to 35 pounds of gold — than that represents a financial commitment by the entity, and thus is a financial constraint. If an entity does not specify that its liabilities are convertible into an asset — that is, it does not peg its liabilties to an asset — than the entity faces no financial constraint in issuing its own liabilities. Of course, in this latter instance, a dilemma arises for the entity, in that, how can it get its liabilities accepted; have can it make its liabilities marketable? In regards to the state, the state makes its liabilities acceptable by demanding that they are needed to pay taxes.
       
      A situation where the government isn’t financially constrained also alters the function of taxes. logically for the non-government sector to pay taxes the state must issue its liabilities (either via spending or a loan) its nonsensical to talk about taxes or bonds as financing operations, when the ability to be able to pay taxes or purchase bonds requires the state it provide them first. In a system where the state has no financial constraint, taxes create initial demand for government liabilities and make them marketable, and bonds function to offset the impact that the treasury’s spending position has upon the interbank interest rate (this is referred to as the reserve effect).
       
      I view this constraint as working at the structural level of the system.
       
      2. The political constrain: This really applies no matter what the position of the state is in terms of its financial constraint, but obviously it is more important when the state has no financial constraint. It is a rule or institutional arrangement which specifies for instance that for every deficit that the state runs, an equal amount to the dollar must be issued. This is different type of constraint, it doesn’t represent any financial commitment, it’s simply a rule which is imposed for whatever reason. The rule could easily be, for every $1 spent a politician has to run a lap around the block. Fullwiler (2010) has made the following analogy: if a human being ties their shoes together, they obviously can’t run, but they can’t run because of a self-imposed constraint (political constraint), not because of any inherent structural constraint (financial constraint).
       
      The way I view this is that political constraints work at the institutional level of the system. They are the result of the subjective beliefs of agents. It says nothing about the structural characteristics, but it does have its own implications and consequences — a life of it’s own if you will, with its own dynamics.
       
      3. Real resource constraint: this is the only constraint that MMT sees as being important for the state. It relates to the utilisation rate of the economy; the productive capacity of the economy, and whether the economy is operating at full capacity. In this sense it is concerned with how the supply-side of the economy will respond (adjust) to government spending. In a situation where the economy is operating at below full capacity, then the economy can adjust to the increase in demand by increase output, and hiring more workers. If the economy is operating at full capacity, then the increase in demand will mean the economy will adjust by increasing prices — resources will be bid away from other uses — potentially leading to inflation.
       
      Hope that helps.
       
      source: Fullwiler, S. 2010. Modern Monetary theory – a primer on the operational realities of the monetary system. (accessed via: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1723198)

    55. J.V. Dubois,
       

      But then please admit that government expenditure (in case private AD is sufficient), IS actually “financed” by future taxes.

       
      As Bill noted above this is nonsensical within a fiat monetary system — i.e. a system where the state has no financial constraint. What you are essentially saying is that the state needs to finance its issuing of liabilities by collecting its liabilities before it can spend. It makes no sense, and furthermore it is logically impossible for the non-government sector to pay its taxes or purchase government bonds without the state providing its liabilities beforehand, either via spending (treasury) or a loan (central bank).
       
      What you are suggesting isn’t an applicable operation within our current monetary system. The structural characteristics are that the state has no financial constraint on issuing its liabilities, because it hasn’t pegged its liabilities to another asset (such as in a gold standard). Read my post above for more.
       
      If you can provide a balance sheet explanation for why the above is wrong, then I’d love to read it.
       

      But then again, I see that core of the MMT is monetary policy denialism. You guys indeed see all the world as if it is in liquidity trap.

       
      You will have to clarify what you mean by ‘monetary policy denialism’. From my understanding interest rate is a complex variable whose impact upon the economy is hard to discern, because firstly of its distributional impact, and secondly, because factors such as, the institutional arrangement of the finance sector matter, the liability structure of the economy, and the position of net financial assets in the private sector. This is just including the quantifiable things, how then do we measure the qualitative things such as the impact upon subjective expositions (Keynes)?
       
