Thursday, March 28, 2019

Should governments finance themselves through their central bank?



In places like the U.S. and Europe, it is actually difficult—if not impossible—for a government to have its central bank pay for government programs. All government spending must be financed by issuing bonds to the public or collecting taxes.

Canada, my home country, is an interesting counter-example. The financial relationship between the Federal government and the Bank of Canada—our central bank—is fairly permeable. The government has the authority to ask the Bank of Canada to directly fund a portion of its spending.

This avenue is rarely taken, however. Justin Trudeau, our current Prime Minister, currently uses bonds and taxes to fund almost all of the Federal government's spending. Just one small and unknown government program is directly funded by the Bank of Canada: the prudential liquidity management plan, an old Stephen Harper-era program. (I wrote about it here and here). The goal of the prudential liquidity plan is to provide a cash cushion that the Federal government can rely on to “safeguard its ability to meet payment obligations in situations where normal access to funding markets may be disrupted or delayed.”

The details of the program aren't really that important. The point I want to make is that the Federal government hasn't had to issue bonds to the public in order to fund the prudential liquidity management plan, nor has it had to wait for taxes to be paid. All it did was tell the Bank of Canada to create some dollars for it out of nothing, and the Bank of Canada shrugged and complied.

So would it make sense for Justin Trudeau to have the Bank of Canada fund other programs than just the prudential liquidity management plan? Why not get it to fund the Federal government's share of health spending, or national defence, or Old Age Security?

Let's take the example of national defence. Say that the Trudeau government has been planning to follow conventional funding procedure and intends to issue $400 million in new treasury bills to pay the salaries of our soldiers for the months of April and May. But Trudeau changes his mind and tasks the Bank of Canada to create $400 million in fresh deposits for the government, ex nihilo. As the soldiers' salaries come due, the dollars will be wired to the commercial banks where the soldiers do their banking, these banks in turn crediting the soldiers' accounts.

Are there any real differences between the two funding scenarios? Under both the treasury bill and Bank of Canada routes, the soldiers will get paid. What about cost savings? The Bank of Canada is obligated to pay interest to banks on the $400 million in new balances it has created. It pays a rate of 1.75% or so, which is pretty much equivalent to what the government would have paid on $400 million in new treasury bills.

Thus, from a cost savings perspective there's really no difference between the two scenarios. Either way, the government is going to be paying 1.75% in interest to whomever happens to be holding the instruments it has issued.

So my initial reaction is: meh, who cares which way Trudeau funds soldiers' salaries.

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There is one asymmetry that might worry me as a citizen. Treasury bills are a useful instrument for individuals and businesses (like insurers) because they are quite safe. Bank of Canada deposits are likewise very safe, but whereas anyone can buy a treasury bill, deposits are exclusive. Only commercial banks can keep an account at the central bank. So if our soldiers are to be paid $400 million by the Bank of Canada, the supply of treasury bills will contract by $400 million leaving folks like me with fewer options for investing.

But there's an easy way to fix this shortage. Introduce central bank accounts for all. In short, allow non-banks like insurers and individuals to keep accounts at the Bank of Canada. A similar fix would be to provide a means for commercial banks to establish 100%-reserve pass-through accounts. Life insurers and individuals who open a pass-through accounts at a bank would be assured that these accounts are 100% backed by Bank of Canada deposits, the interest flowing straight from the Bank of Canada to the account holder. These accounts would function just like treasury bills.

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There is one other potential asymmetry. It has to do with the unit-of-account function of money.

Like the metre, kilogram, or minute, the dollar is a key element of Canada's system of weights and measures. The dollar is by far the most complex of these standardized measurements. Unlike metres, kilograms, or minutes, Canadian prices are measured in terms of a set of items—banknotes and Bank of Canada deposits—that are constantly fluctuating in value. By carefully regulating these items, the Bank of Canada tries to keep the pricing standard as stable as possible.

Treasury bills have no role to play in the pricing standard. If a car has a sticker price of $10,000, this indicates ten thousand one-dollar banknotes, or a thousand ten-dollar banknotes. The "$10,000" indicated on the sticker is not represented by a given quantity of treasury bills.

This has important implications. If all Canadians simultaneously decide that they want to reduce the quantity of Bank of Canada notes and deposits that they hold, then every price in the Canadian economy will have to rise. After all, these instruments are the standard media that people use for describing prices. But if all Canadians decide they want to hold fewer treasury bills, goods and services prices needn't adjust—treasury bills aren't the media that Canadians use to describe the dollar. Only the price of treasury bills will have to adjust.  

