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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. Sergei, so do you know any countries that had MB comparable to its GDP and didnt encounter hyperinflation?

      Some Guy: “Absolutely wrong. The core of your mistakes.” If you or your claims were correct no bank would ever go bankrupt. Because they would always make loans to cover their liabilities (i.e. deposits).

      Neil Wilson: “Consider an economy with a single bank that does all the loans and clears all the transactions.” But that’s the issue: because there are many banks there is a risk that people could withdraw their money to place it to a different bank. If there was only one bank this risk would be much smaller but still existent (you can hold your money in your home).

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

      You are conflating two distinct processes – the creation of a loan (capital-constrained), and the subsequent behaviour of depositors, which bears on liquidity. Your argument is a logical fallacy, along the lines of “I can’t drink this glass of orange juice because later I will need to excrete it”.

    3. ParadigmShift, I’m not claiming that you can not make loans without deposits but in order to have save balance sheet banks have to acquire money from people. And thsese deposits are a base for loans.

    4. And do you really think that all that matters for banks are creditworthy borrowers? If that was true they wouldnt advertise themselves so eagerly promising high interest rates on deposits. They would just advertise loans and dont care about deposits if they arise automatically.

    5. Maybe I’m confused as to what you’re saying Tom. You said “In general if you want to give someone money (make loan) you have to acquire it first from someone else” which sounds like you think you cannot make loans without prior deposits.

      Bill’s blog below may help you understand the MMT way of looking at things:
      http://bilbo.economicoutlook.net/blog/?p=14620

    6. Tom: Because the state makes it that way, bank money is as good as state-money for all purposes except payments of the bank to the state – e.g. reserve transactions, tax-payments. You can pay your taxes with a bank check. But the bank can’t. (Pay its taxes, or create the reserves to pay your taxes for you). Of course I should have expanded on that, but one can’t explain everything in a short comment. The state does restrain its delegation of money-creation power to the banks. And this keeps them from being completely invulnerable to bankruptcy; they need and can’t create state-money.

      Bank (& shadow-bank) money creation has to be restrained legally (as it is a power given to banks legally). And it is very dangerous & prone to abuse, fraud and corruption of bank regulators. It causes financial crises like the one the world is in now. The “loans create deposits” theory is an old theory, a century or two old at least. This is not in essence a new theory of MMTers & post-Keynesians, but the theory which was basically held by the overwhelming majority of economists from say the 1920s- 1960s or 1970s, including Keynes in his Treatise on Money. Look at Schumpeter’s History. p 1111 or thereabouts. At which point economics departments stopped teaching banking, finance, accounting and history (nobody read Schumpeter), and started to teach astrology-homeopathy-witchdoctor economics, using pseudomathematical cover.

      The underlying point is – your “absolutely wrong” statement cannot logically be true. (Probably generalizing it more than you intended) In general if you want to give someone money (make loan) you have to acquire it first from someone else.If so, if everyone needs to acquire money to give money, where does money come from? What is it?
      This verges on what Abba Lerner called the “Immaculate Conception of Money” theory – that all money was created in the past by God, and so interfering with his work, mere humans creating money is sacrilege.

    7. Tom, as I mentioned before, secondary deposits created internally by a bank are not associated with a liquid reserve asset, while primary deposits sought by banks also bring an inflow of reserves. Also, primary deposits are more likely to be of longer maturity than secondary deposits.

      Banks seek primary deposits but create secondary deposits, which may later become primary deposits for another bank. I don’t see a contradiction there, but it takes some thinking about.

    8. Some Guy, you have some valid points on meta level but I dont agree completely because you can say that money comes first from printing press and then is multiplied (altough I dont want to argue on this level). But my main point is if you believe that “loans create deposits” from the perspective of particular banks then why they advertise not only loans but also deposits?

    9. ParadigmShift, I understand your reasoning but which deposits prevail in a typical bank’s balance sheet in your opinion? Using your terminology: primary (acquired from general public) or secondary (created internally)?

    10. Dear Tom (at 2011/08/22 at 8:45)

      Okay, you have constantly indicated there will be hyperinflation with monetary base creation (US look out!) and taxes fund government deficits in the long-run. We have read your input – not that we haven’t read those sort of claims constantly before in mainstream macroeconomic textbooks and the conservative media for years. Nothing new is being offered by you in that regard.

      So please if you want to keep this thread going – write a detailed explanation as to why Japan is not hyperinflating after two decades of zero interest rates and rising budget deficits, why the US with its substantial increase in its monetary base is not hyperinflating and why interest rates are not sky-rocketing around the world given the rising public debt ratios.

      best wishes
      bill

    11. Guys do you agree with Billy that fed should buy all of US government debt (in this way it would become interest free). And I remind you that it doesnt have anything to do with current crisis. According to MMT it should be a standard thing (interest free government debt) in any era. And if you agree do you know of any countries that had MB comparable to its GDP and didnt encounter hyperinflation?

    12. Bill, I’ve read your answer after writing my last post. So I want to ask if you think that fed should buy government debt because of this crisis or regardless?

    13. Japan is in liquidity trap i.e. nominal short term interest rates equal zero and the same US. That’s the reason of current problems. But it doesnt mean that government debt should be interest free in any era and circumstances.

    14. Bill, just because MMT “theory” is accidentally correct (because of current crisis) doesnt mean that it is universally correct.

    15. Tom:

      I have a response to your question to Bill: “I want to ask if you think that fed should buy government debt because of this crisis or regardless?”

      Quantative easing is simply a process of unborrowing money, i.e., the opposite of what Bill says doesn’t work (in the very title of this posting). IMHO, if bond issuance doesn’t work (i.e., dimnish the risk of inflation), then by symmetry, buying them back doesn’t increase the risk of inflation.

      I like the idea of paying off the national debt with “cheap money” so long as it doesn’t cause inflation, which Krugman thinks is the case right now but would not be so in “normal times.” Apparently, Bill thinks that buying up bonds would never increase the risk of inflation, for reasons I posted in other comments.

    16. Tom,

      ParadigmShift, I’m not claiming that you can not make loans without deposits but in order to have save balance sheet banks have to acquire money from people. And thsese deposits are a base for loans.

      My previous post discussed this issue. Banks are not constrained by their reserve position when making a loan. They are constrained by their assessment of credit-worthy borrowers (subjectively determined) and sufficient capital. If these conditions are met, then it is the price of obtaining reserves in the interbank market, and where the spread over costs and return of the loan is sufficient to cover costs.

      In Australia, and depending upon the value of the transaction (high-value) or (low-value), which will determine when and how settlement occurs, if the bank finds that it has a negative reserve account (ESA) balance, then it will needs to borrow the necessary amount of reserves (Exchange settlement funds) to return its reserve account positive. On the other hand, if its reserve account is positive and if it is holding a desirable amount, then it will lend any excess in the interbank market. In either case the profitability of the bank will be impacted, in the first case due to increased costs, and on the second hand, increased profit.

      Attracting depositors with various financial instruments, is another method that the bank has available to cause an inflow of reserves. This represents a source of funds, and what is important is the price at which the bank can obtain these funds (reserves).

    17. MDM

      “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”

      Well i thought that was clear and then i thought……..what actually do you mean!

      What is MMT? Can it be described using existing information or is it a proposal for future government?

      I need a simple answer on this please.

      If it can be described using existing information including the legally based accounting is there somewhere i can see this worked thru? MMT so far seems to require giant leaps of faith. Like for example ‘here is all the accounting but obviously that is a charade – as per Neil Wilson, or where does the spending come from? ‘Obviously nowhere any sovereign government can never be constrained in spending’ – as per Bill. Or ‘they just burn the taxes once you have left the office’ as per Warren. And so it goes on. Can MMT be presented in such a manner i dont need faith?

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

      To expand on this, most economists believe that the “maturity transformation” performed by banks is a valuable public service. Well, that’s what debt monetization is, maturity transformation!

      This is a good argument to hammer on because it doesn’t require believing in any MMT theories. It’s just pointing out an inconsistency in the mainstream view. Monetization by banks = good! Monetization by government = bad?

