Does the Money Supply Increase When the Fed Buys Bonds?

I keep getting this question over and over again so I think it’s time I address it more directly.  First, let’s begin by understanding what I mean when I say “money”.  When I refer to “money” I am referring to the most widely accepted media of exchange – primarily currency and bank deposits.  It’s true that almost anything in the world can serve as “money”, but as it pertains to our every day lives it is bank deposits and currency that function primarily as money for purposes of transaction.

I won’t get into what gives this “money” value, but I do think it’s important to distinctly differentiate the primary types of money that exist in our monetary system.  “Inside money” is the dominant form of money.  It is created “inside” the private sector in the form of bank deposits through loan issuance.  “Outside money” is a facilitating form of money.  It is created “outside” the private sector and exists in the form of cash, coins and bank reserves.

Inside money is created through the issuance of loans.  And banks create these loans without having to multiply their reserves or check with the government first.  Contrary to popular opinion, the money multiplier is a myth.  The way banks create money is quite simple.  When creditworthy customers walk in their doors they issue loans which create deposits and find bank reserves (as required) later.  Banks are not constrained by their reserve balances as many neoclassical economists believe.  In this form, banks rule the monetary roost by controlling the most widely distributed form of money in our monetary system.  In essence, the government has privatized the money supply in what is really a market based system controlled by an oligopoly of banks who compete for loans.

Outside money is created outside the private sector.  This includes cash, coins and bank reserves.  Cash and coin distribution is maintained by the Federal Reserve who acts as an intermediary for the US government.  The actual cash and coins are created by the US Bureau of Engraving and the US Mint, branches of the US Treasury.  Bank reserves are deposits held on reserve at the Federal Reserve banks.  All member banks in the Fed system are required to maintain a percentage of deposits on hold at the Fed.  This system allows the banks to settle interbank payments in a way that is overseen and organized by a third party (the Fed).  You can think of this as an exclusive banking system where only banks can transact.  You and I cannot use bank reserves.  This is the “money” that banks deal in when settling transactions among one another.  Think of it like a nationalized banking system (as if there is one bank) without actually having to nationalize the banks (in other words, the interbank system brings settlement between different banks into one place, but maintains the market based competitive system in the private banking system).

So what happens when the Fed uses “outside money” to purchase bonds?   Like any bank, the Fed can create money “from thin air”.  This is how it creates reserve balances to transact monetary policy.  It has always done this.  For instance, in 2006 reserve balances increased by $50B at member banks as the Fed implemented policy, but no one complained about “money printing” and “debt monetization” back then.  In other words, this is ALWAYS how the Fed implements policy.  But QE has caused a great deal of confusion, thanks in large part to the neoclassical confusion regarding the definition of the “money supply”.

When the Fed purchases bonds they are simply changing the composition of the bank balance sheets.  Lets look at a simple breakdown here showing the bank balance sheet before and after QE:

It’s important to note that the net financial assets of the bank are exactly the same after QE as they were before.  In other words, the bank has experienced no change in its balance sheet except the composition.  We know that banks don’t lend their reserves so this policy is unlikely to have a material impact on the primary form of money – inside money.  There is much debate about some of the more nuanced points here (like QE’s impact on interest rates and bank recapitalization), but I don’t have the time nor the space to get into those details here.  The message I am trying to convey clearly is that the transmission mechanism via QE to increase the money supply is much weaker than most presume.

If we want to get very technical we would have to add that outside money in the system has increased.  Ie, since bank reserves increase the money supply that neoclassicals focus on (such as M1) has been altered substantially.  Assuming non-banks have been divested of a deposit, the supply of inside money has increased, however, the amount of net financial assets remains unchanged.  Hence, the reason why monetary policy appears to be so broken.  If they use that deposit to pay down debt then money has been destroyed.  In an environment where demand for credit is weak, the Fed’s policies simply cannot effectively and directly increase the money supply that matters to the everyday economy.

* See here for more on the actual workings of our monetary system.  

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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  • SS

    A bit oversimplified, but another very good piece on the basics. Thanks, Cullen.

  • Johnny Evers

    In your example, you’ve taken $40 billion out of the economy. The T-bond, while it not be money according to your defintion, has the potential to be ‘spent’ into the economy — either the bond holder exchanges it with a saver and spends the money, or, potentially, the Fed must redeem the bond (if no saver emerges).
    It’s worth noting that either result would be good, as it would get money circulating.

    You have made the point that deficit spending creates a net financial asset — a bond. But you are making the assumption that this bond will never be spent, merely held. That seems like a speculative assumption. We do not save merely as an end in itself, but as a means to spend later.

    It’s interesting in your argument that Q2 increases reserve, which in your description is money that does not enter the real economy. But wouldn’t the Fed want to decrease reserves if it wasn’t worried about inflation but wanted to generate economic activity.

  • Gary-UK

    As always, what is not mentioned is that commercial banks only create CREDIT money, which can (and often does go bad), or otherwise needs to be repaid by the borrower.

    The Fed of course creates new BASE money, which is permanent, never to go away, and every dollar is intrinsically backed by the promise to print an actual dollar (when the time comes the printer will be on overload).

    Funny how this point is ALWAYS omitted in Cullen’s analysis isn’t it, a gap in his understanding, or just a bit inconvenient to explain the implications of the differences (i.e. monetary base increases, higher prices, collapse in dollar confidence).

  • http://www.orcamgroup.com Cullen Roche

    Bonds are securities. People don’t use securities to transact. You exchange securities for money to transact. You can’t spend the t-bond at a Wal-Mart. It is a security.

  • http://www.orcamgroup.com Cullen Roche

    Gary, the whole article emphasizes credit money or inside money.

    And yes, the Fed can decrease the size of its balance sheet. It’s not necessarily permanent. Excess reserves could decline as the Fed sells the bonds or allows them to mature and lets the Treasury reissue. I’ve never ignored that. You just don’t read my articles very closely. :-)

  • Mark

    I’m not an expert but I would think that banks would be very hesitant to sell their treasury bonds to the Federal Reserve and just leave the cash on the books doing nothing. Maybe they wouldn’t go out and make long term mortgage commitments with these reserves but they would not let them sit there idle. When the Fed did QE II you saw a jump in commodity markets which I believe was a result of banks funneling some of this money to hedge funds etc.,

  • Johnny Evers

    Fine, you’ve reduced the number of NFA that can be spent.
    If I have a T-bond, I can very easily transform into into cash and take it to Wal-mart.
    In contrast, reserves can never get into the economy, you state.
    Now T-bonds can be exchanged for cash and go from one hand to another, but at some point it matures and the Fed must redeem it. What happens to your theories if you conceded even a 1 pct chance of this happening?

  • http://www.orcamgroup.com Cullen Roche

    Avg treasury duration is 0.7%. reserve yield 0.25%. It’s not a huge loss. But it’s not nothing. More importantly, the banks don’t really have a choice in the matter. When the fed says sell the Primary Dealers say “how much?”…

  • But What Do I Know?

    Thanks, Cullen–for some reason this makes sense to me when I didn’t get your point about inside and outside money all those other times. Maybe I’ve been bludgeoned into submission, but I think I’m starting to get it.

  • But What Do I Know?

    On the other hand, doesn’t the fact that the Fed is lowering long rates by buying up some many Treasuries increase the money supply (by making borrowing more attractive–at least in theory)? The Fed may be indirectly increasing the money supply in this way–by altering the price of money.

  • http://www.orcamgroup.com Cullen Roche

    Right, but demand for credit is still in the dumps. So, despite the lower rates the demand for credit hasn’t really picked up all that much. Some segments like business lending have picked up, but household credit (the biggest chunk) is still in the dumps:

    http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=CMDEBT&scale=Left&range=Max&cosd=1949-10-01&coed=2012-07-01&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Quarterly%2C+End+of+Period&fam=avg&fgst=lin&transformation=pc1&vintage_date=2012-12-17&revision_date=2012-12-17

  • Alex Gloy

    Cullen, do you agree with the “deficit owl” Stephanie Kelton?
    Furthermore: why would grown men (Fed) go for all this QE stuff if it didn’t do anything? Getting yields down could be done much easier by simply stating the Fed would buy any Treasuries yielding more than, say, 2%. Wouldn’t require 1 trillion per year.
    Finally, wasn’t it you who wrote that it is the government that “spends” money into existence? So isn’t then the Fed in cahoots with the government in helping to do so?
    Tx.

  • http://www.avondaleam.com/ Scott Krisiloff

    If banks are required to hold a certain percentage of their deposits on reserve at the Fed, would you agree that they are reserve constrained in a normalized environment?

    Also, just clarifying, does MR contend that bank lending creates all deposits?

  • http://www.orcamgroup.com Cullen Roche

    Kelton is MMT. It’s a good description of the monetary system, but I think it’s off on some points. MR is largely an extension of our disagreements with MMT over the years. The biggest difference is that MMT describes the govt as the monopoly supplier of money to the system and builds a very govt centric view of the monetary system. MR starts with the banking system and describes the govt as a facilitating feature. See my MMT critique for more.

    http://pragcap.com/mmt-critique

  • tbill

    The Fed’s QE and monetary operations don’t create net financial assets, but federal government deficit spending does. The Fed is an enabler of deficit spending. Creating new net financial assets distorts and influences future distributions of wealth to some degree (degree depends on the deficit size).

    So let’s not act like deficits and monetization don’t matter, but let’s not freak out about them sending us back into the dark ages either.

  • http://www.orcamgroup.com Cullen Roche

    No, this is a very important point. Bond buying is done on the primary market and funded entirely by the Primary Dealers who are required to make a market in govt bonds. They then on-sell their inventory on the secondary market (as they always do). The Fed is not enabling them to buy more bonds because they’re required to buy the bonds anyhow. This was the mistake many investors made when QE2 ended and they assumed yields would rise due to a lack of demand. That was wrong because the demand for bond auctions is there by mandate whether the Fed buys the bonds on the secondary market or not.

  • http://www.orcamgroup.com Cullen Roche

    Lending, by definition, creates deposits.

    Even in normal times, capital constrains bank lending. Reserves are an asset of the bank. But it’s wrong to assume that banks multiply their reserves. In any environment….

  • krb

    Cullen,

    Thanks for the clear description. It leads to a few questions…..

    1. Your description seems to remove the distinction between inside- and outside-money reserves…..and an acknowledgement that total reserve levels, as your example defines them, are at least partially under the control of the private bank…for example…if outside money reserves at fed goes up for an individual bank the inside money reserves set aside for loan losses or asset impairment can be reduced?

    2. By not addressing the impact on capital ratios, aren’t you sidestepping a very key breakthrough in thinking that Scott K raised in last week’s discussion? That dynamic may be THE key to understanding why Bernanke is pursing this strategy when it otherwise appears there would be no transmission mechanism for affecting the wider economy.

    3. Your example treats PD-Fed transactions as all done at par. This may be another gap between theory and reality, or what benefit the fed is actually providing the banks….especially when considering the mark-to-fantasy MBS are now within the scope of policy and when longer dated issuance now has greater interest rate risk with rates at generational lows. If their balance sheet assets had to again be marked to reality (what a novel concept!!), wouldn’t their capital ratios persistently be under pressure?

    4. Lastly, doesn’t your clear description of nothing but at-par transactions undermine the argument that “there is no monetization going on”, or at least “practical”/”effective” monetization? If the PDs had to on-sell their inventories to other banks or businesses there would be the persistent capital-ratio and interest-rate-risk pressure that the sellers and buyers would be quarreling with? Having virtually all longer dated issuance end up on the fed’s balance sheet helps remove that market-driven concern……going to such extremes to avoid using the “m” word seems silly…especially after reviewing your picture of the PD-pass-through role inherent in: 1)PD balance sheet stasis, and 2)all long dated issuance ending up on fed balance sheet.

    Thx, krb

  • Geoff

    Lol, Johnny, so you now think that QE is deflationary?? Actually you may be right, but not for the reason you think. To the extent that QE reduces interest rates, thus reducing the govt deficit, it is indeed deflationary.

  • Ray

    Cullen,

    The Swiss have for 18 months been buying foreign bonds to weaken their currency & boost inflation, and now the Japanese appear to be buy foreign bonds to weaken their currency and boost inflation, they appear to being doing via central bank balance sheet expansion. Both these countries have very low interest rates, why does the fed not pursue a similiar policy to Japan and the Swiss and try and weaken its currency to boost exports and inflation ?

    Any help incites you can provide would be great?

    Down here in NZ we appear to be wearing this currency war due to our high real interest rates.

    Tks

    Ray

  • http://www.orcamgroup.com Cullen Roche

    1. Bank reserves are always outside money. There is no “inside money reserves”.

    2. Capital ratios matter. But the fed has been buying mostly high quality paper. They cannot buy anything of low grade because they’re not legally allowed to. So I wouldn’t emphasize this point on quality too much. Plus, I’d say this has a much bigger impact in an environment in 2008 than it does in 2010 or 2012.

    3 & 4. The Fed buys at market prices. It’s a myth that the fed is buying assets well outside of the range of market prices. http://pragcap.com/is-the-fed-overpaying-for-bonds

  • Johnny Evers

    Hi, Geoff. I’m just trying to understand what is happening. Inflation is a loaded terms in here so I want to stay away from that.
    But yes, in Cullen’s example, we have taken a Net Financial Asset out of the system, so that would technically be deflationary — but only if you assume that a T-bond is only an asset.
    A T-bond is a Net Financial Debit, too.

  • http://www.orcamgroup.com Cullen Roche

    No, QE does not remove net financial assets. It is a swap. No change in NFA. You could say it’s deflationary if it reduces the budget deficit, but that’s not really going on in any substantive way.

