About Those “Invisible Bond Vigilantes”

* This one’s long, but important in my opinion as it will help the reader better understand many different concepts….

In a post last week Paul Krugman provided a simple model explaining why fears over bond vigilantes in the USA was wrong.   He ended with this:

“If there’s something more going on here, I’d like to hear about it.”

I’ve had a lot to say about this for years so I figured I’d chime.

Bond traders are a simple species.  If you offer them a low risk arbitrage opportunity they’ll almost always jump on it.   But there’s an intricate dance that occurs in US government bond markets.   Before we dive into the details, it’s important to understand why the US government even borrows money in the first place.  After all, the government could theoretically just print up its own money and spend it (and the USA has at times done precisely that).  Of course, that’s not what the US government does.  Instead, the US government outsources the creation of money to its banking system (the private sector) in a design structure that is in keeping with a capitalist economy.  The US money supply is essentially privatized to an oligopoly of private entities in an attempt to create a competitive market based (demand driven) money system.  So the government makes itself a user of  money in this regard.  It MUST obtain funds from the private sector before it can spend. It achieves this via taxation and bond sales.  In a representative republic like the USA we essentially choose to move resources to the public domain for public purpose.

Although the Treasury must obtain funds before it can credit bank accounts there is really never a concern about this being achievable.  The government will either tax, sell bonds or, in an absolutely worst case scenario, use its central bank to create money.  In this regard, the government imposes its powers as a possible currency issuer.  As I often say, there’s no such thing as the US government “running out of money” even in a worst case scenario like hyperinflation.  So all the fears about the USA having a solvency crisis are unfounded.  But that doesn’t mean the USA can’t have a currency crisis resulting from hyperinflation.  As I’ve previously explained in my reasoning as to why hyperinflation is an extremely low probability event in the USA, hyperinflation is usually the result of extremely rare exogenous events.  This usually involves a collapse in production, loss of war, loss of currency sovereignty, etc.

On the bond side, the US government has a very specific design structure.  First of all, Primary Dealers are required to bid at Treasury Bond auctions and must maintain reasonable markets in US government debt.  That’s just part of the deal when working with the government (which is lucrative for the banks in various ways).  As I often point out, you’ll notice in the details of the auction results, that the auctions seem predetermined.  That’s because they essentially are.  The Fed, Treasury and Dealers all work together in close unison to ensure that auctions can be filled.  The Dealers, being required to bid, will always be able to take down the entire auction (and can usually take down 2X the auction).  Again, that’s by design.  If you check the data you’ll see this is just about always the case.  It doesn’t matter how much China is buying or how much individuals are buying via Treasury Direct.  Auctions are designed not to fail.  So they don’t.

The banks are happy to make markets for the government as long as they can keep their books hedged, scrape the fees and on-sell most of their inventory.  That is, banks are engaging in a relatively low-risk game here and in exchange the government gets to maintain a private competitive monetary system and obtain the funding current monetary design requires it to obtain.

But the real question is – who’e controlling price here?  Who sets yields on government debt?  The bond vigilantes or the government?  As I’ve previously mentioned, the government cannot “run out of money”.  This is very important.  Unlike Greece, the USA has a cohesive banking system, Treasury and Fed.  In essence, the banks agree to buy for the Treasury and the government agrees to guarantee solvency (always deliver payment).  So traders in US government bonds don’t worry about getting 100 cents on the dollar when the bonds mature – seasoned fixed income traders just know you don’t fight the Fed in this regard.  So the banks just have to manage their risks flipping the bonds for a profit (either scraping fees or arbing the spread on their books) and managing their inventory in a manner that reduces their exposure to the real risk of owning this paper – purchasing power loss.

In a low or falling inflation environment this is a low risk game that the banks are happy to engage in.  It becomes trickier as inflation rises.    One could easily imagine a scenario in which inflation is raging out of control (for whatever reason) and the banks can’t on-sell their inventory or adequately manage the risks on their books.  The Fed could buy, but true monetization has already set-in which collapses the currency and spells the endgame for the monetary regime.

Inflation becomes problematic when it outstrips productive capacity.  But this works two ways.  In a healthy economy inflation outstrips productive capacity when output is high, unemployment is low, etc.  This is bad, but “bad” in the same way that eating chocolate cake is “bad”.  Inflation can also become problematic in a world of collapsing production (think Weimar, Zimbabwe).   This is a very different scenario and a far more dangerous scenario.  In this scenario inflation outstrips output and we enter a classic case of too much money chasing too few goods.  After all, currency demand is ultimately a function of the quality of the goods and services this tool of exchange offers you the possibility to purchase.  The value of the currency and the bonds the government sells are largely derived from this underlying output.  So, with collapsing output there is little to no reason to hold either currency or bonds.

So again, who’s controlling bond yields?  The government or the bond market?  The analogy I often use here is a person walking a dog.  Think of the bond market like an untrained dog leading the person.  The Fed is akin to the person while the bond market is akin to the dog.  The bond market will always try to lead the Fed (traders front-run, that’s what they do).  But the Fed, as the supplier of reserves to the banking system can ALWAYS control the price of bonds.  It can literally set the price of US government bonds (on any part of the curve) at whatever price it wants.  But Fed policy is ultimately a function of their expectations of the future economic environment.  If the Fed expects the economy to remain weak they’ll try to stimulate the economy by keeping rates low.  The bond market can try to lead the Fed, but can’t set price.  So the bond market ultimately has to adhere to the Fed (who adheres to the economy).  So this dance is more complex than the one sided debate most of monetary theory tries to imply.

But what about that collapsing output scenario?  What happens then?  What does the Fed do?  In this scenario I would argue our dog resembles something more like a tiger.  The Fed suddenly has very little control.  Yes, the Fed could theoretically still pin rates at zero, but they would never do this because interest rates and inflation would be soaring.  In an attempt to get control of the economy they would try to set rates high.  But the banks would already be front running the Fed selling bonds like a wild tiger pulling a person around at will.  The Fed can set rates, but the government can’t set the economy.