    19. mdm: “Attracting depositors with various financial instruments, is another method that the bank has available to cause an inflow of reserves. This represents a source of funds”. Ok so if you believe that deposits can be a source for reserves why they dont be a source for loans? Reserves and loans are both assets for a bank.

    20. Tom,

      You wrote that:
      “Japan is in liquidity trap i.e. nominal short term interest rates equal zero and the same US. That’s the reason of current problems. But it doesnt mean that government debt should be interest free in any era and circumstances.”

      Interests can be (or rather are) paid on bank reserves so the argument that MMT recommendation about abandoning selling bonds makes setting interest rates above zero impossible is a straw man argument. I have told you so already and you are repeating the same ridiculous claim again.

      Please go to the Fed website to confirm that they are paying 0.25% on reserves.

      You refuse to put any effort to understand how banks create money (“checkable deposits”). It is not what’s written in the Krugman’s “Macroeconomics”. When you understand this process you will also instantly see that there is no liquidity trap as the loanable funds market does not operate in the way Krugman thinks. There is a mental trap instead – preventing otherwise smart people from understanding quite obvious facts.

      We have a debt deleveraging process going on in the US that is debtors are repaying back more of their loans than taking in money in fresh ones. This makes desired Savings greater than Investment. The same affected Japan during the last 2 decades.

      There is no monetary cure to this disease – only a fiscal one. That’s why Bill is correct. The government has to directly support aggregate demand until the private sector repairs its balance sheet. Some leakage to the foreign sector is inevitable but the currencies are free floating so central banks will not run out of foreign reserves or gold.

      The failure to understand the root causes of the GFC will cost the West (and specifically the US) the global position as they strangle their economies – unless the corrective actions proposed by MMT are undertaken ASAP.

      Understanding endogenous money creation only requires understanding accounting principles and banking procedures. Krugman doesn’t understand these and he leads his followers away from sound economics. He parrots some arguments taken from Keynes and then casts them into a completely incorrect neoclassical in essence model of the economy. You could read Michal Kalecki instead. The Chinese “universally correctly” do it that’s why they are so successful.

      Below is what an anonymous commentator “Lyonwiss” who is an economist and a former banker wrote on Steve Keen’s blog. You will hardly find a person who are further away from the MMT principles of aggregate demand management but his explanation of the loan creation process is probably the best I have ever seen.

      “In the following description, the triplet of numbers refers in order to loans outstanding, deposits and capital respectively. (Asset=loan outstanding + capital, liability=deposits and equity=asset-liability) So starting with $10 of equity or capital and nothing else, we have a (0,0,10) position for a bank.

      The bank makes an initial loan of $9, so we have (9,9,10). But the borrower extract the money immediately from the deposit account, which must be paid out of capital, so we have (9,0,1). This satisfies regulation, because capital ratio=1/9=11.1% (>8%). Note equity is always $10.

      Without new capital, the bank cannot lend further and credit expansion ceases. But the borrower’s withdrawal usually lands in other bank’s deposits, without that bank having extended a loan to get it. Lending creates deposits, but it may go somewhere else. Suppose our bank happens to get $20 deposit at random. So our bank has now a (9,20,21) position, an excessively high capital ratio 21/9.

      Suppose the bank extended a $18 loan, so that its position is now (27,38,21), still with a high capital ratio. But the borrower pulls out its deposit so that the position, as partly anticipated, becomes (27,20,3), with a capital ratio 3/27=11.1%, still OK.

      But there was an unexpected deposit withdrawal of $1 at the end of the day. The bank’s position becomes (27,19,2), with a capital ratio 2/27=7.4% breaching regulatory requirements. The bank is “short”, so it approaches the central bank for an overnight loan of $0.25, so that its position is now (27,19.25,2.25) with a capital ratio of 2.25/27=8.3%.

      The lending process goes on similarly the next day. Based on its initial equity of $10, the bank can reach its ultimate, extreme position of (125,125,10), with a capital ratio of exactly 8%. No more loans can be extended even with more deposits, being constrained by the level of equity capital.

      Any unexpected deposit withdrawal (a large one is a “run”) will need central bank assistance in liquidity management. Barring bad loans, the bank is solvent as at all times it has $10 equity, even if it may be briefly short of capital, at various times.

      This description simplifies a few things, but accurate enough to explain what you’re after.”

      “It is irresponsible to spread misinformation. There is enough of that from vested interests. Let’s clear up how the banking system works, from data.

      Central banks have very little to do with day-to-day bank lending; their mandates are monetary policy, setting official interest rates. The US banking system is a mess with multiple regulatory institutions (FED, OTS, OCC, FDIC etc, Obama started merging OTS and OCC to simplify). In the UK, banking supervision is with FSA and in Australia with APRA. The RBA also looks after the payment system and provides short-term liquidity as required.

      Bank lending is regulated by APRA essentially through two criteria. One is related to solvency: capital ratio = capital / risk-weighted assets > 8%. The other is related to liquidity: liquidity ratio = capital / deposits > 9%. Under normal circumstances, bank equity is about the same as capital. Reserves play an insignificant role in bank lending.”

    21. Adam: I dont think you understood my argument. I didnt say that MMT believers claim that bonds can be the only source of interests of government debt. As I understand MMT position it claims that government + central bank liabilities dont have to pay interests because the only proper way of regulating aggregate demand is by adjusting budget deficit. Correct me if MMT claims something else. And I dont think that “Lyonwiss” is in condratiction with mainstream “multiplier” economics. He clearly states that “Lending creates deposits, but it may go somewhere else”. So every particular bank has to acquire deposists before making loans. He also states: “Suppose our bank happens to get $20 deposit at random our bank has now a (9,20,21) position, an excessively high capital ratio 21/9. Suppose the bank extended a $18 loan” So loan happens after deposit.

    22. Tom: “Sergei, so do you know any countries that had MB comparable to its GDP and didnt encounter hyperinflation?”

      Did I have a look at MZM? Do you think it is not comparable to GDP? Can you find hyper-inflation or anything close to it in the USA?

    23. Adam

      Lyonwiss’s explanation is wrong. He/she thinks a $20 deposit adds to bank capital, and that an $18 withdrawal reduces bank capital. He goes from (9,0,1) to (9,20,21) with a $20 deposit. It should be (9,20,1).

      A pretty fundamental error there.

    24. Tom, I am very glad that we have some agreement on the “meta level”, which I think is crucially important.

      Responding to your And do you really think that all that matters for banks are creditworthy borrowers? If that was true they wouldnt advertise themselves so eagerly promising high interest rates on deposits. They would just advertise loans and dont care about deposits if they arise automatically.

      Well, “don’t care about deposits” is roughly how things work in some European banking systems like France. Commercial banks there make loans and are then usually indebted to the central bank for the required reserves. Here is a post from Ramanan’s blog with extracts & a link to one of Marc Lavoie’s (several) papers describing this. The MMT / Lavoie idea is that the French system makes “what really happens everywhere” more transparent, while the US system only looks different enough to mislead some economists.

    25. Sergei, I dont think MZM is that important during hyperinflation because banking sector doesnt work properly and people dont want to hold there their money. So deposit parts of diferent monetary measures are not comparable to normal times. And MB is just hard i.e. printed money and I dont know any country that had high MB/GDP ratio and didnt encounter hyperinflation. And I’m not saying that there is a direct causation between the two just that there is a higher probality that that would happen if this ratio was extremaly high (btw in Japan this ratio is below 30%).

    26. Tom:” I dont think MZM is that important during hyperinflation because banking sector doesnt work properly and people dont want to hold there their money”

      Tom, what is so special about MB that you think does not apply to MZM for the “benefit” of hyperinflation story? Why do you need banking sector to make it happen? You only need ATMs which represent a short-cut to the printing press of the CB.

      If hyperinflation is caused (in a classic QED) by too many money chasing too few goods then MZM fits the task as well as hard-printed cash because MZM can start chasing goods any moment. So it is not about thinking whether MZM is important or not but rather applying your own rules of hyperinflation and see whether they hold or not. And on this ground MZM clearly refutes your argument since in the USA MZM *is* comparable to GDP. Beside this, the causality between GDP and MB or MZM can be the opposite, i.e. GDP drives MB and MZM.