  • http://www.avondaleam.com/ Scott Krisiloff

    Ok, but how has deposit growth exceeded loan growth over the last 4 years, and why is the systemic loan to deposit ratio at a multi-decade low? Should the systemic loan to deposit ratio always be 1:1 if lending is the only thing that creates deposits?

    In terms of the reserve requirement and multiplication of reserves, I’m not saying banks multiply their own reserves but would argue that in a normal environment the reserve requirement does put a check on systemic loan growth. It does set the maximum potential level of loans in the economy doesn’t it?

    –begin rant–

    I’m not sure the paradigm of believing that banks are able to create their own deposits out of thin air (while perhaps technically accurate in some sense) is necessarily the right one. In the real world banks fight each other for the right to a customer’s deposits. The funding source of a bank is its lifeblood. Good banks cultivate a stable low cost source of deposits. Bad banks purchase their deposits in the market as time deposits. The deposits facilitate the lending. I think that MR currently downplays this dynamic, correct me if I’m wrong.

  • Johnny Evers

    Accepting that the bank is in the same situation as far as NFA after QE, what about the Fed?
    It now has a gain in NFA, since it holds the T-bond.

  • JJTV

    It should also be noted there is a significant demand for treasury securities, to be used as collateral behind a contract, in tri-party repurchase agreements. The size of this market has been reduced since 2008 but as of Oct 2011 the current position was around $1.7 trillion. I think there is mis-information out there concerning “monetization” of the debt. i.e. primary dealers are purchasing securities only because the fed is buying them back. Understanding the role treasury securities play, amongst other vehicles, in short-term financing arrangements, let alone all other faucets, should be indicative of why primary dealers are always willing to buy securities, independent of Federal Reserve policy.

  • http://www.orcamgroup.com Cullen Roche

    It’s impossible for MR to “downplay” this. If you understand how banking works you understand that banking is a business of spreads. It’s about having cheaper liabilities than assets. You could say that banks fund their loans through deposits. But this doesn’t make them reserve constrained. It makes them capital constrained.

  • http://www.avondaleam.com/ Scott Krisiloff

    As I understand MR, the central thesis of the ideology is that banks have been given the outsourced right to create money via deposit creation. (please correct me if I have misrepresented MR)

    It would seem to me that this implies that the causal relationship in MR is that banks make loans, loans make deposits.

    The reason I’m saying that the importance of deposit aggregation is “downplayed” is that the real world causal relationship (based on conversations that I’ve had with practicing commercial bankers) is that banks gather deposits and make loans from those deposits. I think it’s a subtle but important difference.

    It’s the difference between viewing the banking system as a more passive distribution mechanism and as an outsourced quasi-governmental body. (It’s also the impetus for the question about a sub 100% loan to deposit ratio, which I’d be interested to hear your view on).

  • Geoff

    The T-bond is effectively taken out of circulation when the Fed buys it.

  • Johnny Evers

    And there you have it — monetizing.
    :)

  • LVG

    Loans create deposits. Banks make money on the spread between their assets and liabilities. Banks don’t lend out their deposits. They make a spread on their deposits relative to their loans.

  • LVG

    It’s monetization in the sense that it adds outside money to the system by turning a bond holding into bank reserves. But this doesn’t change the fact that the private sector’s money is unchanged. In other words, banks don’t use their reserve balances at Home Depot. So it’s not monetization in the sense that Zero Hedge and conspiracy theorists use the term.

  • Ricky

    What about QE3? The Fed is purchasing $40 billion each month in agency MBS’s, and will continue purchasing at least into 2015. At that rate $1 trillion dollars of inside money securities will be monetized.

  • Johnny Evers

    Thanks, LVG.
    I see an increase in the private sector’s holding.
    The bond holder gets his money back and the recipient of the defict spending still has the money he received.
    Don’t worry — not going to rant about inflaton. This is a very neat trick.

  • http://Avondaleam.com Scott Krisiloff

    Ok, I hear that dogmatically repeated here, but if you listen to bankers, that’s not the way that they talk about their businesses.

    Why do banks actively gather deposits if they can create them for themselves out of thin air? And how can the aggregate loan to deposit ratio be sub 100% if deposits are by necessity created by loans?

  • JK

    Scott,

    From what I understand, if you think of depositing cash into a bank account as a loan to the bank, which the bank will you pay a small amount of interest on, then the reason banks are interested in deposits is because they are the least expensive form of “borrowing” for them. Although banks can borrow in the interbank market, this would be more expensive than “borrowing” from new depositors.

    But I’m not describing this well I think because I’m not confident in how exactly this relates to Reserve requirements (if I’m even correct at all here).

    Cullen?

  • Anon

    LVG, Cullen, I do get where Scott is coming from…

    Thinking about this from an accounting perspective, if a bank makes a loan they create themselves an asset (the loan) and a liability (the deposit of the loan into the customer’s account at the bank). If that deposit is withdrawn, spent and ends up in another bank, the lending bank now has a mis-match in assets and liabilities.

    I think this is the heart of Scott’s issue. The bank does need to “fund” the loan by making its balance sheet balance – correct??? They need more liabilities – they could take on a deposit or something else. Back to your simple little table in the piece above, what’s their other options? How do they create more liabilities and “fund” the loan??

  • Pierce Inverarity

    Cullen, to be fair to Scott, I share in his confusion, and have for some time. I think we both understand the idea of interest margins. I worked at a bank and have analyzed them from a securities perspective. But when you introduce the notion of loans creating deposits (which, I believe is true…) it flies in the face of the big push for banks at the retail level to attract new deposits.

    The long of short of it is: why do banks attract deposits when they can just create their own via loans?

  • Pierce Inverarity

    That too.

  • Pierce Inverarity

    Ah, I think I have it. If Bank A creates Loan A/Deposit A and Deposit A goes over to Bank B, Bank A has to cover this transfer of capital somehow. It can either do it via Intrabank lending, Fed Funds, raising equity, finding new deposits, or marking down equity. Is that it?

  • http://www.orcamgroup.com Cullen Roche

    Deposits are just cheap liabilities. Banks don’t need your deposits. But they want them. Because if they don’t obtain deposits they have to fund loans through other more expensive forms of liabilities like money markets. This eats into their margins. This explanation from Scott Fullwiler is very good. You might want to review.

    http://www.nakedcapitalism.com/2012/04/scott-fullwiler-krugmans-flashing-neon-sign.html

  • Pierce Inverarity

    *Interbank, not Intra.

  • jt26

    @Scott Krisiloff
    Could the answer to your question be just accounting classification?
    For example, does “loan” really mean only personal, business, commercial and industrial loans, but not MBS (or other loans securitized)? Similarly deposits, may only be time deposits < 1year … etc. I don't know myself.

    Intersting from google … seesm to vary a lot …
    http://www.economicsfanatic.com/2012/06/highest-loan-to-deposit-ratio-and.html

    A more general form of your question is: does all (USD) credit == all USD money (inc. overseas banks), and has anyone showed this?

  • http://Avondaleam.com Scott Krisiloff

    Cullen, obviously a bank or any financial institution can choose to fund themselves in the money market. This actually reinforces my point. Non-bank lenders like CIT for instance will fund themselves in money markets at a slightly higher cost because they are making less plain-vanilla loans to riskier credits and therefore will earn a higher rate of interest on a given loan. In fact CIT is a GREAT example of an entity trying to attract deposits to fund its loan book because after its funding markets collapsed in 2008/09 it is shifting its balance sheet to be more substantially deposit funded. We’re not debating NIMs or the business model of a bank.

    My understanding is that MR is a deposit centric view of money. And the central tenet of the thesis is that banks’ power to create deposits via loans is how they create money (again, please correct me if I’m wrong that this is THE primary thesis of MR). The point is that if deposits are solely created via loans without any sort of multiplication from base money, then there should shouldn’t be a need to obtain funding via deposits, the banks can create their own funding for themselves. (I would still really like to hear an explanation of how the systemic loan to deposit ratio could be less than 1 in this framework). Instead, the fact that banks compete for deposits seems to support the framework that banks are an intermediary which shifts a liquid monetary base through loans.

    This brings us back to discussions that we’ve had in the past, in which you rely on intra-bank transactions to justify the idea that banks don’t have to settle transactions with outside money at all. Per this discussion on deposits, you are implicitly acknowledging that banks exist in a world in which they cannot rely on settling transactions on an intra-bank basis, and therefore must ensure that all loans are made with outside money and not created “out of thin air.” Otherwise if a customer received a loan from one bank and moved the “created” deposits to another, the bank would not have sufficient liquidity to clear the transaction. The bank must rely on an existing deposit base of “outside” money (or a call thereon e.g. a t-bill) to make the loan. In this way deposits fund loans. When a new customer deposits money at a bank, they are depositing cash, outside money, whatever you want to call it. Only once a bank is in possession of this outside money can it re-lend it to another customer. The bank can only re-lend a fraction of this money though (due to reserve requirements) thus the reserve requirement does provide one ceiling on aggregate loan levels in the economy.

    Of course a bank could get around this by borrowing in money markets, but then there is still the issue of the capital constraint which inhibits infinite leverage.

    The fact that the bank can issue liabilities into securities markets speaks to the fact that there really needs to be a whole other arm to MR which encompasses securities markets if it really is to be a holistic theory of money. I’ve argued that point since I started posting here. You can’t ignore securities markets, especially not in the US where securities make up the majority of household financial savings. As much as you talk about cash being anachronistic, for a good deal of the early 2000′s securitization was making it appear as if bank loans and deposits were similarly anachronistic. We have stepped back from that path for a bit after getting burned in 2008, but I actually happen to be one who believes that long term the banking system is likely to become more and more disintermediated and securities markets will continue to take share of household financial savings.

  • Greg Porter

    I completely agree with your conclusions, but I would describe it a little differently.

    In our credit based system, much of what we consider money is really credit and much of what we consider to be credit has many of the characteristics of money. For example, demand deposit accounts are credit relationships (despite the fact that many still think of their bank as a custodian for their money), but they are universally considered money because they are universally accepted as in payment.

    OTOH, much that we consider credit has some of the characteristics of money. For example, if you look at the footnotes to Apple’s financial statements, you will see that they consider money market funds, U.S. Treasury securities, U.S. agency securities, some non-U.S. government securities, CDs and commercial paper to be cash equivalents. All of these are credit securities, but Apple and the accounting profession considers all of them to have some aspects of money.

    U.S. treasury securites trade in the largest, most liquid market in the world. They form the backbone of the multi-trillion dollar repo market. They have become very “money-like.” I would suggest that when the dollar amounts are large enough, U.S. goverment securities have more of the characteristics of money than even physical currency. It would be impossible to effectuate a transaction for $1 billion in physical currency, but you would have no trouble getting a counterparty to accept $1 billion of short duration treasuries (most would prefer treasuries to a bank deposit as well, or at least will after the end of the year when TAG expires).

    So, I would agree that when the Fed prints money in QE, it doesn’t really add to the money supply, but mainly because the Fed is substituting one form of money for a security which has many of the characteristics of money.

  • Anon

    Ray, depending on your view, the Fed is trying to achieve exactly what you describe – i.e. lower currency and higher inflation!

    Regarding comments re interest rate policy, they are reasonable to make – lower interest rates should reduce the currency and give the NZ economy a boost. But the problem with the concept is that monetary policy is a very blunt instrument – central banks can influence the “price” of money (being the level of interest rates domestically and the exchange rate internationally) and they can also create liquidity. The thing they have no real control over is where it all ends up! Ask Spain what happens if all of a sudden you have a heap of cheap money flowing freely around (hint – there is a huge risk that it will be used for speculative foolishness rather than encouraging thoughtful investment).

    I’m across here in Aust and we have the same dilemma. Fortunately, we both still have some real potency in monetary policy (we’re not at zero% yet!) Is is a good idea for our central banks to cut rates by 2% tomorrow? Depends… it depends on what that brings – if all it does over here is further fuels our already silly housing market then the economy will look better…until we have our own Spain/USA moment.

  • http://www.orcamgroup.com Cullen Roche

    I have no idea where you came up with all those implicit assumptions. You are literally just making things up that I have never said. Maybe read the Fullwiler link I sent. That gets the banking right….

  • Pierce Inverarity

    The step you are missing is that in QE it’s not inside money that is swapped for the asset. It is still outside money that is, ostensibly, even less useful to the private sector (Fed reserves) that treasuries are.

  • Pierce Inverarity

    Thanks. I’d forgotten about that article. That cleared it up.

  • Tim

    Cullen,

    Help me with this. If the bank reserves are increase because of the fed swap, cannot the bank and or fed reduce the reserve requirements and hence free up “money” to be lent?

    See definitions of reserves.

    Definition of ‘Bank Reserve’
    Bank reserves are the currency deposits which are not lent out to the bank’s clients. A small fraction of the total deposits is held internally by the bank or deposited with the central bank. Minimum reserve requirements are established by central banks in order to ensure that the financial institutions will be able to provide clients with cash upon request.

    Investopedia explains ‘Bank Reserve’
    The main purpose of holding reserves is to avoid bank runs and generally appear solvent. Central banks place these restrictions on banks, because the banks can earn a much larger return on their capital by lending out money to clients rather than holding cash in their vaults or depositing it with other institutions. Bank reserves decrease during periods of economic expansion and increase during recessions.

    Read more: http://www.investopedia.com/terms/b/bank-reserve.asp#ixzz2FNZk27YD

  • http://www.orcamgroup.com Cullen Roche

    Hi Tim,

    Bank lending is not constrained by reserves. Banks are capital constrained. If a bank wants to make a loan it does not check its reserve balances. It makes the loan and find reserves after the fact if necessary. Hope that helps.

    Cullen

  • http://Avondaleam.com Scott Krisiloff

    So if I read this correctly you’re arguing that banks basically make a loan & create deposits simultaneously and then have to find other deposits to replace lost deposits if the borrower moves the deposits to another bank. The lending and the funding are totally separate activities in this framework. Is that correct?