So, who controls price?  Bond vigilantes or the Fed?  The answer is “it depends”.  99% of the time the Fed controls price.  But it’s that 1% of the time that the Fed loses control that ends up destroying 100% of the economy.  But most interestingly, it’s really neither the Fed nor the bond market who controls the value of bonds or currency.  They’re just secondary players in a much bigger game where the outcome is decided by the quality of the output society creates and the willingness of the currency users to use this tool of exchange to obtain that output.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Cullen,

    I recently read this article which stated that the digital economy or what the Author calls the second economy, will generate approximately 2% productivity over the coming 20 years. This is an extract from the article by W. Brian Arthur.

    “How fast is the second economy growing?

    Here’s a very rough estimate. Since 1995, when digitization really started to kick in, labor productivity (output per hours worked) in the United States has grown at some 2.5 to 3 percent annually, with ups and downs along the way. No one knows precisely how much of this growth is due to the uses of information technology (some economists think that standard measurements underestimate this); but pretty good studies assign some 65 to 100 percent of productivity growth to digitization. Assume, then, that in the long term the second economy will be responsible for roughly a 2.4 percent annual increase in the productivity of the overall economy. If we hold the labor force constant, this means output grows at this rate, too. An economy that grows at 2.4 percent doubles every 30 years; so if things continue, in 2025 the second economy will be as large as the 1995 physical economy. The precise figures here can be disputed, but that misses the point. What’s important is that the second economy is not a small add-on to the physical economy. In two to three decades, it will surpass the physical economy in size”.

    I have not thought this through, but there would be only a small chance of high inflation in the future (barring discussions on metal and mineral demand levels).

    For example, if there was an explosion in demand for a product, let’s say a record album, then there was a chance of inflation as the production process took the time to expand and meet the demand. however, these days there can be no inflation because it is a digital download and there is very little production pressure.

    The other implication is can rail traffic be used as an indicator, if the services and digital sector increase without increased rail traffic?

    So maybe we can have our (chocolate) cake and eat it?

    Sorry if this is off-topic.

  2. Excellent article Cullen thanks

    I would only quibble with 99%. Its more likely 99.5 or higher since we have never had a real currency crisis with our currency. The US has had periods of depression, but those are deflationary not inflationary. We have had a very good record of low inflation. I know the 1913ers will probably chime in here but its true. And our times of relatively higher inflation did not occur with output collapses, which is really what its about …..output.

  3. Having exhausted its supply of short term paper during Operation Twist, how would the Fed control the short end now? They can bid it up, but they can’t sell it down.

    At the opposite end, they have bought an awful lot of bonds and were forced into MBS to execute QE3.

    Seems to me they are running out of “leash”. And to extend your analogy, leashes do not prevent a tiger from turning around and attacking you.

  4. “…how would the Fed control the short end now?
    Term repos of any security they are currenly holding would have the same effect as outright selling – reserves are drained in the same way as a sale drains reserves.

  5. JB, when the Fed runs out of short paper to sell, there has been some talk about Operation Twist 2 (OT2), in which the Fed would borrow short-term paper and use the proceeds to buy longer-term bonds. There would probably be very strong demand for the Fed paper from the likes of money market funds and treasury departments. These entities are always in need of increasingly rare, high quality short-term paper.

    Of course, OT2 is completely unnecessary. The Fed doesn’t really need to borrow anything. But appearances matter. OT2 doesn’t look like “printing money” as much as QE does.

  6. Cullen, as someone who as traded more than few bonds in my lifetime, I commend you on this excellent piece.

  7. The Fed will have a problem ever raising rates because of the sheer quantity of debt, much of it which has to be rolled over in the next five years, not to mention the $5 to $10 trillion in new debt that must be issued in the next five years to keep financing the government.
    If you’ve got $10 to $20 trillion of debt at 5 percent, the interest will eat up most of the tax receipts.

  8. Great article Cullen. I think one of your best. Lot’s of big ideas tied up nicely in this.

  9. It seems like a lot of whistling past the graveyard here.
    So many questions:
    Will investors accept 2 pct return on Treasuries when inflation runs at 3 4, 5 percent (or higher)?
    Do you really think we can’t have price inflation in a recession? History shows otherwise.
    What’s with the emphasis on productive ‘capacity’, rather than actual production. It presumes that debt can replace production (as we see in Greece, where it is believed the German money can stand in for Greece economic reform.)
    What happens to investor sentiment when it becomes clear the Fed is monetizing spending?
    You’ve described a system which works only if rates are falling. Don’t you see that such a system is not very robust?

  10. CR wrote …. Unlike Greece, the USA has a cohesive banking system, Treasury and Fed …


    More like … the USA has a designed in COLLUSION (Treasury, FED and TBTF (PD) ) …

    Wrapped in a facade of Independence amongst said players … the Ultimate ILLUSION masterminded in 1910-1913 when the FED Creature was created.

  11. to Cullen, or any other qualified bond trader: i get that auctions takedown will never be a problem. so the treasury can always sell it´s stuff.

    but which role does the secondary market play here?

    IN THEORY you just need enough market players to put on a short treasury trade (or sell their holdings) and there go yields. our todays markets are all about trends. once a trend is in place things can get out of hand quickly, if enough people buy in. best example was the oil blowoff in 2007 just before an ecb rate hike killed it. back then there was no fundamental justification for 150$ oil. yet more and more people were just playing an incredibly strong trend (in fact it was the only trend left in a major asset class. stocks, bonds were broken). do you think something similar could happen in the bond market?

    and you argue that the fed sets rates according to its economic expectations. but lets say we get inflation above 3% or more and the economy still remains weak. so the market would be divided – the fed which wants low rates, while bond buyers expect some kind of return.

    do you think there is a level of negative real yield when the fed can´t hold things together any longer? let´s say 5% inflation and 1.5% treasury yield. would a -3.50% real yield be possible?

    i get that the fed could set a fixed price because of it´s unlimited ability to buy. but how realistic is such a scenario? let´s use the 1.5% from above. let´s say they communicate that target. wouldn´t they become the only buyer at some point thereby ending up monetizing the debt?

    and are there any limits to this policy? i´ve seen numerous central banks trying to maitain a certain forex rate by unlimited buying/selling, but many failed.

    thanks a lot!