So if Trudeau decides to use Bank of Canada deposits for financing, he is involving himself with the standard itself. Every price in the Canadian economy may have to adjust to his actions. But if Trudeau relies solely on treasury bills/bonds for financing, he avoids implicating himself in Canada's pricing standard, and so his influence will be much more muted. It would be better if Trudeau's political ambitions couldn't entangle Canada's system of weights and measures... more on this later.

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It may be useful to work through an example in which Trudeau decides to use the Bank of Canada for a large percentage of government spending. Say that Justin is fighting for his political survival, so he comes up with a bright idea. Let's increase the number of Canadian provinces by occupying Burkina Faso. That way Canadians will have a warm place to go in the winter. Trudeau promises voters that he will carry out the invasion without burdening Canadians with new taxes. That very month he tells the Bank of Canada to start creating billions in new deposits and quickly spends them on military equipment.

At some point the recipients of these new deposits (anyone with a Bank of Canada account) will suffer deposit bloat. They will try to get rid of their excess, and as they do so prices across the Canadian economy will start to rise.

In order to preserve the standard unit, the Bank of Canada has a useful tool for halting this incipient inflation. It can increase the interest rate it pays on reserves. A higher reward will coax those who would otherwise have spent their unwanted Bank of Canada deposits into keeping them on ice. And this should alleviate the pressure on prices.

But what happens if Trudeau keeps on spending? His next idea is to send a fully-manned space mission to Pluto without raising taxes or issuing treasury bills to fund the mission. He tells the Bank of Canada to create $50 billion and immediately starts to spend it on building a rocket.

The Bank of Canada can of course raise rates again. But if you think about it, the Bank of Canada gets the money to pay higher interest by issuing more brand new dollar deposits. If the underlying cause of the inflation is Trudeau bringing too much money into existence, issuing even more of the stuff as an inducement to hold what has already been created doesn't seem like a long-term solution. At some point, the Bank of Canada will have to attack the root of the problem--the bloat of deposits itself--by reducing the supply.

There are a couple of ways to reduce the supply of deposits. The first would be to "sterilize" Trudeau's spending. The Bank of Canada can try and coax depositors to lock their funds into central bank term deposits rather than keeping them in their regular Bank of Canada accounts. Transferring the funds to a term deposit renders them non-spendable and removes the bloat, at least temporarily.

But Trudeau keeps on spending new Bank of Canada deposits, this time on the construction of a 5-metre high border wall between Canada and U.S. The Bank of Canada will have to convince an ever-growing crowd of deposit owners into locking away their funds. At some point the demand for term deposits will be saturated, and the Bank of Canada will have to increase the carrot they provide by raising term deposit rates. Additional deposits will have to be created to generate this reward. But as before, fixing an excess of deposits with more new ones only kicks the can down the road.

The Bank of Canada has a permanent way of removing the deposit bloat: it can buy deposits back and cancel them. But to do this, it needs to have some real assets sitting in its vaults. Gold, property, mortgage-backed securities, bonds, etc. Because Trudeau has been spending deposits into the economy willy-nilly, the Bank of Canada simply doesn't have assets to carry out a buy-back.

Which leaves the Bank of Canada with one last option for removing supply. Rather than repurchasing deposits, it can just destroy them outright. By declaring that x% of all deposits that have been issued will simply cease to exist, it can remove the bloat once and for all. Thus ends the inflation.

But the Bank of Canada doesn't have the power to annihilate depositors' funds. This would basically constitute a tax, and democracies don't generally give central bankers the power to tax (understandably so). Which means that only Trudeau can carry this operation out on behalf of the Bank of Canada.

To do so, he will have to levy a new tax and then destroy the proceeds. (He can't re-spend the deposits, this would only recreate the problem). Once destroyed, the deposit bloat has been remedied. But if Trudeau is determined to follow through on his vote gathering strategy of spending on programs without raising taxes, then he won't see much to be gained in carrying out the annihilation. So the inflation will continue.

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I think that all of these threads can be brought together to provide an argument for why we don't want Trudeau to rely too much on the Bank of Canada for funding.

Low and consistent inflation is valuable to Canadians. Just as our measures of time, volume, and weight stay consistent (the metre doesn't get longer or shorter from one year to the next), the dollar unit should be reliable. If we all have a pretty good idea where average prices will be down the road, we can better coordinate our long-term plans. Price stability is also the fairest way to ensure neither debtors nor creditors benefit at the other's expense.

