THE FED IS NOT MONETIZING THE DEBT

The Fed’s purchases of treasuries continue to attract a huge amount of attention.  Despite solid evidence that the program is failing to have any real fundamental economic impact there are other worries about the program.  None has been more apparent in recent weeks than the Fed’s supposed monetization of the US government’s debt.  These fears of monetization are unfounded due to the various myths that are perpetually touted by the mainstream media, supposed experts on the US monetary system and even Fed officials.

In an article Monday, Bloomberg reported that the Fed has been buying an exorbitant proportion of the recently issued treasury debt:

“More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers’ holdings of Treasuries to the lowest since November 2009.”

Why does this matter?  Because it gives the appearance that the US government is directly funding itself via the Fed’s purchases.  This would be nefarious if it were true and would give credence to the endless complaints about the high rate of inflation in the USA (which is currently running at a staggering 1.5%-2.25% depending on the source).  Fortunately, the concerns are unfounded.

When the US government was working under the gold standard the US Treasury would literally print up certificates to purchase gold from the gold mines.  These gold bars would be delivered to the government and the Treasury would issue a check to the miner.  This new money would end up at the Federal Reserve Bank in the form of deposits.  This would naturally increase the money supply.   An increase in the money supply is scary for obvious reasons.   So, the term debt monetization has its origins in the days of the gold standard, but persists to this day despite the fact that we are no longer on a gold standard.  Not surprisingly, the term is still used today despite the fact that the US government can’t monetize its debt via Fed purchases (I elaborate below).

This issue was magnified yesterday when Richard Fisher of the Dallas Fed invoked the evil “debt monetization” term in his speech:

“the FOMC collectively decided in November to temporarily undertake a program to purchase U.S. Treasuries that, when added to previous policy initiatives, roughly means we will be purchasing the equivalent of all newly issued Treasury debt through June.  By this action, we have run the risk of being viewed as an accomplice to Congress’ fiscal nonfeasance. To avoid that perception, we must vigilantly protect the integrity of our delicate franchise. There are limits to what we can do on the monetary front to provide the bridge financing to fiscal sanity. The head of the European Central Bank, Jean-Claude Trichet, said it best recently while speaking in Germany: “Monetary policy responsibility cannot substitute for government irresponsibility.”

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases. I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation. And I expect I will be at the forefront of the effort to trim back our Treasury holdings and tighten policy at the earliest sign that inflationary pressures are moving beyond the commodity markets and into the general price stream. I am a veteran of the Carter administration and know how easily prices can spin out of control and how cruelly markets can exact their revenge. I would not want to relive that experience.”

Fisher’s implication is that the Fed is directly helping to fund the US government’s spending.  After all, if they’re buying the debt then they’re obviously funding the spending, right?  Wrong.  As regular readers know, the US government is never constrained in its ability to spend.  Our monetary system underwent a dramatic change when Richard Nixon closed the gold window. It removed any constraint on the US government’s ability to spend.  Nonetheless, the operating structure of the gold standard (issuing bonds, etc) still largely remained intact.

It’s important to understand the Fed and Treasury’s symbiotic relationship.  When the US government wants to spend money they do not call China and ask for a line of credit.  They do not count tax receipts.  And they most certainly do not call the Fed to ensure that we have any money left.  The Treasury is actually able to harness banks as funding agents at all times due to the unique relationship between the banking system, central bank and US government.  So the entire implication that the Fed is helping to fund US government expenditures is entirely inaccurate and anyone who implies as much is still working under the now defunct gold standard model and clearly doesn’t understand the workings of the modern monetary system.  Auctions in the USA don’t fail because they’re designed not to fail.

For a brief instant, Mr. Fisher appears as though he is on the verge of understanding the system he now heavily influences as a new voting member of the FOMC.  Mr. Fisher says that the spending effectively comes first:

“But here is the essential fact I want to emphasize and have you think about today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place….The Fed does not create government debt; Congress does.”

Lights should be going off in Mr. Fisher’s head at this point as he says this. Congress can’t “run out of money” unless it decides to.  That is, the US government is always able to raise the necessary funding through bond issuance if it must (see here for more).  The idea that the US government can’t “run out of money” is so foreign to most people that their minds repel it.

By now you might be thinking that this is all semantics.  Who cares if the Fed isn’t helping to fund the spending?  They’re still buying the bonds and the spending is occurring regardless of the Fed’s actions.  Well, it’s important for several reasons:

1) Someone who understands the modern monetary system understands that a sovereign government with endless supply of currency in a floating exchange rate system has no solvency issue.  Therefore, it should not be treated as if it is a household, business or state.

2) If solvency is not a concern then clearly the concern is inflation or potential hyperinflation.  But as we’ve seen over the last few years the Fed has not succeeded at creating inflation anywhere close to the historical average and certainly not dangerously high levels of inflation.  To someone who understands how the modern monetary system functions it not surprising then, that the Fed has been unable to generate inflation during a balance sheet recession.

3) We have to be very precise about monetary operations and the relationship between the Fed and Treasury.  Although I acknowledge that the US Congress is never constrained in its ability to spend this by no means implies that the US Congress should spend beyond its means.  To do so can possibly result in malinvestment or very high inflation.

4) The idea that the Fed is buying government debt might imply that there are is a shortage of buyers of US debt.  This is impossible due to the government’s symbiotic relationship with the Fed.  Auctions are designed around calculated reserves and are carefully designed so as not to fail.

5) Voting members of the FOMC do not understand the actual workings of the Federal Reserve System and the US monetary system and have played a direct role in the misguided policy response in recent years.  Of course, this is nothing new.  This problem has persisted throughout the entirety of the last 40 years and is largely to blame for the structural flaws in the US economy currently.

6) The overwhelming majority of US citizens have no idea how the US monetary system actually functions and therefore are reluctant or unable to force any sort of real change.  Those with political or monetary motivations tend to invoke fearful language that incites anger and in truth only adds to the problems in the US economy by driving the voter base to react to their emotions and not their knowledge of the system in which they reside.