  12. An equally interesting development with the technological age is that the technology itself is changing and evolving so quickly that there’s an inherent deflation in the inventory restocking of these products. Not to mention the pricing power that it gives capitalists over the labor class….Japan’s deflation is about more than demographics and de-leveraging. You’d probably have better thoughts on that than I would though….

  13. Fed controls the short end now via interest on reserves. When they want to raise the FFR they won’t need to sell off their balance sheet. They’ll raise the rate on reserves instead.

  14. Most people don’t consider the alternative. The Fed and the Reserve System are actually rather brilliant when one understands precisely how it works. By creating this interbank market the govt has created a market where the banks can always settle payments and the govt can oversee the process. BUT, they’ve also maintained a private competitive banking system at the same time. So money is not ultimately distributed by the govt, but by the pvt sector in a competitive market based process. In other words, the Fed system creates a world where you have the best parts of a state run system without the state actually running the system.

    I know most people hate the Fed, but it’s not the design you should hate. What you should hate is the way they’ve lopped on monetary policy on top of this brilliant design structure. After all, the interbank market is a brilliant construction in a capitalist economy. It’s the manipulation by the fake bankers (the FOMC) that causes many of the issues (like misguided policy like QE).

  15. This is a very good write-up. You’ve covered a lot of important details and explained the operational realities in a very succinct manner.

  16. I’d like Cullen to take on your ideas directly. I’ve got my thoughts which admittedly may be naive ideas. But here are some counter points the your idea that interest payments on the debt will kill us, or that deficits will just keep going up because that’s what they’ve been doing lately (or because of interest payments), etc.

    First, interest payments if they go to what I call “dead money accounts” doesn’t cause inflation because it doesn’t get spent. China, for example, just keeps adding to its savings account which they will never spend on anything else since we won’t let them buy much of anything of use or value. So in an extreme example, if 100% of US deficits go to dead money accounts, deficits can go to infinity and be virtually meaningless.

    Second, when interest payments go to those who will spend it, that sparks the economy and results in tax receipts for the Gov. In this extreme example 100% of the deficits and interest payments on debt payments go right into the economy – the economy booms and tax receipts skyrocket ending the need for deficits.

    Third, the Gov can probably just arbitrarily tax or fine any massive holder of debt – so another extreme example…. fine China $1T or 100% of their debt holdings for unfair trade practices or currency manipulation. Viola, debt is gone. China can object, but the alternative is raising tariffs and killing their trade with us. Guess which they’ll choose – the dust collecting bonds, or active trade keeping their factories humming???? With uber-wealthy individuals with massive debt holdings – tax savings rather than income, or tax bond income at 95%.

    Whether any of the above ideas are viable or realistic, my point is the Gov can find a way to control its debt and deficits via spending and taxes. So telling me that in x number of years the debt is going to be y amount which will kill us, I say hogwash

  17. The interest rate on the debt is about 1.5%. If the debt rises to $20T then we’ll add roughly $60B per year to the deficit. I mean, we’re talking peanuts here. Even if we let rates rise to 5% then, at 20T we’re still adding $100B to the deficit via interest costs. Not peanuts, but not breaking the bank. Besides, since the interest adds to the deficit it probably just means cuts from something else. I don’t see the fuss. There’s no “exponential” math here that leads the interest to break the govt’s back….

  18. So it boils down to: “there is no free lunch; it is the economy that matters stupid!” What counts is the capacity of the economy to add real wealth, I.e., value added through the transformation of inputs into outputs via capital, labor, and improved technology. The economy is the dog and the money is the tail. The tail wags the dog only in the the screwed circumstances CR describes.

  19. What you are basically saying is that we can monetize spending.
    That might be true and is certainly worth debating, so I would like to see Cullen come right and and say that is what he is advocating.
    To address your points.
    1. Certainly if you take tax receipts and pay down debt that is not inflationary; however, you have spent tax receipts on past spending. Politically, how do you tell people that we can’t have a certain program because $500b is going to pay interest (especially if the taxpayer believes that China is being paid the interest.
    2. Who holds the bonds? As stated above, if China is holding bonds, then this is nice for them. And the idea that tax receipts will boom in the future so we can afford to pay interest rates begs the question — if tax receipts are booming, wouldn’t we want to spending those receipts on young people, either with tax cuts or programs for the young. Deficit spending, after all, primary benefits the old.
    3. This would run all sorts of political and economic risks (how do you tear up the treasury note held by the Chinese but not the one held by the widow), and at any rate, we’re back to my original point. You are monetizing the debt. It’s a stealth argument for monetization. Borrow so much that printing becomes the only option.

  20. At $20 trillion in debt, 5 percent rates mean $1 trillion in interest payments.
    Am I doing the math wrong?
    And yes, I know that some of the debt is locked in, but most of it is increasingly on the short end.
    I know that we have different paradims here. I see that interest on the debt as coming from tax receipts and you see it as money that can be raised from the primary dealers and pushed out to infinity.

  21. Yes, you are right. Major math brain fart there. Sorry. Still, at current rates, we’re looking at $300B a year in interest payments with 20T in debt. And that’s mostly money going to old ladies and retirees. Don’t you fiscal worrywarts always say the Fed is hurting the savers by not giving them enough interest on their savings???? So which is it? Are you worried about savers or worried about the govt not being able to “afford” its interest?

  22. No, my point is that the Fed will be handcuffed in raising rates, so we run the risk that the marketplace will become even more distorted. I’d always thought that raising rates was one tool the Fed could use to combat inflation; however, with $20 trillion in debt, they won’t have that option.
    I’m worried about the consequences of monetizing the debt, which I see as the natural consequence of where we are going. I could be convinced that monetizing debt is the answer … I think that’s where you are going and will be interested to hear that argument. That’s where I am leaning.
    By the way, when we have $20 trillion in debt, it won’t be held by little old ladies, it will be held in the financial markets, right? Institutions borrow in order to buy the debt, then count the bond as an asset against their loan?

  23. “Yes, the Fed could theoretically still pin rates at zero, but they would never do this because interest rates and inflation would be soaring.”