The Bank of Canada has all the tools to provide this service to the public, save one. In the extreme event that the Prime Minister decides to resort to the Bank of Canada for financing of a bunch of novel government services, and the inflation target is exceeded, the Bank of Canada can't salvage things by resorting to the definitive response: annihilating deposits. Instead it must rely on Trudeau to destroy deposits on its behalf via a tax. If the Prime Minister refuses to do this, then the reliability of the unit of account is effectively sacrificed.

Were Trudeau to rely on treasury bills and bonds rather than central bank financing to invade Burkina Faso, send a rocket to Pluto, and build a border wall with the U.S., then the Bank of Canada would never have to ask the Prime Minister to annihilate deposits in order to hit its inflation target. And so the dependability of the unit of account would be assured. Instead of every price in the economy having to adjust to Trudeau's new programs, only the market price of treasury bills and bonds would have to bear the burden of adjustment.

So should governments finance themselves through their central bank? In general, it's probably harmless. For instance, it makes no difference whether the prudential liquidity plan is financed by the Bank of Canada, the taxpayer, or government-issued treasury bills.

But in a scenario where the government is being wildly imprudent, a degree of separation between the Prime Minister and the Bank of Canada is advisable. Imagine if the whims of Canada's politicians could cause metre sticks all over Canada to grow or shrunk a bit each year. That would make for a confusing system of weights and measures, wouldn’t it? The dollar is one of Canada's most important weights & measures. It too deserves to be immunized from the political process.

40 comments:

  1. There is another asymmetry. When the government sells a bond, the buyer, consisting of the orderly bond market, is demonstrating that there is a body of people that consider that the government spending will be prudent and not harmful to the economy.
    Also reducing price inflation by taxing does not replenish resources if it is the case that the price inflation has been caused by the government consuming resources.
    The topic of the money supply and government debt is recognised on the UK deb management office website, where it states that the DMO manages the government debt in way as to to not affect the monetary conditions of the UK economy.

    ReplyDelete
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    1. "When the government sells a bond, the buyer, consisting of the orderly bond market, is demonstrating that there is a body of people that consider that the government spending will be prudent and not harmful to the economy."

      Maybe. I mean, when the Bank of Canada sells a deposit, isn't a buyer of this deposit also weighing the prudence of the Bank of Canada? Why do you imply that only buyers of bonds, but not central bank deposits, will evaluate the issuer?

      Delete

    2. "Maybe. I mean, when the Bank of Canada sells a deposit, isn't a buyer of this deposit also weighing the prudence of the Bank of Canada? Why do you imply that only buyers of bonds, but not central bank deposits, will evaluate the issuer?"

      Indeed, the central bank depositors would also evaluate the issuer and in the examples above that would lead to inflation and possibly even hyper-inflation. Hyper-inflation would arrive the moment depositors come to the conclusion that the Government is running wild, and that would be way sooner than the time when "too much" money is printed.

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    3. "...and that would be way sooner than the time when "too much" money is printed."

      I think that's probably right. Markets are forward thinking.

      Delete
    4. Central banks cannot run out of their own money, can operate with negative equity, and can never go bankrupt. That explains why Japan, which has the highest debt-to-GDP ratio in the world, has no trouble issuing bonds, even at negative interest rates.

      Japan
      William Mitchell is a Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at the University of Newcastle, NSW, Australia
      http://bilbo.economicoutlook.net/blog/?p=31021

      "When QE was first introduced in Japan in the 1990s, mainstream economists rushed to predict that the massive expansion in central bank reserves would be inflationary.

      Students in every mainstream macroeconomics class, and that means almost all students, would have predicted, based on the nonsense they were learning, that the high deficits and high public debt ratios in Japan at the time, should have driven interest rates sky high, that bond markets should have stopped buying government bonds, that the government should have run out of money, and all the time that these disasters were unfolding, that inflation should have been be galloping towards hyperinflation.

      Nothing like that happened.

      Neo-liberal economists wrote off their mistakes by claiming that Japan is ‘so strange’ that it is a ‘special case’ and therefore not generally applicable.

      Their ad hoc defense was convenient because the Japanese experience with sustained high fiscal deficits, the world’s largest public debt to GDP ratio, close to zero interest rates, and deflation, was totally at odds with their economic theories.