      Anyways, if you believe in hyperinflation it is your right and it is good if you bring your doubts and arguments here. However, not so many people on this forum like to go in circles.

    27. Tom,

      ““Lending creates deposits, but it may go somewhere else”. So every particular bank has to acquire deposists before making loans.”

      No this is incorrect. Banks need to equalise their position against the Reserve Bank that is reserve funds. But not deposits. New deposits are equal to new loans because of double-entry bookkeeping rules. Also – time structure of bank assets does matter that’s why banks want to lure long-time savers. But this is another issue.

      You still haven’t got the endogenous money creation. Imagine there are 4 banks in a country (pretty much what we have here in Australia). Where else can the money from the deposits go? Will the people ask for cash? So the banks will borrow from the RBA and get cash. So what? The sum of deposits in the system remains the same. There will be deposits belonging to RBA.

      As long as loans are not written off the banks remain solvent. Liquidity will always be provided by RBA. This doesn’t mean that there will be no impact on interest rates. But this can be moderated.

      Please keep in mind that RBA mops up the excess of funds from the interbank market but also provides funds there if necessary (e.g. if there is a bank run).

      Think about the banking sector as a whole – it is an aggregation of the banks. If 2 banks have the same interest rates on deposits the probability of a flow of 1 dollar of currency from the deposits in A to B is the same as from B to A. There are no net flows of funds between the banks. If there is a net flow, the bank which has a net inflow lowers its deposit rates because having an excess of funding would lead to losses. The other bank increases the rate. There is a negative feedback there.

      “the only proper way of regulating aggregate demand is by adjusting budget deficit”

      If you correctly understand how the banking sector operates as an aggregate you’ll see why monetary policy used as a tool will always lead to instability in the current framework. Because the banking sector works as a sink to savings and a source of loans (“investment funds”) but while savings (+ bank equity) and loans are always equal, their absolute quantity depends on the accrued amount of loans. Please read what Kalecki wrote. Investment determines capitalist consumption and savings. Saving desire can be frustrated.

      You need to look at this from historic perspective and determine which way of regulating the economy has fewer side effects.
      In the immediate post-war period fiscal policy was used successfully despite the existence of the gold standard and post-Bretton Woods order. However in the 1970ies Western economies experienced the effects of the oil price shocks leading to inflation what was used by the opponents of the fiscal policy to discredit “hydraulic Keynesianism”. (this is obviously an oversimplification). The monetary policy took precedence what led to the “great moderation” that is an enormous credit bubble and GFC.

      What is the difference between running moderate budget deficits and throttling bank lending to control inflation rate and running low budget deficits and using monetary policy to adjust aggregate demand?

      Monetary policy works by adjusting the demand for new loans and the redistribution of income between debtors and savers. The side effect was the growth of the debt bubble as affordable loans encouraged leveraged speculation.

      In Australia (and some other Western countries) the universal pensions system system was replaced by the superannuation industry where everyone is saving individually for the retirement. This ensured high saving propensity of some agents creating a gap in the aggregate demand. That gap was filled up by borrowing of other agents not by deficit spending (productive sector did not need so much revolving capital to satisfy the saving needs). Central banks adjusted interest rates minding the inflation rate which was a proxy for productive capacities utilisation related to the aggregate demand. As a result an exponential growth of private debt was observed.

      The monetary policy tool is now irreparably broken because of the size of the stock of private debt. It is not just a “liquidity trap”. If one increases interest rates to 5% in the US or to 10% in Australia the borrowers are bankrupt and the banking system is toasted.

      If you want to determine whether fiscal policy can be effective in halting hyperinflation and purging the so-called “expectations” please read about how Wladyslaw Grabski reformed public finance in Poland in 1923 – he introduced a one-off property tax, reduced government spending and improved collecting existing taxes.

      So yes I do believe that the governments have to take back the responsibility for moderating the economy from the Reserve Banks.

    28. Some Guy, I understand your position and agree that on macro level you can argue on both ways (loans first vs deposits first). But every responsible bank care about its deposits base (or at least should care if it doesnt want to have any problems) and doesnt expand its operation only because of credit-worthy borrowers. And that’s why I prefer mainstream thinking about this problem.

    29. “Lyonwiss’s explanation is wrong. He/she thinks a $20 deposit adds to bank capital, and that an $18 withdrawal reduces bank capital. He goes from (9,0,1) to (9,20,21) with a $20 deposit. It should be (9,20,1).

      A pretty fundamental error there.”

      Obviously reserves are more beneficial to a bank than a deposit liability therefore in reality the accounts do not balance even if by convention they do.
      Reserves via new deposits obviously do add to bank capital more than the liability amount neutralises the additional reserves.
      According to the accounting during a bank run the bank has the same capital. This is obviously nonesense in reality.
      If an idea has sufficient basic errors like this, pretty soon you are going to be talking total nonesense while imagining it is the truth.

    30. ParadigmShift,

      Bank (regulatory) capital is not exactly the same as equity. If you remove the cash (reserve funds) the equity doesn’t change but the capital does. But this can be replenished by borrowing from the Central Bank or sourcing cash deposits.

      “bank capital
      The buffer storage of cash and safe assets that banks hold and to which they need access in order to protect creditors in case the banks assets are liquidated. The bank’s capital/asset ratio is a measure of its financial health. Bank regulators require this to be above a prescribed minimum level.
      It is the funds – traditionally a mix of equity and debt – that banks have to hold in reserve to support their business.”

      Source: Financial Times Lexicon

      I choose to quote Lyonwiss because his description is so detailed that bank accountants cannot claim that it is oversimplified. I can create an example with bank equity, assets and liabilities on my own.

    31. Segei, I dont believe in hyperinflation but I also dont believe in MMT claims that government (including central bank) doesnt have to pay any interests under any circumstances. And I think that my distinctions between MB and MZM are quite clear and reasonable but that is not the most important thing (i.e. which one is more better). I hope you undertsand my position.

    32. tom,

      Attracting depositors with various financial instruments, is another method that the bank has available to cause an inflow of reserves. This represents a source of funds”. Ok so if you believe that deposits can be a source for reserves why they dont be a source for loans? Reserves and loans are both assets for a bank.

      I don’t quite follow what you’re saying here. Are you saying an increase in deposits can be a source loans? This makes no sense.

      This is what I am saying:

      Banks are not constrained by their reserve positionm, only capital and creditworthy borrowers (as I explained above). At the end of each day banks need to maintain a non-negative reserve account balance or meet some positive balance. If a bank has insufficient reserves, then they have a couple of options, either the interbank market, or via liability management (attracting deposits or reducing the assets which require a matching of reserves in the case of RR). The deposits represent a source of reserves, but they do not finance or make possible the creation of loans — reserves function as means of settlement between banks and to meet reserve requirements (if the country has them). The only consideration for the bank when it comes to reserves is the price at which they can be obtained.

    33. Adam, as I replied to Sergei I can agree with you that on macro level you can argue what is first but that doesnt change my position. I understand your criticsm of current system but MMT brings nothing new or responsible. And you should know that Grabski’s reforms relied on fixing polish currency with gold something I think MMT would never approve.

    34. Ak,

      Can I have your email, so that I may talk to you about a certain economist’s views on the idea that banks don’t destroy money, and that the horizontal rows of a stock-flow model don’t equal zero.

      Thanks.

    35. Apologies. My wording was confused.

      “Obviously reserves are more beneficial to a bank than a deposit liability”

      It should be something like. Capital is asset minus liabilities, but loan assets are clearly not as liquid as reserves and therefore by definition, for the bank, reserves are more valueable today than loan assets. In reality the accounts do not balance unless the bank has great skill in creating the loan assets and has not made assumptions that prove to ill considered. Therefore if the bank loses reserves, capital is declining even if the accounts say otherwise – particularly so in times of uncertainty or if the bank has made assumptions which today prove to wrong

    36. mdm “The deposits represent a source of reserves, but they do not finance or make possible the creation of loans “. Deposits are part of liabilites and liabilities are always a source of financing for any firm. I think that we just have to disagree.

    37. mdm,

      You can use this disposable one – obviously when I get your email I’ll respond from my usual address
      a “dot” kkk247 “at” wp “dot” pl

      I can tell you that I wasted over a week trying to explain to him what’s wrong with his approach. I failed. Sometimes lack of accounting or database programming experience means that people simply can’t see obvious things.