      In my opinion monetary policy can work by changing subjective expectations in the economy. If the central bank says it’s going to increase interest rates, and if you’re a property developer, then your expectation about future demand for your product (housing) will depend upon how you believe your customers will react to the news that the central bank is warning that it will increase interest rates.
       
      As for the impact upon investment decisions: From my discussion with people who actually do invest and produce, interest rates play a secondary role (as mentioned above what’s more important is their role upon subjective expectations), the primary factor is the expectation that their will be demand for their product at a future date. Of course, there is a threshold at which interest rates will begin to adversely impact investment decisions.

    56. Tom (at 2011/08/21 at 10:53)

      Please refer to my conclusion for this blog. I will be expecting more than 6,000 words explaining Japan, then the current situation in the US.

      All your responses are in intermediate macroeconomic textbooks and fall short of explaining anything.

      best wishes
      bill

    57. Bill: “Please refer to my conclusion for this blog. I will be expecting more than 6,000 words explaining Japan, then the current situation in the US.”

      It’s sufficient to read Keynes. MMT brings nothing new or important.

    58. Tom: “Also I dont agree with the statement that loans create deposits. It may be true for any particular loan but from the perspective of asset liabillity management it certainly is not. Because banks have to take into accunt if they will be able to replace deposits just created if their clients wanted to withdraw them. So they are constrained by their ability to replace these deposits”

      Banks don’t have to replace ‘deposits’ per se, when loan proceeds are transferred to the customer of another bank, but they may need to source reserves. Reserves are not deposits; they feature on opposite sides of the bank’s balance sheet. Banks can create deposits at will, and are only limited by capital constraints in doing so. Banks cannot create reserves at will, however, which I think is what you are getting at.

      The distinction I think you are alluding to is that between a primary deposit, created when a bank receives a transfer of cash from an external depositor, and a secondary deposit, generated internally by the bank via operations such as the granting of a loan. Banks can create secondary deposits at will, subject to capital constraints, but they have to seek primary deposits elsewhere. And they seek them because primary deposits are associated with an inflow of reserves, which the bank cannot create internally. The maxim “loans create deposits” could be recast as “loans create secondary deposits” if it makes you feel better.

      MMT has never said “all deposits are created by loans”. But “loans create deposits” is as true as 1+1=2.

    59. “Banks don’t have to replace ‘deposits’ per se, when loan proceeds are transferred to the customer of another bank, but they may need to source reserves.”

      I’m not sure you understand accounting. If bank create deposit by granting loan to the investor and investor want to transfer his/her money to other place bank has to find somewhere this money. And for a particular loan which is not big in relation to bank’s balance sheet that is usually not a big problem. But if you believe that you can create deposits via giving loans in principle without actually first acquairing money from clients you are quite ignorant.
      Banks simultaneously monitor their loan and deposit activities and check their durations and convexities.
      And reserves are just a legal thing: usually you have to hold some money at the central bank to cover some of your liabilities.

    60. MDM

      2. Political constraints. – You appear to be agreeing the system is politically constrained? Therefore the system we observe today is as a result of those constraints. And we can follow that system via the accounting.

      So you appear to be agreeing with me? MMT agrees the system is constrained?

      Therefore the system we see today in the UK where there is high unemployment and 5% inflation has arisen with a system so constrained?

      Or does MMT say nothing can be learnt about MMT from the accounts?? That is definately not my understanding so far.

    61. Tom
      If the bank has one million reserves and ten million deposits and it receives another 1000 reserves it is not required to find another 10,000 reserves to create a total of 1,010,000 deposits. The bank still has the reserves it is expected to have. The reserve is just a reserve to be used as required. If the reserve falls below the minimum the bank has many methods of borrowing more money other than from finding more \’clients\’ – unless you include interbank loans and so forth as money from clients. Reserve limit accounting only occurs at the end of business anyway and usually does not apply on a daily basis but rather on for example a two week average of the end of day reserve amounts. A bank that choses that reserve calculation method could have almost no reserves overnight at the beginning of the reserve maintenance period.