    How would lowering rates make rates skyrocket? You just said the fed controls rates. Or is this a yield spread thing…?

  24. The Fed is not using private bank money, it is the other way round. The Fed, acting as the agent of the Treasury simply instructs a bank to change entity X’s account up and creates ex nihilo reserves that it gives to the bank. The reserves that are awarded to the bank didn’t come from the Treasury or some other private bank, they were just typed in out of thin air.

  25. The usual Krugman claptrap. He doesn’t understand how banking works.

  26. I should have been clearer. OTHER rates (not controlled by the Fed) would be soaring because you’d see corporate debt defaults and the like across the private sector as output collapsed. So the spread between t-bonds and corp bonds would soar. Unless the Fed also raised rates. Which they most likely would because they’d be trying to contain inflation. Or, they could keep rates low if they wanted. But it wouldn’t really matter. The bottom line is, in this kind of a situation the Fed’s policies won’t save the day. Any more so than Mugabe’s printing press can save the day when output craters.

  27. No, you’re using the MMT framework, which is not the correct way to understand our monetary design. The dealers don’t just get accounts credited with reserves. Imagine a t-bond purchase via Treasury Direct. I could do this any time I wanted. My inside bank money gets used by the govt which settles in reserves to buy the t-bonds. The Tsy spits this out on the other side as inside money again in someone else’s bank account. I get the t-bond in exchange. It all starts with inside money. The monetary system always starts with inside money. It doesn’t start with the reserves. MMT makes the same mistake all the neoclassicals do by trying to claim the govt or the Fed has some special power where they create, multiply or leverage money. It’s wrong. It’s just not how the system is designed.

    The interbank market is just where inside money settles. Imagine a banking system with just one bank. There would be no need for reserves. All money would be the same thing – so the specialness of reserves is obviously wrong. MMT essentially does the same thing neoclassicals do here by claiming that settlement in state money is something special or unique. It’s a rewording to the money multiplier. MMT just calls it “leveraging”. It’s not correct. Banks don’t leverage anything. They don’t multiply anything. They say, “thanks for outsourcing your money supply to us. Now, support us or we’ll crush this whole system”. It’s designed that way. Mostly by bankers for bankers. In the name of capitalism and private competitive markets. The Fed is a facilitating entity. “Support or die” should be the Fed’s motto.

    So it’s best to think of the reserve system as a separate market that facilitates payment settlement between banks. It’s not some special market where money starts and ends as MMT claims (or gets “destroyed” or created). The Fed system is a middleman overseeing payment settlement and ensuring recirculation of inside money can be achieved by the US Tsy. The interbank market is just the middleman in all these transactions. There’s really no special significance to it aside from the fact that its hugely important in helping to maintain private banks without forcing them to settle payments amongst one another without govt oversight. After all, this is the whole purpose of the Fed’s existence – to maintain private banking without having a nationalized money creation design. Anyone who studies the creation of the Fed can see that it exists to support the creation of private inside money. It doesn’t exist as some pseudo form of bank nationalization or money supply nationalization. It exists explicitly as a servant to the banks to support their every want and need. Without a nationalized money system the Fed is a totally necessary entity as it’s impossible to have stable private banking without such an interbank system.

  28. “wouldn’t you want to spend the tax receipts on xyz?” No, if the economy is booming you don’t need to spend anything on anyone…. well, you do because you still have the military, social security, etc, but you don’t need to add new spending. And yes, you pay back past spending is the money isn’t needed today. Voters won’t know or care because they’ll be fat, happy and busy in the booming economy so they won’t be whining about wanting more money spent on anything.

    yes, #3 has risks, but “how do you tear up one bond but not another?” is answered in my statement. You pick on the Chinese because you can…. why would you then also try to do it to grandma??? And I’ve only got #3 for the extreme case where interest payments are overwhelming. I’m not suggesting we ever do this – only that should your extreme fears be realized there are extreme ways to handle it.

  29. Cullen,

    Something you never include in these posts is “how” the Fed could control all the rates along the yielf curve. Maybe you assume everyone knows? My understanding is that the Fed would just buy/sell in an unlimited amount at a certain price to maintain their targets. Is that correct? I think it’d be useful for you to include that in your explanations.

  30. The explanation of the bond trade is a little too simplistic for me.

    1)Yes, primary dealers are required to bid on government debt but this isn’t always a profitable venture. There have been serveral long periods when the Fed/Treasury conducted auctions with substantially less than 32 primary dealers. Poor margins in bear markets such as 1994, even when the book is fully hedged, often turn negative. If the sales force can’t move the inventory fast enough then credit lines can become fully utilized, thus creating a potential basis trade that eats up any positive carry. Goldman, JPM, Morgan Stanley, Blackrock often operate their primary dealerships at a loss but make up the margins on underwriting and in corporates and MBS sales.

    2) The walking the dog analogy is correct virtually all the time, but I wonder if the Fed is now walking something closer to the size of a bear/elephant. I agree that the Tsy can always print cash to avoid default. I recognize that this ability takes default off the table. But the coupon only stays tethered to the rate of inflation expectations only due to confidence that the Fed/master will operate in the interest of sound moeny and prevent inflation from rising too far. In this example, it is predicated on the dog feeling/knowing its master won’t ask it to walk in front of a train. The Fed is conducting a real time experiment, As such the Fed has exposed itself to second guessing by the bond vigilante and could lose the market’s confidence thru a policy misstep. It is strongly implied that the Fed leash won’t fail, but I have to surmise that it could take a very high price relative to realized inflation for the Fed to restore order to a market that has lost confidence in policy direction. I don’t mean to guaranty that this will happen, but merely point out that this a fat tail risk that is seemingly ignored by the monetary realism school of thought.

  31. I think he might be referring to the way rates are set. The Fed just issues reserves. You obviously understand this as you’ve explained it 1 million times in QE operations.

    I’d add that he does have one other thing wrong though. The Fed doesn’t act as the agent of the Treasury. The Fed acts as the agent for the banks supply reserves where required and hitting interest rates as needed to support the banking systme.