      NB there is something even worse lurking in these models.

    38. MDM
      “The only consideration for the bank when it comes to reserves is the price at which they can be obtained.”

      In reality banks do not operate so close to the wire as this statement implies. It is not just capital they need but also liquid assets which can be exchanged for reserves. In canada for example the banks begin operations each day by depositing a few hundred million of bonds with the central bank so they can get reserves when sending payments. The United states payment system is unusual in that they dont require collateral for fedwire but on the other hand they are unusal in that they require reserves be kept to minimums each night. The BOE requires cash ratio deposits for liquidity purposes. In australia banks have to have an amount of easily available liquid assets sufficient for ordinary purposes – some of which can be deposits with other banks.

      Making so much of loans create deposits while trashing the money multiplier sort of amounts to another distortion. Quality capital amounts to the same thing as reserves more or less. Conceptually it is the same thing.

    39. Tom,

      Grabski could only fix Zloty to gold after throttling the hyperinflation. He stabilised Polska Marka first.
      Also – do you remember “Popiwek” in 1990? Was it an element of a monetary or fiscal policy? “Pure” monetary policy was applied in 1997. The result was 20% unemployment in 2003.

      I think that the critical element is not that “loans create deposits” which is just an accounting observation but that the loanable funds market model is totally invalid. Once you reject that theory all the “modern” neoclassical models have no sense because the loanable funds market provides a closure to the models.

      This model may apply to the economy without modern banks where credit societies are the only institutions lending money.

      If you read my earlier comments this can be shown even if the money multiplier model of bank lending is assumed.
      Simply the volume (quantity/time) of savings is not a fully exogenous variable and therefore you cannot consider an equilibrium on this market as something what determines both the price and the volume of new loans. The price is determined or transmitted from the input to the output (that’s why central banks can influence credit rates). But the volume (quantity/time) is mainly determined by the demand (with some constraints related to the capital of the banks). Think about the elasticy of supply of funds parameter.

    40. Adam, I’m not historian but I think that fiscal reforms were as important as monetary reforms (btw do you think that Grabski’s reform would be succesful without fixing zloty to gold?). And I dont think MMT proponents would accept popiwek to fight inflation. Also from my memory we had unemplyment above 15% before 1997 and below 9% after this year so I dont see your point. I agree that this “loans create deposits” thing is not the most important problem. For me it is the claim that government + central bank liabilities dont have to pay interests because the only proper way of regulating aggregate demand is by adjusting budget deficit. I disagree and you can find many instances when countries experienced hyperinflation because of this thinking.

    41. Adam (ak)

      Ah, I see. I was assuming he was using capital and equity interchangeably. Thanks for clearing that up. I still don’t see that depositor withdrawals reduce bank capital, but I can see that they affect capital ratios.

      Far be it from me to dispute the FT, but isn’t capital on the RHS of the balance sheet, as a solvency provision? I didn’t think it was on the LHS (liquid assets) as a liquidity provision.

      I’m obviously having a Homer Simpson moment..

    42. Ak,

      Email sent thanks.

      Tom,

      If a bank has zero reserves in its reserve account can it make a loan? Or if you prefer, what are the conditions which need to be satisfied in order for a bank to make a loan. I have argued that it is bank capital and credit worthy borrowers.

      Andrewjudd,

      This is how I understand it:
      reserves != capital. They operate on two different sides of the balance sheet. Reserves are used as a means of settlement between banks, and affect the liability side — i.e. when a deposit is withdrawn. Whilst capital is used to offset risk on the asset-side. It absorbs losses when an asset goes bad.

      I’m familiar with the Canada situation, the lagged reserve accounting situation in America, and the case in Australia. If I have made a mistake please point it out.

      What I am saying about the price of reserves is that this represents a cost for the bank, if the expect income from a loan is not sufficient to cover costs, then a loan won’t be made.

      Making so much of loans create deposits while trashing the money multiplier sort of amounts to another distortion. Quality capital amounts to the same thing as reserves more or less. Conceptually it is the same thing.

      Unless I am misunderstanding you, you are conflating reserves and capital. As I mentioned above reserves and capital are not the same thing. Reserves affect the liability side (e.g. when a deposit is withdrawn) and capital the asset side (when an asset goes bad) a bank that has insufficient capital is insolvent.

      The point about the money multiplier is that it is an identity. It is assumed to be an ex ante constraint, in that banks are constrained in their ability to make loans by their amount of reserves. Let me ask you a question, if a bank has zero reserves can it make a loan?

    43. mdm, bank can make any particular loan without deposit which is created simultaneously (I dont deny it) or reserves (it can seek it later). But it doesnt change the fact that banks have to also seek deposits from general public if they want to have safe balance sheet. So in my opinion loans policy of the bank is not the same as a process of giving a particular loan. For example if one bank doesnt have any branches and its only source of funding is financial market it will have different loans policy than a bank that have a lot of indivdual clients who are used to put there their money.

    44. For example if one bank doesnt have any branches and its only source of funding is financial market it will have different loans policy than a bank that have a lot of indivdual clients who are used to put there their money.

      I don’t think anyone is denying this, but it doesn’t refute the “loans create deposits” assertion that is key to understanding the banking system. The point is that when a given bank creates a loan, that loan results in a deposit somewhere in the banking system. The more credit that is extended, the more money that goes back into banks as deposits. That’s my understanding, at least. If anyone more familiar with banking/MMT can weigh in, I’d be happy to be corrected. It just seems to me that too much is being made of it, and that people are talking past each other as a result.

    45. Another thing I wanted to add is that the idea of the money multiplier in fractional-reserve banking is most certainly flawed in at least one direction (if not both). Even if one doesn’t accept that banks are not really reserve constrained, it should be obvious that reserves do not automatically result in loans being extended, given the level of excess reserves now in existence. That point alone, even with the assumption of a reserve constraint being in place, makes the money multiplier irrelevant for most purposes.

    46. WHQ, mdm is denying this because he stated: “what are the conditions which need to be satisfied in order for a bank to make a loan. I have argued that it is bank capital and credit worthy borrowers.” I have just showed that these conditions are not sufficient (bank may refuse giving some loans if for example it can only rely on financial market as a source of money). So statement that “loans create deposits” is only valid if loan can be actually made. And it can depend on depository base of the bank. So of course in this case deposits can finance loans and money multiplier is true. And currently excess reserves are not being loaned because of liquidity trap. But that’s a difference story.

    47. Tom: But every responsible bank care about its deposits base (or at least should care if it doesnt want to have any problems) and doesnt expand its operation only because of credit-worthy borrowers

      These are independent issues. You knowledge of ALM seems to be quite weak though you keep on making references to it. Caring about deposit base means caring about the structure of liabilities. However by the accounting definition the size of assets equals the size of liabilities. When banks give loans they create demand deposits. Then ALM kicks in, regulations kick in, liquidity management kicks in, individual risk/profit logic kicks in and some other things as well. What all these things do is they define for each and every bank its individual risk appetite on the liability side. This risk appetite defines the structure of liabilities, i.e. are they short-term or long-term, or are they customer deposits or interbank, or are they retail or corporate and so on. Many-many questions to answer. BUT there is one thing which always holds: the assets of the banking system are equal to its liabilities. And while the structure of assets is very much demand driven, the structure of liabilities is where the banks are pushed by regulation to exercise certain level of management. And to get to the structure each and every bank likes and the one that is compliant with regulations banks agree/are forced to pay. Key thing to remember is that this all happens within the overriding constraint on the (consolidated) level of the banking system as well as individual banks and this constraint is: assets = liabilities.

    48. Tom: “For me it is the claim that government + central bank liabilities dont have to pay interests because the only proper way of regulating aggregate demand is by adjusting budget deficit”

      This is absolutely correct but I think the complexity goes several levels deeper than this statement says. It is wrong to take it at face value which is the mistake many people make. One critical assumption you make is that tax system is not adjusted. This is wrong.

    49. MDM

      I know what reserves are and i know what capital is. i know that in theory if the bank has no reserves and no high quality bonds and has loan assets it can have plenty of capital. Many of the banks being seized by the FDIC have capital. Lehmans i think had capital.