      It was a mind-boggling failure to explain reality."

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    5. When the government repays a loan made specifically from a bank, there is a difference in the operational reality regarding the monetary conditions of the economy, as to when a member of the public or a business does the same. When the government repays a loan made from a bank, by taxing the money that it created it only reduces the money supply. When a member of the public repays a loan from a bank by selling something they reduce the money that they created and they also increase the goods and services introduced to the market place by the act of selling.

      Delete
  2. In your "unit of account" asymmetry how would all Canadians be able to simultaneously reduce their holdings of banknotes and deposits?

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    1. Canadians would all try to simultaneously reduce their holdings of banknotes and Bank of Canada deposits. But while an individual Canadian can achieve this, Canadians as a whole cannot. Someone has to hold the stock of banknotes and Bank of Canada deposits.

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    2. Well they could start spending the cash. Or buying foreign currency , the deposits would then be with the FX traders and an effect on the exchange rate.

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  3. It's ridiculous to imply commercial and central bankers who loan money into existence from nothing are stalwarts and stewards of a stable banknote pricing standard, considering the last decade of quantitative easing and the orgy of crime-saturated real-estate loaning that made QE a necessity.

    Any small group of individuals who are given the power of seigniorage over medium-of-exchange units are eventually, over a long period of time, going to debauch those units, as has happened innumerable times throughout history, whether that small group of individuals is a group of bankers or a group of politicians.

    The public-private partnership known as banking is the world's most powerful monopoly, and therein lies the problem: there is no balance-of-power-based democracy in money-creation, nor in the control of the subsequent flows of the newly created money.

    If such a democracy existed, I think better price stability across all goods and services would result because the opportunities for MCFCs (Money Creation and Flow Controllers) to profit from their inherent economic advantages (seigniorage scavenging; insider trading grounded in information asymmetries; innumerable forms of rent extraction) would be spread out across a much larger group of individuals.

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  4. "Financing through the central bank" is sometimes called "Overt Money Creation". Positive Money has advocatd that for about ten years, and more recently Adair Turner (former head of the UK's Financial Services Authority), Ben Bernanke and the deputy governor of Japan's central bank have said they have no big objections to OMC.

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    1. I wrote about that here with reference to Canada's prudential liquidity management plan.

      https://jpkoning.blogspot.com/2016/07/helicopter-money-canadian-style.html

      Meh, I don't see what helicopter money can do that regular bond financing can't.

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  5. Following up from Twitter: a long-time MMT point is that "central bank independence" is something of a fiction, because fiscal policy affects monetary policy implementation at an operational level, and same for monetary policy affecting fiscal policy operations.

    More concretely, government spending adds to bank reserves, while payments to government reduce bank reserves. In order for the central bank to hit its overnight interest rate target, it must offset the impacts of these operations on bank reserves. So, in practice, Treasuries and central banks work together, to ensure that 1) payments made by the Treasury settle successfully, and 2) the central bank is able to hit its interest rate target.

    Just because the central bank isn't directly providing funds for the Treasury doesn't mean it isn't *indirectly* providing them. Speaking to the case of the US, because that's what I know best: in the US, the private counterparties that the Fed uses to implement monetary policy are the Primary Dealers. Being a PD is quite profitable, but it comes with the requirement that the PDs bid on all Treasury security auctions, so that there's always a bidder. If the PD's don't have the reserves to purchase securities from the Treasury, then the Fed lends to them. So the Fed is lending to the private sector so that the private sector can buy Treasuries. The Fed *indirectly* finances the US Treasury. The net result turns out to be exactly the same as if the Fed had directly financed the Treasury.

    This is why, at least for discussions of policy, MMTers tend to use the consolidation hypothesis: treat the central bank and the Treasury as a single unit. In that lens, all payments by government create money, and all payments to government destroy money.

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    1. "In order for the central bank to hit its overnight interest rate target, it must offset the impacts of these operations on bank reserves."

      The way this works in Canada is that the Bank of Canada auctions off a certain quantity of receiver general balances each afternoon (i.e. Federal government deposits), and thus reinforces the Canadian overnight rate. It's an interesting institutional detail, but I'm not sure what relevance it has.

      "Being a PD is quite profitable, but it comes with the requirement that the PDs bid on all Treasury security auctions, so that there's always a bidder. If the PD's don't have the reserves to purchase securities from the Treasury, then the Fed lends to them."