    62. Andrewjudd,
      Reserves are conditional on deposits (not the other way as you claim) because they are only a legal thing. It’s not the most important thing (in some countries there are practically no reserve requirements). So by your statement “If the reserve falls below the minimum ” you show that you dont understatement the problem very well. And the problem is that you have to fund somehow your loans on the agregate basis. And most banks do this by acquiring deposits from general public. So it’s not true that loans create deposits from the perspective of bank’s balance sheet.

    63. Tom,

      If bank create deposit by granting loan to the investor and investor want to transfer his/her money to other place bank has to find somewhere this money.

      The only constraint upon bank lending is bank capital (in the very short-term) and credit-worthy borrowers (which are measured on a subjective basis). In regards to reserves, what is important is the prevailing rate at which these can be obtained, not the actual quantity of reserves that the bank currently has. If the bank can maintain a sufficient spread between its costs and the return on the loan, then it will make the loan. This loan creates a matching deposit as a matter of accounting. The reserve position will only determine the profitability of the loan. A bank with sufficient reserves will be able to sell them in the interbank market, whilst a bank with insufficient reserves will need to obtain the reserves at the prevailing price.
       
      I’ll use this example of Australia:
       
      In Australia each morning the Reserve Bank of Australia (RBA), in consultation with financial institutions forecasts the daily liquidity (exchange settlements) needs of the system. It classifies ‘transfers’ or transactions into high-value transactions or low-value transactions. The former is cleared on a real-time basis and the latter on the next business day. The RBA pays particular attention to the high-value transactions as these have an immediate impact upon system liquidity and the payment system. If in your situation the institution finds itself short of reserves, then the RBA will provide liquidity via an intraday loan.
       
      If the transaction is a low-value transaction, then these are settled on a net basis. What matters is the banks exchange settlement account (ESA)(reserve account) at the end of each day. If a bank finds it has a negative ESA, then it can obtain the necessary ES funds from the interbank market. If the interbank market is short, then the RBA will provide the necessary funds to ensure that the overnight rate remains consistent with its target rate.
       
      See: RBA, 2010. Domestic Market Operations and Liquidity Forecasting. (via rba.gov.au).
       

      if you believe that you can create deposits via giving loans in principle without actually first acquairing money from clients you are quite ignorant.

       
      Loans create deposits as a matter of accounting. To suggest otherwise is tantamount to saying that a financial asset doesn’t need a liability and vice versa; it makes no sense.
       
      A bank needs reserves if its reserve account isn’t positive. When this occurs the bank can obtain the required reserves from the interbank market. If the banking system is deficient in reserves, then the central bank will provide the necessary amount to ensure that the interbank rate remains consistent with its target rate.
       
      As I mentioned above a bank’s reserve position doesn’t constrain its ability to lend. What constrains its ability to lend is sufficient capital, and credit worthy borrowers. A bank will make a loan if the expected return of the loan is greater than its costs.

    64. Andrewjudd,

      No I am not agreeing with you. A political constraint isn’t a structural feature of the system. It is an institutional arrangement. A political constraint is binding so long as the subjective beliefs of agents impose various rules on how the state is to behave. The system isn’t constrained, but the way agents and institutions behave can suggest otherwise.

      Therefore the system we see today in the UK where there is high unemployment and 5% inflation has arisen with a system so constrained

      High unemployment and inflation has arisen because of the subjective beliefs of agents within the system, not because of any fundamental structure reason.

    65. mdm

      “To suggest otherwise is tantamount to saying that a financial asset doesn’t need a liability and vice versa”
      This doesnt imply that loans create deposits but rather that they are created simultaneously (from the perspective of balance sheet).
      And read my earlier remarks about reserves because I dont want to repeat myself.

    66. Tom
      You mentioned legal reserves. So i explained from that point of view.
      Banks can fund loans by having stand by lines of credit or by having deposits with other banks.
      If a bank has just opened for business it can have zero deposits but still have millions of reserves of cash and cash equivalents (reserves). Loans then tend to create a flow of cash and cash equivalents (reserves) outwards from the bank. The banks only requirement is that it can allocate a capital amount for each loan and satisfy whatever reserve requirements and demands that are made upon it. Naturally since reserves do leave the bank from time to time, the bank has to be continually mindful of ensuring it has sufficient reserves.
      However for example using Fedwire a bank can borrow hundreds of millions from the fed during the day when it has no reserves simply by having this facility agreed with the feds.