  32. Sorry. I should be more explicit. The Fed sets a target rate by announcing it. This is usually enough to keep the rate in a target range since bond traders know you don’t fight the fed. But the NY Fed does do some clean-up on occasion by buying and selling to help keep the rates tightened up. As you know, the fed has an infinite supply of reserves so the SOMA desk can just go in and pick up whatever is necessary to set the rates where they desire.

    So, for instance, if the fed wanted to set the long-term treasury at 1% they’d actually go in an announce the rate. The rate would immediately collapse as the market would front-run the action. But then the NY Fed would likely have commands to buy up certain amounts to keep the rate where the fed wants. It’s Bruce Lee. “Willing is not enough, you must do.” The Fed has to SET the long rate explicitly unlike what they’re doing now via QE. Then the SOMA desk cleans up the residual idiots who bids against the Fed. Slam a few bond traders around, take out the trash and call it a day. But you don’t fight Bruce Lee because he’s got an infinite supply of kick your ass. Just like the fed with their monopoly on reserves.

  33. I hereby propose that we rename “fractional reserve banking” to “fractal reserve banking”. There is always more reserves.

  34. Fractal. Does that make sense? A fractal is a smaller piece representing the whole. I guess that kind of describes modern banking, huh? The destructive connection is this idea that banks multiply or leverage reserves. We need to get rid of that terminology….

    You’re good at coming up with names here so I trust your opinion. I already stole “recirculates” to explain govt spending. :-)

  35. ha. I like the analogies. You cleared up a point of confusion for me…. that the Fed just announces it’s target and the bond market goes there on their own, i.e. front runs. And then in case any idiot wants to try to fight the Fed, the NY Fed then steps in and sets them straight.


  36. Well, erm, we’re practically guaranteed falling rates the way I see it. Not month to month but definitely decade to decade.

    Our economy only functions because we inject new money into it. FRED says something like $14tn in household debt at last count.

    Try to raise interest rates in this situation and the economy tanks. Sure if we start seeing inflation for whatever reason they’ll raise the rates a little, and the economy will cool RIGHT off again.

    This debt-to-income ratio has been rising since forever. Could it change? Possibly. I don’t think it will. Lower rates means you can tolerate bigger house loans than last time. And again, ad nauseum. And the rates keep dropping.

    See hourly wages vs house prices: http://research.stlouisfed.org/fred2/graph/?g=cKZ

    Or disposable income vs debt:

  37. To answer your final question: Is it very robust? No, I don’t think it is. We might be able to stay with debt shooting up a bit further with rates dropping but it does seem like it needs to grind to a screeching halt at some point..? Or will banks end up being happy with 0.5% spreads because the sums involved are ridiculously huge?

  38. I still think private monopoly on money creation is wrong. With money exiting the economy, new money needs to be injected to compensate (or pay the price in ongoing recessions). And long-term it just looks untenable to me to do ALL of that via debt. Some? Yeah. All? No.

    Granted I like it a lot better than the nonstop roller coaster ride that is gold standard or any other fixed money supply system.

  39. Why do you think the secondary market matters? If no one wants to buy from the primary dealers, the banks go reserve starved and Fed to the rescue with QE, swapping bonds for USD.

    Unless I’ve totally misunderstood something.

    Does it smell like monetizing the debt? Sure does! Problem? =)

  40. Technically, it’s an oligopoly (sorry to be a stickler for the details!). And I too have my concerns about private competitive bankers having so much control. But I am not sure what the alternative is? Any thoughts on how to create a better system?

  41. Cullen, when you deal with Treasury direct your inside money is not used for anything. It is just debited by the bank which is debited reserves. The Treasury doesn’t get the same inside money to spend, it gets a number typed in by the Fed, which then allows it to instruct the Fed to increase someone else’s reserve account and at the same time order the bank to create inside money out of nothing. It is important to know (and you know this) that the fact that the Fed changes numbers in the Treasury’s account is irrelevant, it is just a design that people who don’t understand how state money operates imposed on ourselves. It means nothing. In each case the inside money is created and destroyed, not transferred anywhere, just like you don’ transfer numbers in Excel, you erase them and type them in. Maybe this is the MMT framework, it is the correct framework. Imposed constraints are just that, imposed. They don’t help you understand anything, you can lift them at any time.

  42. Sorry, but this is just completely and factually incorrect. Let’s use taxation since it eliminates all the meaningless reserve accounting that MMT trumpets as being so important (which it isn’t). When the govt taxes you they are moving resources from the private sector to the public domain. Society is choosing to use inside money for public purpose. There is no money destruction in this process. There is no money creation in this process (contrary to the claims of MMT). There is only recirculation. The govt takes from Peter to give to Paul. That’s really how it works. Our monetary system is designed so that the govt must be able to procure funds from its citizens. Even in the most authoritarian regime, a govt that cannot procure funds from the private sector is defunct. So it’s meaningless to claim that taxes don’t fund spending just because there is some mythical world where the govt just creates money for its own uses. In the real world, and in the factual accounting world, when the govt taxes us they debit pvt accounts, credit govt accounts and then debit govt accounts and credit someone else’s private account. That’s really how the accounting works. That’s really how the govt moves resources. It doesn’t just change numbers in a computer system.

    I know that MMT doesn’t like the fact that the govt has CHOSEN to outsource the creation of money, but that’s really how the system works. We have a system by the banks and for the banks designed around private competitive banking. You can dislike it, but you can’t refute it no matter how badly you try to. The idea that we have a state money system is just not a correct representation of the system. And as a result, MMT describes not the system we have, but an alternative one in which money is created by the govt and not by the banks.

    MMT has taken the interbank market and tries to apply some special significance to it as though it is the equivalent of a nationalized banking system. It’s a total manipulation of the way the system actually works!

  43. Helicopter money into every citizen’s account? =) I’d say monetize the debt but then the conservative enclave would cry out against the establishment. The same money to everyone might be more palatable.

    Long term I think something like Kelso’s Binary Economics; the aggregate productivity benefits from the past half century just has to reach more people somehow. But I also see the same sort of cry-outs against allowing Joe Worker the same kind of access to greenbacks that some take for granted belonging only to themselves.

