This post may get a bit rambling. It's an attempt to tie together a couple of different strands that I've been thinking and reading about.
Modern monetary theory (MMT) in a nutshell, at least as far as I see it, goes something like this. Back in the 1990s a couple of clever guys came up with the idea of a government-provided jobs guarantee. They realized that this program would be seen by the public as an expensive boondoggle requiring sky-high taxes and huge debts. Could they outflank these criticisms by finding another way to fund the jobs guarantee?
To find the funds the early MMTers worked backwards through the labyrinthine relationship between the Federal Reserve and the Treasury. What they claimed to have discovered at the end of their trek was certainly shocking. The US Treasury, they said, funds itself not by the conventional route of taxes and bonds, but by creating and directly spending fiat (i.e. inconvertible) money. Furthermore, it is not only the government's prerogative, but its obligation to spend this money into existence, since people need a stock of fiat money to pay their taxes. Bonds, contrary to what most of us think, are not a sign of government indebtedness—rather, they drain spending.
This bit of monetary jiu-jitsu is powerful because it has the ability to disarm people's instinctual aversion to expensive social programs. If all it takes to fund a jobs guarantee is that the government spend money, and debt and taxes are not the great evils we have been trained to think, then why resist it?
Most governments don't create fiat money—their central banks do. For a government to have this power, it needs to be able to force its central bank to add new money to the government account. One way to do this is for the government to print up a bond and give it to the central bank. The central bank then credits the government's account for the full amount of the bond, and now the government can spend, say on a jobs guarantee. Alternatively, the transaction can be completed without the transferral of the bond—just have the central bank automatically credit the government's account prior to spending. When the government can require its central bank to create money on its behalf, we say that they are effectively consolidated into one entity.
The earliest MMT tome, Wray's Understanding Modern Money, is very insistent on the consolidated nature of the Fed-Treasury:
"The important thing to notice is that the Treasury spends before and without regard to either previous receipt of taxes or prior bond sales."Now as their critics were quick to point out (see Lavoie, for instance), the relationship between Fed and Treasury is such that the two are not consolidated. The Treasury cannot ask the Fed to credit its account, nor can the Treasury print up a bond and give it to the Fed in exchange for spending power. The only way the Treasury can spend is by moving previously acquired funds that are held in the private banking system into its Federal Reserve account—and the only way it can acquire these funds is through taxes and bond issues. Using the Fed to print money and fund a jobs guarantee program is impossible.
"...permanent consolidated government deficits are the theoretical and practical norm in a modern economy... Further, government spending is always financed through creation of fiat money - rather than through tax revenues or bond sales."
"While it appears that the Treasury 'needs' the tax revenue so that it can spend, that is clearly a superficial view... The government certainly does not need to have its own IOU returned before it can spend; rather, the public needs the government's IOU before it can pay taxes."
The MMT wish, it would seem, was the father to the thought—Wray's 1998 tome was too hasty in consolidating the Fed and Treasury. MMTers are left with an intriguing theory of how modern money works, yet their theory corresponds to no underlying reality. That doesn't mean that MMT is without some merits. MMTers are hackers. In their efforts to reverse engineer the Fed-Treasury nexus in order to fund their pet project, they've come across plenty of interesting minutiae about monetary operations. MMT papers and blogs go into these details and are worth reading if you want to hone your understanding of the monetary system [just take anything they say about consolidation with a grain of salt].
Has the lack of overlap between Wray 1998's theory and reality stopped MMTers? Not at all. When your theory doesn't describe reality, don't bother changing your theory—change reality so that it conforms to your theory. Enter the platinum coin.
The idea of issuing a trillion dollar platinum coin rose to prominence with the onset of yet another US debt ceiling crisis. The MMT blogs hummed about the coin, a huge coin crescendo grew on Twitter, and the issue went all the way to the White House, which demurred. My hunch is that beating the debt ceiling is only a tertiary motive for MMTer excitement over the platinum coin. Far more important to them is that the platinum coin, if implemented, will effectively consolidate the Fed and Treasury, finally redeeming Wray 1998. This opens to door to their beloved jobs guarantee.