  • Geoff

    Ironically, the more Treasury bonds the Fed buys, the less liquid, and therefore the less “money-like” the remaining Treasuries become.

  • Richard from Canada

    Did you not miss something on the “timeline” of that balance sheet transition? Did T-Bonds not actually rise in price substantially with the drop in interest rates ? Did this price rise on the asset side not translate into increased capital on the liability side ? When the T-Bonds were then pushed (swapped) by the FED did it not lock in that gain in capital for the banks ?

  • Roger

    It also reduces future government outflow by reducing interest payments, which reduces future money levels relative to what they would have been had rates been higher.

  • Hans

    Everyone says QEs increases the money supply, except here and the MMT community…

    So a bank surrenders a Treasury note earning 1% and in return the Central Bank (now) gives it 25 bases points.. Without using the cash, the financial institution is now facing reduced income. Why? Is the bank a tool of the Fed ? Would this be considered a Nationalized Financial Transaction ?

    Moreover, does the bank now have more monies to lend ? After all, it can not loan on its previous Treasury note ?

    This Federal debt (note), is now being carried by the Federal Reserve, on its balance sheet, which it did not previously do so…If the banks lend that cash, then the Fed lack the ability to simply reverse the transaction…

    If the banks are not allowed to use the money for loan activity, then there would be no increase in the money supply…

  • http://Avondaleam.com Scott Krisiloff

    Yep, that’s my point jt. Loan only means loans provided by commercial banks and deposits are liabilities of those commercial banks. However the discussion ignores the role of securities markets in supplying savings products to the economy–savings products which represent the bulk of US household financial savings.

  • http://Avondaleam.com Scott Krisiloff

    My understanding of the Fullwiler banking paradigm above is that its central claim is that if a bank makes a loan and generates deposits and then the deposits leave, then the bank can always go out and replace the deposits with money market funding. Therefore it claims that banks are not reserve/deposit/liability constrained.

    While technically possible, it doesn’t acknowledge the fact that 1) the bank is still funding the loan by borrowing and lending outside money market funds 2) it doesn’t explain where the money market comes from. Who creates that money? If it’s the Fed (as implied by the Fullwiler article), then that makes it pretty clear that an increase in reserves can fund loan growth. However, in the real world there is not a single bank that you can point to that counts “Fed Funds Borrowing” as its primary liability balance sheet entry (even though this would be WAY cheaper than deposit funding). In the real world banks are obviously liability constrained in that they can only make loans up to the point which they can find a sufficient funding. Real money markets (CDs, money market funds, etc.) are finite, not infinite, unlike reserves provided by the Fed’s balance sheet.

    I would also add that the discussion of reserve constraints here seems to revolve around the lending requirement of reserves, which is confusing considering that reserve constraints are defined as a deposit requirement. Per the FRB: “Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.” Reserves are traditionally thought of as lending constraints in that a bank can only lend 90% of the deposits that they take in and must retain the remaining percentage as reserve balances at the Fed, not because the bank has to borrow reserves to clear a deposit transfer (necessitated by loan creation) to another bank. The Fed will always make sure that there is a sufficient level of reserves in the system to process such transfers, but only to the extent that a borrowing bank has assets of sufficient collateral (e.g. cash, t-bill) to obtain those funds. The Fed is not in the business of providing uncollateralized funds to the banking system.

    Additionally, it’s instructive to think about the fact that if the banking system really worked as Fullwiler suggests then a bank run could NEVER occur, because when a depositor came to withdraw deposits the bank could alway borrow to replace that deposit without collateral in infinite money markets. Obviously Wachovia, WaMu and IndyMac teach us that this is not the case and prove that banks are indeed liability constrained.

  • http://www.orcamgroup.com Cullen Roche

    Scott, MR was formed in part because MMT didn’t focus on the precise thing you’re discussing. Maybe read JKHs 40 page paper on S=I…..

  • http://www.orcamgroup.com Cullen Roche

    Scott,

    You’re just stating the obvious. Balance sheets must balance. No one ever said otherwise.

  • Pierce Inverarity

    Fed funds borrowing is in NO WAY cheaper than demand deposits. Demand deposits, by and large, are free money to a bank.

  • Geoff

    It should also probably be noted that retail demand deposits are not the only type of deposits, at least in some countries. In Canada, for example, banks issue Deposit Notes (or Senior Notes) which rank the same as regular deposits, but are large (often $billion+) and are issued mainly to institutional bond investors. These Deposit Notes are often issued for fixed terms (say 5 years) which is beneficial if banks have 5 year loans to match.

  • warrenprosser

    “Amen, Preach on brother”

    simple, but unfortunately, our nation needs simple examples.

  • http://Avondaleam.com Scott Krisiloff

    Non interest bearing deposits are not free. They come with high operating expenses in the form of advertising, branches and relationship managers who can gather the deposits. Check out CYN for an example of a bank with a high percentage of NIBL.

  • http://Avondaleam.com Scott Krisiloff

    I think I said a little more than that Cullen…

  • http://Avondaleam.com Scott Krisiloff

    Link?

    Also legitimately still trying to figure out how loan/deposit ratio can be 80%. Thoughts?

  • Pierce Inverarity

    Covering Fed overdrafts has to be done by EOB. The Fed Funds market are all short term loans. There are other considerations besides expense, which is why a run on the bank can still most definitely happen.

  • Nephric

    Thank you for this good explanation. I struggle with the concept of whether inside or outside money is the ‘dominant’ form. Surely there is much more inside money but couldn’t outside money be dominant at times, like right now? The inside money creation is decentralized and at the whim of the varied decisions of many large and small banks while outside money creation is centralized at the US gov’t level. At a time when banks are not lending as much isn’t it the role of our elected officials to create more outside money to spur growth? Since outside money creation is based on Congress’s budgetary decisions and deficit spending can’t it become more ‘dominant’ at necessary times such as during a recession or during deflation?

  • Johnny Evers

    So the institution trades a Treasury bond — either redeemable for money by the Fed, or an asset that can be sold for money — for ‘outside’ money, which it cannot use.
    Why would it do this?

  • LVG

    Scott, you sound confused on the exact details MR states. Here’s how MMT says it. They both understand how the actual funding of loans works. And I know that Cullen has never said banks don’t need funding. They just don’t need to fund their loans through multiplying reserves or obtaining deposits.

    “What does that all mean? Loans are not funded by reserves balances nor are deposits required to add to reserves before a bank can lend. This does not deny that banks still require funds in order to operate. They still need to ensure they have reserves. It just means that they do not need reserves before they lend.

    Private banks still need to “fund” their loan book. Banks have various sources of funds available to them including the discount window offered by the central bank which I explained above. The sources will vary in “cost”. The bank is clearly trying to get access to funds which are cheaper than the rate they charge for their loans. So they will go to the cheapest funding source first and then tap into more expensive funding sources are the need arises. They always know that they can borrow shortfalls from the central bank at the discount window if worse comes to worse.

    So the profitability of the loan desk is influenced by what they can lend at relative to the costs of the funds they ultimately have to get to satisfy settlement. So the price that the bank has to pay for deposits (one source of such funds) impact on the profitability of its lending decisions. As noted in the introduction, at the height of the crisis, as wholesale debt funding sources became more expensive, the commercial banks in Australia turned to a greater reliance on fixed term deposits. The rate they were prepared to pay on these deposits also rose as competition for them increased.”

  • Pierce Inverarity

    It’s all with the idea to enhance lending and keep rates low so more people want to borrow.

    The latter normally works, if the private sector isn’t already overencumbered with debt.

  • http://www.nowandfutures.com bart

    As long as the definition of the terms and the scope of the area being discussed are limited, one can prove almost anything.

  • Johnny Evers

    That doesn’t address why an institution would give up an asset for a reserve.
    As for encouraging the institution to lend — how does it do that, if institutions do not lend from reserves.

  • Geoff

    Johnny, the reserve is also an asset. The institution isn’t necessarily “giving up” anything. It is just swapping one asset for another. One main difference between the two assets is duration. The reserve is very short-term, whereas the T-bond is longer term. Perhaps the institution wanted to shorten the duration of its assets for whatever reason. Perhaps the institution was bearish on rates.

  • Pierce Inverarity

    1) The institution is not forced to sell. That’s not part of the mandate as a primary dealer.
    2) Institutions sell because that’s the price they can get. They’re not going to get a better price than from the Fed. The Fed in this instance is a complete and total price setter. Or, rather, can be. Cullen and others have often argued they should be targeting price not volume, but that’s another discussion.
    3) QE doesn’t actually encourage lending. It’s part of the reason MR & MMT devotees have been so opposed to it. In a BSR it literally has next to 0 impact on lending? Why do it? Misguided belief that continued low interest rates, reinforced by QE, will spur lending. But if there is no demand for loans (from high quality borrowers), and banks tighten credit standards (as they have done), low interest rates will not be stimulative to lending.

  • Johnny Evers

    In that case, the bank has the same number of assets, but the public doesn’t have a debt anymore.

  • http://www.orcamgroup.com Cullen Roche

    Also see this Japan post. Anyone who says QE increases the money supply needs to be able to explain why Japan’s expansionary policies have resulted in deflation….

    http://pragcap.com/the-economics-of-japans-lost-decade

  • Pierce Inverarity

    Technically speaking the public still does. The Fed doesn’t actually retire the debt. The Treasury still owes the principle and interest to the Fed, the Fed can, and likely will, sell those securities back to the private sector once it needs to raise interest rates.

  • Pierce Inverarity

    I’d say that’s correct. The loan department at a bank is completely separate from the deposit taking and settlements arm(s).

  • http://www.avondaleam.com/ Scott Krisiloff

    LVG (and hopefully Cullen), there is clearly a disconnect here and I think that it has something to do with how we’re defining our terms, but lets go step by step:

    1) Banks hold a tiny fraction of their assets as reserves. Most liquid assets of a bank are held as t-bills or other securities. Do we agree?

    2) Assets must be funded by liabilities. For most banks this means gathering deposits. Banks can also fund themselves through credit/securities market borrowing and repos. Do we still agree?

    3) When a bank obtains a new deposit dollar in order to fund itself it obtains both an asset and a liability. The transaction is cleared through reserves at the Fed. The receiving bank receives reserves and then typically takes those reserves and buys a tbill or other liquid security.

    4) As established by the reserve requirement the bank is only allowed to loan up to 90% of these new deposit funds. It must retain 10% of these funds as reserve balances at the Fed.

    5) Later the bank makes a loan. At the “birth” of the loan the bank adds a loan to its assets and a new deposit liability. However, when the borrower goes to retrieve these deposits and spend them or transfer them to a new bank, the lending bank either sells the tbill that it bought with the initial deposit dollars (from step 3) or repos that security at the Fed in order to obtain “outside” money to transfer to the receiving institution.

    6) The new bank then repeats steps 3, 4 and 5.

    7) The reserve requirement puts a limit on the amount of deposits that can be created in this process because the loop of steps 3, 4 and 5 generate diminishing loan balances at each successive bank.

    8) If bank from step 5 wants to make a new loan without first obtaining a new deposit dollar (which contributes a liquid asset to its balance sheet on the asset side) it could theoretically do so. However when the borrower goes to retrieve and spend his deposit at another institution, the bank must obtain outside money to complete the transfer.

    9) The bank can obtain outside money by selling the loan into the market, or borrowing in money markets, but this is functionally the same thing and only a replacement of step 3, when the bank needed to obtain a deposit prior to lending so that it could obtain an asset which could be sold or otherwise converted into “outside” money in order to settle the transaction via the Fed.

    Where do we disagree at each of these steps?

    Also another question. In MR what are money markets? Are they inside or outside money? Why are they different from deposits? Before being borrowed by the bank, who created the money market dollars? Is whoever created these dollars also an “outsourced creator of USD”? Who’s liability are money market instruments? Why are deposits USD and not money markets in the framework of MR–or are they deposits?

    And can someone please answer how deposit balances can be higher than loan balances??

  • Pragmatic Liberal

    I don’t understand why no one in the MMR/MMT/Minskyite/Keensian/post-Keynsian world is willing to come out and say that government bonds are basically money. Because that’s really all this is saying. It is a good argument. They are safer and more liquid than many things we do consider money, like, say, time deposits. It is pretty hard to argue with.

    The point is not that “banks are not reserve-constrained.” The point is that banks treat their highly liquid assets just like reserves, and they immediately convert reserves held as assets into reserves held as base money when needed. The Federal Funds market is liquid and efficient enough to basically mean that banks can freely convert the portion of their reserves held as highly liquid assets to money whenever they need to.

    On a somewhat separate note, I really don’t think it’s fair to dismiss QE’s impact on interest rates. I mean, ostensibly, the whole point of QE is to lower interest rates, encourage lending, and increase the money supply that way. And there is considerable evidence that QE would have a real effect on interest rates if rates were not at the lower bound. Of course, higher rates would mostly incentivize banks to convert their cash excess reserves into assets, but there simply aren’t enough assets available for immediate purchase for that process to take place immediately, so a rational actor bank would probably lower its interest rate a little to encourage lending out its reserves. The convertibility of cash reserves into asset reserves strongly diminishes this effect, but part of the reason why we are seeing pretty much zero effect from QE really is the zero lower bound.

  • http://www.orcamgroup.com Cullen Roche

    PL,

    MMT says bonds and reserves are basically the same thing. So, for all intents and purposes MMT does say bonds are money equivalents though they wouldn’t use the term “money”. I say govt bonds have a very high “moneyness”, but I certainly don’t think they’re equivalent to bank deposits. After all, you can’t walk into a Wal-Mart with US Tsy bond and buy a box of cereal. There’s a big difference between a note, coin, deposit and US govt bond. That latter three all have the very highest level of moneyness because they are accepted for transactions in any business in the country and lead directly to helping facilitate the output of the nation. I say govt bonds are securities. Like stocks or corporate debt, they are liquid instruments that give one a claim on money.