7) Quantitative easing does not increase the money supply and is therefore not inflationary.  Although this operation can have significant psychological impacts (such as inducing undue speculation) QE can only work in the same manner that traditional monetary policy is implemented at the short-end of the curve.  This occurs by setting a target rate and by being a willing buyer of any size at that rate.  This is NOT how the current policy is designed.  The current structure of QE leaves interest rates entirely controlled by the marketplace and not the Fed.  Therefore, the mixed results should come as no surprise to anyone as the policy was poorly designed to begin with and is likely doing little more than contributing to excessive speculation and promoting the continued financialization of the US economy.  The Fed’s implementation of such policies (such as QE) and complete misunderstanding of such policies does nothing but help create disequilibrium in the marketplace and increase the odds of future instability.


See the QE primer for more details such as the proper discussion of “monetization” with respects to the various QE transactions.

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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Comments

  1. Once again I respectfully disagree with your statement that The Fed is not monetizing the debt. In fact, in two of today’s press articles The Fed even admits to doing so.

    And according to Marc Farber, “Money printing is essentially when the central bank expands its balance sheet”. (Which, by the way, The Fed admits to now.)

    Here are two key snippets from today’s Fed Posts:

    (1) Richard Fisher, the president of the Federal Reserve Bank of Dallas, said in a speech Tuesday: “Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases. I would be very wary of EXPANDING OUR BALANCE SHEET further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”

    http://finance.fortune.cnn.com/2011/02/08/feds-fisher-vows-to-oppose-qe3/?iid=EAL

    (2) Ben Bernanke himself said:

    …that quantitative easing would not permanently increase the money supply, since the Fed plans to reverse the policy once the economy recovers.

    Bernanke repeated that point several times throughout the Q&A session, constantly reassuring representatives that the Fed fully intends to increase interest rates ahead of a rapid rise in inflation.

    “If the economy begins to grow very quickly, and inflation begins to rise, then we would reverse it,” he said.

    http://money.cnn.com/2011/02/09/news/economy/bernanke_paul_ryan/index.htm

    I believe you can continue to argue the wrong side of this tale all you like, but The Fed itself counters your argument.

    • “intends to increase interest rates ahead of a rapid rise in inflation.

      He is covering is bets but it will be to late when the money supply fires on all cylinders.

  2. Until you have proof it’s just religion, but it ‘feels’ right to me and I don’t believe Bernanke is trying to ‘screw’ people out of their money. And I use the term ‘print money’ much too often as a bad habit.

    I am just looking for real world ‘pragmatic’ tools to fix the problems or know when things are getting outa whack. And last time I checked they were looking for ideas in Washington too. (Some send-in-your-ideas by letter campaign) Heard the tail end on NPR .

  3. …in the US, the government may spend till the cows come home, but the Supply of Money out of which debt needs to be repaid is under absolute Fed control…hence Finance Capitalism rules since 1913

    Kind Regards

  4. Mr Roche,
    So let me get this straight, you understand our monetary system better than government officials, federal reserve officials, or more to the point, anyone who disagrees with you? Or are you suggesting those in positions of power simply perpetuate these myths so as to more easily manipulate the public vis-a-vis their MSM apparatus?

    • No, there are people in government who get this. But most do not. So, do I understand it better than most? Yes. For instance, most Fed officials have been working under the money multiplier theory until just recently. The Fed just recently issued a paper admitting that the theory is entirely incorrect. Nonetheless, you still have people like Richard Fisher claiming that the added reserves pose some sort of inflation threat. Even though I can prove that this is entirely false.

      So yes, I guess I am claiming that I know more than some Fed officials. And in fact, I can prove it.

      • Well, I do like your self-confidence, although I’m sure you understand how it can sound a lot like arrogance. I am certainly open to exploring MMT, esp considering how the current theories haven’t done much, and in fact have seen conditions get worse. Reading through the link you’ve provided, it’s almost like an English speaker learning Chinese by way of Russian. Wonder what Mauldin, Mish, and Denninger would say about this.

        • I have followed your blog for quite some time and have found it transformational. Thank you for all you efforts in enlightening and educating. I was curious as to how the shadow banking system relates to MMT, particularly since said shadow banking system has contributed (to some extent) to the problems we now face.

  5. real simple question here.

    i look at a US dollar and it says it is a note, or obligation, issued by the federal reserve.

    so currency, the simplest form of money supply, is an obligation of the fed.

    now let’s go to QE1. fed buys maiden lane cdos from some private bank and issues in exchange reserves (bookentry rather than issuing a piece of paper currency), which are obligations of the fed. more obligtions of the fed outstanding after transaction than before.

    looks to me like there is more money outstanding than before.

    now lets go to QE2. fed buys obligations of the fed treasury and issues in exchange reserves (bookentry rather than issuing a piece of paper currency), which are obligations of the fed. more obligtions of the fed outstanding after transaction than before.

    so how is it that, looking at the liability side of the federal reserve, that more money hasn’t been created by the fed in these last two situations, as much as if it issued paper currency in those transactions to pay for the cdos and treasury debt?

  6. Dear sir, are you also refuting the words of The Fed Chairman which are in accord with Richard Fisher’s? Are you implying that even Ben himself does not understand the purpose of his committee’s policy as well?

    For as I shared with you, Ben stated several times before the Congressional Banking Committee today…

    “…that quantitative easing would not permanently INCREASE THE MONEY SUPPLY,…”

    For me, this affirms that the Fed is intending to and has knowingly increased the money supply (if albeit hoped for only a relatively short period of time).

    If Ben, himself, believes The Fed has increased the money supply, then one is obviously lead to the conclusion that the Asset side of the government’s Balance Sheet equation has increased! One is therefore, in turn, to believe that Fisher’s statement is in alignment with Ben’s and also correct.

    • The Fed has technically increased the monetary base. But that does not mean they are “printing money”.

      now you have really lost me with this one!

      we may have to agree to disagree on this, but the fed is the lender of last resort for a reason: because its obligations are qualitatively different from every other US banks’ obligations.

      you cant just equate the fed’s obligations to a private party’s obligations, and say that they are all financial assets being swapped around, with no new net issuance of financial assets when the fed issues its obligations in exchange for a private party’s (or the treasury’s) obligations.

      the fed issues obligations and they are “money good”. a private party or the treasury issues obligations and they are as good as the underlying credit (and while the treasury may not be solvency constrained, they can certainly be credit constrained)

      • the monetary base and the money supply are different measures. maybe this is where you’re struggling?

