Saturday Quiz – February 27, 2010 – answers and discussion

Many people have written to me asking me to post answers to the Saturday Quiz. I am sympathetic to these requests but on the other hand the Quiz (which takes a few minutes to compile) is my “day off” the blog and so building in extra work would sort of defeat the purpose. But as it happens I was about to announce that from soon I was going to stop posting a regular Sunday blog. I play in a band which takes time and in a few weeks will have regular new commitments on Sunday evenings. If there is something happening that warrants comment I will but in general I was going to extend my “day off” to the whole weekend. But then I thought – I can write the answers up with some discussion on Sundays and so the weekends can become The Quiz Weekend, which should satisfy both the requests for more quiz feedback and my desire to grab some extra free (well non-blog) time. So that is the plan from now on. If you haven’t already done the Quiz from yesterday then have a go at it before you read the answers. I hope this helps you develop an understanding of modern monetary theory (MMT) and its application to macroeconomic thinking.

Question 1:

Government spending which is accompanied by a bond sale to the private sector adds less to aggregate demand than would be the case if there was no bond sale.

The answer is false.

The mainstream macroeconomic textbooks all have a chapter on fiscal policy (and it is often written in the context of the so-called IS-LM model but not always).

The chapters always introduces the so-called Government Budget Constraint that alleges that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. The writer fails to understand that government spending is performed in the same way irrespective of the accompanying monetary operations.

Anyway, they claim that money creation (borrowing from central bank) is inflationary while the latter (private bond sales) is less so. These conclusions are based on their erroneous claim that “money creation” adds more to aggregate demand than bond sales, because the latter forces up interest rates which crowd out some private spending.

All these claims are without foundation in a fiat monetary system and an understanding of the banking operations that occur when governments spend and issue debt helps to show why.

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

Like all government spending, the Treasury would credit 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. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), 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, expands the money supply.

However, the reality is that:

  • Building bank reserves does not increase the ability of the banks to lend.
  • The money multiplier process so loved by the mainstream 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.

You may wish to read the following blogs for more information:

Question 2:

If the external balance is always in surplus, then the government can safely run a surplus and not impede economic growth. However, this option is only available to a few nations because not all nations can run external surpluses.

The answer is false.

I noted several questions in the comments section about this particular problem. The secret to understanding the answer is two-fold.

First, you need to understand the basic relationship between the sectoral flows and the balances that are derived from them. The flows are derived from the National Accounting relationship between aggregate spending and income. So:

(1) Y = C + I + G + (X – M)

where Y is GDP (income), C is consumption spending, I is investment spending, G is government spending, X is exports and M is imports (so X – M = net exports).

Another perspective on the national income accounting is to note that households can use total income (Y) for the following uses:

(2) Y = C + S + T

where S is total saving and T is total taxation (the other variables are as previously defined).

You than then bring the two perspectives together (because they are both just “views” of Y) to write:

(3) C + S + T = Y = C + I + G + (X – M)

You can then drop the C (common on both sides) and you get:

(4) S + T = I + G + (X – M)

Then you can convert this into the familiar sectoral balances accounting relations which allow us to understand the influence of fiscal policy over private sector indebtedness.

So we can re-arrange Equation (4) to get the accounting identity for the three sectoral balances – private domestic, government budget and external:

(S – I) = (G – T) + (X – M)

The sectoral balances equation says that total private savings (S) minus private investment (I) has to equal the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.

Another way of saying this is that total private savings (S) is equal to private investment (I) plus the public deficit (spending, G minus taxes, T) plus net exports (exports (X) minus imports (M)), where net exports represent the net savings of non-residents.

All these relationships (equations) hold as a matter of accounting and not matters of opinion.

Thus, when an external deficit (X – M < 0) and public surplus (G - T < 0) coincide, there must be a private deficit. While private spending can persist for a time under these conditions using the net savings of the external sector, the private sector becomes increasingly indebted in the process. Second, you then have to appreciate the relative sizes of these balances to answer the question correctly. Consider the following Table which depicts three cases - two that define a state of macroeconomic equilibrium (where aggregate demand equals income and firms have no incentive to change output) and one (Case 2) where the economy is in a disequilibrium state and income changes would occur. Note that in the equilibrium cases, the (S – I) = (G – T) + (X – M) whereas in the disequilibrium case (S – I) > (G – T) + (X – M) meaning that aggregate demand is falling and a spending gap is opening up. Firms respond to that gap by decreasing output and income and this brings about an adjustment in the balances until they are back in equality.

So in Case 1, assume that the private domestic sector desires to save 2 per cent of GDP overall (spend less than they earn) and the external sector is running a surplus equal to 4 per cent of GDP.

In that case, aggregate demand will be unchanged if the government runs a surplus of 2 per cent of GDP (noting a negative sign on the government balance means T > G).

In this situation, the surplus does not undermine economic growth because the injections into the spending stream (NX) are exactly offset by the leakages in the form of the private saving and the budget surplus. This is the Norwegian situation.

In Case 2, we hypothesise that the private domestic sector now wants to save 6 per cent of GDP and they translate this intention into action by cutting back consumption (and perhaps investment) spending.

Clearly, aggregate demand now falls by 4 per cent of GDP and if the government tried to maintain that surplus of 2 per cent of GDP, the spending gap would start driving GDP downwards.

The falling income would not only reduce the capacity of the private sector to save but would also push the budget balance towards deficit via the automatic stabilisers. It would also push the external surplus up as imports fell. Eventually the income adjustments would restore the balances but with lower GDP overall.

So Case 2 is a not a position of rest – or steady growth. It is one where the government sector (for a given net exports position) is undermining the changing intentions of the private sector to increase their overall saving.

In Case 3, you see the result of the government sector accommodating that rising desire to save by the private sector by running a deficit of 2 per cent of GDP.

So the injections into the spending stream are 4 per cent from NX and 2 per cent from the deficit which exactly offset the desire of the private sector to save 6 per cent of GDP. At that point, the system would be in rest.

This is a highly stylised example and you could tell a myriad of stories that would be different in description but none that could alter the basic point.

If the drain on spending outweighs the injections into the spending stream then GDP falls (or growth is reduced).

So even though an external surplus is being run, the desired budget balance still depends on the saving desires of the private domestic sector. Under some situations, these desires could require a deficit even with an external surplus.

You may wish to read the following blogs for more information:

Question 3:

In the same way the spending multiplier indicates the extent to which GDP rises when there is a given rise in government spending, the tax multiplier captures the impact of rising tax rates on GDP as people reduce their labour supply because of the disincentives associated with taxation.