      A bank is allowed to operate because it has capital. Amongst the capital are a few quality assets which can easily be used in payment. Now if we say reserves are some super special important thing for payment purposes and yet we say a bank can loan money without these other important assets, such as gold or bonds then we can only distort reality. Settlement banks in the uk for example have a large number of bonds so they can self insure they can handle their liquidity risks. The other UK banks then rely on the settlement banks for their liquidity needs by having deposits with the settlement banks.

      Therefore my comment that lending because of capital or lending as per the money multiplier amounts to the same thing. It is just not a big deal when bonds and reserves or gold or even bank deposits are easily exchangeable.

      Then you ask me a question. Can a bank make a loan if it has no reserves.
      Can it lend cash? no.
      Could it make a loan that is payable greater than existing lines of credit or bonds the bank already possesses? Already it is getting harder.
      Can it commit to a cash loan or other loan. Yes. It could do more or less anything it wants. An unused Heloc for example is not even a loan until used and requires no capital adequacy against that liability. Same with a credit card.

    50. Tom Hickey @ 1:42: Thank you. If I am getting this correctly then, would it be the MMT position that a lack of final end demand (because no additional NFA’s) would ultimately undermine any short term inflation from increased asset prices due to those portfolio preferences?

      Or, would it be correct to say that the world would simply adjust to higher asset prices (lower yields) on other savings vehicles?

    51. I have just showed that these conditions are not sufficient (bank may refuse giving some loans if for example it can only rely on financial market as a source of money). So statement that “loans create deposits” is only valid if loan can be actually made. And it can depend on depository base of the bank. So of course in this case deposits can finance loans and money multiplier is true.

      I think the rub lies in the words “may” and “can.” Banks may not make loans if they, themselves, have to borrow to do so. Then again, they still might. And, though deposits can finance loans, they aren’t necessary. I think the point is that, if, say, I were very wealthy and wanted to open my own bank, I could loan someone else money with my own capital with no one making a deposit in my bank. I might also be able to borrow money with my capital as collateral and loan out that money at a higher rate than I’m paying to borrow it. Thereafter, a deposit somewhere in the banking system is created. The loan created a deposit. That this deposit may be used later to fund another loan does not change that.

      I can’t speak for mdm and I can’t say whether or not I agree with him or her. But I think you’re taking “loans create deposits” to a conceptual level that the statement isn’t meant to operate at.

    52. Andrewjudd: Can a bank make a loan if it has no reserves. Can it lend cash? no.

      You confuse banks with pawn shops. Banks are part of the national payment system. Central banks have an explicit legal mandate to ensure operations of the payment system.

    53. Tom,

      “Also from my memory we had unemployment above 15% before 1997 and below 9% after this year so I dont see your point.”

      When did you leave Poland? I left in 2003 when the official unemployment rate was 20% – please check the data as it is available from GUS.

      Yes it dropped to below 10% but much later and this was a result of the massive emigration (about 2 mln people left), money flowing from the EU and a credit-financed local housing bubble (which is going sour right now).

      “I agree that this “loans create deposits” thing is not the most important problem. For me it is the claim that government + central bank liabilities dont have to pay interests because the only proper way of regulating aggregate demand is by adjusting budget deficit. I disagree and you can find many instances when countries experienced hyperinflation because of this thinking.”

      Please give an example of a country with free floating currency which experienced hyperinflation because the interest rates on government debt were too low (or zero) and the fiscal policy consistent with the Functional Finance approach failed to control the aggregate demand.

      I can give you two examples of countries which tried to implement the usual mix of IMF-recommended policies (high interest rates and a currency peg) which ended up bankrupt, with a stunted growth and with a bout of high inflation: Russia and Argentina.

    54. Dave: “If I am getting this correctly then, would it be the MMT position that a lack of final end demand (because no additional NFA’s) would ultimately undermine any short term inflation from increased asset prices due to those portfolio preferences?
      Or, would it be correct to say that the world would simply adjust to higher asset prices (lower yields) on other savings vehicles?”

      What I am suggesting is that ceasing tsy issuance makes a difference wrt asset price level cet. par. There are other differences it could make too, e.g., interest rates, therefore, cost of capital, etc. While I don’t see inflation as a concern due to increased demand from increased liquidity (there is no change in non-government), there probably will be other effects cet. par. Those effects could be modulated by other policy shifts.

      For example, if asset price level rises, this could translated into increased demand through the “wealth effect.” This would be most obvious if the funds were to go into the equity markets, for example. Is that a reasonable assumption. Probably not, since those who would have held governments would prefer a near substitute and that’s likely not equities for most. These are the kinds of issues that need to be hashed out in addition to the inflation assumption.

      Elimination of tsy issuance would certainly make some difference, and these differences need to be examined. Too often the only or biggest issue is assumed to be inflation due to increased spending. While I think that is wrong since there is no increase in NFA, there are other issues for consideration, too.

    55. Andrewjudd: “Is it really so hard to believe a bank cannot lend you cash without having cash?”

      You have built a strawman in your mind. I do not know a single bank with capital but without cash. And you?

      Anyways, cash is part of inventory management (liquidity) at banks with attached cost/benefit analysis. In countries where there are positive reserve requirements (most countries in the world) vault cash is typically counted towards required reserves.

    56. Sergei

      We both agree that generally speaking banks have a large number of reserves.

      The question however was can a bank make a loan if it has no reserves. I pointed out it could not lend cash.

    57. Adam, under your conditions you want me to give examples of hyperinflation under liquidity trap. Please be serious. I’m talking about printing outside of liquidity trap.You can find on wikipedia (or in Reinhart and Rogoff’s book) many instances of hyperinflation in countries which were not in liquidity trap. And in these cases floating or fixed exchange rate doesnt matter. Btw I still live in Poland so I know our situation quite well and your description is not correct (for example people who emigrated were usually still registered as unemplyed so it didnt influance unemployment rate) and I dont see how this 1997 year was so important. But that’s not the main point of our discussion.

    58. Tom,

      I did not mention the conditions identified by some economists as liquidity trap. You stated that not paying interests on government sector liabilities would make the prevention of hyperinflation impossible in some cases.

      “the claim that government + central bank liabilities dont have to pay interests because the only proper way of regulating aggregate demand is by adjusting budget deficit. I disagree and you can find many instances when countries experienced hyperinflation because of this thinking”

      So please give us examples of the countries with market economies and floating fiat currencies where fiscal policies consistent with Functional Finance failed to stop hyperinflation. We would like to analyse these cases – otherwise the readers may reach a conclusion that you have conceded that point.

      I am aware that unemployment statistics in Poland may not be accurate but I would prefer to leave this topic as it might be too difficult to reach any conclusion.

    59. And Adam besides hyperinflation there’s another problem with this MMT “theory”. If you want to keep inflation under control using MMT tools you have to cut budget deficit. But mainstream economics allows to have temporarily high budget deficits + low inflation if investors want to buy government debt (of course not interests free).

    60. Adam, look at wikipedia examples about inflation. Most of these countries were not in liquidity trap and printing in these cases was not a good solution. Maybe you disagree but I stand on my position.

    61. Tom,

      In this discussion you have made certain claims and I expect you to illustrate your thesis with concrete examples, not to repeat and rephrase the same statements over and over again.

      This is the claim you made:
      “the claim that government + central bank liabilities dont have to pay interests because the only proper way of regulating aggregate demand is by adjusting budget deficit. I disagree and you can find many instances when countries experienced hyperinflation because of this thinking”

      If you don’t have historic examples illustrating your point I can assume that your positive claim that “you can find many instances when countries experienced hyperinflation because of this thinking” is unsubstantiated and needs to be withdrawn.

      Please see “Philosophic burden of proof” on Wikipedia.

      Also – I don’t understand why under normal circumstances (not in a war) a government which is supposed to represent the interests of all the citizens should pay some people interests to convince them to spend less so that the government has more room for its own spending. What is the social benefit of this kind of income redistribution? Accommodating saving needs of the private sector while low inflation is maintained is a different issue. But what’s the point of enriching already rich people?

    62. Andrewjudd: “The question however was can a bank make a loan if it has no reserves. I pointed out it could not lend cash.”