    67. MDM

      Are you saying the government constrains themselves or they do not constrain themselves?? Why is this so hard for me to understand from your answers??

    68. Andrewjudd

      “Banks can fund loans by having stand by lines of credit or by having deposits with other banks”.
      But these other banks have to acquire these funds somehow. You are only postponing the problem.

      “If a bank has just opened for business it can have zero deposits but still have millions of reserves of cash and cash equivalents (reserves). ”
      But it only means that they will make loans from capital acquired by issuing stocks. And this capital can be treated as a deposit with a very long duration. So in your example loans are created by deposits (i.e. money that was acquired earlier).

      “However for example using Fedwire a bank can borrow hundreds of millions from the fed”
      But that is to fulfill reserve requirements not solvency issues which may arise from insufficient depository base.
      Again you have to first acquire money from people if you want to make loans on regular basis (0n aggregate basis).

    69. But guys I think that you are avoiding a main problem of this topis i.e. Billy’s claim that “bond issuance doesn’t lower inflation risk”. If you agree with this statement do you think that it wouldnt matter if all of US government debt was in the form of monetaty base (100% of GDP)? Because it is a straightforward coclusion from Billy’s claim.

    70. Tom
      “However for example using Fedwire a bank can borrow hundreds of millions from the fed”
      But that is to fulfill reserve requirements not solvency issues which may arise from insufficient depository base.
      Again you have to first acquire money from people if you want to make loans on regular basis (0n aggregate basis).

      You are confusing the definitions for “required reserves”, with the useage of “excess reserves”, where banks lend each other “excess reserves”. During the day in the USA and elsewhere there are no legally “required reserves” so all reserves are legally “excess reserves”. But a bank still needs to have “excess reserves” to pay another bank during the day and if it has none it can borrow them from the central bank.

      So if a bank is paying out depositors during the day it might have zero “excess reserves” (where legally the “required reserve” level is zero) but it *must* get “excess reserves” to pay depositors and other banks who are demanding payment , and it can borrow them from the feds until close of business and by end of day borrow from the market or sell assets.

      When there are never legally “required reserves” for that bank, then all cash and reserve balances at the fed are legally “excess reserves”. It makes no practical diffference to what i am saying.

      In Australia where there are no “required reserves” the banks lend each other there “excess reserves” and can if necessary borrow from the RBA at zero interest if they have preregistered government bonds recorded in the system used by all of the banks for registering the ownership of bonds where this process can happen programmatically at the RBA without a phone call in advance, and if necessary the RBA payment settlement system waits for one minute before it fails a payment.

    71. Tom: “I’m not sure you understand accounting. If bank create deposit by granting loan to the investor and investor want to transfer his/her money to other place bank has to find somewhere this money.”

      Yes, as I stated in my post (did you read it carefully?), the bank may need to acquire reserves, which it can do after the loan is created; primary deposits are but one (relatively cheap) source of reserves. It is just nonsense to say that a bank must prefund a loan by first obtaining a primary deposit of equivalent value (which seems to be what you are saying).

      “But if you believe that you can create deposits via giving loans in principle without actually first acquairing money from clients you are quite ignorant.”

      See above. BTW, you don’t endear yourself to anyone by proclaiming others are ignorant when it is quite clear you haven’t followed what they have actually written.

      “And reserves are just a legal thing: usually you have to hold some money at the central bank to cover some of your liabilities.”

      They are the means of settling interbank transactions, not simply a “legal thing”; I really don’t know what you are saying there, but you seem to be stuck in the “reserves are just deposits that are not loaned out” model that Bill and others have thoroughly debunked ad nauseum.

    72. “Monetary policy is ineffective in stimulating aggregate demand”

      Nope. MMT says that monetary policy can stimulate aggregate demand, but that it is distributionally inefficient. Of course it can since it lowers the interest rate across the board and alters the demand for Horizontal Money in the form of loans at the bank’s loan desk. But it runs out of power at the lower range and it loses controls when the private sector is extremely depressed or extremely euphoric. That’s why it is ineffective now, and why it is ineffective during asset bubbles.