The answer is false.

Mainstream economics analysis does posit that rising marginal tax rates distort the labour supply choice – by increasing the hourly cost of work and providing greater incenctives for workers to choose more leisure. This allegation forms the basis of their case for substantial tax cuts and proportional tax systems; and, as a consequence, reduced budget deficits.

As an aside there is no empirical evidence to support this claim. Most of the credible studies find very little evidence of a negative tax elasticity within normal ranges that these variables shift. The most significant tax effect is found at the intersection of the welfare system and the wage system where workers who work an extra hour while on benefits often face 100 per cent marginal taxes (loss of benefit equal to earnings). But that is another story again.

However, in terms of this question, the trick was in understanding what the tax multiplier is trying to conceptualise.

First, it is a macroeconomic rather than a microeconomic concept. Households are assumed to pay some tax out of gross income and the tax rate (keeping it simple) specifies that proportion. In reality, there are a myriad of tax rates but the total effect can be summarised by a single (weighted-average!) tax rate.

Households consume out of disposable income. Assume the overall propensity to consume is 0.80 – which means that overall consumers will spend 80 cents for every extra dollar of disposable income received.

So, if the tax rate rises, then disposable income falls. If nothing else changes, then this fall in disposable income will lead to a reduction in consumption (equal to the propensity to consume times the fall in disposable income). The resulting fall in GDP is defined as the tax multiplier.

Similarly, when tax rates falls and increase disposable income, the reverse occurs.

You should not confuse the hypothesised tax multiplier effect with the increase in tax revenue that occurs as a result of the automatic stabilisers. This effect occurs with no discretionary change in the tax regime. It is a common mistake to assume that because tax revenue is rising that tax policy is becoming contractionary.

Further, at the individual level, as GDP growth recovers most people will not be paying higher taxes at all while others will be paying a substantial increase – why? Because they move from unemployment (zero taxes paid) to earning an income (some taxes paid).

You may wish to read the following blog for more information:

Question 4:

Assume the government increases spending by $100 billion in the each of the next three years from now. Economists estimate the spending multiplier to be 1.5 and the impact is immediate and exhausted in each year. They also estimate the tax multiplier to be equal to 1 and the current tax rate is equal to 30 per cent (30 cents in the $). What is the cumulative impact of this fiscal expansion on GDP after three years?

(a) $135 billion
(b) $150 billion
(c) $315 billion
(d) $450 billion

The answer was $450 billion. In Year 1, government spending rises by $100 billion, which leads to a total increase in GDP of $150 billion via the spending multiplier. The multiplier process is explained in the following way. Government spending, say, on some equipment or construction, leads to firms in those areas responding by increasing real output. In doing so they pay out extra wages and other payments which then provide the workers (consumers) with extra disposable income (once taxes are paid).

Higher consumption is thus induced by the initial injection of government spending. Some of the higher income is saved and some is lost to the local economy via import spending. So when the workers spend their higher wages (which for some might be the difference between no wage as an unemployed person and a positive wage), broadly throughout the economy, this stimulates further induced spending and so on, with each successive round of spending being smaller than the last because of the leakages to taxation, saving and imports.

Eventually, the process exhausts and the total rise in GDP is the “multiplied” effect of the initial government injection. In this question we adopt the simplifying (and unrealistic) assumption that all induced effects are exhausted within the same year. In reality, multiplier effects of a given injection usually are estimated to go beyond 4 quarters.

So this process goes on for 3 years so the $300 billion cumulative injection leads to a cumulative increase in GDP of $450 billion.

It is true that total tax revenue rises by $135 billion but this is just an automatic stabiliser effect. There was no change in the tax structure (that is, tax rates) posited in the question.

That means that the tax multiplier, whatever value it might have been, is irrelevant to this example.

Some might have decided to subtract the $135 billion from the $450 billion to get answer (c) on the presumption that there was a tax effect. But the automatic stabiliser effect of the tax system is already built into the expenditure multiplier.

Some might have just computed $135 billion and said (a). Clearly, not correct.

Some might have thought it was a total injection of $100 billion and multiplied that by 1.5 to get answer (b). Clearly, not correct.

You may wish to read the following blogs for more information:

Question 5:

In a stock-flow consistent macroeconomics, we have to always trace the impact of flows during a period on the relevant stocks at the end of the period. Accordingly, government and private investment spending are two examples of flows that adds to the stock of aggregate demand which in turn impacts on GDP.

The answer is false.

This is a very easy test of the difference between flows and stocks. All expenditure aggregates – such as government spending and investment spending are flows. They add up to total expenditure or aggregate demand which is also a flow rather than a stock. Aggregate demand (a flow) in any period) determines the flow of income and output in the same period (that is, GDP).

So while flows can add to stock – for example, the flow of saving adds to wealth or the flow of investment adds to the stock of capital – flows can also be added together to form a “larger” flow.

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    38 Responses to Saturday Quiz – February 27, 2010 – answers and discussion

    1. Ramanan says:

      Hi Bill,

      Also the notion that bond issue will reduce aggregate demand is a hangover of mainstream ideas such as agents maximising some objective function and notions such as that. People (incorrectly) tend to think that since the government has issued an interest bearing security, people will give up on some consumption to purchase those bonds and hence seem to conclude that

    2. JKH says:

      “When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), 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… 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”

      The aggregate demand comparison is OK, but the central bank typically sells bonds to non banks, with the result that bank deposit liabilities are drained along with reserves.

      I think you have to modify your explanation of the liquidity effect to include the fact that the bonds themselves are liquid (I believe Scott does this in his explanation of same).

      Still, even with this liquidity, there is a technical difference in the duration and risk of government liabilities, which should be acknowledged even if only slightly at the margin. Markets aren’t perfectly liquid, and liquidity choice between cashable bank deposits and government bonds isn’t perfectly indifferent. This is particularly the case if households end up owning bonds.

      So there is a technical liquidity effect, but certainly not enough to make a big deal of in terms of aggregate demand. And to the degree the liquidity effect is real, it is transmitted through the deposit liability/bond trade off rather than the reserve/“multiplier” feature, which is a bogus concept.

    3. Ramanan says:

      JKH,

      I think what Bill is trying to say is that a bond sale is one big reserve drain and nothing more.

      Typically the “bond as money” arguments run something like the ones referred to in the last two paragraphs in the Econbrowser post In Search of…Crowding Out. However they miss talking about household income and wealth.

      There is a hierarchy of decisions. Households decide to allot a part of their wealth and income into Treasuries and various asset classes. The total amount is indifferent to interest rates. The amount alloted in each asset class is dependent on the rates/yields.