    I also wouldn’t say that QE has zero impact on rates. But I think we’re probably overemphasizing the impact. After all, even the NY Fed said QE1 only had a 17 bps impact on rates during its time in force. That’s obviously not nothing, but all this for less than the equivalent of one rate cut? That’s not much in my book.

  • pollen_catcher

    What if the bank gives a loan and the borrower puts the cash….aka deposits….in another bank? What if he immediately converts the loan to cash to pay suppliers?

  • pollen_catcher

    Your accounting is totally wrong which is probably why this doesn’t make sense to you. The loan is an asset for the bank, but a liability for the borrower. For a very simplistic example, you would debit loan receivable and credit cash. Thus, the banks assets/liabilities don’t change when the loan is issued. Over time, the loan gets paid back, with interest. This decreases the loan receivable (asset) over time as it is is paid, but is replaced with principal repayment+interest in the form of cash, also an asset. Equity would increase (tier 1 capital which is important). Reserves are also Tier 1 capital. Of course, banks can loan more than just their cash on hand which is why the above example is simplistic. The example is to show that 1. an asset and liability is not created on a single bank balance sheet when a loan is issued, but a bank asset and borrower liability. 2. Loans do create deposits and that is how and 3. Lending is not constrained by some ratio on deposits…which aren’t reserves…but by capital…Tier 1 and 2 almost exclusively now. Again, capital includes reserves and common equity, mainly.

  • Pierce Inverarity

    Well, if you create an MBS and it gets bought by the Fed that loan is off your books in return for reserves. The balance sheet still balances, but the loan is now with the government.

  • JK

    Cullen,

    I think you should be more precise here in your differentiation…

    “MMT says bonds and RESERVES are basically the same thing.”

    “I say govt bonds have a very high “moneyness”, but I certainly don’t think they’re equivalent to bank DEPOSITS.”

    [my BOLD in each]

    Does MMT say that bonds are equivalent to bank deposits? If not, then the way you phrased this comment seems jumbled.

  • pollen_catcher

    A bank funds assets with equity. Deposits are liabilities of the bank, not assets. You keep getting that completely wrong. Reserves and common equity are Tier 1 capital for the bank. Bank lending is constrained by capital requirements, ie, you have to have a certain % of high quality equity as a % of total assets in order to make the loan. Not JUST by reserves.

  • http://www.orcamgroup.com Cullen Roche

    I don’t know if MMT says bond are equivalent to bank deposits. My guess is no since MMT’s model is designed around NFA of which govt bonds would count. Bank deposits are just leveraged vertical money in MMT. I totally disagree with that thinking, but you know that. :-)

  • JKH

    1) Banks hold a tiny fraction of their assets as reserves. Most liquid assets of a bank are held as t-bills or other securities. Do we agree?

    (Let’s assume the entire response here and below assumes pre-2008 non-QE reserve conditions.)

    Then, yes on this one.

    2) Assets must be funded by liabilities. For most banks this means gathering deposits. Banks can also fund themselves through credit/securities market borrowing and repos. Do we still agree?

    Yes. Also, paid in and retained equity capital constitutes funding for this purpose.

    3) When a bank obtains a new deposit dollar in order to fund itself it obtains both an asset and a liability. The transaction is cleared through reserves at the Fed. The receiving bank receives reserves and then typically takes those reserves and buys a tbill or other liquid security.

    “In order to fund itself” suggests a netting at the reserve account level. If a bank takes in a new deposit sourced from another bank, it will be up reserves. It can then buy a t-bill and the reserves will clear out to the seller’s bank as payment. The deposit will have funded the t-bill purchase; the reserves are the mechanism for clearing the interbank transaction effect. in both directions.

    4) As established by the reserve requirement the bank is only allowed to loan up to 90% of these new deposit funds. It must retain 10% of these funds as reserve balances at the Fed.

    Here, actual operations are much more complicated.

    First, there is a time lag between the creation/attraction of a new reservable deposit and the appearance of a reserve requirement against that deposit. E.g. a bank attracts a new deposit from another bank, and there is no immediate complication from reserve requirements.

    Reserve requirements, including new and pre-existing requirements, are treated in batch mode. There is an actual job in a bank that manages the reserve position. That job includes allowing for any non-zero required stock reserve position, in addition to managing the daily flows that cause the total position (required and excess) to fluctuate. The net balancing mechanism on a daily basis is the bank’s money market operations, which you refer to below. The required stock reserve position needs to be kept in tact, while generally minimizing the excess position (again, assuming non-QE environment here).

    The total operation is more complicated than “holding back” 10 per cent of an individual deposit for reserves. Banks have sophisticated internal systems whereby all funding coming into the bank is “sold” to a central treasury operation and all funding required to support assets is bought from that center. Banks price all of that funding internally in order to match against he characteristics of the deposit providing the funding or the loan requiring it. This internal centralization of the sources and uses of funds externally is fundamental to the risk management process.

    One of the assets requiring funding is the required reserve position itself. And that position will “buy” funding from the center, probably at a short term wholesale deposit rate.

    So, the reserve position itself, in addition to all of the banks loans, will be funded quite separately from the fact that some pool of deposits generated that reserve requirement.

    The bank will then calculate the cost of funding the entire required reserve position with deemed funding from the center, and in some way pass that cost as deemed appropriate to the pricing of loans and other assets. Banks may differ on exactly how this cost is allocated across the asset spectrum.

    5) Later the bank makes a loan. At the “birth” of the loan the bank adds a loan to its assets and a new deposit liability. However, when the borrower goes to retrieve these deposits and spend them or transfer them to a new bank, the lending bank either sells the tbill that it bought with the initial deposit dollars (from step 3) or repos that security at the Fed in order to obtain “outside” money to transfer to the receiving institution.

    Yes.

    6) The new bank then repeats steps 3, 4 and 5.

    7) The reserve requirement puts a limit on the amount of deposits that can be created in this process because the loop of steps 3, 4 and 5 generate diminishing loan balances at each successive bank.

    It’s important to distinguish the case in which the system is expanding its reservable deposit base versus the case where that it not happening but where deposits are merely being transferred from one bank to another. The second case jworks itself out through competition, where reservable deposits and required reserves increase at one bank but decrease at another.

    At the system level, an increase of reservable deposits leads to an increase in required reserves, with the latter occuring with a time lag. At the time point when the reserve requirement takes effect, the Fed will inject the incremental supply of reserves necessary for the system as a whole to meet that requirement (again, pre-QE here), and individual banks will compete to fund that requirement according to their own share of the requirement. That cycle repeats according to the time lag periodicity.

    8) If bank from step 5 wants to make a new loan without first obtaining a new deposit dollar (which contributes a liquid asset to its balance sheet on the asset side) it could theoretically do so. However when the borrower goes to retrieve and spend his deposit at another institution, the bank must obtain outside money to complete the transfer.

    Yes – it must obtain new funding in order to leave its reserve account level unaffected on a net basis.

    9) The bank can obtain outside money by selling the loan into the market, or borrowing in money markets, but this is functionally the same thing and only a replacement of step 3, when the bank needed to obtain a deposit prior to lending so that it could obtain an asset which could be sold or otherwise converted into “outside” money in order to settle the transaction via the Fed.

    OK

    Where do we disagree at each of these steps?

    Generally OK. Just bear in mind the internal mechanism I described, which is quite a huge operation in itself

    Also another question. In MR what are money markets? Are they inside or outside money? Why are they different from deposits? Before being borrowed by the bank, who created the money market dollars? Is whoever created these dollars also an “outsourced creator of USD”? Who’s liability are money market instruments? Why are deposits USD and not money markets in the framework of MR–or are they deposits?

    “Money market” is a generic term for the set of markets through which institutions including banks manage their short term liquidity positions. In particular, the banks manage their reserve account levels by participating in the “money markets”. Treasury bill, repo, bankers’ acceptance, commercial paper, loans to investment dealers, short term wholesale deposits, etc. are all part of the “money markets”.

    And can someone please answer how deposit balances can be higher than loan balances??

    At least two generic examples:

    a) Banks buy securities (e.g. bills, bonds) from non-banks. This will expand the banking system balance sheet, with the increase in assets matched in some way on the liability/equity side. Some of this latter increase is likely to be in the form of newly created deposits.

    b) Banks pay dividends on their outstanding common and preferred stock. The typical result is a debit to bank equity and a credit to bank deposits. I.e. the liability/equity side of the bank is recomposing itself in this process, without reference to the asset side.

  • Richard from Canada

    I think if you assume book value = market value this is probably correct. However if market value of the T-Bond is higher than the book value the transaction triggers a capital gain. A capital gain is realized as increased Reserves and increased capital ! You actually will get more outside money on the balance sheet !?

    http://overthepeak.com/wordpress/archives/10796

  • http://Avondaleam.com Scott Krisiloff

    No one ever said deposits were anything but liabilities. But as long as we’re talking about things that are “completely wrong,” the reserves we are talking about are not a component of tier 1 capital. Reserves are assets of the bank (which happen to have a risk weighting of 0 in tier 1 capital ratio calculations).

  • http://Avondaleam.com Scott Krisiloff

    JKH,

    Thanks for the courtesy of a response. Not sure if you speak for the MR guys, but glad to see that we agree on most of these points. The treasury function of reserve management was an interesting description of a bank’s inner gears, so thanks.

    On the money markets issue, and the issue of deposits exceeding loans, my whole point is that there’s clearly a third entity, securities markets, which can effect bank deposit markets, and are in reality much larger than deposit markets. However MR in its dualistic framework of inside and outside money doesn’t adequately account for the influence of securities markets.

    The fact is that because of the influence of securities markets, banks are absolutely not outsourced manufacturers of USD or even solely in control of the inside money supply through loan creation.

    A non-bank corporation can create inside money by issuing a debt or equity security and receiving cash which is then deposited in a bank. This process further reinforces that “outside money” is the liquid money that facilitates all transactions and does in some sense “multiply.”

  • pollen_catcher
  • http://Avondaleam.com Scott Krisiloff

    Those aren’t the reserves that we’re talking about. I think that the reserves that you are referencing are known as retained earnings in the US. We’re talking about reserve balances at the Fed, a specialized asset.

  • http://www.orcamgroup.com Cullen Roche

    Scott,

    A non-bank corporation does not create inside money. It creates securities, which are money-like. Securities are claims on money. You still don’t seem to have some of the basic facts right here.

    And no, JKH’s comment doesn’t confirm your view that outside money rules the monetary roost. He wouldn’t be an MRist if he thought that….

    Also, please see the MR website. We’ve talked about money like instruments in great detail.

    CR

  • SS

    Debt and equity securities are claims on the corporation’s cash flows. They are liabilities of the corporation.

  • JKH

    agree with Cullen

    non-bank issuers of securities transact in inside money

    they have no direct access to outside money in the form of bank reserve balances

    the securities markets are big – but this is orthogonal to the inside/outside money framework

    nothing inconsistent about the co-existence of the two

  • Geoff

    “A non-bank corporation can create inside money by issuing a debt or equity security and receiving cash which is then deposited in a bank. ” – Scott

    Scott, the cash to buy the security originated from a bank deposit in the first place. So no new bank deposits have been created.

  • jt26

    Summarizing (because I found this discussion interesting) … and the above threads were getting too nested …

    (1) “issue of deposits exceeding loans” …. simply, any non-bank loan market (securities, MMFs etc.) will affect bank loans-to-deposits.
    JKH 12/19/2012 at 5:22 AM
    Scott Krisiloff 12/19/2012 at 10:25 AM

    (2) non-banks do not create inside money
    Scott Krisiloff 12/19/2012 at 10:25 AM
    Cullen Roche 12/19/2012 at 11:10 AM

    BTW, Cullen didn’t really say this explicitly, but in your example money isn’t really being created, it’s just moved from one bank to another.

    ref:”A non-bank corporation can create inside money by issuing a debt or equity security and receiving cash which is then deposited in a bank.”

  • http://Avondaleam.com Scott Krisiloff

    Cullen,

    A [bank] does not create [money]. It creates [deposits], which are money-like. [deposits] are claims on money. You still don’t seem to have some of the basic facts right here.

    The whole point is on the scale of “moneyness” where does “money” start and stop? I can draw the line a step before you do and then say the exact same thing you just said to me. In previous debates we more clearly defined that we are debating what is “USD,” which is a clearly defined line, and most accurately defined as what you describe as outside money.

    JKH,

    As to the corporation example, I specifically stipulated that if I buy the security for cash (outside money that I have on hand) then a new deposit can be added to the system without a bank loan.

    Also, nothing is inconsistent about the existence of inside/outside money and securities markets, agreed. However, the fact that securities markets do not play a prominent role in MR demonstrates that the lines drawn by MR are arbitrary and that MR is an incomplete theory.

    I say that securities markets do not play a prominent role because of the 10 bullet points that define MR in the “understanding the modern monetary system” manifesto, 0 talk about securities markets directly.

    It seems that a much better description of the monetary system would begin with:

    What is money? Answer: money is a means of exchange, store of value, etc. Anything can technically be money. All assets exist on a scale of “moneyness” though. Higher moneyness is determined by its ease of exchangeability, societal acceptance, etc. etc.

    I know that recently people here have acknowledged that anything can technically be money and that money needs to be more narrowly defined, but I’m not sure that that has always been the case, because to my knowledge the concept does not make an appearance in the MR manifesto. Please refer me to your earliest discussions on this topic.