      If a Canadian primary dealer doesn't have the firepower to participate in a government bond auction, why would the Bank of Canada even bother lending to that primary dealer so as to coax it back in? The Bank of Canada can itself plug any hole left by an inadequately subscribed auction! Remember, the BoC can directly lend to the government.

      I think you've mostly missed the point of my post. I've admitted that the Bank of Canada can fund great gobs of Federal spending. The point is that it probably shouldn't.

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    2. The point I'm trying to make is that even when the central bank isn't directly "funding" the government, it is supporting the private market's ability to fund the government. That might be directly lending to institutions so they can buy government bonds, or it might be ensuring that enough reserves are circulating so that the bonds can be purchased by somebody without undue stress on the money markets.

      So, scenario a) central bank directly funds government, vs. scenario b) central bank indirectly funds government by supporting the private sector's ability to buy government bonds. Is there really an important difference between those two things? I don't think so. If the net balance sheet position is the same in either case at the end of the story, then it makes no difference which one actually happens, they're have the same results.

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    3. "The point I'm trying to make is that even when the central bank isn't directly "funding" the government, it is supporting the private market's ability to fund the government."

      Ok, maybe that's true, maybe it's not, but how is that relevant to my post? Perhaps you could quote the specific paragraph that I've written where your point has bearing.

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    4. I mean, the whole thing? The underlying premise of your article is that it makes a difference whether or not the CB directly funds the Treasury. I'm arguing that it actually makes no difference, because if they aren't directly funding the Treasury, then they are indirectly funding the Treasury, by supporting the private sector's ability to fund the Treasury (except in the Euro). But here's a few quotes:

      "Were Trudeau to rely on treasury bills and bonds rather than central bank financing to invade Burkina Faso, send a rocket to Pluto, and build a border wall with the U.S., then the Bank of Canada would never have to ask the Prime Minister to annihilate deposits in order to hit its inflation target"

      This isn't really right if the CB is supporting the private sector's ability to buy Treasuries.

      Same here: "But in a scenario where the government is being wildly imprudent, a degree of separation between the Prime Minister and the Bank of Canada is advisable."

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    5. "The underlying premise of your article is that it makes a difference whether or not the CB directly funds the Treasury. I'm arguing that it actually makes no difference, because if they aren't directly funding the Treasury, then they are indirectly funding the Treasury by supporting the private sector's ability to fund the Treasury (except in the Euro)."

      I see you've done some homework on Europe. I trust you've also done your homework on Canada?

      I suppose that the main point of my blog post is that up here in Canada, the Bank of Canada can help the Department of Finance (we don't have a "Treasury" up here, as you call it) fund pretty much all its spending. Whether the Bank of Canada can indirectly help out government bond dealers (a point you seem to enjoy repeating) or not is irrelevant, given that the Bank of Canada can automatically credit the government's bank account with new funds.

      That the Department of Finance has adopted the practice of not exercising its right to tap the Bank for funding is probably prudent.

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    6. Right, I understand that the Bank of Canada can directly fund the Department of Finance in Canada (although I didn't know it was called the Department of Finance).

      But I'm saying that when the BoC *isn't* directly funding the Department of Finance, then they are indirectly doing so, by supporting private financial institutions. There isn't really an option for "no central bank support." There's only direct support, or indirect support. So, the correct question is, what are the differences between direct support and indirect support? And I'm arguing that there are basically no important differences. Therefore changing it all over to direct support (as you might say, "tapping the Bank" far more) probably makes basically no difference (assuming the levels of taxes and the Bank's policy interest rate target stay the same in either case).

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    7. I'm not sure what you mean when you imply that the Bank of Canada indirectly support financial institutions.

      The Bank of Canada can't just give free money to banks. Any loan that the Bank of Canada makes to a bank must be fully secured by eligible collateral (ie federal and provincial government debt, high-quality corporate bonds, bankers' acceptances). It applies a suitable haircut to risky and long-dated assets submitted as collateral. If a bank wants to get a $1000 loan from the Bank of Canada, it'll have to submit around $1040 in, say, provincial bonds to qualify.

      Delete
  6. From William Mitchell blog:

    http://bilbo.economicoutlook.net/blog/?p=34557

    T or F?

    The expansionary impact of deficit spending on aggregate demand is lower when the government matches the deficit with debt-issuance because then excess reserves are drained and the purchasing power is taken out of the monetary system.

    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.

    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.