  7. cullen,

    you say in that piece (paraphrasing) that no new money is being created through QE because the private party’s B/S remains the same, except for the substitution of fed reserves for the t bond.

    “Because they are not adding net new financial assets to the private sector. The assets already existed! They are merely swapping reserves for bonds.”

    but i think you are looking at the wrong B/S. if you look at the fed’s B/S, as opposed to the private counterparty in the QE transaction, you will see more federal reserve obligations outstanding than before.

    you should look at the federal reserve’s B/S because they are the issuer of money, put simplisticly.

    too take my question to the extreme, suppose the fed issue bank reserves for every mortgage obligation outstanding and held by private parties? in such a case, hasn’t the federal reserve massively expanded its liabilities (read money outstanding).

    i don’t mean to be argumentative, and we may ultimately be simply having semantic differences, but as far as i can see, a t bond is as different from fed reserves as a cdo is different from fed reserves, insofar as we are talking about the federal reserve’s role in creating money. )getting closer in credit quality too.)

    • I get your point. But it’s kind of like saying that the govt has created new money if it prints up 8 trillion and buries it in a hole. Who cares that they did that? The important factor is whether it gets injected into the pvt sector. Clearly, that is not happening.

      • “The important factor is whether it gets injected into the pvt sector.”

        now that is a horse of a different color. bank demand for money (fed reserves) is greater than willingness to extend bank credit. that can change, and methinks that will change as economic conditions improve, especially as long as the yield spread remains high.

        • Increasing the size of the Fed’s balance sheet (the monetary base) is not inflationary. It does not directly add to the broader money supply. If this were so inflationary Japan would be up to their neck in hyperinflation by now. Heck, we wouldn’t even be having this discussion if QE1 had generated inflation and that program was TWICE as large.

          “The nonbank public – nonfnancial
          corporations, state and local governments and
          households – cannot use deposits at the Federal
          Reserve Bank to effectuate transactions. Moreover,
          currency is not suffciently broad to be considered a
          temporary abode of purchasing power. For Friedman,
          high-powered money can be properly regarded as
          assets of some individuals and liabilities of none.
          So, let us be clear on this subject. In 2008, when the
          fed purchased all manner of securities, to the tune of
          about $1.2 trillion, the fed was not “printing money”.
          Bank deposits at the fed exploded to the upside, the
          monetary base rose from $800 billion to $2.1 trillion,
          yet no money was “printed”. Deposits did not rise,
          loans were not made, income was not lifted, and
          output did not surge. The fed could further “quantative
          ease” and purchase another $1 trillion in securities
          and lift the monetary base by a similar amount yet
          money would still not be “printed”. It is obvious the
          fed authorities would like to see money, income, and
          output rise, but they cannot control private sector borrowing. If banks were forced to recognize bad
          loans and get the depreciated assets into stronger
          more liquid hands, it could be debated on how much
          reserves should be in the banking system. Until that
          cleansing process is completed it will be a slow grind
          to cure the one factor which makes the fed “impotent”
          and unable to “print money”….overindebtedness.”

          http://www.hoisingtonmgt.com/pdf/HIM2010Q2NP.pdf

          • all true but all termporally bound to the past 3 years of recovery.

            but what happens when private member banks start to desire extending credit (holdig private assets) more than holding money (fed reserves)?

            to use your metaphor, what happens when the private member banks go to the fed and say that it is time for them to use their shovels and get at those reserves buried in the ground?

                • so the real inflationary risk that may occur once the economy starts gathering steam is the large amounts of cash corporations are sitting on, rather than the reserves the banks hold. and more lending, etc.

                • “YES!”

                  well no.

                  the more excess reserves that banks hold on their balance sheet, the more that banks can lend because there are no (or very low, i admit to forgetting most of the fed banking regulatory law that i used to know) capital lending haircuts to holding fed reserves.

                  to illustrate (and i am using this as an example, don’t hold me to quoting what the exact haircut percentages are because they have flown my memory coup):

                  if a bank owns nothing but OREO, it would then be severely restricted in an attempt to leverage its balance sheet (eg issue CP) and make new loans.

                  if a bank owns nothing but fed reserves, it would be able to lever up its balance sheet significantly to make new loans.

                    • “Banks don’t ever lend reserves. They lend first and find reserves later if needed…”

                      true, in normal times.

                      these aint normal times.

                      this post was good at generating thought and discussion; for that, a tip o hat.

                      you probably could find three ideas in these posts that you could use as the basis for further posts

              • excess reserves support bank lending. zero haircut on capital etc…though i am not a fed banking regulatory expert. maybe someone reading this can help here

  8. Chris,

    In QE you are dealing with exchanges of monetary assets, not roads, houses, services etc. IN TARP, you could argue that the gov’t was increasing money supply b/o it was exchanging something of value (US$)for something of questionable value (MBS’s marked to banks’ valuation as opposed to market). So, $100 might have been paid for $20 worth of goods. This would be a vertical creation of money as long as the assets being exchanged (troubled assets versus currency) were not of equal value.

    In QE II, the Treasury note already in circulation has an (approximate) equal value to the $$ purchasing it, so it is an equal exchange of assets without anything new being added to the system (private sector). Only the term structure of the instrument is changed from 2-30 years (trsy) to 0 years (dollar bill).

    hope this is correct

    rhp

    • i just differentiate between a t bill or bond, on the one hand, from a federal reserve bank obligation. these are two different issuers and different obligations.

      the fed issues reserves (money as far as i understand the term, although i know economists go way beyond my simplistic views), while the treasury issues debt, much like any debt a corporation might issue.

      the corporate issuer has monopoly control over the issuance of its debt, just like the us treasury does. they both can create some more, they each are in sole control over that decision, they each just need to make sure they have a buyer for what they create.

      the corporate issuer’s debt is backed by the full faith and credit of its corporate existence (unless it is nonrecourse), just like the us treasury backs its debt with its full faith and credit.

      fed reserves, treasury debt and corporate debt are all financial assets, which can serve as collateral and provide a return on principal. it’s just that the fed reserves are the only one that is money (as i understand the term).