  • http://www.orcamgroup.com Cullen Roche

    Scott,

    You have multiple things backwards. You can’t access outside money except by drawing down an account of inside money to obtain cash. The bank makes that cash (outside money) available to you only if you have an account with them. You can’t just obtain outside money for use in the economy unless you have an inside money account already. The only way ANYONE ultimately obtains cash is by drawing down an account of inside money with a bank. The Fed makes cash available merely for convenience purposes. Cash is merely a facilitating feature of a monetary system built around inside money.

    And no, you haven’t clearly defined the terms here at all. You keep moving the goal posts to try to confirm your initial position, which has already been proven wrong whether you understand that or not.

    I don’t see the point of this conversation. I can see that you’re not interested in understanding our position. You’re simply interested in confirming your original position. That’s fine. I am not going to twist your arm into seeing the world the way MR sees it. I am not here to convert followers. We explain how things work. If you want to believe they work differently then be my guest. Lots of people disagree with our explanation of the world so get in line!

    Happy holidays!

    CR

  • Geoff

    So, Scott, you’re buying the security with cash you happened to have under your mattress? In that case, you still haven’t created any new money.

  • SS

    Scott, you can create cash out of thin air? Do we need to call the Secret Service and report you to them?

    Obviously, you obtained the cash from someone else who obtained the cash from someone else who obtained the cash by going to an ATM where the money was inserted into the machine by someone who withdrew it from a bank account where the bank made an order for cash from the Fed who made an order from the Treasury for the cash. Whew!

  • pollen_catcher

    Pull up a flow of funds release from the FRB and you’ll see which form dominates the economy…

  • Cyridame

    I think the key point is (and Cullen can correct me if I’m wrong) while loans create deposits, they do not create additional reserves in the banking system in aggregate. New inside money is created, ready to chase after goods and services, but the amount of outside money has remained the same.

    Banks can’t simply lend money to itself, simultaneously creating deposits and reserves at the same time, thereby precluding the need to go out and procure additional deposits (i.e. cheap liabilities).

  • http://Avondaleam.com Scott Krisiloff

    jt, thanks for summarizing.

    Let me clarify where I stand after the discussion. I think this will address both points.

    After thinking some more about the issue of non-banks creating inside money I am willing to acknowledge that I am wrong to say that anyone has the ability to create “inside money” as MR defines it. In trying to incorporate MR’s framework and definitions into my framework for looking at savings markets, I erred and do see that banks are the only entity that can create deposits. We are now 100% in agreement on this point. Deposits are the sole domain of the commercial banking system. This explains why deposits are created when a bank buys a security but not when a non-bank individual buys a security.

    The reason that I said that non-corporate entities could contribute inside money was based on my intuition that there is clearly net financial value created outside of the banking system in securities markets, which can be converted to deposits. If I buy an equity security which appreciates in value, net value is being added to society. If a company issues a corporate bond, a net savings product is being added to society. In attempting to draw a link between deposits and securities as a savings mechanism I do concede that I overextended the ability of securities markets to unilaterally effect the banking system.

    However, this does not change the fact that I continue to believe that the MR framework is incomplete as a description of the modern monetary system because of the lack of incorporation of the bulk of the way that modern households do store their wealth. Empirically deposits are not the primary way that Americans save. In order to spend savings it is true that a crucial step is to clear through bank deposit markets. However, this clearing step should hold no more significance to aggregate economic purchasing power than the interbank clearing process via what MR refers to as “outside money.” Both are facilitating transactions based on purchasing power that is not dictated by the quantity of deposits held within the commercial banking sector.

    To the extent that a monetary framework should describe the aggregate purchasing power and savings of a society, a truly modern paradigm for the US must include the securities markets as a centerpiece. As of March 2012 an average American household holds 15% of their financial assets as deposits. Any attempt to describe the liquid purchasing power of American households must include the other 85% of their financial holdings, which can easily be converted to bank deposits.

    At the other end of the money spectrum lies USD. What is USD? I will continue to contend that the US dollar is the sole domain of the US government and that quantity in circulation does not matter only that it does have a specific value. It is a yardstick of economic value. There doesn’t need to be enough yardsticks to measure everything in the world to define what a yard is. The yard is a clearly defined unit of measurement endorsed by a) the government, but more importantly by b) the people and convention. The USD is no different, and derives its direct value from the quantity of the liabilities on the Fed’s balance sheet relative to the value of the assets on that balance sheet. This is no different from a foot deriving its base from a monarch’s forearm. A foot is “backed” by the length of the king’s forearm. Importantly although the size of the monarch’s forearm may change from monarch to monarch and the numerical value of feet from my couch to my door may change, there is nothing that the unit of measurement can do to change the real physical distance that I observe.

    So where do deposits fit in this framework? They are a specific type of security which has a value generally equal to 1 USD. They are backed by the assets of the issuing bank ALONE, and their value cannot exceed 1 USD, even if their uninsured value can be less than 1 USD. (Just ask uninsured depositors of Indymac bank).

    Deposits are a type of security. USD is a type of security. Corporate Bonds are a type of security. Equities are a type of security. All have an issuer and a holder. None is “ruler” of any other. All are means of saving. All have tradable value in relation to each other. All are “money” in some sense. Only one is USD.

  • SS

    You’re getting closer. Now you just need to recognize that banks deposits are not a claim on government money. They are their own form of money. In fact, they are the form of money everyone wants. After all, none of us in the non-bank private sector can even use government money if we don’t first have a bank deposit account.

  • http://Avondaleam.com Scott Krisiloff

    “Deposits are a type of security. USD is a type of security. Corporate Bonds are a type of security. Equities are a type of security. All have an issuer and a holder. None is “ruler” of any other. All are means of saving. All have tradable value in relation to each other. All are “money” in some sense. Only one is USD.”

    Agreed. Deposits are no more a claim on government money than any other asset. It may be easier to get to USD from them, but I can accomplish the same thing (although it may take a few mechanical steps) with a share of stock, a bond, a house, an ipad, a pencil, and anything else of hedonic value. I can also convert any of those things to deposits by selling them. I can also convert any of those into any other of those things provided I have sufficient value. The path of the transaction is not what’s important. It’s the result of the transaction.

    I’ll trade my bank deposits for shares of S&P 500 companies all day. In fact I frequently do. 15% of a household’s financial assets are deposits. Seems like that’s empirical evidence to refute that they are the type of money that everyone wants.

  • LVG

    Securities only exist because they give the issuer deposits. They’re only issued because someone wants deposits. What do you not understand about that?

  • http://Avondaleam.com Scott Krisiloff

    They want deposits to buy a real asset. Nobody wants deposits. You don’t eat deposits.

    How do you explain the fact that more people want securities than deposits as evidenced by aggregate financial holdings?

    Of your avatar’s $60B fortune, how much does he hold of that in bank deposits?

  • LVG

    Now you’re confusing money and wealth. Money is a medium os exchange that gives us the ability to own real wealth like corporations, houses, food, etc.

  • http://Avondaleam.com Scott Krisiloff

    Now you’re confusing money with USD. Money is anything that’s a means of exchange and store of value. USD is a specific type of security which helps to measure the economic and hedonic value of real assets.

  • http://www.orcamgroup.com Cullen Roche

    Scott,

    Deposits are every bit the same moneyness as cash. 99% of retailers and people in this world accept bank deposits for payment. What they don’t accept are stocks and bonds for payment.

    Cullen

  • Pierce Inverarity

    Deposits are almost the only way you can ever eat. You don’t exchange Microsoft shares for groceries at the store.

  • LVG

    Money is only a sufficient medium of exchange if it is widely accepted. What is more widely used for payment than bank deposits? Not cash. And certainly not stocks.

  • http://www.avondaleam.com Scott Krisiloff

    How about credit cards?

  • http://www.orcamgroup.com Cullen Roche

    Credit cards are a payment system created by banks so you can deliver payments to people in….inside money!

  • http://www.avondaleam.com Scott Krisiloff

    If I walked up to someone on the street with 100000 shares of Apple, I’m fairly certain I could buy things from them. Maybe not for the same amount per share as I could sell them for on exchange, but I could get something (probably even their house). If I went to Michael Duke, CEO of Walmart with the same shares and asked him for all the inventory in just one of his stores, I’m pretty sure he’d figure out a way to accommodate me as well.

    Anyone who doesn’t believe me please send me all of your shares of Apple!

    The fact that there is institutional friction to exchanging one type of asset (shares) and institutional lubricant to exchanging another (deposits) doesn’t change the fact that useful assets have purchasing power.

    By the way I can easily establish a financial institution in which all “deposits” are backed by physical gold and the value of the deposits are tied to the price of gold. In fact this does exist and it’s called the GLD. I like to refer to the shares I own of GLD as “inside” GLD money. Their production is outsourced to a private monopolistic issuer named State Street.

  • http://www.orcamgroup.com Cullen Roche

    Come on Scott. We all know a share of stock is nowhere near as useful as a form of money as a debit card, for instance. It’s hard to take you seriously when you start saying shares of Apple are money in the same sense that a bank deposit is.

    And no, an ETF doesn’t create new inside money, but that’s a different matter….

    I can see this is going nowhere so I’ll have to bow out of this one going forward. Happy holidays.

  • http://www.avondaleam.com Scott Krisiloff

    I don’t eat deposits, but if you can process electronic digits into energy I think that could be a huge business opportunity!

    The statement was about what people want, and my point is that people don’t want money or any savings for that matter. They want to shift the purchasing power of their labor from one period of time to another so they can buy stuff they enjoy at a hedonic level.

    The entire banking and monetary system revolves around this singular truth. In our modern economy, deposits are only a small fraction of the way that we accomplish this goal.

  • http://www.avondaleam.com Scott Krisiloff

    Cool. Thanks for your input Cullen. Happy Holidays to you as well!

  • LVG

    You are still confused. Unless you bank at your mattress then all cash transactions are exchanges of inside money facilitated through outside money.

  • LVG

    It’s amazing how many people think credit cards are money. No, they’re a payment processing system. You have a line of credit you can draw on. And you must deliver payment or you get penalized.

  • http://www.avondaleam.com Scott Krisiloff

    Pierce, I initially wrote this response out but decided not to post it because it’s a little obnoxious, but there’s some information content behind the obnoxiousness so I did want to post it anyways. Please don’t take the tone seriously.

    I don’t eat deposits. I eat cows.

    The sun gives energy to the planet so that plants can photosynthesize nutrients so that cows can eat the plants so that I can eat the cows (which human beings have done for thousands of years)

    But how do I compensate the farmer for that cow? What is that cow worth? I know it’s worth something, but how do I measure that in comparison to what I (with my labor skillset) can give to the farmer?

    If we made a standard unit of measurement that we could all agree on to value the cow and value of my labor, that would make it easier, right?

    …so that I can convert my labor to SAVINGS and then I can pay for my food with SAVINGS denominated in that unit.

    To do this I exchange: deposits denominated in that unit which I generated by transferring purchasing power from my money market account denominated in that unit to my checking account denominated in that unit (only when I decide I want to pay my credit card balance), which I funded by selling my shares of AAPL which can be valued by that unit of measurement. Which I purchased in the reverse order when I converted my labor to an instrument that allowed me to save its production.

    In that whole equation there were a number of asset exchanges including the exchange of the cow for my deposit. Which was the most important? Which was money? Which was USD?

    A major point in this discussion is that none of that was USD. USD was just how we measured the assets at each step of that equation.

  • http://www.avondaleam.com Scott Krisiloff

    LVG, with all due respect I think you’re confused. Inside and outside money are meaningless distinctions–just different terms for previously defined instruments.

  • LVG

    I am confused? In one comment section you’ve proven that you don’t know what a credit card is, what stocks actually are, what ETF’s actually are and a whole host of other things. I don’t even think you know that you don’t know these things because you keep telling Cullen he’s wrong when he’s just been correcting your mistakes for days. So yes, the distinction might not seem to matter to you because you don’t even know what the difference is between stocks and bank deposits. Sheesh. Give it up man.

  • warrenprosser

    household credit is not the biggest my friend- maybe biggest sector, but there remains 124 trillion in US total liabilities on US balance sheet.

    http://content.screencast.com/users/wprosser/folders/Jing/media/83b0a9cc-6edd-4bf5-b3e5-805204887872/2012-12-21_0615.png

    barely 80% of GNP, while non-financial business CMO is now 76%. Total bank liabilities are 2x the size of M3 and still larger than household and business (non financial) combined.

    http://content.screencast.com/users/wprosser/folders/Jing/media/a3ebc75a-2965-456f-bcd1-960a4cd2268f/2012-12-21_0606.png

  • jt26

    Adding to above, probably all credit card issuers have a banking subsidiary as well. If you’re every curious about how CC co’s are set up read the annual report of one of the independents like Discover Financial. Have a look at some of the reports during the boom years 2004-07 as well to give you an idea of how they fund themselves and how it changes (vs. 2012).

  • flow5

    The FRBNY’s “trading desk” plans to conduct POMOs totaling $480b of newly-issued agency MBS & $540b of 9 year average-duration treasuries for 2013. These purchases won’t have an immediate economic impact unless the secondary market counterparty (clearing & final transfer of securities & funds) is with the non-bank public (as in 3rd party settlement).

    The non-bank public includes every institution (non-banks), the U.S. Treasury, the U.S. Government, State, & other Governmental Jurisdictions, & every person (except the commercial & the Reserve banks).

    Transactions between the Reserve banks & the commercial banks (between primary dealers/bank holding co.) directly affect the volume of bank reserves without bringing about any change in the money supply. The trading desk “credits the account of the clearing bank used by the primary dealer from whom the security is purchased”. This alteration in the assets of the commercial banks: (IBDDs) increase – by exactly the amount the PD’s government securities portfolio decrease.

    Purchases & sales between the Reserve banks & non-bank investors directly affect both bank reserves & the money supply.