      Very simply it’s about price, not quantity.

      “There is no difference between bonds and high powered money with regards to price level. MMT considers them only as “Net financial assets” and as such they are interchangable.”

      There is no difference between bonds and bank reserves at interest, because they are both government liabilities paying exactly the same rate of interest – so why would there be any difference.

      There is a difference with physical cash because that doesn’t have any interest attached when it is in a wallet (or in a wheelbarrow if you prefer).

      The mix of physical cash (paying no interest) and bank reserves/bonds (paying interest) matters. If you change that then you change the interest rate which will have a monetary effect.

      That’s why it is vitally important that you consider the entire mix of government liabilities and the interest rates attached to them all.

      Everything you have accused MMT of has been effects due to the reduction of the interest rate.

      Don’t change the interest rate, and none of that happens.

    73. Hi Bill, I need something cleared up:
      IS THE US FEDERAL RESERVE NO MORE FEDERAL THAN FEDERAL EXPRESS?
      your statement
      “A sovereign government that issues its own currency can never be revenue constrained in that currency as an intrinsic fact.”

      The premise of a sovereign govt. being able to issue its own currency has confused me when my brief research on the US Federal Reserve indicates that the US Federal Reserve is not part of the government.

      Rather the US Federal reserve is no more ‘federal’ than the US entity, Federal Express i.e. it is a private entity which was given a sole license by the US govt (back in 1913) to be able to issue debt free money.

      Bill can you please confirm/deny whether from your understanding the US Federal Reserve is a Private Entity and furthermore if the Australian Reserve Bank is a Private Entity.

      To complete my understanding of MMT, can you confirm that Private Banks have a license to only issue money with debt attached. i.e. when you take a loan from a private bank, they issue currency to you (out of thin air and tap tap of the keyboard) by creating a deposit in your account, however the issued funds have a debt attached in the form of your obligation to repay it back through exertion, speculation (gambling) or productive investment and are secured (in most cases) by an asset of ‘equivalent value’ such as a house, car, boat etc.

      Your clarification about the status (i.e. whether govt. or private) of the US Federal Reserve and the Reserve Bank of Australia will be much appreciated.

      Thanks

      MMT FS

      p.s. (in jest) how would I go about applying for a govt. license to issue debt free money (I also would like to contribute to the spirit of competition and capitalism to provide market efficient services of issuing debt free money to sovereign governments)

    74. Followng MMT Foot Soldiers line of questioning.

      I understand that, when the Fed buys paper currency from the Treasury, it reimburses the Treasury only for the costs of printing, etc. So, my question is: when does the Fed mark that money up, i.e., record its seigniorage. Does that happen when it receives the currency and puts it into its vault? Or does it wait until it sells the currency to banks that need it?

      Thanks.

    75. There’s probably a couple of other points about the model that are worth mentioning.

      Firstly MMT sees monetary policy as providing a risk free income to the private sector, ie it is government spending. So a higher interest rate equals a higher injection of government funds into the economy. And a lower interest rate a lower injection.

      This feeds into QE which is an attempt to replace long bonds at a higher interest with liabilities at a lower interest rate (reserves at interest).

      So reducing interest rates reduces the amount of financial assets and increasing interest rates increases the amount of financial assets. How that feeds through into inflation/deflation then depends on the secondary order effects which are difficult to predict (increasing interest rates can cause temporary booms due to the different timing effects of the change between borrowers and savers for example).

      Secondly it is not the loans themselves that causes a stimulus, but of course people spending the demand deposit created by the loan on real stuff. If you take out a loan and sit on the demand deposit then there is no (or little) real effect. Most people tend not to do that (I did, so its not unheard of).

    76. Neil wilson
      >>“There is no difference between bonds and high powered money with regards to price level. MMT considers them only as “Net financial assets” and as such they are interchangable.”

      >>There is no difference between bonds and bank reserves at interest, because they are both government liabilities paying exactly the same rate of interest – so why would there be any difference.

      Yesterdays, todays and tomorrows yield is what matters to the investor who holds the bond rather than the actual interest paid on the face value.