      The decision to consume – which is a big decider of aggregagte demand – is a different one. Households first decide to allot a part of their wealth and income into consumption and then allot the remaining on assets. The hierarchy here is – consumption and then wealth allocation. So a bond sale by the government does not change their decisions to consume. In the long run, there will be – interest payments add to wealth – but that leads to higher consumption, not lower and hence higher aggregate demand in the medium/long run.

    4. JKH says:

      Ramanan,

      I know what Bill is saying and I know what you’re saying.

      But the argument depends on perfect liquidity indifference, which in my view is false.

      The effect may be small, but it’s not zero.

    5. Ramanan says:

      JKH,

      Let us assume that the US Treasury does not issue any Treasury in this financial year and that the Fed purchases all the “debt”. This will not change the household decisions to consume. That has already been determined by the level of the deficit. The monetary aggregates such as M1/M2 will increase, but consumption does not depend on M1/M2 – it depends on incomes.

      Coming back to the normal case when the government issues debt, there is of course a liquidity preference, as far as allotment of wealth is concerned, but that determines the yields on Treasuries and households’ allotment to Treasuries vs. bank deposits etc. not the total amount alloted. The latter is the leftover from income minus taxes minus consumption.

      I understand that some of this is adamant – but I have found most MMT stuff adamant and extreme :-) (Only to later realize that it is not)

      I think you are refering to a Scott argument which compares bond + deposits vs. deposits. One may get an idea from his argument that he is assuming that there is no difference. However, I guess he has inherently assumed what I have mentioned above. Something like this – the wealth which is chasing bonds has already been decided – if the government decides to not issue bonds, it will chase some other financial asset but will not increase consumption or investment (the I of the GDP)

    6. Like all government spending, the Treasury would credit 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.

      Question: but what happens when credit is tight or demand for credit is extremely low? Bank assets MAY rise but they are not rising because of loans being made. Bank will search for other “investment” opportunities which can lead to more speculation. Or could banks just buy treasuries as a ‘safe haven’ until credit situation improves and by removing treasury securities will force banks to look for more ‘risky’ investments?

      Just thinking this through.

    7. pebird says:

      Bill:

      Really appreciate you doing this – this is very helpful. Have fun in the band!

      Thanks,

      P.E. Bird

    8. NKlein1553 says:

      Since in the example of your stylized case 1 you show that it is *possible* for the government to safely run a surplus I’m going to go ahead and unilaterally give myself an extra 0.5 points on this week’s Saturday quiz. 4.5/5…not too shabby. I really like this quiz Saturday explanation Sunday format Professor Mitchell. Please keep up the great work.

      …Also, I agree with JKH. When I took the quiz I was thinking along the same lines as JKH, but then I just figured I was over analyzing things and picked false for question one. My thought is government bonds can’t be spent in the same way as cash so I’d think that adding to net financial assets via bond issuance rather than simply crediting bank accounts directly would be slightly less stimulative.

      Ramanan, you say: “…Households decide to allot a part of their wealth and income into Treasuries and various asset classes,” but I don’t understand why you are lumping all household together? Don’t the people who own government bonds tend to be on average a bit wealthier and so probably have a lower marginal propensity to consume?

    9. There are several points to make regarding the bond sale vs. deposit:

      1. Nobody is ever constrained because they hold a Treasury from spending. It’s highly liquid–though, as JKH points out, the greater the maturity/duration, there could be some issues, though not large in the agg sense. It’s also the best collateral for borrowing. And loans create deposits.

      2. The bond is sold to someone who was already a saver. We aren’t talking about someone who was ready to spend and then suddenly had an illiquid bond forced upon them. Nobody is ever forced to purchase a Treasury (aside from pension funds, in some cases, but they are already savers).

      3. That a private sector saver buys a Treasury doesn’t somehow reduce funding available for private sector borrowers than a deficit without a bond sale. Loans create deposits.

      4. The deficit itself, whether a bond is sold or not, creates a deposit for the recipient of the spending, or (in the case of a tax cut) leaves a taxpayer with more deposits than otherwise. A bond sale doesn’t change this fact, unless it is the exact same recipent of the spending/tax cut that also purchases the bond. Again, though, this just means that the recipient was already a saver.

      5. The bond sale, compared to no bond sale, adds an additional interest payment on top of the deficit. Thus, the NFA created by the deficit with accompanying bond sale is greater.

      6. Bill has noted many times in his research that there could be some effect on longer-term rates from Trasury sales at greater maturities given increasingly less indifference among investors.

    10. Ramanan says:

      Scott,

      Great points. I have a minor point about

      1. Nobody is ever constrained because they hold a Treasury from spending. It’s highly liquid–though, as JKH points out, the greater the maturity/duration, there could be some issues, though not large in the agg sense. It’s also the best collateral for borrowing. And loans create deposits.

      This will have issues with yields not consumption and aggregate demand issues during the period of the sale.

    11. JKH says:

      Scott,

      “the greater the maturity/duration, there could be some issues, though not large in the aggregate sense’

      Agreed; this relates to my secondary comment, which was the one Ramanan picked up on.

      “The deficit itself, whether a bond is sold or not, creates a deposit for the recipient of the spending, or (in the case of a tax cut) leaves a taxpayer with more deposits than otherwise. A bond sale doesn’t change this fact, unless it is the exact same recipient of the spending/tax cut that also purchases the bond. Again, though, this just means that the recipient was already a saver.”

      This relates to my primary comment. Uncharacteristically, we differ a bit on approach here. Since most bond sales are to non-banks, the necessary macro effect is a reduction in deposit liabilities as well as reserves. That was my main point. The fact that the particular recipient of the spending isn’t the one purchasing the bond doesn’t change what must happen at the macro level. In conjunction with this, the recipient of the spending and/or the factors of production that earn the income related to the spending obviously don’t necessarily save all of that income as NFA, yet that is the amount of income that must be saved as NFA at the macro level as a result. My general point is that the micro distribution of spending and bond purchases doesn’t change the point I made about the effect on deposit liabilities at the macro level, given the predominance of bond sales to non banks.

      I agree with everything else.

      Returning to the secondary point about bonds versus money, it is a question of materiality. I believe the materiality is near zero at the institutional level, but may be more relevant in the case of direct purchases of bonds by households, which again are not substantial. Consider a slightly more typical rate structure. If I am a recipient of fiscal NFA related income, and I make a decision to purchase a 5 year bond at 3 per cent rather than leave my money in the bank at ½ or ¾ per cent, either choice represents saving at the moment. But that choice may reflect my intentions regarding the permanence of my saving, based on the interest rate opportunity. Isn’t it reasonable to think that my decision to stay in the bank might be associated with a decision to spend that money at some point, and make some small contribution to the Keynesian multiplier? Conversely, if I’m a typical retail investor, I may sit on my bond investment as a primary strategy, rather than use it as collateral to borrow from the bank. The difference in intentions may well lie in the interest rate opportunity.