      • Imo many MMT conclusions (e.g. regarding QE2) are only fully correct if bonds were exactly money.
        To get as near as one can to this “moneyness characteristic” of US bonds two things must be ensured by the US:
        a) The Fed has to guarantee indefinitely and in all circumstances that US bonds are accepted as collateral for repos e.g. (and set the discount rate as low as possible, meaning zero).
        b) There is a functional stable extremely liquid secondary market for US bonds (perhaps for all assets).
        The better a) and b) are implemented the more confident the banks (foreign banks included) are in their ability to get reserves (perhaps other assets) no matter what.

        But still you can’t deny the fact that bonds are less liquid than reserves = “money”, even if they are very close to money.
        So QE2 e.g., even if not adding NFA, ultimately increases liquidity.

        MMT is a very good approximation to the real monetary operations, but you still have to see the fine differences.
        Imo this also applies to the question “Does the US finance itself through bond issuance”? As US bonds are not money, but almost (see a) and b) again), the answer is “nearly not”. But imo the answer isn’t no.
        The conclusion “Under the current monetary system the US doesn’t finance itself through bond issuance” is an approximation depending on how well a) and b) are implemented.

        • I wrote: “MMT is a very good approximation to the real monetary operations, but you still have to see the fine differences.”

          I meant: “MMT is a very good explanation of…”

        • The problem with your analysis is you don’t understand what “liquidity” is in this case. Adding reserves doesn’t help any bank do anything they couldn’t have already done. Trading Tsy’s for deposits doesn’t help anyone spend–they can always sell the Tsy if they want deposits as it’s the most liquid market out there with dozens of bidders who are using the repo market to acquire funds (created out of thin air–it’s not a case of shifting deposits from one person to the other) to purchase Tsy’s from others. Tsy’s, even if they aren’t deposits, are never a constraint on aggregate or individual spending. Again, QE here only “works” if somehow it encourages greater spending out of existing income–having deposits instead of Tsy’s doesn’t mean someone necessarily wants to spend more out of existing income. As an analogy, if the Fed bought my stock portfolio from me and I now have deposits instead of equities, I don’t necessarily go out and spend what previously was my retirement savings.

          • Hmm, here’s the way I see it (correct me if I’m wrong):

            Let’s say I’m a bank that bought US bonds in the primary market (UST auction) with all my excess reserves of $1m. If I want to buy risky securities right now I have three options:

            1) If accepted just use my US bonds as collateral to buy the securities.
            Problem: The margin requirements are e.g. 10% (and can change).
            So I can only buy $900k worth of securities. Also collateral use of US bonds could be prohibited.
            2) Do repos with the Fed by using the US bonds as collateral to again get reserves of $1m . So I can buy $1m of securities.
            Problem: The Fed could stop accepting the US bonds as collateral for repos (not very likely). And: The discount rate at which I have to borrow at the Fed could change and get significantly higher than my coupon of the US bonds when I want to refinance myself.
            3) Sell my US bonds in the secondary market in exchange for reserves.
            Problem: I can incur losses due to price volatility, spreads or other costs. Also the secondary market for US bonds could get somehow instable or could cease to exist etc. (of course not very realistic).

            These are all risks/restrictions for bondholders in the current monetary system.
            I don’t have these risks/restrictions if I just have reserves instead of US bonds (e.g. because of QE2). I’m more encouraged to buy risky securities right now than without QE2.

            This is what I mean when refering to liquidity. The differences between US bonds and reserves are very small, but they exist.

            Even if 1)-3) is not a problem in the US at the moment it could eventually become one in the future. It is improbable, but not impossible.

            Just my 2 cents. Perhaps I’m wrong, but this is how I see it.

            • Add:
              Of course another possibility for me as a bank is I could borrow reserves from other banks through the interbank market. But almost the same risks/restrictions apply as in 2).

              Also I fully agree with you that QE2 as a pure monetary operation has no direct effects on private spending and so on as it doesn’t add NFA. But it isn’t a non-event (not to mention the psychological effects). If it is the right thing to do is another question.

              Altogether I really appreciate the eye-opening conclusions of MMT and am glad I found this blog (and others).

              • Portfolio shifting, perhaps. The real point is for spending, QE doesn’t add anything except the hope that people will spend more out of current income. Portfolio shifting, where it does occur, may or may not lead to more spending out of current income. Most dealers selling Tsy’s to the Fed will simply use the proceeds to pay down other repo debts or lend it in the repo mkt. But they could and in fact already do all that without QE. And, in the process, QE actually extracts interest income from the non-govt sector via the swap of an interest earning Tsy for reserve balances earning 0.25%.

                • Yes, and you could also argue that any spending due to the equity “wealth effect” is like spending more money on dinner tonight because your stocks went up only to realize tomorrow that they declined as much. The point being, if there is not a fundamental effect that justifies the increase in these asset prices then the price increase will ultimately revert. It’s impossible to decipher how much of the recent rise in equities is due to the Bernanke Put vs real economic improvement, but I think it’s safe to say that QE has added a level of comfort about the economic recovery that will not be supported by any fundamental effect. We see more and more people slowly beginning to admit that QE isn’t really helping….It’s essentially a replay of the Greenspan years. Blow the bubble, make everyone feel great, get them to spend, and then find out that they’re bankrupt later…..

              • for a bank holding the Tsy, it’s always about what they have on the asset side vs. the liability side. since a bank never needs the reserves to “buy” anything, it’s all about the net interest margin of what they buy/hold vs. how they finance it. what really happens in QE vs. no QE if the bank were holding a Tsy before is that the spread b/n the assets and liabilities decreased as the Tsy is replaced with reserves. that’s the net effect of everything you’ve described. Actually less profit and less “fuel” to the economy. An individual bank might buy something with a higher yield with the reserves, but that just shifts them to another bank, doesn’t get rid of them.

                A few other things:
                1. the Fed would NEVER stop accepting Tsy’s for repo collateral–good luck getting that by Congress even if they wanted to. Pretty inconsistent with Fed’s stated desire–embedded in its own operating procedures–to minimize its own risk.