    (click link for further detail)

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    1. Before I get to reading your comment, can you add a short preface for why exactly it is relevant? i.e. what part of my post does it apply to?

      Delete
    2. Mitchell points out that if aggregate spending of gov't and private sector exceeds resource capacity, inflation will result. But whether or not spending is matched by bond issues makes little difference. Bond issue will only affect the asset composition held by the financial sector - either they will receive bond interest or interest on reserves, but any differing effect on inflation would be moot. The first part of your argument seems to lead to the same conclusion.

      But then it seems to me you change your argument by making the presumption that a government receiving funding from its central bank will suddenly lose touch with reality, invade Burkina Faso, and vastly overspend. If that is your argument, why not make it simply and directly instead of a convoluted argument involving central bank maneuvering to uphold the dollar price standard? Your argument appears to be against wasteful overspending, not against central bank financing per se.

      PAUL SAMUELSON ON DEFICIT MYTHS
      TIME TO DROP THAT OLD-TIME RELIGION

      By L. Randall Wray
      http://neweconomicperspectives.org/2010/04/paul-samuelson-on-deficit-myths.html

      "Yes, government must be constrained. That is what elections and budgeting and accounting and accountability are all about. We need more democracy, more understanding, and more transparency. Politicians need to listen to Main Street—not just Wall Street—before deciding where and how much to spend. They need to be controlled by a budgeting process—whose purpose is not to balance the budget, ensuring tax revenues match spending outgo, but rather to give us some idea of the size of the programs (hence, what percent of our nation’s resources will be devoted to their projects) and, equally important, to hold our leaders and project managers accountable. When managers run over budget, it does not threaten our government’s solvency but it should threaten its credibility. Fraud and over-reach are always a threat where government’s spending is unconstrained. And, yes, too much government spending generates competition over resources, bottle-necks, and even excessive aggregate demand, all of which can generate inflation. We don’t need myths. We need more democracy, more understanding, and more transparency. We do need to constrain our leaders—but not through dysfunctional superstitions."
      ___________________________________________________________________________________
      P.S. Re: "At some point the recipients of these new deposits (anyone with a Bank of Canada account) will suffer deposit bloat. They will try to get rid of their excess, and as they do so prices across the Canadian economy will start to rise."

      Note there was a massive increase in deposits in the banking system in the U.S. as a result of quantitative easing, but despite what many establishment economists predicted, no general inflation. When BoC account holders try to get rid of excess reserves, the main result would likely be a fall in interest rates unless the central bank intervenes. Do you agree?

      Delete
    3. "But then it seems to me you change your argument by making the presumption that a government receiving funding from its central bank will suddenly lose touch with reality, invade Burkina Faso, and vastly overspend."

      I wasn't trying to say that a government receiving funding from its central bank will suddenly lose touch with reality. My point is that if a government is going to lose touch with reality, better that it does so when it is relying on the bond market rather than the central bank. If it relies on the former, only one price will have to adjust (the price of government debt), but if it relies on the latter, the entire measuring system will be thrown out of whack.

      "Note there was a massive increase in deposits in the banking system in the U.S. as a result of quantitative easing, but ... no general inflation. "

      QE was an asset swap. Trudeau using the BoC to finance a Pluto expedition, an invasion of Burkina Faso, and a wall would be a different sort of enterprise.

      "When BoC account holders try to get rid of excess reserves, the main result would likely be a fall in interest rates unless the central bank intervenes. Do you agree? "

      Yep.

      Delete
    4. Re: "If it relies on the former, only one price will have to adjust (the price of government debt), but if it relies on the latter, the entire measuring system will be thrown out of whack."

      If this is your argument, what evidence do you provide to back it up? It seems to me you are admitting on one hand that the inflation is caused by the overspending, but then your argument switches to blaming the method of financing. Yes QE was an asset swap, but was effectively a form of central bank financing, and despite massive QE in places like the U.S. and Japan, the entire measuring system was not thrown out of whack. The build-up in reserves led to a decrease in interest rates, not changes in the price level. If the build-up in reserves was caused by direct government spending from central bank funding, we would expect the same result. Whether or not inflation erupts depends on spending in relation to resource capacity, not on the level of reserves, or whether bonds were issued to the private sector.

      Delete
    5. I don't agree that QE was a form of central bank financing.

      The Fed engaged in a form of QE during WWII. The government financed itself by issuing debt to the private sector, which the Fed in turn purchased at *below market prices*. So during WWII the Fed was indeed financing the government by reducing its borrowing costs.