      I’m almost ashamed to be sounding like a monetarist here, but it’s only a marginal thing.

    12. Min says:

      I think that “can” is ambiguous in Q2: “If the external balance is always in surplus, then the government can safely run a surplus and not impede economic growth.” If it denotes ability, then the statement is false, but if it denotes possibility, then the statement is true. NKlein’s point about Norway indicates the possibility. Here is one possible restatement: “If the external balance is always in surplus, then a government surplus will not impede economic growth.” Or this: “If the external balance is always in surplus, then the government can always safely run a surplus and not impede economic growth.” The explicit quantification removes any ambiguity. :)

    13. JKH

      “The fact that the particular recipient of the spending isn’t the one purchasing the bond doesn’t change what must happen at the macro level.”

      I completely agree with you on the micro and macro levels regarding deposits. My point is related to AD effect–if a deficit raises deposits for a SS recipient, for example, while draining one for a bond purchaser who was already a saver, then the fact that a saver now doesn’t have a deposit doesn’t change the fact that someone with a potentially higher marginal propensity to spend now has additional income and a deposit. My point is that it’s often forgotten that the fact that a bond is sold doesn’t alter the stimulatory effect, whatever it is (or isn’t, as they case may be), of the deficit itself. I wasn’t suggesting you had made this mistake, though.

    14. Ramanan says:

      JKH,

      I actually “picked up on” the other point you made at 4.41 – about the pemenance of saving.

      What I mean is this. Let the disposbale income, consumption be DI and C. Let M be deposits and B be bills/bonds. The household saving is (DI – C). The allocation of (DI – C) is dependent of factors about deposits and Treasuries, but that just decides which fraction of (DI – C) is alloted between the two. A higher yield offered by the Treasury does not impact either C or (DI – C) – just impacts the fraction of (DI – C) allocated between M and B.

    15. JKH,

      “If I am a recipient of fiscal NFA related income, and I make a decision to purchase a 5 year bond at 3 per cent rather than leave my money in the bank at ½ or ¾ per cent, either choice represents saving at the moment. But that choice may reflect my intentions regarding the permanence of my saving, based on the interest rate opportunity. Isn’t it reasonable to think that my decision to stay in the bank might be associated with a decision to spend that money at some point, and make some small contribution to the Keynesian multiplier? Conversely, if I’m a typical retail investor, I may sit on my bond investment as a primary strategy, rather than use it as collateral to borrow from the bank. The difference in intentions may well lie in the interest rate opportunity.”

      I would say that someone who is savvy enough to purchase a Treasury is also savvy enough to know that a term-CD would be a better substitute than a deposit. However, I do think that if you suggested a money market account instead of deposit then I would be more likely to agree. But, as you said, it’s a very small effect, if any.

    16. Ramanan says:

      Hi Bill,

      Just noticed this:

      (3) C + S + T + M = Y = C + I + G + (X – M)

      There are some extra Ms here. Probably you have different definitions in the two for consumption – consumption produced domestically as C ? In the definition consistent with the right hand side, the left hand side should be C + S + T ?

    17. bill says:

      Dear JKH

      Thanks for your comment.

      Clearly, what you are saying is correct in detail and we could go even further into the real arrangements if we wanted to. For example, central banks are not the “government” organisation that engages in the vast bulk of debt sales. These are typically handled these days by specialist units (sometimes derivatives of the treasury departments) which have been constructed to “manage” all government debt.

      They typically only deal via the tender systems in place with “registered” traders who act on behalf of the big investment funds – like superannuation funds etc.

      I thought that rather than go into all that detail it was best to understand that in general there are no interest rate effects arising from the operations and that banks can lend to customers any time they like. Which, if taken together, means there is no squeeze on funds in the non-government sector and in many cases the cash alternative which is in a bank deposit somewhere is not able to be accessed anyway (as in the case of superannuation).

      But it is true that individuals may buy debt from funds they have in bank deposits which withdraws “money” from the non-government sector. But then in a world of endogenous money this only presents a minor friction.

      best wishes
      bill

    18. bill says:

      Dear Ramanan

      Thanks very much for picking up the error.

      Always assume that when there is an error that I was rushing or alternatively I am stupid.

      I have fixed it now.

      best wishes
      bill

    19. JKH says:

      Ramanan 5:07,

      The “other point” was the point to which Bill responded. It’s not a huge issue, just a detail.

      Agree with your rest, thanks.

    20. Ramanan says:

      Yes JKH – just a minor thing.

      Btw, I saw Nick Rowe commenting at Moslers and he said somthing like tracked the “lair”

      I think he has understood what you were trying to tell him. Probably not in detail but at some level. I think he will try to argue that central banks can control the supply of reserves and if you point out to him that they do not, he will go in the direction … they should be etc …

    21. SCC says:

      Dear Bill,

      Thank you for providing such detailed answers. This is great.

      I intuitively understand the sectoral balances approach as outlined in your answer to question no. 2; however, I\’m having a difficult time deriving the actual balances for each sector in the US from either the Fed\’s Flow of Funds or BEA (NIPA) numbers. I know it can\’t be that difficult, but I\’m missing something as the numbers are not tallying as they should. I\’ve tried to find research that would outline exactly what line items to use from the US accounts but have not been able to find anything comprehensive. Could you please suggest a source that would take me through it, or alternatively, could you provide a primer during one of your upcoming Q&A posts? I would really appreciate it as this would help me take the theoretical to the actual.

      Again, thanks for your dedication to teaching.

      Best, SCC

    22. JKH says:

      Ramanan 8:18,

      I disagree. None of them understand either the functionality of the monetary system, or the importance of understanding that functionality in developing any “monetary theory”.

      What the gang of 3 (Sumner, Woolsey, and Rowe) don’t get is that the general architecture of the monetary system is a constraint on the monetary transmission mechanism. That constraint in turn has a consequence for the relevance of any other theory they may come up with about monetary policy. Central banks have no choice but to make a choice about where to set the risk free interest rate. Think through the architecture whereby central banks interface with their commercial banks, and this becomes obvious. (One indirect proof of it lies in the MMT explanation of the zero natural rate pricing architecture, which lies at one end of the choice continuum.) Governments and central banks that transact with their own fiat monetary systems have no choice but to affect the level of bank reserves in some temporary or permanent way. The pricing rule they choose for reserves and/or interbank trading of reserves determines the risk free rate. That in turn affects the general level of interest rates. It is impossible for central banks to avoid the necessity of such a pricing rule choice.