    The member banks are unencumbered in their lending & investing operations (except for bank capital adequacy ratios, eligible borrowers, & investment grade assets). I.e., there’s nothing currently to stop the CBs from expanding new money & credit…so sopping up longer-dated securities isn’t going to expand the system’s capacity or opportunity.

  • http://www.nowandfutures.com bart

    “The Fed’s QE and monetary operations don’t create net financial assets, but federal government deficit spending does. The Fed is an enabler of deficit spending.”

    Bingo.

    The primary reason that MR is so tough to understand and explain is that it’s just plain incorrect. It’s easiest to see on QE with Treasuries, per Accounting 101. Treasuries go up, and so does actual money creation on the Fed’s balance sheet.

  • http://www.orcamgroup.com Cullen Roche

    The bonds get bought and then sold by the PDs no matter what. The Fed doesn’t enable the spending. It was going to happen regardless….

  • flow5

    “Direct bidder” demand (at Treasury auctions) may indicate an increased demand by the “non-bank public” for governments. Likewise, whenever the PDs act as a third party (i.e., when the “trading desk” conducts its POMOs out of its SOMA securities), then the money supply is more likely to expand.

  • http://www.nowandfutures.com bart

    Of course, that’s why the Treasury sold them in the first place.

    You again ignored the key Accounting 101 issue. The Fed adds Treasuries to their balance sheet during Treasury based QEs – and ***they don’t get them for free***!
    That’s called money printing by the Fed, plain and simple.

    It has virtually nothing to do with inside money.

  • http://www.nowandfutures.com bart

    Indeed.

  • http://www.nowandfutures.com bart

    QE2 and Twist both had quite substantially more than a 17bps affect on rates.

  • http://www.nowandfutures.com bart

    Interesting… at least CR admitted that stocks are money by definition (as in a medium of exchange), just that they don’t have the same degree of ‘moneyness’ as cash or close equivalents.

    That’s progress.

  • http://www.nowandfutures.com bart

    Invalid logic, especially in adding an arbitrary like ‘widely accepted’ to limit what money is. It’s like saying that all the examples he or anyone else gave were completely impossible.

    The simple fact is that stocks don’t have the same (using the MR term) moneyness as cash, but are **actually used as a medium of exchange** like during stock buyouts with the buying company’s stock.

  • http://www.orcamgroup.com Cullen Roche

    Bart,

    I’ve already explained how you’re wrong. You were wrong 4 years ago when you said this would cause hyperinflation. You’re wrong today. Move on.

  • http://www.orcamgroup.com Cullen Roche

    Stocks aren’t money. This argument is ridiculous. You and Scott are totally wrong. Stocks and bonds are securities, not money.

  • http://www.nowandfutures.com bart

    That avoids the actual factual evidence of stocks being used as money during buyouts, etc. They have ‘moneyness’.

    You may call it ridiculous as many times as you like, but it doesn’t make the actual facts false.

    Feel free not to let this post go public.

  • Paul

    I don’t think it’s necessarily about wanting deposits… they want customers. They want to charge you all them fees, get you a line of credit, use them to refinance your car loans, etc. It’s a trap!!!

  • http://www.nowandfutures.com bart

    One of many key reasons why Japan’s so called “expansionary” policies haven’t worked.

    http://www.nowandfutures.com/images/boj_money_simple.png

    And as far as deflation in Japan – it’s just ain’t so. CPI has been level since roughly the early 90s.

    http://www.nowandfutures.com/images/boj_cpi1990on.png

  • http://www.nowandfutures.com bart

    “The trading desk “credits the account of the clearing bank used by the primary dealer from whom the security is purchased”. ”

    And where does that money come from?

  • Dan-USA

    Isn’t the bottom line (or at least one bottom line) that the Fed is creating new money that goes to the Treasury and the Federal Gov’t then spends the money by paying its’ employees, military contractors, etc and giving money to the States who also spend the money by paying their employees and contractors, etc. So the newly created money from the Fed ends up in the REAL economy in the end, doesn’t it?

  • http://www.orcamgroup.com Cullen Roche

    The actual funding comes from the private sector. Govt spending is always a redistribution of existing money. So, when the govt deficit spends it redistributes existing money and credits the private sector with a net financial asset in the form of a t-bond. The money that the govt uses comes from the private sector. It is not created by the Fed. The Fed buys on the secondary market in order to achieve monetary policy, NOT fiscal policy.

  • Dan-USA

    Cullen, thanks for your reply. I’m not sure I get it though. We’re spending much more than tax revenue from the private sector can support. Therefore the gov’t has to “borrow”. But that looks to me like “money from nothingness”, or brand new money. The fed puts a debit on its books and gives that new credit to the banks. The banks turn around and buy t-bonds from the Treasury and the gov’t spends it. Is the private sector you mention these banks? So then the banks now have a bunch of IOUs from the gov’t (which I believe will never be repaid – just endlessly rolled over while principal grows exponentially as the borrowing and rolling over continues). Are you saying these IOUs cancel out the new money?

  • http://www.orcamgroup.com Cullen Roche

    Hi Dan,

    The way the auction process works is as follows. The bank creates an intra-day loan to buy the bonds, then obtains the bond and repos the bond out in the money market thereby allowing the bank to close the intra-day loan. So, the money to buy the bonds ultimately comes from existing money. It’s not new money creation. The new money creation (if you want to call it that) is in the new security the private sector has. So, to simplify things, the govt obtains money from the private sector, spends that money into the private sector and ALSO credits the private sector with a new bond. So there is an increase in net financial assets held by the private sector, but there is not more “money” (there are more bonds/securities though).

    The Fed enters this process in the secondary market buying bonds (the funding process already occurred on the primary market at the auction). They’re not actually increasing the private sector’s net financial assets or money. They’re swapping bank reserves for t-bonds just as monetary policy ALWAYS does.

    Make sense?

  • Jose Guilherme

    I’m sorry to step into the conversation, but I just have to point out that Cullen’s presentation of government spending is very different from that written by Marc Lavoie in his paper on neo-chartalism that I can recall this site has fondly quoted on past occasions (http://www.boeckler.de/pdf/v_2011_10_27_lavoie.pdf).

    Cullen says that “Govt spending is always a redistribution of existing money”. But if we check out Lavoie’s accounting tables on government deficit spending – particularly Table 3, page 18 of said paper – he starts the process with the government selling a newly-issued T bill to a commercial bank. This creates new “inside” money – a government deposit that is a bank liability. There isn’t merely a “transfer of existing money”.

    The process described by Lavoie then goes on in four additional steps, with the end point being new NFAs created in the form of reserves and T bills (assets on commercial banks’ balance sheets) as well as “new money” in the form of commercial bank deposits that are assets of the private sector – the result of the government deficit spending. The private (household) sector also keeps monetary units in the form of currency/banknotes – a part of the new NFAs created.

    I think it’s very important to clear up this point. IMO it’s vital that PK schools – whether MMT, MR, whatever – agree on a common language for presenting the accounting and operational details involved in the process of government deficit spending. For otherwise their credibility will be severely diminished.

    Summing up: can deficit spending by the government create new money in the form of new bank deposits – yes or no? I’d answer with a clear yes, based on my reading of Lavoie.

  • Detroit Dan

    The government pays for spending by issuing bonds. The private sector receives money from the government spending & spends money to buy the bonds, but on net the private sector provides no money…

  • http://www.orcamgroup.com Cullen Roche

    “I’ d say the author was perhaps in a moment of low mental concentration”

    Not sure why MMT insists on insulting us every at twist and turn. It is you all who have an inconsistency in your story of govt spending. Kelton and Mosler have totally contradicting views, but most of you don’t even understand your own theory well enough to realize it. And no, JKH, Carlos and Mike don’t disagree with what I say. I just don’t have the time to write on the MR site as much as I’d like. We all agree 100% on these details and talk almost daily via email.

    Oh, and the “low mental concentration” is due to my discussions with people on the NY Fed’s capital markets group. The details on govt spending are not my own creation. They are the result of direct conversations with THE SOURCE. Not some academic “modern monetary theory” that is based almost entirely around a political agenda. I didn’t just make this stuff up to fit some model that I hope is right. I actually went to the source and got pure confirmation on how it works. There is zero “ideology” here. There is only description. You are free to reject it in favor of your theory. I am not here to twist people’s arms.

    More importantly, here’s some friendly advice (AGAIN) on getting people on board with your thinking. If you want other people to actually entertain your theory then I recommend you try to do so in a manner that doesn’t insult the person you’re questioning. Otherwise, your points fall on deaf ears drowned out by the screaming insults by people who sit in blog comment sections pretending to be experts as they anonymously sling insults at people. Frankly, I am tired of the childish and anonymous insults MMTers endlessly sling in internet comment sections. I don’t know why anyone would entertain conversations with you all. It’s beyond absurd. You all need to grow up. I don’t know how many times people need to ask you to be polite. Insults are the last refuge of weak arguments. No one takes MMT seriously because you sound like a group of screaming angry old men most of the time. I’ve recommended on multiple occasions that you try to behave like adults, but it seems like you’re all totally incapable of acting maturely. I have no idea why. It’s incredibly strange behavior for grown men to run around the internet screaming at other people on their websites and calling everyone who disagrees with them various names. You do yourselves no favors and it severely hurts your cause.

    PS – I’ve also explained how the USA is basically one big transfer union and that this system of redistribution is crucial to its success. If the MNE readers want to insult someone they might want to actually understand that person’s positions. Comments like Paul’s over there are flat out misrepresentations and he looks silly for saying things like that when I’ve written pieces about this that were disseminated broadly over the internet and likely reached more people than anything MMT ever wrote about this.

    http://pragcap.com/the-usas-federal-system-of-state-redistribution-why-it-keeps-us-from-turning-european

    Plus, I find the “ideology” comments hilarious. MMT is nothing but an ideology. It’s a political agenda that messily molds a description of the monetary system around it resulting in multiple contradicting stories. It’s so messy you had to evolve the theory to include “general” and “specific” cases….

  • http://www.orcamgroup.com Cullen Roche

    That’s not correct. I’ve confirmed this with the NY Fed’s capital markets group. Here’s how they explained it to me:

    “The primary way dealers finance their bond purchases is in the repo market. So here is one scenario. Funds are wired from the dealer’s account at its clearing bank to Treasury on issuance day. During the day, the clearing bank provides intraday credit to the dealer, so the dealer is borrowing from the bank. That same day, the dealer enters into a repo, pledging the newly acquired Treasury as collateral. The other side of the repo is likely to be a money market mutual fund or other money market investor. Therefore, by the end of the day, and for the overnight period, the money market investor is effectively funding the dealer’s position. Of course, there are a variety of ways in which positions can be funded, but the repo market is the key one.”

    There is no inside money creation in this process (from start to finish). It is all a redistribution and the creation of NFA in the bond. Just like buying via Treasury Direct (which is a rather simple process for anyone to understand). And yes, the source on this is someone high up in the NY Fed’s capital markets group. It is not a reputable source. It is THE source.

  • Jose Guilherme

    You didn’t answer the point of substance: can deficit spending by the government create new deposits – aka money? Are Lavoie’s accounting tables correct or do you have a (no doubt legitimate) issue with them?

    That is the only relevant question.

    But then again – maybe your comment on the government never creating new money was really a mis – statement of your position. That could happen to anyone and pointing it out shouldn’t necessarily be seen as another instance of evil MMTers trying to get you :)

  • http://www.orcamgroup.com Cullen Roche

    See my comment to Dan.

    I am not here to validate Lavoie’s description. If MR was simply MCT we wouldn’t have called it something different. I am a big fan of Lavoie, but if we were just copying MCT I’d have jailed myself for plagiarism long ago.

    And frankly, I don’t know why MMT is out “to get” anyone (very strange phrasing on your part). This isn’t a war. It isn’t one big mud slinging contest contrary to the absurd behavior that’s constantly on display at MMT websites. When you all begin to realize that this is a civilized conversation between adults (and not a war in internet comment sections) then people will probably start taking MMT seriously. You want people to take MMT seriously? Beat them with the facts. Not your name calling and petty insults. I’ve said this a million times to you guys, but you all just can’t resist a nice jab at someone who disagrees with you.

  • http://www.orcamgroup.com Cullen Roche

    And yes, so the boys at MNE know – of course this is different than the trillion dollar coin. That’s the WHOLE POINT of the coin idea – to circumvent the current design. It’s only a “conflict” with the standard MR view if you misrepresent the MR view.

  • Jose Guilherme

    Ok, then. If I understand your position, a commercial bank can NEVER lend directly to the government and thereby create a new deposit (money). Only the non bank sector may buy tsys directly from the government, acquiring a new NFA in the process – a govt bond.

    I realise that you are not “here to validate Lavoie’s description”. But if things really proceed as your Fed source claims – implying that Lavoie gets it wrong on such a basic fact (in his paper, he was trying to describe the U.S. monetary system as it is in real life)- then we’d have to conclude that it’s not only the neoclassicals that present an unrealistic picture of money creation. A frightening conclusion, IMO.

    As for the “MMTers trying to get you” part, it was just a bit of humour. Your first answer really seemed to imply that you see MMT proponents as people who are not exactly 100% well disposed towards you :)

  • SS

    Jose, are you saying that all deficit spending is money creation PLUS a net financial asset? Do you really think the US government has increased the money supply by 5 trillion dollars PLUS 5 trillion in bonds in the last 4 years? Some basic math should make you question that conclusion.