      Obviously cash and bonds are substantially different even if at this moment we can say they can be identical on paper. Words like ‘can’ or ‘might be’ or ‘perhaps’ need to be considered before words like ‘identical or very similar or interchangeable’ and so forth.

      It is peculiar to think of a bond as being interchangeable with cash. It might be or it might not be.

    77. Tom: “Also I dont agree with the statement that loans create deposits. It may be true for any particular loan but from the perspective of asset liabillity management it certainly is not. Because banks have to take into accunt if they will be able to replace deposits just created if their clients wanted to withdraw them. So they are constrained by their ability to replace these deposits. ”

      From this I read that you do not understand the ALM business of banks. There is nothing wrong with it as many banks themselves including ALM managers do not understand it in all details.

      But lets take an example of an “ideal” bank from your perspective, i.e. the bank where all client loans are funded with client deposits and therefore the loan to deposit ratio is 100%. So let me ask you one question: what is the matching asset type for the liability called “capital”? And I’ll give you the answer: it is government bonds. Most banks call it liquidity book. And liquidity book is used … you know :) … to manage liquidity, i.e. inflows and outflows of government money (cash and reserves). So in the worst case the bank either sells/buys government bonds or repos them with CB. In the regular business the bank goes to the interbank market.

    78. Andrewjudd, I understand your reasoning but you still are not able to prove that loans create deposits. In general if you want to give someone money (make loan) you have to acquire it first from someone else. Of course if you are big you can make loan without getting deposit first. But it doesnt change the fact that banks are very eager in promoting themselves to convince regular people to put their money as a deposit. They are doing it to be able to make loans without solvency issues.

      ParadigmShift,
      You dont have to have any reserves if duration of your assets matches duration of your liabillities. So reserves are not important if you are able to fund your loans on deposits acquired from public. You can create deposits by loans only if they are small in relation the size of balance sheet.

      Sergei,
      I can agree with you but it doesnt have anything to to with reserves (bonds are not reserves). And you still have to have enough bonds to cover your potential liabilities. So again you just cant say that loans create deposits because you have to have enough liquid assets to cover these deposits. And to be able to buy these liquid assets you have to first acquire deposits (or capital).

    79. And guys I would like to know if you agree with Billy that it wouldnt matter if monetary base in the USA was equal to its GDP. ($15 trillion)

    80. Tom

      Nearly every loan created by a bank results in a deposit being created in the banking system. I think you lack awareness of bank payment systems and how they settle, together with knowledge of interbank operations and usual practices? You appear to think the banks are like piggy banks? The banks are essentially empty vessels with no ability to pay out all depositors on demand as advertised. A few hundred years ago it was standard practice in Italy to execute bankers outside their counter if they could not pay out all depositors. Today you and I help the banker to pay out the depositors as and when necessary and there simply are no laws that require a bank to operate as you believe they operate. The previous deterrant was execution by beheading.

    81. @ Tom

      But guys I think that you are avoiding a main problem of this topis i.e. Billy’s claim that “bond issuance doesn’t lower inflation risk”. If you agree with this statement do you think that it wouldnt matter if all of US government debt was in the form of monetaty base (100% of GDP)? Because it is a straightforward coclusion from Billy’s claim.

      And guys I would like to know if you agree with Billy that it wouldnt matter if monetary base in the USA was equal to its GDP. ($15 trillion)

      What is the difference between tsys, which are essentially savings account at the Fed that pay interest and reserves that pay interest if there are no tsys and the Fed pays a support rate? In the first case, the owner of the tsys gets the interest and in the second case the bank holding the reserves gets the interest. If entity that would have owned the tsys were not the bank, then the funds remain in a customer deposit account at no interest unless the bank pays interest on deposit accounts. Therefore, it is likely that the hold of the deposit account would not just leave the funds in the deposit account but rather either save at interest, invest, or spend, or some combo thereof. Since this is a counterfactual, we don’t know empirically and have to speculate. (QE doesn’t add much since it is a special case.)

      The most logical answer seems to be to be that an entity who would have held tsys if they were available — look at who the typical tsys holders are and extrapolate — would seek the nearest substitute or at least the most appropriate risk-weighted return wrt portfolio management in a given context. This is essentially a portfolio management issue. It is actually an issue at present since there are not enough government securities to meet global demand, which is creating demand for more securitization and expanding shadow banking.