      The gang of 3 and their cohorts absolutely ignore all of this. One great example is Sumner’s “solution” of central bank intervention in an NGDP futures market. He simply doesn’t understand that his own proposal, because it requires parallel central bank intervention in OMO transactions, must have a consequence one way or another for the pricing of interbank reserve trades and therefore for the risk free rate. Like any other monetarist targeting idea, the NGDP futures market simply becomes a guideline for what to do with the risk free rate. Yet the gang of 3 absolutely the role of interest rates in monetary policy. On the subject of reserves and interest rates, their refusal to think about the actual workings of the monetary system is beyond hubris and ignorance. It’s as if they’re idiot savants whose particular area of genius is the manufacture of stupidity.

      The other issue is capital versus reserves. The most recent exchange at WCI on all of this was an absolute disaster in terms of language on the capital dynamic. We’ve now entered a parallel universe (reserves/capital) of accounting ignorance and misunderstanding. One person there who’s been persistently and obstinately backward on reserves succeeded there in being perfectly backward on capital as well – from a bad dream on reserves to a nightmare on the combination of reserves and capital. Scott picked up on it politely. I was too exhausted by earlier efforts to have intervened or been nearly that polite. Apart from capital not being an accounting asset, I wish people could reflect a bit on the distinction between the meaning of constraint, binding constraint, and non-binding constraint. The comparison between reserves and capital is a comparison relating to the capital constraint per se – not about the particular binding condition of the capital constraint. I don’t know how many times I’ve repeated that point on that particular site. If you approach it only on the basis of a binding condition, which is what most of them are doing there, you completely lose the intended meaning and importance of the comparison with reserves. This is a subtle point that means everything. If they don’t get reserves per se, they’ll certainly never get the point on capital.

    23. Ramanan says:

      JKH,

      He he . . . I just meant that Nick probably understood delta of what happens with reserves and settlement etc . . . or atleast thinking about it. Should have worded differently. Completely agree.

      I check WCI sometimes. The Money Illusion idea of an NGDP futures market is funny. I mean – oh god ! They’ll continue to believe that central banks target the money supply. It is amazing that even after the set of events that have happened, the mainstream position continues to be the same. John B Taylor continues to argue in his blog that the crisis happened because the Fed didn’t follow his rule correctly. I was reading some article which says that he seems to say the target only the interest rate but a few paragraphs down, he commits the mistake of the money multiplier.

      Bank capital is too complicated for mainstream- they don’t even talk about it in their work. Reminds me of the Mark Thoma video – he just talks of government liabilities, seems to do the accounting correctly but completely messes up on everything else – talks of a money multiplier! He gets the reserves dynamics completely wrong. I guess they see banks as intermediaries not as a special sector.

    24. JKH says:

      Ramanan,

      I’m content that nobody responded to Rowe at Mosler’s. For all I know, Nick is a very fine fellow, even “charming” as winterspeak says. But if he wishes to engage with Chartalism and related ideas, he needs to give much more serious thought to the operational explanations that have already been presented to him by a number of us at considerable length and effort.

    25. ParadigmShift says:

      The WCI guys are like Aristotelians in a Copernican world. Trying to force reality to conform to their notions of how things should work, as they have learned from reading the Holy Scriptures of Economics.

      You guys do a great job in trying to sway them, but remember the Chinese proverb: “A closed mind is like a closed book: just a block of wood”.

    26. bill says:

      Dear JKH and Ramanan

      I have followed your discussion about the monetarists with a sense of deja vu. I was an undergraduate student and then postgraduate student during the monetarist hey day. Among other universities I studied at I did my first postgrad degree (a masters) at a very monetarist (right-wing) department (Monash University). They used to bring Milton Friedman out to talk to students. I sort of grew up with them. On a personal level some of the preachers were fine some not. But uniformly they were in total denial of the reality.

      I sat and listened and participated in so many “tea-room” and seminar discussions where their lunacy was rehearsed. And then as my career progressed I listened to rational expectations, real business cycle theory, new keynesian theory and the rest of their idiotic play games. I am well aware of their vacuous strut – the air of self-importance as they talk about our economic world in ways in which anybody who has taken the time to understand it would not identify. They do it in such a vehement way – always coming up with “novelties” (concepts or constructs) that “prove” their perspective.

      When the facts get in the way – the deny the facts – as our friend the other day intimated – his supervisor at Harvard said that the “computer must have made a mistake”.

      My advice – leave them to their own irrelevance. They cannot be changed which is why I don’t participate in their discussions even though they purport to be discussing things that are germane – or in their twisted vision – core to my own research program. Life is too short to deal with them and to some extent these are not the people who have much influence anyway – except on their students and I note that I get increasing traffic on my sites (blog, CofFEE etc) from IP addresses at their universities and direct enquiries from their students. I now have a regular “Harvard” group of macroeconomics students who tell me what is going in their lectures – with some contempt being aired.

      best wishes
      bill

    27. JKH says:

      Good advice, Bill. Thank you.

      The only similar experience I can relate to is trying to persuade investment bankers how commercial banks work, where persuasion was required due to circumstance.

      In both cases, there is the fleeting temptation of a small opening, followed by utter closure. It takes some repetition of the process to understand that such repetition itself becomes insane.

      Nevertheless, maybe one learns a bit by trying at first.

      Thanks also to ParadigmShift.

    28. Ramanan says:

      Thanks from me too on the good advice, Bill

      Going by what you say about them in your posts, they want to continue believing those things I guess (am sure). Monetarism is one way or the other deeply ingrained in their minds. It is difficult to even go in a direction where I am going to be telling the person I am talking to that mainstream textbooks will end up with just the front and the back cover! Its amazing how after such a deep crisis, they don’t want to change their views.

      I can only imagine a fraction of what Galileo must have gone through in his life. ParadigmShift’s analogy with Aristotelians is a good one!

    29. RSJ says:

      Re: bonds and inflation

      “The deficit itself, whether a bond is sold or not, creates a deposit for the recipient of the spending, or (in the case of a tax cut) leaves a taxpayer with more deposits than otherwise”

      If you view the stormy seas of the economy as operating by the same principles as the plastic aquarium of the interbank market, then you will make statements like this, and then get into debates about whether the increased number of deposits is inflationary or not. But in no case will a system wide reserve surplus or an increase in deficit spending force households, businesses, or investment funds to store more assets either as demand deposits or as accounts with banks.