I'm not sure how MMT will evolve, but one thing we'll probably see more of is platinum coin-style activism. Though the rest of world has moved on from the coin, the MMT blogs are still buzzing about it. I'm sure more clever ways to hack the Fed-Treasury nexus will be found, thereby giving the Treasury other routes by which to force Bernanke or whomever follows him to print dollars on demand. These hack-arounds will be publicized. Perhaps a political movement will form. This wouldn't be unique. All sorts parties have formed around monetary ideas—Greenbackism, Free Silver, and Social Credit.
I've always wondered why MMTers ignore Canada. Of all the major central banks, the Bank of Canada conforms most fully to the MMT ideal. Consider this—the Bank of Canada routinely buys bonds directly from the government. The Fed, ECB, and other central banks can only buy government debt on secondary markets. This degree of consolidation goes beyond the ability to participate in bond auctions. The BoC is permitted to lend directly to both the Federal and provincial governments without requiring any security whatsoever. Section 18(j) of the Bank of Canada Act says that the Bank may
make loans to the Government of Canada or the government of any province, but such loans outstanding at any one time shall not, in the case of the Government of Canada, exceed one-third of the estimated revenue of the Government of Canada for its fiscal year, and shall not, in the case of a provincial government, exceed one-fourth of that government’s estimated revenue for its fiscal year, and such loans shall be repaid before the end of the first quarter after the end of the fiscal year of the government that has contracted the loan.The US Treasury was once allowed to go into overdraft at the Fed, but this hasn't been permitted since 1981. And even when it could have its account credited, overdraft loans were quite limited in size and duration.
The Bank of Canada is engaged in a very MMT-like operation right now. As I wrote in an earlier post, the Federal government is currently implementing what it calls a prudential liquidity management plan. The BoC typically buys 15% or so of bonds auctioned off by the government. It does so on a non-competitive basis, meaning that it pays the average of all competitive bids submitted to the auction. The traditional 15% allocation is enough to ensure that maturing government debt held in the BoC's portfolio is replaced. In late 2011, the government asked the Bank to fund its prudential liquidity plan by raising its allocation at government bond auctions to 20%. Because this larger allocation is more than enough to make up for maturing debt, the BoC's balance sheet has been growing quite fast. At the same time, the government's account at the BoC, which usually hovers at around $2 billion, now clocks in at $11.5 billion, and by 2014 or so, should rise to $20 billion. Below is a chart of the Bank of Canada's balance sheet. Note the large jumps in government bond holdings (red) and deposits (bottom green).
MMTers might not agree with the prudential liquidity plan, but it surely represents the sort of consolidation they are so anxious to see in the US.
So what happens when the Federal government begins to spend down its prudential balances held at the BoC? Private banks will quickly realize that they have far too many clearing balances and will try to get rid of them. Canada's overnight lending rate will collapse below its target rate. In order to bring the rate back up to target, the BoC can do any number of things.
1) Sell assets from its existing portfolio, thereby withdrawing excess clearing balances.
2) Issue Bank of Canada sterilization bills, which banks will purchase directly from the BoC with excess clearing balances.
Alternatively, the BoC can work together with the government:
3) Ask the government to issue more bonds, depositing the proceeds at the Bank of Canada. Bonds here are fulfilling the money-draining purpose that MMTers like to emphasize.
4) Ask the government to increase taxes, depositing the proceed at the BoC. Just like bonds, taxes would be draining previously spent money.
Finally, the BoC can simply leave this spending unsterilized.
5) Rather than withdraw (i.e. sterilize) balances, let the excess supply drag the overnight rate to the deposit rate. All clearing balances now earn the deposit rate.