      This would mean that more funds would flow into other savings vehicles (financial investment), some funds would also likely flow into primary investment, and some into commodities and real assets, increasing price levels. There is little reason to expect increased spending on consumption. If some increases in consumption did occur, whether this would be inflationary depends on the employment rate. If all tsys were redeemed immediately, a one-off rise in financial and real asset price level could be expected in adjustment. More likely is that the Treasury would cease issue and redeem existing tsys as they matured, which would largely cover a span of ten years. This would imply a more gradual asset price level adjustment.

      The optimal solution would be that funds would shift substantially from saving to investment. The problem the world is facing at present is over-saving and under-investment. This is creating a demand for financial innovation, creating new assets classes such as commodities and farmland, and increasing the role of shadow banking and other issues that led to the GFC.

      The MMT claim is that elimination of tsys would not be inflationary since there is no causal transmission mechanism from increased reserves to increased consumption. But that doesn’t mean that eliminating tsys would not make a difference in portfolio management or the financial markets. Those differences would have to be addressed.

    82. Tom: And guys I would like to know if you agree with Billy that it wouldnt matter if monetary base in the USA was equal to its GDP. ($15 trillion)

      MZM in the USA is not exactly 15 trln but high enough to kill your argument.

    83. Tom, and for the rest of your argument you are just going in circles.

      ” And to be able to buy these liquid assets you have to first acquire deposits (or capital).”

      Sure, there are no bank without capital. That is the requirement No.1.

    84. MMT FootSoldier

      Bill Woolsey, an economics prof at Citadel and Libertarian wrote an article for Liberty Magazine, Oct 2004, entitled “Who Owns the Fed,” in order to correct mistaken Libertarian views that the Fed is private and separate from the government. The archive is available for download as a pdf here. Woolsey’s article begins on p. 34.

    85. MDM commented on a comment from Ikonoclast, who cited Brad Delong, as so:

      So to suggest that MMT is a mere tautology is to miss the forest for the trees — you cannot do economic theory with identities alone. You can’t even do theory with tautologies alone.

      I have no source for DeLong’s statement re: MMT as tautology. I wonder, though, if he is not making a very basic, and rather stupid, mistake. As in, the kind of basic and stupid mistake that anyone in any scientific field other than economics could not possibly make without becoming a laughing stock. A cite would be appreciated. If DeLong is making the mistake I think he is, he should be called on it, vociferously.

      A tautology conveys no information about the world, in that it does not distinguish the world concerning which the proposition is made from any other possible world. A theory does. A theory is built on theorems which are themselves statements of equivalence, or “identities”. Newtonian physics is a theory; F=ma (where “F” is force, etc.) is a theorem; ma=ma is a tautology. Now, it may be that any other identity using the same terms (e.g., F=2ma) is hard to fathom, incompatible with any realistic axioms, etc., but that does not mean that the identity is a tautology. So, to say, e.g., F=ma is a “mere tautology,” or that the Newtonian physics “built” or derived from it is a “mere tautology,” would be wrong as a matter of logic, whatever the truth or significance of the theory/theorem.

      MMT as a theoretic approach is in some sense built on macroeconomic accounting identities, if I understand it right. (Mind you, I’ve read the blogs some, but have no economic background at all.) We may question the applicability, significance, aesthetic qualities, etc., of those identities, but to say that MMT is thereby a “mere tautology” is silly. That’s like saying the Pythagorean theorem was meaningless, having “merely” derived from the “axiomatic identities” of Euclidean geometry.

      I hate making stale blog comments (i.e., more than a day after the original post), but while walking my dog this morning, this tautology stuff wouldn’t leave me alone.

    86. Selling bonds raises interest rates. Higher interest rates encourage saving, thereby diminishing the demand for goods and services, thereby lowering the risk of inflation.

      Of course, higher interest rates pump more interest revenue into the economy, some of which will be saved but the rest will be spent on goods and services, thereby increasing the risk of inflation.

      Which of these effects dominates depends on the marginal propensity to save with respect to interest rates ( i.e., the partial derivative of that propensity with respect to interest rates).