      Banks do not lend cash. They are not pawn shops.

    63. Adam: “I expect you to illustrate your thesis with concrete examples”. here you go: Angola (1991 to 1995), Argentina (80’s and 90’s), Belarus (90’s), Bolivia (80’s), Bosnia (90’s), Brazil, Bulgaria etc. dont be lazy and check yourself. I’ve posted a direct link but it’s still in moderation.
      “I don’t understand why under normal circumstances government should pay some people interests to convince them to spend less so that the government has more room for its own spending” because of inflation risk (if it wanted to spend otherwise).
      “What is the social benefit of this kind of income redistribution” This is normative question and you ma be right that there is no social benefit but we are talking about positive economics.
      But Adam please comment this statement: “If you want to keep inflation under control using MMT tools you have to cut budget deficit. But mainstream economics allows to have temporarily high budget deficits + low inflation if investors want to buy government debt”.

    64. Sergei

      I cannot be the first person in the world to have got a cash loan.

      In my experience banks make it fairly easy for you to borrow cash. The only stipulation for cash withdrawals is a maximum daily limit of 2000 unless you order a larger sum for the next day. Also they could unilaterally cancel credit cards and helocs. I have a heloc which is a line of credit if i require it where i only pay interest if i borrow money. Most businesses are going to have the ability to borrow cash when they need it up to their agreed daily maximum, where an in credit account can be overdrawn if necessary for a small annual fee.

    65. Tom,

      The list was most likely copied from the Wikipedia article. None of these countries adhered to principles of Functional Finance I am afraid. Bosnia and Angola were affected by wars. Other countries experienced transition from communism or right-wing dictatorships. Do you want me to praise the macroeconomic management skills of Batka (“Daddy”) Lukashenko?

      Look at what happened in Bolivia (this is also copied from a Wikipedia article)
      “After a military rebellion forced out García Meza in 1981, three other military governments within 14 months struggled with Bolivia’s growing problems. Unrest forced the military to convoke the Congress elected in 1980 and allowed it to choose a new chief executive.
      In October 1982 –22 years after the end of his first term of office (1956–60)- Hernán Siles Zuazo again became President. Severe social tension, exacerbated by economic mismanagement and weak leadership, forced him to call early elections and relinquish power a year before the end of his constitutional term.
      In the 1985 elections, the Nationalist Democratic Action Party (ADN) of Gen. Banzer won a plurality of the popular vote, followed by former President Paz Estenssoro’s MNR and former Vice President Jaime Paz Zamora’s Revolutionary Left Movement (MIR). But in the congressional run-off, the MIR sided with MNR, and Paz Estenssoro was chosen for a fourth term as President. When he took office in 1985, he faced a staggering economic crisis. Economic output and exports had been declining for several years.
      Hyperinflation had reached an annual rate of 24,000%. Social unrest, chronic strikes, and unchecked drug trafficking were widespread. In 4 years, Paz Estenssoro’s administration achieved economic and social stability. The military stayed out of politics, and all major political parties publicly and institutionally committed themselves to democracy. Human rights violations, which badly tainted some governments earlier in the decade, were no longer a problem. However, his remarkable accomplishments were not won without sacrifice. The collapse of tin prices in October 1985, coming just as the government was moving to reassert its control of the mismanaged state mining enterprise, forced the government to lay off over 20,000 miners.”

      The same applies to Brazil – you can visit Wikipedia and check what happened there in 1985.


      Let’s look at Argentina which is actually an excellent example proving the point that mainstream policies used to fight endemic inflation only made things worse. Please read Bill’s post “Hyperbole and outright lies”

      “In April 1991, Argentina adopted a rigid peg of the peso to the dollar and guaranteed convertibility under this arrangement. That is, the central bank stood by to convert pesos into dollars at the hard peg.

      The choice was nonsensical from the outset and totally unsuited to the nation’s trade and production structure. In the same way that most of the EMU countries do not share anything like the characteristics that would suggest an optimal currency area, Argentina never looked like a member of an optimal US-dollar area.

      For a start the type of external shocks its economy faced were different to those that the US had to deal with. The US predominantly traded with countries whose own currencies fluctuated in line with the US dollar. Given its relative closedness and a large non-traded goods sector, the US economy could thus benefit from nominal exchange rate swings and use them to balance the relative price of tradables and non-tradables.

      Argentina was a very open economy with a small non-tradables domestic sector. So it took the brunt of terms of trade swings that made domestic policy management very difficult.

      Convertibility was also the idea of the major international organisations such as the IMF as a way of disciplining domestic policy. While Argentina had suffered from high inflation in the 1980s, the correct solution was not to impose a currency board.

      The currency board arrangement effectively hamstrung monetary and fiscal policy. The central bank could only issue pesos if they were backed by US dollars (with a tiny, meaningless tolerance range allowed). So dollars had to be earned through net exports which would then allow the domestic policy to expand.

      After they introduced the currency board, the conservatives followed it up with widescale privatisation, cuts to social security, and deregulation of the financial sector. All the usual suspects that accompany loss of currency sovereignty and handing over the riches of the nation to foreigners.”
      —-
      The fact that countries which experienced hyperinflation as direct result political instability are used as an example to prove that Functional Finance doctrine cannot be successfully implemented only demonstrates how much we are manipulated by the mainstream economists and politicians like DSK who until recently run the IMF (but is certainly more than “fit for office” even without taking Viagra as shown by the latest scandal involving sex with a hotel maid).
      —-
      Let me formulate my hypothesis: in the modern era there is not much pressure on big government spending in Western countries. Quite the opposite, politicians are often elected on a mandate of pursuing austerity (like in the UK). But there is another reason why high interests have to be paid on the government debt, obvious to anyone living in Australia. Once the finance sector has been unshackled by the deregulation and the monetary policy replaced fiscal policy as the tool of choice to control the aggregate demand, high interest rates become the only tool available to moderate the credit expansion (leading to increased investment and consumption spending) by affecting the demand for credit. We need to look at the way short-term interest rates are correlated with the long-end of the yield curve.

      This is in my opinion the reason why we have to provide free lunches to the bond investors: the maintenance of the interest rates. Not because the government wants to spend more and wants to induce higher propensity to save. The government in Australia actually wants to spend less. There is absolutely no reason to beg the bond investors in Australia, Japan and China to save more in Australian dollars. But the monetary authorities (RBA) know that lower interest rates would mean an explosion in bank lending leading to credit bubbles and possibly higher inflation. This is the correct transmission mechanism but you will only understand it once you stop thinking in terms of money multiplier and the loanable funds market.

      Do you think that I have invented all of these? Please read the following paper:
      “BIS Working Papers. No 297. The bank lending channel revisited. By Piti Disyatat. Monetary and Economic Department. February 2010”
      —–
      The side effects of the monetary policy on the real economy are more than visible if you know what to look for. Our (Australian) currency is overvalued due to carry trade. This kills local manufacturing and weakens the service sector (tourism and education). Australia is becoming an underdeveloped country with a colonial-type economy (mining and agriculture are the main sources of export income). The private sector has a record level of indebtedness – this is the side effect of the expansion of the private credit. (By the way how are these lemmings who borrowed in CHF are doing in Poland?) We are starting to pay the price for the experiment which was started in the 1970ies.

    66. Andrewjudd: “In my experience banks make it fairly easy for you to borrow cash”

      When you get a loan, the bank creates an (additional) deposit on your account. It is a balance sheet operation. Withdrawing this deposit in cash or transfering it to another account in the banking system are cash flow operations. And there is another accounting statement called income statement. All these statements are independent from each other which does not mean that there are no connections between them. What you do in the quote above is you are mixing up operations with different accounting statements into one “combined” operation and then say that there is no difference. There is a HUGE difference even if you as borrower who takes cash (upto a daily limit, i.e. subject to cash inventory management of the bank) do not see it.

    67. Sergei

      You appear to think i am a complete idiot. You began by saying the banks dont lend cash because of some power the central bank had now you want to lecture me on the basics of running a bank.