      During the three recent QEs, the Fed's purchases of government debt from the private sector were at *at market prices*. The government's cost of financing would be the same in a world where the three QEs happened or if they didn't happen.

      Delete
  7. Whether the "cost" is at market or below market, there will be a build-up of reserves in the commercial banking system, just as there would be if no bonds had been issued to the private sector in the first place. Your argument that central bank financing should be avoided seems to hinge on the fact that a build-up of reserves per se through direct government spending (i.e. assuming no resource constraints) will be inflationary ("the entire measuring system will be thrown out of whack"). Do you agree with my understanding of your argument, and if so, can you explain the mechanism that would lead to inflation in your view, bearing in mind that real-world experience has demonstrated no such inflation in cases of excess reserves (Japan, U.S.)

    ReplyDelete
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    1. Yes, you are right that either way, there will be a build-up of reserves.

      However, when reserves get built up through direct government spending, the central bank doesn't receive an asset in return that it can re-sell in order to draw reserves back in. Eventually this will result in inflation. (Likewise, when the central bank has purchased assets for more than they are worth it won't have adequate backing power to undo the expansion). With the QEs that ran between 2009-2013 (as well as Japan in the early 2000s), the central bank bought assets at their correct price, and so it has enough ammo in hand to retract, and so there has been no inflation.

      "Your argument ... seems to hinge on the fact that a build-up of reserves per se through direct government spending (i.e. assuming no resource constraints) will be inflationary."

      Well I wouldn't go as far as to say "will be." I prefer a more ambiguous "could be".

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    2. Please clarify whether you believe a build-up of reserves per se "will result in inflation" or rather "could be" inflationary, as it seems to me you have said both things in the same message.

      Also please describe the mechanism which explains how a build-up of reserves "will" or "could" result in inflation.

      The crux of your argument is that spending not matched by bond issue (and without assuming a resource constraint) "will" or "could" be inflationary, yet it remains just an assertion without any logical underpinning argument nor evidence provided.

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    3. "Please clarify whether you believe a build-up of reserves per se "will result in inflation" or rather "could be" inflationary, as it seems to me you have said both things in the same message."

      Apologies. So in my previous comment I said that when reserves get built up through direct government spending, the central bank "doesn't receive an asset in return" that it can re-sell, and eventually this "will" result in inflation.

      I then backpedaled this to "could" result in inflation. The reason for softening my stance is the possibility that as upwards pressure on prices builds, the government itself can step in and restore price stability by annihilating as much reserves as are necessary to remove the excess (remember, the central bank is helpless to do anything). But this subjects one of our most important measures, the $, to politics.

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    4. Re: "as upwards pressure on prices builds" What is the mechanism that leads from excess reserves to inflation? This is the third time I have asked that question. Your conclusion that monetary financing should be avoided rests on that inflationary premise, yet you continue to assume it without providing any argument nor evidence to back your assertion.

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    5. " What is the mechanism that leads from excess reserves to inflation?"

      Say banks collectively hold too many central bank deposits relative to demand. A single bank can sell enough deposits to bring itself to its preferred level, but then another bank ends up with the unwanted deposits. Since the banking system as a whole can't destroy central bank deposits, balance can only be restored by all prices rising. Once they've risen enough, deposits will once again be willingly held.

      Central bankers have a neat tool for dealing with unwanted central bank deposits: they can repurchase them and destroy them. So there never need be a selling cascade (as described above) to restore equilibrium. But if a central bank lacks the means to destroy central bank deposits, and the government refuses to help, then unwanted deposits will be spent (not destroyed), putting upward pressure on prices.

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    6. If the banking system as a whole can't destroy central bank deposits, please explain who will be doing the spending, what they will be buying, how this will lead to a rise in the general price level, and how they will know when balance is achieved. I look forward to your explanation.

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    7. One way it could work is this: banks spend their excess reserves on bonds and other safe assets, driving their prices higher. The existing owners of these assets see that other riskier assets like equities and real estate are now relatively cheap relative to fundamentals, and they drive the prices of these risky assets higher. Existing owners of stocks and real estate are wealthier and buy more goods and services, pushing the CPI up.