      If that marginal propensity is sufficiently high, it would seem that issuance of bonds would indeed lower the risk of inflation. Otherwise, not.

    87. wigwam, that is exactly the problem with monetary policy. Noone in the monetarist club cares to even try to solve it. It is just assumed away.

    88. Thanks.

      So the usual trick is to assume linearity,which is usually a sound assumption within a sufficiently narrow range. After that, it becomes an empirical problem to somehow measure/determine that marginal propensity from the available data. I’d imagine that someon somewhere has already attempted to do this. I’ll start looking around and asking people.

    89. Here’s my simplistic, non-economist’s way of looking at bond issuance versus printing money, from an MMT perspective: If deficit spending matches the private sector’s desire to save, there is no reason to expect that bond issuance will raise interest rates (unless the CB wants it to), just as we are now seeing in the US. Interest rates are prices for credit. If the supply and the demand continue to match, there should be no change in the price, that is, the interest rates. If there is not a dollar-for-dollar matching of bond issuance to deficit spending, it will be no more inflationary. It will simply mean that the private sector will look for a substitute for bonds, another way to save.

      So, bond issuance does not, in and of itself, change interest rates, which the CB can set through various means. Therefore the propensity to save, as opposed to spend or invest, is not changed. If interest rates do rise, it is because the private sector does not seek savings, but spending or investment, in which case the need for deficit spending is diminshed, reducing either the printing of money or the issuance of bonds. I mean, that’s what I take as the main point of MMT, that net government spending should match net private saving.

      And I don’t think MMT says that monetary policy can never, under any circumstance, be effective at stimulating or depressing economic activity, like when interest rates are already high and credit is tight, or when the economy is overheating and interest rates can be raised. It just might not be the most effective thing, and sometimes, like now, might be almost totally ineffective.

      But that’s just my take, and I’m no expert. Also, if you conflate capital with deposits, you can come up with some very different ways at looking a banking, though they won’t be meaningful to someone who doesn’t conflate those two very different things.

    90. “So again you just cant say that loans create deposits because you have to have enough liquid assets to cover these deposits. ”

      Consider an economy with a single bank that does all the loans and clears all the transactions. Why would it need liquid assets given that any cheque issued would be deposited back in the same bank?

    91. Tom: In general if you want to give someone money (make loan) you have to acquire it first from someone else

      Absolutely wrong. The core of your mistakes. Wrong for banks, wrong for the state.

      Tom, you are thinking about banking as pre-modern banking. Modern banking is different. Banks simply create money when they extend a loan. Anybody can create money, the trick is to have other people accept it (as money). (Minsky)

      Banks don’t have any special power to create money – all a bank deposit is is a bank debt/customer credit = an IOU from the bank to the customer = same thing as old-fashioned bank notes. Why can’t you set yourself up that way? Why can’t you have people give you dollar bills, and you give them Tom-notes in exchange? Why can’t you regularly take $11 dollar IOUs due in one year while giving out only a $10 Tom-note?

      Because nobody would accept Tom-notes for payments, not because you couldn’t create them. The state stands behind banks – it accepts their “Tom-notes” for payments to the state – it says Tom-notes are as good as state money. That is what all the other state backings of bank-deposits, bank-note, Tom-notes is: the state saying bank-money is as good as state-money ( lending reserves, deposit insurance). Banks are given an immense, sovereign power, structurally the same as the sovereign’s power to issue money, and only restrained by regulations, fees & capital requirements.

      The correct statement is:
      In general if you want to give someone money (make loan) you have to acquire the power to make your money worth something.

      Banks do this by being profit-making enterprises (their loans are paid back, destroying the bank-deposit-money, the debt of the bank, that they created) and by being backed by the state, which destroys its debts by taxation, and so makes state money, state debts, scarce and worth something.

    92. Andrewjudd,

      I’m sorry that you haven’t found my posts clear.

      Are you saying the government constrains themselves or they do not constrain themselves?? Why is this so hard for me to understand from your answers??

      I am saying that yes, governments do self impose constraints upon themselves. These constraints are political constraints and have nothing to do with the actual financial constraints.

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