  • http://www.orcamgroup.com Cullen Roche

    The quote says “The primary way dealers finance their bond purchases”….PRIMARY way. I am not here to say Lavoie is wrong or right. All I know is that most of the descriptions of the US monetary system are not correct. MMT included. Lavoie spends a good deal of time describing Canada’s system in that paper. They’re quite different systems since the Fed doesn’t buy bonds directly. Lavoie knows that and while I haven’t reviewed his paper in quite some time I am pretty sure he states that specifically. But again, I am not here to dicredit MMT or MCT or anything else. I describe the system using the sources I’ve contacted and the understandings that I have. If you think my descriptions are wrong then fine, but you’re directly disagreeing with officials who are literally in the operations desk where this stuff all occurs. I didn’t make this all up. I went straight to the source. Frankly, I agree with the NY Fed as their description sounds entirely accurate.

    And yes, it’s not a big secret that MMTers dislike me. After all, they dislike just about anyone who disagrees with anything they say so it’s not a big surprise. What continually surprises me is how you all insult people relentlessly as if that’s going to help your cause or something. You just sound like the Austrians who no one takes seriously because they behave like children. I am not here to tell you all how to behave, but I can assure you you’re not doing yourselves any favors running around all over the internet slinging insults at everybody.

  • Jose Guilherme

    @SS

    I’m saying this:

    If a commercial bank lends directly to a government, at the end of the process of deficit spending the non-bank private sector (households and firms) will have an additional asset: the bank deposits created originally by the government (that is, new money).

    If lending to the government is done by households and firms, bypassing the banks, than the additional assets will be in the form of tsys. No new “money2 is created (the private sector – households and firms – paid initially for the bond with deposits and then was credited back the same amount of deposits via deficit spending; in net terms, it gained a tsy).

    This process can be clearly observed by having a close look at the tables in the Lavoie paper I mentioned above.

  • Jose Guilherme

    I’d read it this way: the investor will buy the bond with a previously-existing deposit so in this case there is no new money creation.

    However, if a bank buys a bond directly from the government by crediting the Treasury with a new deposit, then new money is created.

    Can this “direct lending to a government bu a bank” happen in the present instotutional structure of the U.S? That’s the question in search for a definitive answer.

  • Jose Guilherme

    @ Cullen Roche

    ” …it’s not a big secret that MMTers dislike me”

    Aren’t you generalizing a bit too much? I’m sure many MMTers have got nothing against you – after all, MMT and MR do have much in common.

    This is a hard fact that no amount of (sometimes harsh) debate can override.

  • http://www.orcamgroup.com Cullen Roche

    As explained by the NY Fed official – the PD borrows from its bank intra-day, but the loan is only temporary. So there is no new inside money created in the process except temporarily. The bond purchase is funded in the money market ultimately via repo of the t-bond. So, the only new asset creation in sum is the t-bond. Deficit spending expands NFA via bond issuance, but is a redistribution of inside money. This is at the heart of my disagreements with MMT.

    I am a little surprised that you all are only just catching onto the fact that this was the central disagreement about the “money monopolist” and JG arguments that occurred almost a year ago. I am beginning to think that most of the people at MNE who are slinging insults our way do not even understand what MR is. In fact, I am pretty certain that MMTers have no idea what MR is and have no real interest in understanding it because it would put a wrinkle in the rationale behind the policy ideas. But again, I am surprised that none of you seem to actually understand this since my monetary paper has been revised for a year now and this was the central point of my disagreement with the JG arguments which were the cause of the MR/MMT split to begin with….It’s also interesting that this description comes straight from the NY Fed and is described as “pure misunderstanding”, “BS” and “dead wrong” by three different people at MNE. I guess all these anonymous internet commentators know better than guys sitting on the SOMA desk watching these operations occur for a living. Pardon me if I trust my source at the Fed over a bunch of anonymous commentators at MNE. :-)

    For people who spend so much time insulting/discussing MR you sure don’t seem to understand it.

  • http://www.orcamgroup.com Cullen Roche

    Actually, I am extremely cordial with many of the founders. It’s the anonymous commentators at various sites and the ones who frequent this site who seem to have a big problem with me. But again, that is not my concern. I am not here on the planet to discuss MMT or discredit MMT. In fact, I haven’t written anything about MMT in almost a year. I answer questions on occasion when someone comments here, but I do that when someone has a comment about Austrian econ or any other position. I’m much harder on Peter Schiff, Paul Krugman and Scott Sumner than I am on any MMT founder, but none of their followers harass me in the comments here. It’s really bizarre behavior and it’s rather relentless. I really don’t get it. But these sorts of comments at MNE and other sites are practically relentless. If you all think MR is so wrong then just let it go. Who cares what I say? I am just a lowly finance guy who writes a moderately popular website. Surely, MMT has bigger fish to fry?

  • http://www.orcamgroup.com Cullen Roche

    Yes, it’s quite obvious that this process would have created a substantially stronger economy and much higher inflation if it were as Jose claims it is. M3 is only 15 trillion or so right now. If the govt were actually “creating” 1.2 trillion in new money per year then we’d have a much different economic environment. A little common sense blasts big holes in this thinking….Interestingly, I’ve described deficit spending as positive in a BSR because it creates a “flow” and adds NFA. The commentators at MNE obviously don’t even know what MR is since I’ve been using this “flow” commentary for a long time.

  • http://www.orcamgroup.com Cullen Roche

    Also, it’s worth emphasizing that there are two conflicting views in the MMT story about how this works. Brett and JKH detailed this conflict and it’s obvious that it’s unresolved gauging from the comments at MNE. I’ve asked MMT founders directly about this and they never agree on the view. Mosler actually banned JKH when he pressed him on this because Mosler surely realized that it makes MMT look very bad. Someone is wrong and it’s either Mosler or Kelton or both. Based on the NY Fed’s description they’re both wrong since deficit spending isn’t even a creation of money (unless you change the definition of money to include t-bonds, which is another MMT view that’s also wrong, but a slightly different matter). I must admit though – I find it rather alarming that this INCREDIBLY important point is not understood by all the expert commentators at MNE. It proves that they don’t even understand the theory they spend so much time insulting other people over. This point is central to the MMT argument and the MRists understood it a year ago. Hence, why we disagree with MMT. If the MNE commenters understood this point they wouldn’t agree with MMT either, but they don’t and it’s crystal clear that they don’t given the comments there tonight. It’s clear that most of MMT’s biggest proponents don’t understand this point yet and the founder themselves completely contradict one another on it and have never clarified why they have written many different conflicting papers over the years describing this process. That’s a huge red flag about the theory. You might want to explore this one a bit further and obtain a clear answer from both Kelton and Mosler (and find out why their past descriptions conflict). They can’t both be right, but ultimately, I don’t think it matters much since the Fed officials comments prove that they’re both ultimately wrong.

  • Jose Guilherme

    I understand you all right.

    You are saying – based on your Fed source – that accounting entries for financing deficit spending, such as those presented on Lavoie’s paper for commercial banks balance sheets:

    Assets: government bond (newly-issued)
    Liabilities: government deposit (created “out of nothing”)

    Can’t happen in real life in the U.S. as of 2012-13.

    Had anyone at MR made this observation before?

    For instance, JKH has praised many times (correctly, in my view) the quality of that specific paper by Lavoie. But now it seems that it contains – as implied by said Fed source – at least one glaring mistake.

    So I’d say that our knowledge of the real workings of the U.S. monetary system is still evolving as we speak, so to say, with new discoveries forcing us to reassess our beliefs with disturbing frequency.

  • Jose Guilherme

    I agree with you that this is a very relevant point. And it’s not only Kelton and Mosler. Lavoie – who represents a different school of tought – also says that commercial banks can finance directly the government’s deficit, creating new deposits for the government in the process.

    It’s an important issue. It concerns facts, not theory. I guess it should be easy to settle in an empirically oriented science such as economics :)

  • http://www.orcamgroup.com Cullen Roche

    There are many methods by which banks can finance their position. But the primary one is the one I have described. And I assure you it’s accurate as the source of the information is not someone who would get this stuff wrong. I have also confirmed this with the other side of the trade because I talked to an analyst in the bond department at a major ibank who has access to the PD unit.

    It’s my opinion that the MMT position on this is wrong. In fact, I don’t think anyone in the field of economics actually describes it the way MR does which would render the entire field wrong. I don’t doubt that I could be wrong on this, but I would be shocked if all my sources are wrong since they’re literally specialists in how these operations actually work within the key institutions involved….

  • Jose Guilherme

    “There are many methods by which banks can finance their position. But the primary one is the one I have described”.

    If – underline, if – this is so, then the primary way that the U.S. government finances its deficit does not create new bank deposits for the government (new money).

    It would remain to be seen whether there is any institutional obstacle to the banks directly financing the Treasury, or if this is just a matter of actual practice that could change any time the government wills it.

    I just don’t find it very logical that the commercial banks can lend to any third party (it’s their very reason for existing, in the first place) except when that third party happens to be the U. S. government. Doesn’t seem to make much sense.

    But, yes, it could be so – again, it’s a simple matter to be decided in an empirical inquiry.

    And yes, academics should settle this issue once and for all for the benefit of their reading public.

    It’s the very least that we can ask of them.

  • http://www.orcamgroup.com Cullen Roche

    Empirical inquiry? You know, to be frank – I am tired of relying on academics to understand how the world works. If there’s one thing I’ve learned from most economists it’s that they have no idea how the actual world works and instead prefer to work on theories that rationalize some preconceived policy or political bias. That’s all well and good, but when it comes to understanding complex operational realities it’s pretty useless. So, I go to people who actually work in these institutions who make their living by understanding these things. So, in my opinion, no academic opinion is necessary here since I’ve already obtained the answers from the people who know.

    I’d add though that yes, in theory, the system could always be changed or utilized in ways that differ from my description. But I don’t focus on what can be. I focus on what is.

  • Jose

    ” If there’s one thing I’ve learned from most economists it’s that they have no idea how the actual world works”

    How true – sadly true.

  • Jose

    Anf yet there is an academic who previously worked in the banking sector – Prof. Richard Werner – basically making points similar to your Fed source.

    Here in an excerpt from the recent primer coordinated by Werner on “Where does money come from?”.

    (Page 123): “…government spending merely reallocates pre-existing money around the system. It does not create new money. The only way new money could be created is if a commercial bank directly purchases a government bond – via the creation of new credit – and the recipient of government spending is not a bank”.

    Interesting, wouldn’t you say?

  • http://www.orcamgroup.com Cullen Roche

    Not just interesting, but right! It sounds very similar to MR. I’ve just started reading more and more of Werner’s work. I believe he’s a Positive Money guy. You might be interested in this paper by him. It’s quite good. Many similarities with MMT, but probably more similarities with MR than MMT.

  • Cowpoke

    “But I don’t focus on what can be. I focus on what is.”
    Yep, ya have too. Which is why these long term CBO projections and relying on them for plicy directions of politicians is silly:

    In 2002, CBO predicted 2012 US debt would be 7.4% of GDP. In reality, it was almost 74% of GDP
    http://www.aei-ideas.org/2012/12/in-2002-cbo-predicted-2012-u-s-debt-would-be-7-4-of-gdp-in-reality-it-was-almost-74-of-gdp/

  • SS

    Cullen, the reason why you are making progress with MR is because economists are discredited and as a practitioner and someone with access to practitioners, you have credibility. Some people think a PhD in economics gives someone credibility. Thats baloney.

  • Jose

    On second thoughts the relevant point is whether it was a depository institution or a non-bank entity who financed the deficit in the first place.

    Non bank entities (households, firms, pension funds) must buy the bond by debiting a bank deposit. Then, as the government deficit spends they will receive the same amount of deposits back – because they are the beneficiaries of said deficit spending. The net creation of money (deposits) will be zero but the non bank sector will have gained new assets in the form of Treasury securities.

    When it is a bank that buys the government security in the primary market (whether this is done by using pre-existing reserves or by extending credit to the government does not really matter for the point that concerns us) no deposit will be debited in the first place. Thus, when the government spends by crediting household or firm accounts in the banks a new deposit will be created – aka “money”.

    In this case, for the private sector (bank and non-bank) as a whole the NFAs will be in the form of government securities because the newly-created bank deposits are assets for households and firms but liabilities for the banks. The “net” assets of the private sector will thus be the Treasury bills or bonds – just like it happens when it is the non-bank sector that buys the bonds in the primary market.

  • http://catalystofgrowth.com/ DOB

    Banks are not constrained by their reserve balances as many neoclassical economists believe.

    Hi Cullen,

    I agree that fractional reserve banking is taught in a misleading way, but I don’t think neoclassical economists believe that. I think nearly all economists understand that at the individual level, the scarcity of a resource is manifested by its price, not by direct visibility over the total amount available. That’s true just as true for bank reserves as it is for bank reserves.

    MMT-ers love to ridicule the establishment by attacking the wrong straw man, but generally they quote journalists or Austrians.

    Maybe I’m wrong, but do you have any evidence to show that the establishment is really that clueless about the banking system?

  • http://www.orcamgroup.com Cullen Roche

    Right. And the primary way this occurs is through the non-bank financing route as I described.

  • http://www.orcamgroup.com Cullen Roche

    Read your 10:15 & 10:31 comments at MNE. They are correct. Consistent with Brett, JKH and all of MR. Also confirmed by my NY Fed source.

    So, looks like you’re an MRist? :-)

  • http://www.orcamgroup.com Cullen Roche

    Also, your 10:15 is very important. MMT likes to blur the lines on what money is so they can include tbonds in their description. Tbonds are securities. They are a claim on zero duration money and have no use as a medium of exchange in the same sense of moneyness that a bank deposit or currency has. Take a tbond into Wal-Mart if you dont believe me. Also, this gets messy when describing other securities. Does this mean AAA pvt sector entities issue money as well?? You can see the tangled web MMT weaves here.

  • Jose Guilherme

    I like the rivalry between MMT and MR because it helps us to improve our knowledge of the monetary system.

    No struggle, no gain :)

  • Jose Guilherme

    Money is currency in circulation plus deposits; Tbonds are not money.

    An interesting point made by Richard Werner is that only 3% of money (deposits) is created by the government – the rest being created by banks as a byproduct of new loans.