                2. the repo example doesn’t work too well for a bank. If a bank wants to buy something, they buy it, and if necessary, clear an overdraft at the Fed via money markets. Then, if they are holding a Tsy and they don’t want it, they sell the Tsy and could use proceeds to pay down money market borrowings. Possibly a little bit of difference on the edges vs. starting with reserve balances, but not that economically significant, particularly since the spread earned prior to buying something with the reserves was smaller than if the Tsy had been held to that point.

                3. If the bank is worried about capital loss with a Tsy, then they shouldn’t be holding it anyway, with or without QE, or they should be protecting against capital loss via swaps, etc. The discussion of QE and liquidity ASSUMES from the beginning that there is someone already holding a Tsy who clearly thought it was a good financial asset to be holding at least to that point vs. the alternatives. Moreover, there’s already a capital loss to many Tsy holders selling to the Fed WITH QE, since the Fed purposely organized QE to have as little effect as possible on yields, aside from where markets take them, and markets have taken yields up. QE didn’t help with that risk at all.

          • “The problem with your analysis is you don’t understand what “liquidity” is in this case. Adding reserves doesn’t help any bank do anything they couldn’t have already done. Trading Tsy’s for deposits doesn’t help anyone spend–they can always sell the Tsy if they want deposits as it’s the most liquid market out there with dozens of bidders who are using the repo market to acquire funds (created out of thin air–it’s not a case of shifting deposits from one person to the other) to purchase Tsy’s from others.”

            you confuse liquidity with money.

            right now and for awhile, treasuries all along the maturity spectrum are losing value. banks have anticipated this, they sort of thought we wouldn’t have 2% 10yr yields for long. dont need a phd for that call.

            hence, if you are a bank with shareholders (as opposed to a phd with research students), if you want a low-to-no haircut on your capital with no degradation of value, you go for money (fed reserves) rather than treasuries (even if BB will give you a bid to hit).

            a little harsh, but i detected a little ivory tower in your posts. apologies in advance.

            • you confuse liquidity with money.

              NOPE.

              right now and for awhile, treasuries all along the maturity spectrum are losing value. banks have anticipated this, they sort of thought we wouldn’t have 2% 10yr yields for long. dont need a phd for that call.

              I ACTUALLY MADE THAT CALL SEVERAL MONTHS AGO, TOO. AS I SAID ABOVE, THE FED CHOSE TO DO QE OPERATIONS SUCH THAT THEY HAD MINIMAL EFFECT ON WHERE MARKETS DROVE YIELDS. AS ECONOMY IMPROVES, WHICH IT WAS DOING BEFORE QE, YIELDS MOVED HIGHER.

              hence, if you are a bank with shareholders (as opposed to a phd with research students), if you want a low-to-no haircut on your capital with no degradation of value, you go for money (fed reserves) rather than treasuries (even if BB will give you a bid to hit).

              THAT’S COMPLETELY BESIDE THE POINT I WAS MAKING. THE QE DEBATE IS ABOUT WHETHER THE TREASURIES OR RESERVES ARE MORE STIMULATIVE. YOU’RE SUGGESTING THE BANK WOULD RATHER HOLD RESERVES THAN HOLD TREASURIES (AND IT’S A BIG “DUH!” AT THAT IN A RISING YIELD ENVIRONMENT–MY STUDENTS WOULD FAIL IF THEY GOT THAT ONE WRONG). THAT ACTUALLY MAKES MY POINT THAT QE DOES NOTHING FUNDAMENTALLY TO STIMULATE. GUESS THAT PH.D. COMES IN A BIT HANDY WHEN IT COMES TO UNDERSTANDING HOW TO DEVELOP AN ARGUMENT THAT ACTUALLY DEFENDS YOUR POSITION?

              a little harsh, but i detected a little ivory tower in your posts. apologies in advance.

              AND I DETECT A BIT OF CLUELESSNESS IN YOURS. APOLOGIES IN ADVANCE.

  9. your right chris, it is new money and it is creating commodity inflation and a stock market bubble. that is exactly what bernanke wants, to create inflation and pay for ever increasing government spending. If we don’t stop the fed they will destroy our currency and america’s economic dominance will be over.

  10. Cullen, you’ve got lots of threads to handle in this comment section!

    Following my thread: “The point is that the reserve drain (call it an additional liability if you want) can be achieved without a govt bond market.”

    But my point is that in operational reality there IS a govt bond market mandated by law that MMO (or MMT) has to account for. The point I am trying to understand is what feels like a disparity between MMT’s statement that “bonds are only issued to drain reserves and hit a targeted rate, versus “bonds are issued by congressional mandate to achieve the appearance of an accounting identity”. It seems like the two do not necessarily intersect, thus my confusion…..

    If the second statement is true, then it seems like there is a limitation in the operational reality of MMT, because it is not describing the actual constraint on monetary operations that IS in effect due to congressional mandate…..

    thanks,

    rhp

  11. @Chris: so currency, the simplest form of money supply, is an obligation of the fed.

    The government is obliged to accept dollars in payment of taxes and it guarantees it will do so.

    Taxes drive the system. They fund nothing. They are used in principle to lower aggregate demand. They also function politically, of course: who gets taxed at what rate.

    • @brendan

      well this is cullen’s blog, but if i may respond, i think there is as much of a difference, in terms of whether one thing is money or not, between equating citibank’s demand deposits to fed deposits, on the one hand, as there is in equating a t bill to fed deposits, on the other hand.

      forgetting the corporeal character of currency, we dont exchange citibank deposits for goods, just as we dont exchange t bills for goods. we exchange fed deposits (really currency as a form of money) for goods.

      now, once the fed has substituted a couple trillion of its deposits (which i call money) for private assets on the b/s of its member banks, it has expanded the money supply accordingly. it may not have added financial assets to the system, but it has added money to the system (as i understand things).

      cullen is right to say that this money is not circulating, and it has not served as the base to support the expanded creation of private credit.

      but unless i am missing something, if the fed doesn’t reverse its course, it is just a matter of time (assuming continued recovery) until that money expansion serves to support a credit expansion.

      i try to keep things simple in order for me to understand them, and i may have oversimplified. won’t have been the first time.