      Zero maturity rates are typically negative, in real terms, and short maturity rates are typically zero in real terms. Because of this, the quantity of assets held in these accounts is solely a function of the transactional needs of the asset holder.

      In the same way, pension funds do not rotate out of short duration assets and into government bonds, but sell a corporate bond to buy the government bond, or vice versa; their allocations across the term structure are not a function of the government’s bond issuance policy, but of their own dollar matching and maturity matching requirements.

      The government can force the assets of banks into an excess zero maturity position, but it cannot force the non-finacial or investment sector into such a position. Reconciling these are those financial businesses that perform maturity transformation, e.g. banks, money market funds, funding corporations, the repo market, ABS issuers, etc. These are the only actors in the economy that can be forced to hold more zero maturity assets.

      These are also the primary consumers of treasuries in the domestic market, as the main use of treasuries is for financial engineering purposes, not for investment. Treasuries facilitate private sector balance sheet expansion, and the most important such operation is maturity transformation, which is required each time a borrower expands their balance sheet by adding a long term liability and a short-term asset (e.g. a business selling a bond and placing the proceeds into a bank account or MM fund). The rest of the market must shift in the opposite direction, increasing its stock of long dated assets and short dated liabilities.

      The safest way of performing such a maturity transformation is to hold a risk-free asset on the long side and a short duration asset on the short side. Although banks do not hold many bond assets, they have enormous backing and mark-to-model accounting rules. For the majority of maturity intermediaries that cannot escape market pricing or have no access to government liquidity provisions, it is critical to minimize the risk on the asset side, so they will use a treasury (or agency).

      For example, a business sells a bond to a market maker, who will short a treasury, with the corresponding long treasury position in a money market fund. The MM fund does a (safer) maturity transformation operation, and the market maker can focus on pricing the bond. This allows the bond to be placed whenever the borrower wants to borrow, without forcing the investment sector to alter the maturity of its assets, or waiting until an existing bond matures. Equivalently, a bank or broker can pledge a treasury in a repo operation (going short the treasury) and obtain cash to buy a bond. This also allows the bond to be placed without shifting the maturity of the investor sector.

      If maturity transformation operations were not available, the business would need to offer an additional premium in order to compensate the investment sector for holding maturities that it did not want, or it would need to wait as existing bonds matured before placing new issues.

      The ability to remove credit risk on the asset side of this operation reduces the overall risk and adds liquidity to the bond markets, lowering yields on the margin. In this respect, a steady supply of government securities of the appropriate maturities are as critical to the operation of corporate bond issuance as the discount window is to household borrowing. The recent crisis highlighted what can happen when the balance sheet of maturity transformation businesses exceeds the stock of risk-free assets that can anchor those balance sheets: the intermediaries were holding agencies and other private label MBS on the long side, and when these fell in value the short term funding markets seized up. As only treasuries could be repo’d for short term funding, there was a general scramble for treasuries. The CB addressed the situation by accepting any paper signed in ink (even equity of businesses in bankruptcy proceedings) as acceptable collateral for short term funding, and this ended the “run” on the non-bank maturity transformation entities, tiding them over until the government took the bad debt on its books via refinancing to GSE guaranteed debt, or direct aid to guarantors such as AIG or GMAC.

      One of the reasons why the U.S. debt markets are so deep and liquid is because of the large amount of government debt that allows relatively cheap placement of large issues due to the low costs of maturity transformation. This also lowers the cost of arbitrage operations generally, making the markets more elastic, and even though we should reform the financial system in many ways, we will not be able to eliminate the presence of non-bank maturity transformation, as this is the definition of buying a bond.

      So it is the businesses that perform maturity transformation, and only these, that will bear in the asset side of their balance sheets the choices of government bond issuance policy. Households, non-financial businesses, and investment funds will continue to control the maturities of their assets independent of government policies. They will not hold more deposits as a result of banks being in an excess reserve position. They will not purchase more or less investments or spend more or less money. The only effects of forcing banks into an excess reserve position are that yields might increase on corporate debt and/or the amount borrowed might decrease, possibly putting downward pressure on inflation. These effects would need to be offset against the new aquarium design for banks to decide whether any increase in real estate borrowing would offset the decrease in corporate borrowing. But in no case will a portfolio shift in government liabilities force the non-financial or investment sector to shift its own maturities to match.

    30. Ramanan says:

      Hi RSJ,

      Time for another debate ;-) While what you say shows you know the markets very well, here is what I have to say:

      You said:

      In this respect, a steady supply of government securities of the appropriate maturities are as critical to the operation of corporate bond issuance as the discount window is to household borrowing.

      Do you realize that this sounds “Lobbyish” ?

      Pension funds can buy corporate bonds and hosts of other securities. They don’t need US Treasuries. It’s like saying every household needs some Treasuries for uncertainties about groceries. Also you seem to be saying that Treasuries just shuffle around – nobody holds them. Table L.209 Z.1 accounts: Households hold around $800b and pension funds, mutual funds and insurance companies seem to have a good holding.

      Pension funds holdings are dependent on many things agreed but over the years their holding of Treasuries has increased – just like other numbers such as M1/M2, GDP, wages etc.

      There can’t be an excess of money Your arguments seem to suggest that there is an excess of deposits held than demanded. Remember most economists fail to account for all sectors of an economy. Households buying corporate bonds or equities in exchange for their bank deposits will reduce the amount of loans that firms will take from banks, so that deposits held = deposits demanded.

      I remember you had mentioned that deposits just move around – not true. If firms raise equities, they will borrow less from banks – maybe even pay back some of their loans and this leads to less increase of money supply, than otherwise. Page 141 of this article

      Now, to the crisis – it is so obvious to the modern money gang on why the crisis happened – have you seen the sectoral balances approach to studying the crisis ? In many posts in Bill’s blog. Ben Bernanke also blames it on imbalances but he doesn’t quite get it. The unsustainability was written all over the Z.1 accounts and Flow of Funds of other countries as well since the last 10-15 years. No policy maker who understands how government spending, central bank/banks functioning would have allowed the crisis to have happened. There would have been no need the Fed lending to anyone at this scale.

    31. Vinodh says:

      JKH and Ramanan: From what I have read on WCI so far, it just seems like the WCI ain’t that worthwhile

    32. RSJ says:

      Hi Ramanan, I would happy to debate you, but what do you want to debate?