  44. I’m trying to point that out in the comments of both his bond vigilante articles. Maybe I should mail him instead.

  45. Nah it doesn’t necessarily make sense but I almost typoed it that way in another comment and thought it was funny :P

  46. “infinite reserve banking” makes more sense but also looks silly. Sorry, I’m tired ;)

  47. Whatever-The-Fed-Is-Saying Reserve Banking
    WTF-IS-RB for short.

    (I literally thought of that as my head hit the pillow. Back to bed. Pardon my humor, it deteriorates into the wee hours.)

  48. How does the inner workings of our monetary system differ from China’s? As I understand it, all of China’s banks are government owned or controlled, and they lend on command. Apart from the existence of “shadow banking” in China(?), this would mean China’s system more closely approximates pure MMT.

  49. Yeah, but what if the Fed wants to raise rates, and it doesn’t have enough short term T-bills to sell. I know it can raise IOR, but that could prove to be very expensive. Can the Fed simply print the money it needs to pay IOR, or does it legally have to “earn” it from interest on Treasury Bonds? Take a concrete example: Suppose inflation started to take off like a rocket, and the Fed wanted to raise rates to 5% from the current 0% level to nip it in the bud. There is $2 trillion in reserves. A 5% IOR would cost the Fed $100B/year. The long term bonds in the Fed’s portfolio don’t produce that kind of interest, as they earn 1-2%. And if the Fed sold its long term T-bonds and MBS, it would take a massive capital loss, which could be a political problem – especially as long as the Federal Gov’t still retains a legal debt ceiling. So, what does the Fed do in this situation?

  50. Yeah, no issue there. The Fed just credits accounts. It’s ultimately a cost of the US govt as the Fed passes all net profits to the Tsy.

  51. Hangemhi: You can’t tear up the Chinese T-bonds for the same reason oil costs the same whether it’s drilled in Saudi Arabia or Texas. It’s a global market.

    Politics revolves around handing out goodies and sharing resources. Tell me a time when the economy was booming when the various interest groups didn’t want something — tax cuts, cost of living increases, projects.

  52. Well, we differ on inflation. I see real price inflation as closer to 5 percent, whn you count energy and health care and education) while wages are stagnating.
    I see debt growing faster than the production.
    I’ve lived through inflation and recession at the same time, although you’ve said that can’t happen again.
    Lastly, even if the economy does start growing like gangbusters again, deficits can’t fall, simply because the entitlement spending is going through the roof.

  53. JE, it’s hard to discuss these issues when you just make things up.

    1) I never said inflation and recession can’t happen at the same time.
    2) Deficits fall during a recovery primarily due to autmatic stabilizers as spending grows at a slower rate than tax receipts. Check just about any recovery. This is just a fact of economic recovery….

  54. It could be a major political problem if the Fed’s losses push the Gov’t over its debt limit and cause ferocious debate in Congress. Perhaps even bringing up the i-word for the Fed Chairman (impeachment) Bernanke might want to get out of dodge before the Fed has to do something that requires it to take net losses instead of producing profits.

  55. I have heard the US Government will, along with our G20 countries, be shifting to a new gold standard. Any truth to this?

  56. Cullen,

    Just to be clear up front… this comment isn’t meant to endorse the MMT view of monetary operations over the MR description. With that said…

    I think whether or not we call it creating and destroying money is a fair conception. When you say recirculate, that sounds like commodity-money… as if money is “something” (tangible) that actually can be circulated. It’s not really accurate to say that something invisible circulates (or recirculates). Only tangible things do that.

    Mosler makes this point often and I think it makes sense….

    Since money isn’t anything “real” (tangible), it’s a fair conception to refer to money being created and destroyed when numbers go up and numbers go down.

    The same is true for banks when Loans Create Depots… money is being created. Right?

    Is your disagreement (on the wording here, not on monetary operations)… just a matter of conception?

  57. “as if money is “something” (tangible) that actually can be circulated. It’s not really accurate to say that something invisible circulates (or recirculates). Only tangible things do that.”

    JK, that’s just absolutely false and you should know it is. Talk to any physicist if invisible things circulate. Regardless, if I transfer money from bank account 1 to bank account 2 it doesn’t mean the money is not circulating just because it’s not something tangible. By this logic you could recreate the creation of money at any point in a debit/credit process (which is essentially what MMT does).

    The bottom line is, the description of destruction and creation to meet some govt centric view of the world is wrong. It misleads people on the way the system works and where money starts and ends in our system. The MMT description incorrectly starts with the govt and ends with the govt. It’s not accurate.

    My disagreement is about myth vs reality. It has nothing to do with slightly differing views of the concepts. The MMT concept is just wrong. The govt is not the center of the monetary universe and MMT is wrong to teach that it is.

    But I am tired of talking about MMT here. I don’t care about MMT and I am tired of having the same old debates that were settled many months ago. You guys have your view of the world. We have ours. No problems there. You teach your views and I’ll teach my view. I don’t attack MMT and I have no intention of attacking MMT. But you guys are relentless in your commentary here in my comments section. And you’re hurting MMT in doing so because my viewership dwarfs MMT blogs. Why do you do this? You should just save yourself the time and effort and fight these battles on blogs who actually have a beef with you.

  58. There you go lumping me into the MMT bunch, i.e. the people who are wrong :) … I’m actually more convinced by your understanding of the process than by the MMT explanation. BUT… I mean this when I say it… I don’t endorse what you or MMT says 100% and without reservation. If I think either may not be entirely correct, I’m going to question it. I’m surprised you’d look down upon me doing this.

    When I was talking about conception, I wasn’t talking about the MMT state centered view. I believe your description is seems correct But, that doesn’t mean I don’t think MMT has aspects correct. One of those aspects, it seem to me, is the idea of money being created and destroyed when numbers go up and go down in bank accounts. This is a conception of a process, and it can be true or not true for a state-centered view or for a private sector banking view. In this sense, this point is outside of the MMT-MR disagreements.

    I don’t claim to be correct. I’m expressing my understanding as it currently is. It’s a learning process. Again, please view my comments as not defending MMT, but searching for clarity.