      • Your comment is similar to the Anonymous comment above on “moneyness” and also mine on the mix of the private sector’s balance sheet.

        I am starting to get the feeling that MMT confuses in this debate a direct gift by the Fed to the private sector (TARP) with “providing liquidity” or “asset monetization”. It does not matter which asset is monetized (US Treasury or some other). Fact is that in the private sector there are less assets (to be sold for cash to other private sector participants) and more cash (to bid up private sector assets).

        Also this line of thinking at MMT resembles Ben Bernanke’s PROVENLY WRONG assumption that the level of private debt does not matter, as it cancels each other out. As we know the level of private debt is very imporant for the boom / bust cycle, which has very REAL economic impact. Irving Fisher was also of Bernanke’s view, but he had to change his mind and theory after he lost a fortune in the depressionary stock market and came with the debt deflation thory.

        InvestorX

        • What you’re saying is that a checking account is materially different from a savings account. Do you not count your savings account as your money?

          • Well that is the thing – the one is money, the other is credit to a bank that is locked-up or has penalties to be withdrawn etc. Savings account is not money, as you need to convert it to cash first. I know the distinction is small nowadays, but with the same logic you can count your equities and car as money.

            So to me this point is where MMT has a flaw, even if it is not a big deal nowadays to differentiate b/w money and credit.

            InvestorX

            • “Well that is the thing – the one is money, the other is credit to a bank that is locked-up or has penalties to be withdrawn etc. Savings account is not money, as you need to convert it to cash first. I know the distinction is small nowadays, but with the same logic you can count your equities and car as money.”

              I DON’T SEE WHERE THIS HAS ANYTHING AT ALL TO DO WITH THE QE DISCUSSION. QE ISN’T ABOUT MONEY BEING LOCKED UP IN SAVINGS ACCOUNTS. IT’S ABOUT TSY’S WHICH ARE ABOUT THE MOST LIQUID FINANCIAL ASSETS AVAILABLE.

              So to me this point is where MMT has a flaw, even if it is not a big deal nowadays to differentiate b/w money and credit.

              MY GOD, YOU REALLY DON’T UNDERSTAND MMT AT ALL. THAT DISTINCTION IS ABSOLUTELY CENTRAL TO MMT.

        • “I am starting to get the feeling that MMT confuses in this debate a direct gift by the Fed to the private sector (TARP) with “providing liquidity” or “asset monetization”. ”

          WE MAKE A BIG DISTINCTION BETWEEN THIS AND BUYING TSY’S.

          It does not matter which asset is monetized (US Treasury or some other). Fact is that in the private sector there are less assets (to be sold for cash to other private sector participants) and more cash (to bid up private sector assets).”

          BUT FINANCIAL ASSETS DON’T NEED TO BE PURCHASED WITH “CASH” PREVIOUSLY HELD. “CASH” CAN ALWAYS BE ACQUIRED, AND IN THE AGGREGATE, CAN ALWAYS BE CREATED. THAT’S HOW TSY’S ARE ACTUALLY PURCHASED AT AUCTION, FOR THE MOST PART. THAT’S HOW BANKS MAKE LOANS AND PURCHASE FINANCIAL ASSETS. AND THEY MAKE LOANS TO OTHER FINANCIAL INSTITUTIONS (LINES OF CREDIT, ETC.) THAT WANT TO DO THE SAME. ETC. ETC.

          Also this line of thinking at MMT resembles Ben Bernanke’s PROVENLY WRONG assumption that the level of private debt does not matter, as it cancels each other out.

          MMT ABSOLUTELY NEVER SAID THE LEVEL OF PRIVATE DEBT DOESN’T MATTER. QUITE THE OPPOSITE.

          As we know the level of private debt is very imporant for the boom / bust cycle, which has very REAL economic impact. Irving Fisher was also of Bernanke’s view, but he had to change his mind and theory after he lost a fortune in the depressionary stock market and came with the debt deflation thory.

          APPARENTLY YOU HAVEN’T READ MUCH MMT. THERE’S NOTHING HERE THAT MMT’ERS DISAGREE WTIH, EXCEPT FROM THE FACT THAT YOU THINK MMT’ERS ARE SAYING THE OPPOSITE.

          • Ok Scott, I thought that I and Cullen had reached some level of understanding of what each other was talking about and implying. Your somewhat zealous jump in the discussion got me really confused about MMT. So which is your best source of QE relevant MMT literature (or the NFA stuff)?

            InvestorX

            • Sorry about the zealousness. Working on it. Maybe someday I’ll be as even-keeled as Cullen. Kind of pisses me off that he’s a lot younger than me and he can already do that while I still can’t. :)

              Anyway, I’d start with the readings on Cullen’s MMT page. There’s also Mosler’s mandatory readings page on his blog.

              • Yes, younger, but it just means I’ve wasted more hours on the internet trying to “scream” at people. I realized a few years ago that it was a big waste of time and that you’re better off talking to people as if they’re in your living room. :-)

                Fortunately for the rest of us we have someone like you who is willing to take the time and be patient and help everyone better understand this stuff. It really means a lot that you are even willing to take the time and stop by to clarify. I think I speak for everyone when I say we appreciate it enormously.

                • Well Scott, Cullen,

                  Thanks for your patience and discussion. I read again your section on MMT and vertical money. And I have to say that I still disagree and maintain my position. And it is:

                  - I agree that government is not constrained in its spending, because it can always sell Treasuries if it wants or have the Fed print money and buy them (QE). So the only negative result is inflation (or misallocation). China is not the US creditor either.

                  - I disagree though that Treasuries are money. They are assets that bind free cash from the aggregate private sector. This works as crowding out / inflation preventing tool, similar to taxes (but works only temporary) or in case of trade deficit, the crowding out can be avoided. This is looking only at the aggregate levels (private vs. government) and only the vertical relationship. That banks then can come and get leverage for their Treasuries or buy them with FRL created money out of thin air is a matter of horizontal money creation and not part of the discussion. That Tresuries have higher moneyness than say cars changes nothing here.

                  - Thus I also disagree that Treasuries are only a tool to maintain a target rate. I think they are tool to drain money as described above.