      There was a rather comical exchange in this thread between Scott, JKH, and yourself about how if the government increased deficit spending without offsetting bond sales, then the swelling monetary base would force households to hold more deposits. Or alternately how the sale of a long dated government bond would force households to have less deposits. It was similar to Nick R.’s concerns about how swelling reserves would force more loans to be made.

      In both cases, there is no operational mechanism by which the sale or not sale of long-dated bond causes a household to shift its asset holdings away from or into zero maturity holdings. And the same for pension funds or mutual funds. That much is clear, as I hope you acknowledge. If not, then we can debate that.

      If you do acknowledge this point, then you must throw away any notions of the government controlling the maturity of household deposits and instead think about yields and what is happening to the maturity intermediaries during these portfolio shifts. They are the ones bearing the brunt of the shift on the asset side of their balance sheets. And apart from banks, none of these intermediaries is held captive either. No money market fund is forced to hold more cash if the government does not sell bonds.

      So a shortage of safe long term assets can have several repercussions, depending on how the non-bank maturity intermediaries respond. First, they can create synthetic AAA assets of out unsafe ones, but we know that this is an unsustainable approach.

      Or maybe they would charge a premium for the added risk, or perhaps refuse to expand their balance sheets. These are things that should be discussed when trying to determine the effects of a portfolio shift in government liabilities on the portfolio of household and pension fund assets. It is this, rather than the “liquidity” of a long dated treasury bond, that will give rise to changing yields and inflationary pressures.

    33. Ramanan says:

      RSJ,

      Nobody is saying that someone is forced to buy government debt. In fact, if you carefully follow the discussion, the point is that it is demand-led. In fact I thought we were saying not-forced. I mean c’mon!

      I think you haven’t looked at HowStuffWorks for the case of an economy with stock-flow consistency. I believe you have assumed somewhere about a fixed supply of money.

      Imagine – the Fed has an overnight target for Fed Funds at 0-0.25%. The government can spend with issuing debt! (in principle, though not allowed by law). This has the effect of increasing the deposits in the system. Households will find themselves holding more deposits – an issuance of a Treasury security will make them shift to an interest earning security. The word “will” will definitely be misinterpreted by you, so if you wish, you can replace it by “may”. The Treasury can just supply as many Treasuries as wished by households. Again, nobody is forcing anyone in my arguments. I do not see why you can’t see this. Again, important to get the Ps, Qs and the PQs right – you don’t seem to pay importance to them. My point is not to get into a “debate” but to let you know these things.

      Bill’s proposal about overnight rates being permanently set to zero is self-consistent and I guess you do not find it that way. You want Treasuries to be issued because pension/mention funds algorithms for investment are that way. Let them buy corporate securities! Banks are not “forced” to hold excess reserves. They will markup a slightly higher rates on their lending activities to achieve their target profits.

      There is no mechanism for households to buy one thing or the other. However, its the way it has always been happening. The government spends, taxes and the funds to purchase government debt comes from the government – and the private sector has always used this fund to purchase government securities.

      I guess the point I am trying to make is that – going by your arguments – you seem to treat the government as any other corporate entity. Plus the inflation expectations theory popularized by the Federal Reserve is a big myth!

    34. RSJ says:

      Ramanan,

      I think all of the points I’ve made in this thread have flown straight over your head.

      The portfolio shifts made by the government as a result of selling or not selling bonds will not make their way into the household, corporate, or investment sector. They will show up as shifts in those financial businesses that engage in maturity transformation, holding long dated assets and issuing paper liabilities. We are talking about the money market mutual funds, ABS, ABCP, banks, SIVs, the repo market, etc. The supply of safe long duration assets enable or impair the ability of this sector to bridge to absorb bond issues and bridge the gap between the maturities held by households and the available investment opportunities. The effects of a shift away from risk-free bond sales will primarily show up in this sector, appearing as balance sheet expansion or contraction, and an analysis of the resulting change on yields and credit growth is the key to understanding the inflationary or deflationary effects of not selling bonds.

      That is the point.

      I’m sure that I am not explaining this issue in the most easy to understand way, so there may be some cosmic justice that you respond with non-sequiturs about stock-flow consistency or inflation expectations. In either case, it’s best to let this lie; there is too much resistance to viewing the private sector as anything other than a monolithic residual determined by government bank policy.

      Too bad, since insights about what is happening outside the banks are sorely missing here, and are necessary to understanding the effects of the various proposals being floated. The effects of these proposals are typically the exact opposite of what is often believed. I guess that’s to be expected — to a librarian, “the” interest rate is the government fees charged for overdue books, but even a librarian understands that this does not set the price of books, that she is not the marginal supplier or purchaser of books, and that this rate is paid by a very special segmented market that is separate from the larger book-authoring, selling, or reselling public.

      Unfortunately bankers do not have the humility of librarians, and the deadly combination of bankers who are also economists can lead to absurd beliefs about how the overall economy will respond to a change government policy towards banks.

      I think it would be very interesting to get into a meat and bones discussion of how financial regulation, interest rate policies, and government fiscal policies affect inflation, (non-interbank) interest rates, and income inequality, but I can’t do it without an interlocutor that is capable of disaggregation. The private sector consists of households, non-financial corporations, financial investment vehicles, and maturity intermediation sector. The latter consist of banks who can escape mark-to-market accounting and arbitrage funds that cannot. Obviously when you allow banks to own or fund the latter, then there is huge moral hazard risk/regulatory loophole.

      Portfolio shifts of government liabilities affect some of these sectors profoundly and other sectors none at all, and other sectors in the opposite way that you would expect. In the same way there are class issues, etc.

      But as long as the analysis is performed at the cartoonish level of a “non-government” sector that is forced to hold more bank deposits, and that the same sector has a “desire” to hold NFA, then you will not reach the right conclusions about the effect of your policy proposals.

    35. Ramanan says:

      RSJ,

      Oops – I could reply in the same tone, but I wont ;)

      ABS, ABCP, Repo and the securitization market as a whole has absolutely no impact on inflation. Man, you are sounding like Alan Greenspan!

      You seem to be arguing hugely in favour of “free markets”. We started the discussion on whether the availability of a government bond decreases the household’s propensity to consume and the answer is clear “no”.

      Whatever the graph of repo haircuts is irrelevant to the real economy where people produce and consume. I do not know why you brought out the topic of the maturity transformation etc. The fact that Treasuries are needed for the working of some sectors is irrelevant to a policy proposal of zero overnight rates – which seems to have freaked you a lot. If anything, its a lobbyish argument.