      For some reason the statement ‘banks dont lend reserves’ is enormously important to you. A deposit is just a book keeping entry of no particular importance or ability to change the banks realities. The bank is no different to a man in a temple with a set of books. If he agrees to lend me cash then he is unders some obligation to provide me with cash but if the bank is totally out of cash it is not a particular big deal. Never once happened to me though. Millions of people are regularly borrowing cash from banks.
      Apparently it is true that a large bank ATM inside the branchses holds 200,000 cash. The smaller ones outside hold 50,000. Banks have plenty of cash. Retailers are forever depositing plenty of cash. The banks have cash warehouses where in the case of the BOE system the entire off balance sheet BOE cash is held in these warehouses which are operated by 5 companies including RBS, the post offices and the firm the banks use to load their cash machines. Because warehouses are strategically positioned around the country and you can only unload a cash machine so fast the banks are almost never going to run out of cash.
      The banks have no particular problems loaning cash if they have capital.
      Banks loan cash and it is just obfuscation on your part to pretend otherwise.

    68. Adam even countries with zero interests rate (Switzerland, Japan) have overvalued currencies so I dont see your point. You are saying that it’s better to use only fiscal policy to control demand and inflation. I disagree because if you want to keep inflation under control using MMT tools you have to cut budget deficit. But mainstream economics allows to have temporarily high budget deficits + low inflation if investors want to buy government debt (so you can use both monetary and fiscal policy). I think we can only agree to disagree but clearly this MMT “theory” is really bogus for any reasonable thinking man.

    69. Sergei

      “When you get a loan, the bank creates an (additional) deposit on your account.”

      Unused lines of credit, like credit cards, helocs, in credit current accounts with overdraft facilities are not associated with customer loan deposits. The bank records no liabilities for these lines of credit. There is no loan.

      So if you go to the bank and it has no reserves you cannot get a loan and no deposit can be created saying you did get a loan.

      By the way in case it is not clear to anybody here, reserves just means central bank money, whereas it appears many people think it means reserve balances only. No reserves means no cash. You already agree no cash is a very unlikely event
      What actually is the argument you are making??
      What problem do you have with no reserves means no cash loans???

    70. Tom,

      Please go to tradingeconomics and look at the current account balances of these countries. You will see that Japan and Switzerland have mostly surpluses and Australia has mostly deficits (on annual basis).

      You are entitled to your views but I am afraid that you haven’t presented any concrete arguments why MMT is “bogus” except for presenting a few straw-man arguments and quoting a mainstream textbook several imes.

      This is not enough to convince me because I can see the discrepancy between these textbooks and the reality.

      This hasn’t changed since I was a teenager I am afraid. I had to watch one communist idiocy in Poland and now I have to watch another similar dogmatic approach elsewhere. There are more parallels than you may expect and the end of the neoliberal experiment may be similar.

    71. Andrewjudd, jeez .. with all respect…

      Only pawn shops lend cash. Banks lend their own liabilities. The conversion of these liabilities into liabilities of other entities is another topic. To pretend there is no conversion is to obfuscate the reality. And there are plenty of documents even in the mainstream which say what I just wrote. For instance you can have a look here “The role of central bank money in payment systems” link_http://www.bis.org/publ/cpss55.pdf

      The first paragraph from the foreword says:
      Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies. What makes a currency unique in character and distinct from other currencies is that its different forms (central bank money and commercial bank monies) are used interchangeably by the public in making payments, not least because they are convertible at par. Central bank money plays a key role in payment arrangements, as it has proved safe and efficient to have a central reference of value with which all other forms of the currency maintain this par convertibility. This role is long-established and, for the most part, uncontroversial.

      So to say that commercial banks lend central bank money is conceptually wrong. Commercial banks are not pawn shops.

    72. Adam you may not believe me but I’m not using any textbooks only my brain and logical thinking. For me it’s clear that using one tool is not better than using two tools. Btw US has also zero interests rate deficits and overvalued currency (you can say the same about e.g. Czech Republic). You criticize communism and neoliberalism and you have some valid points but I wouldnt treat them as equally bad. And keynesian approach is also present in current mainstream thinking so I think that you little exaggerate in your criticism.

    73. Adam (ak) Have you read Czeslaw Milosz’z book a Captive mind. The parallels he describes are striking, one reality, one way of seeing (of course there are others but if you want to become anything you must toe the party line). That the west will end up mired in the same paranoid totalitarianism is becoming more self evident to me every day.

    74. Daniel,

      Yes I did – in the 1980ies. It was a part of my intellectual formation together with an early adoption and then total rejection of the Catholic faith and religion.

      I do not blindly follow any school of thought and I have my own argument with one of MMT scholars in regards to the supposedly universal benefits of imports and the Janus face of the Chinese mercantilism.

      I am not convinced that the rise of fascism is inevitable at least in the US and Western Europe. I think that if the current Chinese strategy of employing “soft power” works well, the American corporations will act as Chinese proxies and neuter the influence of the military complex. We can see that indirect meddling in Australia already – the mining tycoons have managed to fight off any attempts to limit the extraction and delivery of mineral resources to the new Manufacturing Centre of the World.

      The riots in the UK have shown us that any resistance to the neoliberal paradigm is futile as the rise of the modern means of social communication (Facebook, Twitter) makes the old traditional channels unusable. D. Cameron has manipulated the anger of the mob so that his agenda of turning the majority of the people against anybody who wants to question the predominant paradigm has been implemented. There will be no mass demonstrations against austerity in the UK because people are afraid of the riots and the Police has enough power to stop them. Young people know that they only can bang their heads against a wall as everything is a lie – or just follow the herd. Some may follow the mad idiot from Norway and start shooting innocent people – if other means of venting frustration are not available. But my point is that this atomisation and alienation of the Western society will not lead to the realisation of the capitalist utopia (invented by Ludwig von Mises and Ayn Rand) as it will only enable the remaining “old” (or rather emerging) players to reorganise the global order in their own way. Western corporations – the oligopoly – are not the ultimate source of power because there is only one true global monopolist – China Inc administered by CCP. But they are smart and mimicking the old superpowers simply doesn’t make any sense. The Chinese are not imperialists. They will leave everyone alone as long as their strategic interests are respected. Can you imagine something like Hong Kong in the US? It would be like Puerto Rico with a sharia law. But the Mainland Chinese respect the political status quo. I can only admire their wisdom.

      The neoliberals are destroying the Western capitalism based on production of goods and delivery of the basic services as the main source of profits. The financial capitalism free of crowding out the aggregate demand (and delivery of public goods) by the state creates the real misery of bankrupt workers and middle class and an illusion of wealth of the super rich.

      Nobody will notice any change – except for a lingering recession, rising inequalities and hopelessness. The consumption of real resources in the West must be limited to make enough room for the New Rich.

      Of course there is a possibility that like in 1914 the decadence and decay will be replaced by the well organised madness. But at least Poland is located far away from the main arena of the possible conflict. Australia should also be OK – we are too valuable to be destroyed by anyone.

    75. Tom: mainstream economics allows to have temporarily high budget deficits + low inflation if investors want to buy government debt”

      Tom: “I’m not using any textbooks only my brain and logical thinking”

      If you do not read any text books then what in your logical thinking defines the yields on government debt? It is definitely not whether investors want or do not want to buy government debt. This is what mainstream textbooks tell you.

    76. ” The Chinese are not imperialists.”

      The Chinese are the best traders on the planet. That’s why they’re everywhere. It’s just that they’ve been unusually quiet for about 500 years.

    77. Sergei
      You are getting muddled up. Banks create deposit liabilities for the customer. They dont lend deposit liabilities and still have liabilities for the customer. The banks liability is cash. If the bank lends you the liability it loans cash.

    78. Tom, saying that “market sets yields on government debt” is already different from asking whether investors want or do not want to buy government bonds. But back to my original question: “what in your logical thinking defines the yields on government debt”? Saying that it is the market is no answer but rather escaping the question and defying logic. This is the path of mainstream.

    79. Sergei

      The market is just all of us making decisions. Some good and some bad but the market reaches a conclusion based on our collective actions. The yield is set by the price the buyer is willing to buy the bond for. The yield only has meaning to the current buyer who actually has that yield. The current seller can only assume what the sale price will be. Like selling a house where seller optimism meets market realities.