    Can you tell me something invisible that circulates? Bear in mind when I say invisible, I don’t mean things that are naked to the human eye. I mean things that are not tangible. You brought up physics so let me be more specific… things that have mass can circulate and “move” or transfer from here to there.

    How is numbers going down in one place, and the numbers going up in another place… circulation? To me, that sounds more like creation and destruction.

  59. I would be interested to hear you thoughts on the ongoing deleveraging in the shadow banking system. You’ve said inflation won’t rise significantly because of excess capacity…. but I believe that there is a significant stagflation scenario you may not have explored completely.

    I’ve been reading the NY Fed’s (Pozsar)own analysis of shadow banking deleveraging phenomena. The Fed’s flow of funds report show that shadow banking liabilities have been negative each qtr since Sep 2008. As of the Jun 2012 report, however, shadow banking liabilities are equal to traditional banking liabilities for the first time since Mar 1996 (birthdate of the credit default swap, tri-party repo and a subsequent surge in shadow banking credit).

    If I understand it correctly, the duration of the Fed’s balance sheet is currently 4.25 years for $3 trln. Absent an exit strategy, the Fed will monetize the current balance sheet plus another $2 trln in the next 24 months within 3.65 years assuming the current QE pace is sustained. Duration on total issuance will shorten to about 3.65 years within 24 months.

    As the debt monetizes it will be “moved” into traditional banking liabilities where it can be spent on real goods. While this liquidity/cash is in the shadow banking system it is in the shadow banking system and has been funneled into financial assets but not into real goods.

    Should this occur as it appears likely, wouldn’t the introduction of $3.0 trln-$5.0 trln in cash into traditional banking channels be highly (not hyper) inflationary, or at least create a significantly adverse stagflation scenario? The Pozsar charts show now sign of shadow banking credit reflating in the foreseeable future(the rate of change in deleveraging hasn’t slowed yet, it is quite consisent). If shadow banking credit resumes growing then excess capacity would be eaten up quickly and everyone would assume the Fed would quickly move to a tightening bias. But what if shadow banks continues to delever another 3-5 years at the current pace…then what?

    My thesis is that shadow banking credit can contract quite a bit further in the next five years while the Fed eventually prints a substantial amount of cash to offset this deleveraging, plus some measure of fiscal tightening (higher taxes, reduced deductions etc). This seems to me that it is a recipe for additional economic stagnation for some time, i.e. capacity utilization would not likely rise but a large surge in currency in circulation could significantly worsen commodity inflation.

    With the FOMC willing to tolerate higher inflation until the unemployment rate displays sustained improvement, could this not create some sort of debt trap in a backdrop of stagflation and a significant loss in confidence in the coupon curve? This would meet my definition of a bit of a debt trap. Yields could gradually rise a several hundred bp despite a muddling economy, equities would lose their yield advantage over fixed income and could be vulnerable to rising yields. Rising long term interest rates would be expensive for the Fed and the economy, prompting more Fed intervention/monetization, etc. It could erode into a negative feedback loop over the course of a few qtrs? I’m guessing but I suspect the Fed’s entire balance sheet would be underwater if the 10yr rose to merely 3.25%.

    Maybe not likely yet, but possible , sure. Again, would be interested in your thoughts on the subject.

  60. JK,

    You’re a really nice guy and I love how inquisitive and open-minded you are. Trust me, I am not here to argue with you, demean or look down at you. But I also know you’re a UMKC student who has strong loyalties to MMT. That’s fine. I have no issue there. I am not here to convert people into Cullen Roche followers. All I do is try to explain how things work as best I can. And if a whole bunch of people end up learning something or agreeing with me then I think I’ve moved the ball forward a bit. That’s all I do here. What I don’t understand is the endless stream of MMT people coming here to argue with me about posts that have literally NOTHING to do with MMT. I mean, it’s literally been a year since I stopped using MMT in my work.

    The last thing I am going to do is continue these silly MMT debates and whether something can be “transferred” without tangible exchanges (as if nothing in the world, like the words on the internet or the words spoken into your ears are transferred to your brain unless someone physically delivers them there!). In my opinion, MMT has a real problem with vague metaphors and misleading terminology. I just don’t have the time or energy to deal with MMT any longer.

    Take care.


  61. That’s fair. I think fleshing which conception is more accurate and useful is a good exercise. That’s what I was looking to do. But I respect that you’ve decided circulation is more appropriate and are not interested in debating it.

    And yes, I’m a UMKC student and I definitely do have an affinity toward MMT and what they are doing. At the same time, and more importantly, I’m interested in accuracy and truth. I never come on to your websites and belittle people or tell them they are wrong if they disagree with MMT. I could care less who’s right and who’s wrong. I just want to get it right. I hope you’ll continue to engage my inquires. I’ll do my best to not mention MMT or bring into my comments and questions MMT perspectives.

    As always, I appreciate the time and responses. Thanks.

  62. The banks are NOT resource constrained. Household deleveraging is something they (we) do on our own. Money moving from shadow banking to regular banking does not affect the day-to-day economy.

    The only decision process behind bank lending is “do we think that this person will be able to afford this loan?”.

    Stagflation involves prices and wages rising in tandem. This is unlikely given the current levels of unemployment, the weakness of US unions (yes, really), and the general unwillingness to raise wages (no competition for employees while unemployment holds).

    You also talk about fiscal tightening somehow leading to inflation and that makes no sense whatsoever. Increasing taxes, reducing payouts, or reducing the deficit, all shrinks the economy.

    Yes, printing free money for consumers can lead to inflation IF demand starts exceeding supply, that’s true. But the Fed doesn’t do that. It prints money for bank reserves, and they do not reach the public with anything less than debt creation, and that isn’t wildly on the increase. And also keep in mind the output gap – there is currently MUCH more supply than there is demand. Go count empty parking spots in front of a Home Depot. Or rather, count occupied spots – they’re much fewer.

    If you talk about inflation in a particular asset that’s another matter entirely and I’m not right person to answer that.