    I’d like to know how he arrived at this figure. For the UK in 2012 , I suppose he’d have to sum up all new currency and deposits resulting from deficit spending and then divide by the total amount of net deposits created in the banking system.

  • bb

    “An interesting point made by Richard Werner is that only 3% of money (deposits) is created by the government – the rest being created by banks as a byproduct of new loans.”

    Can you post a link for the above?

    TIA

  • Jose Guilherme

    Forgot to add a term in the end.

    The formula for the percentage of “money” that is issued as a result of the government deficit spending should be something like:

    Currency plus deposits created as a result of deficit spending

    Diivided by

    Currency plus total net deposits created in the banking system

    Times 100

  • Jose Guilherme

    I don’t have a link. The quote is from the second edition of the book “Where does money come from?” co-authored by Werner. It was recently issued in the UK.

    The book is a great read even though the more technical, accounting details are not as clear as the tables provided in the Lavoie paper on neo-chartalism that I cited above.

  • http://www.orcamgroup.com Cullen Roche

    I think “rivalry” is the wrong term. It implies that I am enemies or have angst against someone. I am only seeking the truth. I don’t dislike Mosler, or Sumner or other schools. I just want the truth. As a market practitioner I am concerned with understanding the world for what it is. All of economics describes a world as they want. Austrian econ starts with a small govt ideology and conforms their understanding around it. MMT starts with a big govt view and conforms a view around it. I’m not interested in the policy so much so my view is purely descriptive. In my opinion, MR has become one of the only non-ideological accurate descriptions of the money system that presently exists….

  • http://www.orcamgroup.com Cullen Roche

    Also, your friend “Y” is wrong. He seems to think reserves are the money he has in his bank account. Tell him to call the US Treasury and ask them two questions:

    1) Can the Treasury spend before it obtains credits via taxes or bond sales? (hint: the answer is no).

    2) Can the private sector spend reserves at Wal-Mart? (hint: the answer is no).

    The accounting is rather simple and the reserve voodoo that MMT plays through settlement obscures it all (JKH already explained how the “settlement” idea in MMT is totally misleading – if one actually explores this it’s rather easy to understand how it’s a misrepresentation). The govt procures funds via taxes and bond sales thereby obtaining private inside money which results in a credits to the Treasury’s account. The Fed will intervene to add reserves if necessary (TO ACHIEVE MONETARY POLICY, NOT FISCAL!). Today, with the banks awash in reserves there is no need to intervene so the MMT point on reserves is wrong to begin with. Reserves are issued to help the Fed implement monetary policy. MMT confuses this to obscure the lines between monetary and fiscal policy. It’s wrong. When the Treasury procures funds (as it is legally obligated to do) it can then credit private sector accounts. So, it’s private inside money credit money in and private inside money debited out. The accounting is simple. If “Y” can confirm with the US Treasury that they can spend out of their account without selling bonds or taxing then I am wrong. But I am not wrong and I have verified this with sources at the NY Fed who actually work in these operations on a daily basis.

    Of course, you can obscure this process by consolidating Fed and Tsy balance sheet or by misconstruing what the Fed actually does via reserves, but then you’re not actually describing the US system. You’re describing something else. That’s all well and good, but it doesn’t help anyone actually understand the system we have.

    Govt spending is a redistribution of inside money. It is not a spending of outside money and bank reserves. The reserve process is monetary policy, NOT fiscal policy. MMT confuses the two, plain and simple.

    This was all confirmed by the NY Fed comments. So, you can either trust the guys who do this for a living at the actual institutions implementing it or you can believe a bunch of anonymous commentators on a MMT website. Your choice….

  • Jose

    I don’t think “rivalry” is pejorative. I see it in the positive sense of competition.

    Just like two persons competing for a gold medal can be friends while remanining rivals. Competition will guarantee they they’ll do the most to succeed in their objective.

    They both strive to be the best – and MMT and MR should also try to attain the best, most accurate description of the real workings of the economy in general and the monetary system in particular.

  • http://www.orcamgroup.com Cullen Roche

    Now he says:

    “The treasury receives payment in state money and spends in state money. Bank credit is a promise to pay state money. “

    No, the Tsy receives payment in bank money. Again, the NY Fed official explained this explicitly. I don’t know what else you need to know. Sure, you can obscure via the reserve settlement process (which is monetary policy), but that doesn’t change the facts that the NY Fed officials explained to me.

    Also, bank credit is not a promise to pay state money. You don’t pay your taxes in state money. Private citizens pay their taxes in bank money. But again, MMT obscures the settlement process as if there’s something special occurring just because we have an interbank market managed by the Fed in order to help the govt procure funding.

    It’s all voodoo based on an attempt to rationalize policies based on the myth of the “money monopolist”. The MMT reserve settlement explanation is a complete misrepresentation of the actual flow of funds occurring in the monetary system.

  • Jose

    The answer to both 1) and 2) is no – I agree.

    But a MMT sympathizer might add on 1) that, while no is the technically correct answer, the point is not really very important because in practice the Treasury always manages to sell each and every bond that it decides to issue in order to finance government deficit spending.

    The private sector is always eager for risk free government securities providing it with a nice amount of interest income by the end of each period – a form of corporate and upper class welfare that we know well here in Brazil (for decades, the Brazilian T bonds provided unbelievably huge amounts of interest to said beneficiaries, although that “tit” is now drying up, so to speak, in relative terms).

    As for government spending always being a distribution of inside money, we’ve already agreed that this is so only when the government sells its new securities to the non bank sector. If banks are doing the buying in the primary market then at the end of the process of deficit spending the household/firm sector will have new, net deposits as assets – that is, new money.

    This can be seen in extremely clear terms in the accounting tables provided in the Lavoie paper. If you simply scrap his first step (banks “lending” to the government by crediting new deposits to the Treasury) it’s still the case that the private sector (non bank) will have gained new deposits by the last step.

  • http://www.orcamgroup.com Cullen Roche

    I agree with you, but as Brett has showed in his MMT critique, the banks on-sell their inventory. They hold, what, 10% of the bonds they buy now? It’s a marginal piece of the pie. As my Fed source explained, the “primary” way this is financed is via non-banks. So, MMT can latch onto these minor points and claim they’re right, but they’re obscuring the bigger picture in doing so and doing no one a service in understanding how the system actually works. To me, that’s the very definition of latching onto some ideology. I don’t understand why that’s necessary. It’s not helpful in any way.

    You also said:

    “the Treasury always manages to sell each and every bond that it decides to issue in order to finance government deficit spending.”

    This is a dangerous assumption. If you study LatAm hyperinflations you’ll find that this is most certainly not true. And it’s not due to the usual MMT excuses like currency pegs or whatever. It’s due to the fact that a sovereign currency issuer is not immune to the realities of hyperinflation. And in a hyperinflation the sovereign will not be able to procure funds via taxes or sell its bonds. So, what will happen? The govt will spend via sourcing its central banks funds. That’s all well and good except that it adds to the money supply by ADDING on top of the supply of inside money that already exists. This is why govt spending in a hyperinflation exacerbates the currency collapse. The inability to procure (redistribute) existing money exacerbates the currency collapse. This is really an Achilles heel in MMT. A thorough researching of LatAm hyperinflations would put a wrecking ball through some of the generalizatons and misrepresentations in MMT.

  • Jose

    Yes, but hyperinflations are an exception – an extremely rare exception.

    In normal conditions, the Treasury of a monetary sovereign will have no trouble selling its bonds at a rate of interest close to the interbank rate that is manipulated by the central bank.

    This has been so even in a country recently plagued by hyperinflation, such as Brazil. For the last two post-inflationary decades the Treasury has generally managed to sell its issues denominated in Reais at rates equivalent to the Selic (interbank) rate.

    So that MMT sympathizer interpretation might be true “most of the time”.

  • http://www.orcamgroup.com Cullen Roche

    Well, dying is a rare occurrence in the grand scheme of one’s life. A doctor who doesn’t understand the causes of death in the system they are supposedly an expert on would not be taken very seriously. The sad reality of hyperinflation is that it’s this 1% occurrence that destroys 100% of the economy. So, to misunderstand it is a rather glaring hole in my opinion. Still, none of this even scratches the surface on why MMT’s description of the govt “creating” money is wrong. The govt absolutely does not create money in our current design.

  • http://www.orcamgroup.com Cullen Roche

    Oh, and “Paul” at MNE is saying that cash is the real money. Of course MMT will say this. As if anyone pays their taxes in cash that gets shredded (per Mosler). Ha. No, cash is outside money. It facilitates inside money accounts. You can’t obtain cash unless someone has drawn down an account in inside money. Cash is merely one way the Fed (via the Tsy) facilitates the existence of a private money system designed entirely around inside money. We don’t go through life seeking cash. We go through life seeking inside money. And in fact, cash is going extinct in many modern economies. Sweden, for instance, is going cashless by 2020. Inside money rules the monetary roost. It is a system by the banks for the banks. MMT has it completely backwards!

    This is all plain as day for the person who is willing to open their mind to the realities. There’s no need for the voodoo and misrepresentations.

  • Jose

    IMO, a social science theory that is proved correct 90% of the time is a pretty good theory.

    Say econometric studies show that, in 90% of the instances and countries examined, deficit spending resulted in a statistically significant effect in reducing unemployment and raising economic growth. And that in the other 10% no effect was found.

    I’d vote for deficit spending in a recession, hands down.

    You?

  • http://www.orcamgroup.com Cullen Roche

    Yes, but I think it’s important to understand why deficit spending helps. The primary way it helps is by creating a flow in the economy. As you know, an economy is just a system of flows. I describe this like the human body. When the flow stops, the body dies. The govt can just about always keep the flow going (a flow in INSIDE money). It can almost always procure funds to spend into the economy and keep this flow going. That’s a very powerful tool we have.

    The other important fact about deficit spending is that it adds NFA (but not money). This can bolster pvt balance sheets in a big way.

    What I don’t like is when people describe deficit spending as “money creation” or “money printing”. That misrepresents what actually happens. Deficit spending is an increase in the flow in the economy and an increase in NFA. If people want to criticize where this flow goes then be my guest. That’s a conversation worth having. But don’t misrepresent what it actually is. The operational realities matter.

  • http://www.orcamgroup.com Cullen Roche

    Your 2:49 PM comment at MNE is very important and something I hope MMTers start to understand. This is the point MR has been making for a long time now. Brett made it years ago (he was way ahead of the curve here).

    I just looked up the holdings of banks. Depository institutions hold 3% of the outstanding t-bonds. So your #1 example is practically a moot point. Banks on-sell their inventory or hedge it out so their exposure is not direct. Again, this is all consistent with my NY Fed source which is why I am so confident that he’s right.

    So, should we welcome you onboard the MR train? :-)

  • Jose

    “What I don’t like is when people describe deficit spending as “money creation” or “money printing”

    Well, usually it’s the neoclassicals who obsess about the evil of money printing to finance the deficit – meaning, presumably, the government selling bonds directly ti the NCB and bypassing the private markets.

    In fact, this gets it all wrong. As we’ve seen in our examples probably the most inflationary form of deficit spending occurs when the non bank sector buys the bonds. Because in this case, said sector will have a highly liquid asset (though not “money”) that will provide interest at the end of the period. Whereas, when the government sells bonds to the banks (same would happen if it sold them to the Fed, Canadian-style) the non bank sector will end up with a non interest paying (or lower interest paying) deposit.

    Likely, the household/firm sector will spend more if it ends up holding a bond instead of a bank deposit.

    Thus, inflation risk is also higher in this case.

  • http://www.orcamgroup.com Cullen Roche

    Yes. You should read this Bezemer/Werner paper. I think you’ll like it. I’ve started doing quite a bit of research on their concept of “disaggregation of credit”. It stresses the focus of endogenous money in credit based money systems and the impacts by which the extension of this credit has differing impacts. They argue that there are productive and non-productive credit uses. The housing bubble, for instance, is a clear example of the way that credit can be used in non-productive ways (for speculation rather than real productive uses). I think this is such an incredibly important point. It’s not only MR consistent, but breaks down the thinking into a much more granular view.

    http://mpra.ub.uni-muenchen.de/17691/1/MPRA_paper_17691.pdf

  • Jose

    I’ll read it yes, thanks for the suggestion.

    I did like Werner’s Positive Money book even though I found the technical, accounting parts less clear than those written by Marc Lavoie.

    It would be nice to have a textbook that explained clearly all the accounting steps that are required for deficit spending, clearing and settlement of balances, the role of the central bank, etc. With a realistic description of what happens in reality – as opposed to the fancy models that one reads in the monetary policy chapters of neoclassical manuals.

    There is a very good text on this at the introductory level – the two chapters on money written by Lavoie and Seccareccia in the Canadian edition of the Baumol & Blinder Macro textbook.

    There is also a book by Bindseil on monetary policy in the euro area that has been praised by Fullwiler, but I hesitate to spend the required time on a what is for me a rather unknown product and author (the paper that Bindseil co-authored on TARGET2 is interesting but unnecessarily complex, IMO).

    Perhaps JKH would care to write an intermediate text on Money? :)

  • http://www.orcamgroup.com Cullen Roche

    JKH and Brett have a lot of different things in the works. Unfortunately, MR is all a work in progress to a large degree so the ideas are literally evolving and being developed as we go.

    I’ll look into the books you mention. Thanks. Have a happy new year!

  • Jose

    Thanks.

    I also wrote a paper on debt rollover by eurozone countries and TARGET2 – but it’s in Portuguese, unfortunately :)

    Happy New Year for you!

  • Pierce Inverarity

    From the looks of it you could probably quickly translate it to English! I know the regulars here would be interested in reading it.

  • Jose Guilherme

    Ok, I’ll think about that after the New Year.