    80. Sergei, Andrewjudd explained it pretty well. I would only add that because of higher liquidity yields on bonds change continuously so yields from near past are quite qood indicator of current yields (of coure “black swans” are still possible). But please give us your theory of yields.

    81. Tom, Andrewjudd, this is all main stream stuff which does not answer the question but again delegates it to the “market”. What does the market know about value judging from the current crisis?

      The yields on government bonds are driven by the expectations of the future path of the central bank policy rate because government bonds and central bank rate are effectively substitutes in terms of future income and therefore credit risk. But yields on very long-term government bonds are attached to the long-term nominal growth of the economy (GDP) which provides you with a long-term *risk-free* income rate. With the short-end fixed and long-end fixed the “market” decides only on everything in between. This is what logic can tell us. So there is “market” in this story because it has to establish collective expectations of future interest rate policy of the CB. There *can* obviously be a demand/supply effect driven by portfolio allocations of the private sector (demand) within the *fixed space* of bonds previously sold by the Treasury but these are secondary effects. If you still have doubts about this logic (i.e. you still believe in the mystical market which sets the yields on government debt based on what buyers are ready to pay) then go back several weeks and check how the yields of treasuries reacted to the announcement of the Fed to keep rates low until mid 2013.

    82. Sergei you admit that yields on government bonds are driven by the expectations and on expectations investors decide whether to buy or not bonds. I dont understand your problem or see any condratiction.

    83. Sergei

      The feds announcement that rates would be low until 2013 was accompanied by no additional information about QE and a recognition the economy was in worse shape than expected and as i recall recent talk about spending less than the expectations of people in the economy, and recent talk of fed fears about european banks where a damaged europe will be very adverse for US growth. And the feds statement was as much created by the expectations of people in the economy as it was by the fed. The fed observes a market in action when it makes decisions. Where the market is millions of us making decisions and expecting things

      It is odd to say that long term yields provide a risk free return. The return is only todays “expectations” guess which other people refer to as something to do with the market for long term treasuries. While the feds are insiders and often have better information than many of us, they are still only guessing as to what reality will look like in the future. The long term treasury yield is just an expectations guess.

    84. Tom, the contradiction is that there are no investors. But there is arbitrage instead. And investors take the already arbitraged yields as given.

    85. Sergei, dou you actually know what is “arbitrage”? And who can make this “arbitrage” if not investors themselves? I’m not sure you understand financial markets.

    86. Wigwam (August 20, 2011 at 15:37) points to a flaw in Bill’s argument, and then asks “What am I missing?”

      The answer is “nothing”: Wigwam has spotted the flaw in Bill’s argument.

      Or put another way, as Warren Mosler points out in his Soft Currency Economics article in relation to his “parents and children” analogy, higher interest rates encourages the accumulation of government debt by the private sector, which necessarily means less spending by the private sector.

    87. Bill would probably answer my above point with his claim that “bonds are highly liquid and holding them doesn’t constrain private spending capacity”. My answer to that is: try using bonds to do the weekly shopping at the supermarket. Or try using bonds to buy a car. Of course bonds are pretty liquid. But they certainly aren’t as liquid as cash.

    88. Ralph, higher interest rate are typically associated (in the mainstream) with a booming economy. Booming economy is typically associated with high corporate profits and also typically at the expense of increasing debt at the lower ends of the consumer ladder. Those who buy bonds (sometimes on a “cash-flow” basis) have accounts in private banks and a personal private banker with the whole private banking machinery behind such private bankers (private bankers are dang expensive). And it is typical that those private bankers with their machinery do the “weekly” shopping at the supermarket for bond buyers. And since they are still bankers there is no problem to settle any such transactions especially given the collateral these private bankers have.

      I just want to say that “illiquid bonds” argument is a very weak one and it is a qualitative one. I am sure that Bill or Warren do not deny the effects of “not being cash or perfect substitutes” but how do you quantify it? Why are you so sure that on the grand scale of things such effects are important? It is less than obvious to me. And I tend to agree with Warren who says interest income channel can be a more important factor.

    89. Ralph,

      Try doing your shopping with your deposit account held in a bank that has run out of capital.

      Then you’ll find that bank deposits aren’t that liquid either.

      Government bonds are as spendable as bank deposits. There are market mechanisms that are sufficiently liquid to ensure that the asset does not ever prevent anybody from spending in all normal circumstances.

      The idea that bonds have magic anti-spending powers is a total myth.

    90. Ralph

      “bonds are highly liquid and holding them doesn’t constrain private spending capacity”. My answer to that is: try using bonds to do the weekly shopping at the supermarket. Or try using bonds to buy a car. Of course bonds are pretty liquid. But they certainly aren’t as liquid as cash.

      Also a bank deposit is highly liquid but that does not mean that bank deposits will in aggregate be spent in a way that alters the economy – particularly if interest is paid on deposits in good times or when people are very afraid about their income in the future when interest is low. The liquidity of the deposit or bond does not seem to me to be the relevant issue.
      Surely everybody can agree that higher interest rates on deposits act over time to constrain spending?

    91. Non-expert commentary subject to correction:

      There’s a certain circularity to all of this. The reason yields are so low right now is the same reason that there is such a need for deficit spending – the private sector is trying to save rather than spend or invest. Once that changes, anyone looking for cash will have to pay higher yields to get it, including the government (though, as the lowest-risk place to park money, bonds won’t need to yield as much over time as other savings vehicles). But, once that savings desire reduces, to the extent that it does, the government will need to deficit spend that much less.

      The yields on bonds already issued doesn’t change, except with regard to secondary markets where the price changes according to a given bond’s yield relative to current yields, which is totally irrelevant to the government’s cost of its previous borrowing. Its terms are set once the bond is issued. So if the market changes from a desire to save to a desire to invest, it has no effect on pre-existing government debt, at least as far at the government is concerned. As far as new debt goes, they’d need to auction off less of it if the economy picked back up, and current issues are over-subscribed at historically low yields. The market literally can’t get enough of it. Until bond auctions are under-subscribed, there’d be no need to raise yields (at least not for the purpose of selling the desired number of bonds).

      In any case, government bonds soak up what is already the “slowest” money, and, to the extent that “slow” money becomes more rare, the need (loosely speaking) to issue bonds is reduced. I couldn’t say with confidence that there’s no inflation-reducing effect to issuing bonds rather than not to match deficits, but I can’t see that it’s significant.

    92. WHQ

      In a manner of speaking you are describing current Fed policy which is to reduce interest rates to historically low levels and they have had considerable success with that in that they now have inflation as they measure it rather than something far worse in their terms. If the government now spends more, then the feds will have to raise interest rates or allow higher inflation. Think about the UK with 5% inflation. You can imagine that going to over 10% and they still sit on their hands as the housing market continues to remain depressed. Stagflation is the most likely outcome from all of this i think.

    93. If the government now spends more, then the feds will have to raise interest rates or allow higher inflation.

      Why, how soon, and how much higher? Are you suggesting 10% annual inflation in the US with additional government spending resulting in no significant job growth or proporational increase in wages? How much government spending?

    94. Andrewjudd,

      What you have repeated after the mainstream economists about rising the taxes or allowing for higher inflation in the future if the government spends more during a recession is a nonsense.

      Repeating the same nonsense again and again in a circular way doesn’t make your point more valid. Please read the post where Bill specifically explains why- I am not going to waste my time providing my own detailed explanations.

      Why on earth should we worry about the private sector not willing to save more than it invests in 10 or 20 years time because we provide enough funds satisfying the saving (or rather debt repayment) needs in the current period? We should be concerned about what is going on now.

      Yes I know that I don’t understand. I have never fully understood the loanable funds theory. I am unable to. Because it is b…t.

      If the government doesn’t spend enough now then the GDP in the future will be lower because of the lower investment in the productive capital at the current period.

      So if you stick with the mainstream nonsense your income in 2020 will be $100k in the dollars from 2011 and you will have to pay a 20% tax.

      If you stick with MMT your income in 2020 will be $150k in the dollars from 2011 and you will have to pay a 25% tax because the economy will be running at the full capacity and the government will have to tax at a higher rate to make enough room for its own spending.

      Is this what you mean by “having to pay higher taxes”? Which scenario do you like more?

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