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    8. I see - this is how it "could work": rich people, feeling richer, decide they have been denying themselves inordinately, so they run out and buy themselves an extra carton of eggs, pushing up the CPI. JP Koning, I have some shocking news for you. Rich people have been getting richer for a long time now. Do you have any actual evidence (in monetary sovereign nations like Canada, Japan, the U.S. or the UK) of causation/correlation between excess reserves and rich people causing inflation, or could this simply be the addition of another level of invented epicycles, necessary to defend your opposition to monetary financing to which you seem ideologically wedded?

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    9. Well, I never said rich people cause inflation. The initial increase in reserves is the cause, although rich people are part of the transmission mechanism i.e. the secondary steps by which the initial reserve increase is transmitted to the rest of the economy. And I don't deny that inflation involves distributional issues.

      But there are a tremendous number of ways for the initial increase in reserves to be transmitted to the economy's full array of prices. Once inflation is expected, then consumer prices will react very quickly.

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    10. First let me express appreciation for all your hard work in producing the Moneyness blog with its many interesting and informative articles. Thank you for your continuing public service.

      Having said that, back to the business at hand.

      We have established that:

      1. You firmly believe monetary financing is imprudent.

      2. Your initial position was that it would eventually lead to inflation.

      3. This was backpedaled to maybe causing inflation.

      4. When pressed on the mechanism by which excess reserves caused by monetary financing leads to inflation, there appears to be uncertainty.

      5. You stated that one way it could work is by a concatenation of events leading rich people to feel richer and to throw the price system out of whack. No evidence was proffered. In situations of upper class tax cuts where rich people would also suddenly feel richer, no wave of inflation has followed, so somehow we need to believe that the rich will figure out that excess reserves were the cause of their good fortune in particular cases, and will take appropriate spending decisions that then affect the CPI.

      5. When challenged on the implausibility of your first explanation (which I thought would have been your strongest case), you have chosen not to defend it, but rather now maintain "there are a tremendous number of ways for the initial increase in reserves to be transmitted to the economy's full array of prices". At this point, you have not volunteered any details of these ways, nor any associated evidence.

      6. Presumably when challenged to produce the goods, we can expect an Arabian nights scenario, where a new story is unveiled each day to keep an untenable theory alive to see the light of another dawn.

      7. Recent real-world experience since the 2008 financial crisis has demonstrated that long periods of excess reserves have not led to inflationary outbreaks. In a recent paper, the BIS concluded:
      https://www.bis.org/publ/work292.pdf?noframes=1

      "If bank reserves do not contribute to additional lending and are close substitutes for short-term government debt, it is hard to see what the origin of the additional inflationary effects could be. The impact on aggregate demand, and hence inflation, would be very similar regardless of how the central bank chooses to fund balance sheet policy. For example, it is not clear how inflationary pressures could be more pronounced in a banking system that keeps its liquid assets in the form of overnight deposits at the central bank compared to one that holds one-week central bank or treasury bills."

      A more in-depth analysis can be found at:

      Building bank reserves is not inflationary
      http://bilbo.economicoutlook.net/blog/?p=6624


      I think I have made my point. Your firm conviction that monetary financing is detrimental has not been supported by any coherent and evidence-based argument, and remains simply a matter of your personal conviction, unmoved by real-world experience that would lead to a different conclusion.

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    11. 1. Yep.

      2-3. Not sure why you seem to see this as some sort mark against me. All I did was clarify a point. Clarification = good, no?

      4-6. There are a million ways for an increase in reserves to manifest itself in final prices. Think about it this way. If I add some water to a lake, it'll push the water level higher. But how exactly did the initial addition ultimately cause the rise in the water level? Did it first spread to the east side and then the west? Did it displace some of the water from the bottom and push it to the top? Likewise with the monetary transmission mechanism.

      7. Yep. QE didn't lead to inflation. As I said earlier, it was a like-for-like swap. But if QE was carried out differently, say by purchasing government debt at a 50% premium to their market price, you bet it would have caused inflation.

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    12. Yes, clarification is always good. What I object to is the continued addition of epicycles and Scheherazadian tales to prop up failing theories. If gov't debt were bought at a premium, then the recipients of the premium might spend more and conceivably cause inflation. Any spending including gov't spending can be inflationary if resource limits are breached. But this doesn't depend on whether or not there are excess reserves. The reserves themselves don't know whether they were created to purchase bonds at market, or at a premium or at a discount, or exist as a result of gov't spending. So for clarification, if there are $1000 in excess reserves, please advise how those reserves know whether they have to be inflationary because bought at a premium or not because bought at market?

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