      Somewhere or the other, the argument ends up in zero overnight rates or the exogeneity of the yield curve. Alan Greenspan knows this, Ben Bernanke knows this, many people at the Fed know this that the Fed can put explicit ceilings on the yield curve etc., but you seem to be arguing otherwise. There is historic evidence.

      What is a mutual fund – It manages your “money”. What is a hedge fund – a glorified mutual fund for the wealthy. What is a pension fund – it allocates the contributions of a pension plan. They are many securities in the markets where these institutions can invest. Invest in them – they wont go out of business if the government stops issuing securities.

      The effects of these proposals are typically the exact opposite of what is often believed.

      Yes of course. Please find the name of a few economists (apart from Bill, Scott and some colleagues and a handful of central bankers) who even get the operations of the central bank right. Its important – I know you may start saying the Fed cannot control loan rates but it is important to understand how banks work and the endogenous nature of money. Would you call the endogenous nature of money non-sequitur as well ? The role of banks is different in Chartalist and the PKE literature. Central banks had a great control of things in the gold-standard era (in a negative way) and unfortunately all of those myths remain.

      A good thing about stock-flow consistency – no its not a non-sequitur and offers a radically different (and correct) view of the economy – is it makes it easier to understand what is exogenous and what is endogenous. Any messup on this will lead you back to the same neoclassical and monetarist theories or Paulsonian arguments such as “free markets”.

    36. Oliver says:

      RSJ

      I can’t claim to understand even half of what you’re saying, but if you’ll pardon a complete layman like myself posing a hopefully not too ignorant question: Isn’t the division of ‘risk-free’ assets into different maturities at progressive rates a hidden subsidy from one maturity to the other (and thus often from labour to finance and also foreign holders who don’t themselves contribute to real growth)? Where’s the extra risk in ‘risk free’ to justify the extra interest, especially if nothing is actually borrowed?

      …The effects of a shift away from risk-free bond sales will primarily show up in this sector, appearing as balance sheet expansion or contraction, and an analysis of the resulting change on yields and credit growth is the key to understanding the inflationary or deflationary effects of not selling bonds…

      …The latter consist of banks who can escape mark-to-market accounting and arbitrage funds that cannot. Obviously when you allow banks to own or fund the latter, then there is huge moral hazard risk/regulatory loophole…

      Could you elaborate on these points? I’m curious.

      Thanks, Oliver

    37. RSJ says:

      Hi Oliver,

      First, you raise 2 questions:

      1. Why does return increase with the time commitment
      2. Is this a hidden subsidy, and if so, who is benefitting

      For 1, the returns of a given investment are not set by ethical intuition, but by the facts of production and investment. The borrower benefits by deferring payment as it allows him to re-invest and generate an overall greater return, even on an annualized basis. Therefore a longer term loan is more valuable to him than a short term loan, even on an annualized basis.

      In the same way, for the investor, the opportunities for return increase substantially with the time commitment. A very short (or effectively) zero day commitment only allows the investor to purchase some immutable asset (e.g. gold, land, etc.) and hope that it keeps up with inflation — i.e. there is no “value add” possible. He will not be able to fully do this, of course, so the zero-day risk free rates have traditionally been negative in real terms.

      With a 1 year or 6 month commitment, the investor has a few more opportunities — say financing the purchase of inventory, to be repaid with the proceeds of the sale. Still, the opportunities for return are low. With a 3-5 year commitment, the investor could earn a bigger return — say fund the development and sale of land, or the creation of a new product — that offers greater return possibilities. With a perpetual commitment (e.g. equity), the investor can purchase productive assets outright, and get the overall equity return for the economy as a whole.

      So as the time commitment increases, the opportunities for return increase as well, and it is opportunity cost, not risk of default, that determines the rate of return.

      For 2. the answer is yes, this is a hidden subsidy to the financial sector at the expense of the non-financial sector. The financial sector arbitrages short and long term rates. In theory, you would expect the added risk of this arbitrage to undo the subsidy, but there is no reason to believe, based on fundamentals, that this will be the case. Moreover, the credit cycle is very long, and you cannot go back and seize the bonuses and dividends that were earned during the boom to compensate for the damage caused during the busts. As a result, I have been arguing that the policy vis-a-vis the financial sector should be to ensure that they have zero economic profit all throughout the credit cycle, as opposed arguing that they have zero marginal costs. I.e. the exact opposite of the MMT position, which strangely views the fees imposed on banks as profits to investors rather costs.

      The marginal costs we impose on banks should be such that overall banks cannot earn a profit greater than the non-financial sector. Whether these costs are imposed as higher FF rates, higher FDIC fees, asset-fees, or other fees is primarily a question of which enforcement mechanisms are the hardest to evade. But the marginal costs should be high enough to ensure zero economic profit from yield curve arbitrage operations. If this is the case, then the economy will not be biased towards finance, and the costs imposed on borrowers will be consistent with the return provided. I.e. no borrower should make or lose money simply by shifting their capital structure, and no lender should be able to make money by shifting their portfolio — everything should be priced at the arbitrage free rates, so that money is earned by growth in the underlying economy, rather than by buying or selling financial claims.

      However, for 2. this is not a subsidy to the business sector as a whole, because the returns of this sector are not affected by the rates charged, but by growth in liability issuance. So an artificially compressed yield curve provides banks with lower profits, but provides non-banks with greater profits, and it all nets out to zero as a diversified investor will hold stock in both. In the same way, an artificially expanded yield curve (say by pushing down short term rates, while long term rates stay at the overall growth rate) provides more profits to banks and fewer profits to non-banks, but the sum of dividend and interest payments passing from the business community to investors does not decrease.

      Other than “unfairness” at allowing arbitrage, the real danger here is that you do damage to the underlying economy when financial assets are mispriced, as it can tilt the economy towards unproductive investments. Second, when the cost of capital exceeds the return on capital, wealth shifts from capital to labor, but productive assets are liquidated and there is unemployment and less output. When the cost of capital is below the return on capital, then there may be an investment boom for a while, but wealth shifts away from labor and to capital (which receives all surplus profits as dividend payments). So the risks here are of inequality if rates are too low, and liquidation if rates are too high.

      The socially optimal approach is for the cost of capital to be equal to its return, across all time horizons. This means a zero day rate of approximately zero, except possibly in high inflation period, and a long term rate equal to the long term return. The fees imposed on banks in the form of FF and FDIC fees should be such that the entire yield curve starting at MZM Own Rate and ending at equity returns is undistorted and reflects the rate at which returns diminish with marginal re-investment.

    38. Oliver says:

      RSJ

      Thanks for taking the time to answer my questions. Greatly appreciated!

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