                  - I fully agree that deficit spending is often inflationary (e.g. see Hussman on this) and is more inflationary in a balance sheet recession than QE. I also understand the deflationary process at hand.

                  - I still think that converting of an asset into cash is properly called monetization, because an asset is taken out of the private sector and cash is increased in the private sector. Not that I expected that it will have such a huge effect on speculation or that I expect it to have a big effect on the real economy. The major reason for this is that 95% of modern money creation is horizontal via FRL and we see banks reluctant to lend and that banks are not reserve constrained in FRL, but are only capital restrained if at all. Also I agree that the change of the portfolio mix of the private sector is not big enough to have any meaningful effect of QE. So the effect is mainly psychological. In times of debt deflation, QE’s monetization is mainly an offsetting factor, so its is not (hyper)-inflationary.

                  - The bond vigilantes will only wake up when the USD starts to lose value in an accelerated manner. This will come later than many expect due to its (overabused) reserve currency status.

                  - I compared the NFA concept to the concept of private debt cancelling each other out. I am not sure this comparison is correct. But at least the change of the mix of private sector portfolio seems to be absent from the NFA concept. Another reason I think the NFA concept is not right is because of the above described “sterilizing” effect of US Treasury issuance.

                  • It all comes down to the “moneyness” aspect.

                    And in the FINANCIAL REALITY treasuries ARE “money” in the term you use it.

                    Keep in mind: As a bank you don’t go out like a individual with cash/credit card and shop at the mall.
                    In general there is no need for a bank to have reserves/cash instead of treasuries except for reserve requiremenst regarding private lending (but even reserve requirements are unnecessary as you can see in many countries like AUS, NZ,… that abolished them some time ago), and of course bank runs, when customers demand cash currency.
                    There is nothing a bank can’t do with US treasuries that it can with reserves in financial terms.
                    If banks wants to lend, they just lend and get reserves later if necessary.
                    If banks wants to buy something they just buy as Scott Fullwiler explained above.
                    The slight disadvantages in holding treasuries instead of reserves when buying only become evident in the death of an economy (hyperinflation etc.). Then treasuries won’t behave like “money”. But when speaking of the Dollar this should be the point of world economic collapse. Not very realistic/likely, besides the fact that you and I will have other things in mind than treasuries at that time, I guess. ;)

                    You also speak about inflation prevention by issuing treasuries.
                    But banks act and lend the same no matter if they have reserves or treasuries on the asset sides of their balance sheets. So why should one expect a different effect on inflation by issuing bonds vs. not issuing bonds?

                    Regarding QE2: I also say the effects of QE2 on the markets are simply psychologically driven by investors who don’t understand MMT. ;)
                    Regarding its effect on the real economy, the only way it could increase private spending is by the notorious “wealth effect”. Will this work? I really don’t know.

                    • Ok I agree that the moneyness of Treasuries is so high that the difference of issuing Treasuries or direct cash spending is marginal in practice, especially due to FRL financing of Treasuries purchase. So we have a mixed vertical / horizontal effect here.

                      InvestorX

  12. From virtually all angles, prices in almost every sector of the economy (except for the obvious – housing) have been increasing; this increase is due to inflation caused primarily by the debasement of our currency by all segments of government; including The Fed.

    “There is nothing more insidious that a country can do to its citizens than debase its currency,” Congressman Ryan (R) said (at the Congressional Budget Committee hearing with Ben Bernanke today).

    I believe The Fed’s primary purpose for QE is two-fold: Get money out of Treasuries and into Equity Assets (stocks & business investment). By pushing down the rates on Bonds to near ZERO, the Fed is forcing investors of all size into the one major area where they can seek to get a decent return on investment — Stocks. If Ben can push up the value of stocks, he will make the economy feel like it is “rich” once again. (So far the banks are not lending to small business in any meaningful way, and big businesses have bee using their own increased REV and EPS returns to eliminate debt and clean up the B/S. Recently, big businesses have been going to the marketplace to reduce old, high rate debt with historically low rates with long durations, or to borrow for future needs at this historically low rates. Thank you Mr Bernanke!)

    Meanwhile, folks who have had to try to live on fixed incomes have gotten the shaft and been subsidizing Ben’s big plan.

    The only thing that keeps this lid on this potential ticking time bomb that Ben has created is the fact that meaningful “new employment” has not returned to the US economy. (I hope he says his prayers each night)

    I completely agree with Chris’ comment above that once new employment picks up again, inflation will begin to show its ugly head and Ben and the boys are going to have a wild bull on their hands with the $2T plus animal they will need to tame!

  13. Of all aspects of MMT, “quantitative easing” is the operation that I find hardest to tackle.

    I understand that QE is essentially swapping commercial banks assets – Treasuries are swapped for cash, adding to banks reserves and reducing their Treasury holdings by the same amount. In turn, the Feds holdings of Treasuries increases, as does their deposits liability to commercial banks. Correct?

    Whilst this operation has not reduced the governments total ‘debt’ outstanding, more of that ‘debt’ is owed to the central bank, rather than the private sector. Is this not significant, or have I got it all wrong?

    And doesn’t this just reverse the process and contradict the reasoning behind ‘soaking up excess reserves’ in the first place? Wouldn’t the Fed Funds rate be sent to 0%? Or does the Fed now pay interest on excess reserves?

    My god this is confusing!

  14. To sum up, it all comes down to the evils of deficit spending and amassing huge levels of debt both in the private sector (has to be either paid off or written down) and the public debt (which will never be repaid).

    * Interest on private debt comes from productive output or returns on financial assets
    * Interest on public debt adds to the national debt, unless paid for by taxes (assuming a balanced budget thus no deficit).

    As long as FED will enable the UST to create money without restraint then a balanced budget is the stuff of a fairy tale. The FED can continue to try to meet its mandate of low interest and price stability, but it is fighting a beast that can not be controlled (As BB talked about today, fiscal discipline and a long term plan for fiscal responsibility – aka balanced budget). It is not the job of Gov’t to use debt to grow the economy, it is their role to determine the size of gov’t, fund it through taxes and get out of the way of the private sector so it can innovate, invest, grow and expand wealth.

    As long as the FED is more interested in supporting the banks and the FIRE sector, then we will continue to see the mass transfer of wealth from the taxpayers enabled by the gov’t into the hands of the banks/big business whenever they falter, completing the privatize gains and socialized losses cycle.