  63. Small nit: I’m not so sure MR says anything at all about bond vigilantes really. And the way I see it “Cullen’s opinions” doesn’t equate “the MR school of thought”. Possibly “the pragcap.com school of thought” ;)

  64. 1. Whenever anybody mentions inflation, you generally say that with inflation comes growth. So perhaps I am overstating.
    2. Not this time. The entitlement spending track is too steep and outside the regular budget process.

  65. I said nothing about fiscal tightening causing inflation or anything about household deleveraging. Rather, I discussed the Fed printing money to offset the effects of shadow banking deleveraging and fiscal tightening.

    With regard to the output gap, I don’t believe that this is uniform thruoughout the economy. Some sectors will continue to experience deflationary pressure for the reasons you cited, but also from allowed malinvestment(manufacturing and financial services for example) because government policy hasn’t allowed bad investments to fail. Other under -invested sectors such as commodity production or potentially infrastructure could experience significant capacity constraint, thus inflation.

  66. To elaborate further, I’m talking about bubbles in the some sectors of the economy being blown while other sectors can contract. Why did housing prices surge and collapse in the last decade? Why didn’t manufacturing participate to the same degree? I would argue that credit was too easy and there was an overzealous hunt for lending yield.Isn’t the current monetary policy at risk for some of the same risks going forward if traditional banking liabilities are awash with idling capital?

  67. Now I see why you agree with nothing Cullen says – you refuse to consider any argument. The price of oil and the decision to tax or fine someone have nothing to do with each other. And not accepting that there is FAR FAR FAR less pressure to spend during boom times??? Come on. You even deny Cullen’s statement below that automatic stabilizer spending goes down in boom times. That’s the end of my chat with you. There’s simply no point when you stick your fingers in your ears

  68. 1) Limit private credit extension primarily to support business expansion/innovation/production.

    2) Support household saving (including inter-generational) to provide for housing, education, and needs related to health. (Eliminating easy credit, to support consumption, goes a long way to reverse the CAD and associated negative effects, and in general, to contain bubbles/boom-and-bust cycles.)

    3) Along with basic universal health care coverage, support housing and education for the disadvantaged/lacking in family resources by providing access to federal government loans, strictly on the basis of need.

    Obviously achieving these goals would be a challenge, but without a clear vision of what a just, equitable, and free society should be, progress towards these ends will be limited at best.

  69. Racists in the south had too much control 70 years ago.

    There are useful parallels in the Norwegian countries in the last 20 or so years.

  70. I might misunderstand this graph, but does it account for the HOUSEHOLD income? Seems a whole lot of women have entered the workforce since 1985, some of them at pretty good wages.

  71. Rebased to 1995: http://research.stlouisfed.org/fred2/graph/?g=cOH

    FRED Graph lets you play with these values yourself – it’s an awesome tool.

    I also see that I screwed up my link to the disposable income vs debt graph, and no edit button, so here it goes again:


    This measure does not misweigh household formations as it’s pure income vs total debt. However the income measure includes the top few % so it’s skewed upwards like heck.

  72. The health care bit is only a problem in the USA. The rest of the modern world has it. But we have the same economic problems.

    Not that I’m not saying it’s time for the USA to get on the bandwagon on health care. I think it is.

  73. There was indeed too much easy credit. But the fact that the everyday economy kept flourishing suggests that we could do with a heck of a lot more money NOT created through debt. But money entering the real economy, not money entering bank reserves.

    Heck, the US federal govt has injected $16tn into the economy now. Hyperinflation? Nope.

    Can ginormous bank reserves coupled with bonds & MBSes disappearing into the Fed’s balance sheet have potential bad effects in the financial world with related assets, going forward? Possibly. I won’t argue with that – not my area.

    I just see the financial sector and the rest as two fairly individual systems. There’s mechanisms connecting them yes, but the circulation is quite different.

  74. And thanks for clearing it up. I read general inflation and it wasn’t making sense.

  75. Can you give some data/charts regarding the entitlement trajectory?

    I’m sure I could google my dumb little heart out, but something more specific regarding your point here would be helpful.

  76. Something everyone should read before they come up with ideas for how the banking system should be structured and operated.


    As for what the banking system should be.

    1. Keep the FED, rename it to the Central Clearing System; Eliminate Monetary policy from the FED.
    2. Regulators need to be part of the government, with strict rules on revolving door between Regulator and those that Regulate. Add bonus structure to Regulators pay to incent them to find Malefactors, Fraud, abuse and any circumvention of law / policy
    3. US Treasury in control of the money supply, UST creates all money as US Dollars (NOT Federal Reserve Notes), all debt free instruments. Thereby eliminate the US Bond market as any required system for determining the Money Supply.
    NOTE: Get US BOND market, FED and PD out of the way of private sector bonds, market driven interest rates and Restore Market Signals that can be trusted (and Verified).
    4. Create a multi-faceted, multi-discipline accountability board, with member rotation (no entrenched incumbency) as an oversight / regulatory board to oversee the amount of Money that the UST creates (and congress spends) into existence. There would ONLY be ONE mandate – Keep inflation / deflation in check — try to keep at 0% with the foundational premise that NEITHER inflation or deflation is a good thing.
    5. Ensure DOJ enforces the law, no more Eric “Hold-on” Holder lack of leadership…. Better yet, the Enforcement of the Monetary / Money System / Banking should fall under a Checks-and-Balances
    oversight — NOT JUST ONE AGENCY.
    6. Private Banking system, eliminate Fractional Reserve Banking; or a Strictly Enforced Bankruptcy driven policy such that if a bank over extends (leverages) the Balance Sheet, then the investors and management of the Private Bank will suffer first in the event of Bankruptcy (then any Insurance e.g. FDIC kicks in) … no more free ride from the Money Changers and NO MORE MORAL HAZARD !!

  77. perhaps you can expand a little on “…likely be a disaster” AND propose a solution.

  78. Wray actually covers a number of scenarios for how the government procures real assets in his new book. It’s a worthwhile read.

  79. You know this isn’t an MMT website. I don’t know why MMTers insist on promoting their views and linking to MMT sites here. Sorry if you disagree with my views, but MMT has their own platforms for promotion. Spamming popular websites with MMT links is just that – spam.