The BoC currently maintains a corridor system. During the day, private Canadian banks make and receive hundreds of thousands of payments. By lunch time on a normal day there will be a number of debtor and creditor banks. Debtors can settle with a creditor by borrowing clearing balances from the BoC on a collateralized basis and transferring these balances to their creditor. By the end of the day, the BoC will have typically swallowed up large amounts of collateral as it creates and lends whatever quantity of intraday clearing balances that deficit banks require.
Banks who have borrowed balances to fund a deficit are free to maintain these positions overnight, but are dissuaded from doing so because the rate which they must pay to the BoC, the bank rate, is 0.25% above the market overnight rate. Nor do surplus banks wish to keep the quantities of clearing balances they have received at the BoC overnight, since the deposit rate is 0.25% below the market rate. As a result, those banks holding clearing balances are incentivized to transfer them to those banks that are in debt to the BoC. This transfer allows the deficit banks to pay back their intraday debts to the BoC and get their collateral back. In short, BoC balances are not attractive to maintain so they reflux back to the Bank of Canada. A good visual aid is to think of the central bank as a blowfish: it blows up during the day and sucks itself back in at night when it isn't needed.
If it turns to this last solution, the Bank of Canada will be throwing away its corridor system and adopting a floor system. Steve Waldman generated plenty of discussion on his recent series of blog posts on floor systems. As the Federal government spends down its $20 billion prudential balance at the BoC, all private banks will end up holding excess clearing balances. There is no way for them to contract among each other to remove this excess. Only one option remains to the banks—hold these balances overnight and receive the deposit rate. The Bank of Canada would be a permanently inflated blowfish.
If it adopts a floor, the BoC wouldn't be the first. The Federal Reserve stumbled its way into a floor system in 2008 by injecting so many reserves that it was unable to sterilize them. But a floor system is by no means universally accidental. The Reserve Bank of New Zealand chose to adopt a floor in 2006. When it maintained a corridor, the RBNZ began to notice signs of stress in the banking system that it traced to insufficient liquidity. Evidence included delayed or 'just-in-time' payments, failed settlement, collateral hoarding, and increasing use of the bank's overnight lending facility.
Between July and October 2006, the RBNZ moved to a fully "cashed up" system by injecting $7 billion worth of settlement cash on which it paid interest. Banks had typically required $3-5 billion worth of intraday credit in order to meet their payment requirements. Now that there was a permanent $7 billion worth of balances, there was no longer any need for banks to get intraday loans from the RBNZ, nor scramble for collateral to qualify for these loans. Banks ceased waiting till the end of the day to make payments. The time of day when 50% of all payments were completed was moved up by two hours compared to when the corridor system was in place. (See the RBNZ's account of this here.) Flattening out settlement over a trading day can be desirable since settlement delays, especially if they spread from participant to participant, can be costly.
The Bank of Canada has toyed with an RBNZ-style cashed up system. In response to the credit crisis, in May 2009 the BoC injected $3 billion of excess settlement balances into the clearing system, pushing the overnight rate down to the Bank's deposit rate. This excess was removed in June 2010, a year later. We know from a presentation by former Deputy BoC Governor David Longworth that much like New Zealand, Canadian payments tended to be made earlier in the day during the period between May 2009 and June 2010. If the Federal government's prudential balances at the BoC are spent down, a decision to use the occasion to move to a floor system rather than sterilizing this spending would not be without precedent or merit.
[If you're interested on this subject, this paper relates the US experience with excess reserves. Much like Canada and New Zealand, US payments after the onset of excess reserves were more evenly distributed throughout the day.]
Back to MMT, where this whole ramble started. Much a large corporate conglomerate, MMT might benefit from being dismantled. Beholden to the jobs guarantee division, the monetary division has made unrealistic claims about the nature of consolidation. Now it is turning to monetary activism. The monetary division would be less conflicted, and therefore be taken more seriously, if it was spun off from its parent. As separate corporations, the jobs guarantee folks could focus on lobbying governments like Canada to use their central banks to fund social programs, freeing the monetary folks to focus on how monetary systems actually work. Why not deconsolidate MMT?