    Solving these problems would take structural changes to build a self correcting system, but unfortunately we have corruption that runs throughout all of our institutions that are supposed to provide the checks and balances. Any system that becomes corrupted will ultimately fail and what we are witnessing is a failing system. We as a people can demand changes to save, restore and protect a competitive free market capitalism system or witness the corrupted system implode.

    • Don’t conflate pvt sector and pubic sector debt….There is technically no such thing as “having to pay back” public sector debt.

      • That is what I said in the first sentence.

        … public debt (which will never be repaid).

          • hmm, When a bond matures that holder will be paid with funds receive from the next buyer of new issue bonds (the bond rollover). Step and repeat until such time confidence in UST is so low that the rollover process is affected, then FED the UST can spend/create money to pay back bonds as they mature devaluing the dollar in the process.

            • “…Step and repeat until such time confidence in UST is so low that the rollover process is affected…”

              this does not follow

  15. i saw this headline this morning and knew the comments would come hot and heavy. TPC, you must’ve been itching for (yet another) fight about monetary operations.

  16. Cullen,

    thanks for your attempts. And I may not simply understand MMT well enough to be able to be in the same question-answer sphere as you.

    To me, the political BECOMES operational reality. If a law creates apartheid, political though it may be, apartheid still exists, even tho’ there is no need for it. If a law mandates issuance of bonds after the spending fact, then those bonds have to be accounted for in the world system. This does NOT mean that bonds fund anything, I totally agree. But the operational reality of bonds becomes much more than “draining reserves”.

    Maybe this is where Kid Dynamite and I have trouble understanding a couple of your points and vice versa. Because of politics, I would say bonds operationally are NOT solely issued to drain reserves, but to conform to a politically induced reality. This then is a part of Modern Monetary Operations describing how the system actually works.

    I’m not sure how to say it any differently either, but hopefully in ensuing conversations something will become more clear to me or you in terms of bridging the misunderstanding.

    Thanks for all you do.

    rhp

    • If you think about it, Treasury issuance is indeed intended to bind the private sector’s cash, so that it does not compete with the government’s newly printed cash for increased spending (Is this what you call “reserve draining”? I doubt reserve draining is there to just keep some Fed rate at a level, but rather to decrease the inflationary impact of increased govt spending.). So if you monetize then Treasuries you end up with more unbounded cash in the private sector and it will start looking for a home (yield, speculation, or inflationary consumption unless you increase taxes / decrease govt spending).

      So there are several points on which MMT does not seem to be convincing to me.

      InvestorX

  17. The author shows a shocking ignorance of the workings of the modern U.S. money supply. When the Fed purchases a bond, it creates an electronic demand deposit in the name of the bond seller, in this case, the U.S. Treasury. The treasury then spends this money out of this account. The Fed created that demand deposit out of thin air, and in that way “printed” money. This tool, among others, is the key mechanism used by the Fed to manage the monetary base.

    The U.S. Treasury does not “print” money to pay its bills. It taxes and borrows, and in the modern and quite unprecedented case, is selling bonds to the Fed, which creates the money out of thin air as an electronic account entry.

    How else to explain this chart, the growth of the US money supply:

    http://www.chartingstocks.net/2009/03/chart-of-the-us-money-supply-1917-2009/

    Who knows what the author is trying to say? that the US money supply is not increasing, that the government can spend all the money it wants, that debt doesn’t matter? All wrong, sad to say.

    • @MEB

      The point you’re missing is that the Fed is not legally permitted to buy Bonds directly from the Treasury. Direct monetization of US debt is illegal. Instead, the Fed must engage middlemen, the Primary Dealers.

      The point that Cullen is correctly making is that the Primary Dealers can’t just create money out of thin air in order to purchase Bonds, instead they must use existing money. In so doing, the Primary Dealers draw down their own reserves in order to purchase Bonds. The Fed then swaps those bonds for reserves, reinstating the reserves of the Primary Dealers in the process leading to no change in the money supply. What has really happened in this process is a transfer of debt (therefore money) from the private sector to the public sector, that is all. More technically, according to MMT, vertical money is being generated in place of horizontal money.

      Described another way, when deleverage hits the private sector and lending contracts, the result is deflationary. As the private sector pays down debt, horizontal money is eliminated (the money multiplier breaks) resulting in reserve expansion within the PDs. To prevent deflation, the government must step in to borrow in place of the private sector, which is does through the issuance of bonds. This is only effective if there are buyers for these bonds which can prove problematic if the PDs are under-capitalized. The Bond swap procedure allows PDs to provide an adequate demand for US Bonds (at a reasonable price) by continually refreshing reserves (as Bonds are swapped to the Fed).

      In reality though, there *is* an expansion of reserves because the Fed does *not* swap for Bonds at the price that the Primary Dealers paid. Rather, the Fed routinely overpays in order to provide an incentive for the Primary Dealers to participate at all. Further, the Fed then offers to pay interest on excess reserves in order to emulate the effect of PDs hanging onto the original bonds and taking regular coupon payments. This expansion is countered by debt defaults within the private sector.

      Finally, it must be noted that replacing horizontal money with vertical money results in some scary looking money supply stats. Vertical money and horizontal money provide different contributions to the various money supply measurements. Vertical money is over-represented in MB, M1, and M2 relative to horizontal money. M3 is a better measure but is, unfortunately no longer published by the Fed. Independent measures of M3 don’t show a huge expansion due to the offset of expanding vertical against contracting horizontal money.

      • “The point that Cullen is correctly making is that the Primary Dealers can’t just create money out of thin air in order to purchase Bonds, instead they must use existing money.”

        agreed. but you are looking at the wrong party. look at the counterparty.

        the fed DOES create money out of thin air in order to purchase bonds.

        now if you want to mash up fed reserves with other financial assets and say one is vertical and the other horizontal money (doesn’t help me but i may be spatially challenged), or one is 24k and the other 18k, then go ahead.

        but i don’t see how that helps analysis in this case…

        • Think of MMT’s vertical money as hard cash (real money) while MMT’s horizontal money is credit money, generated through the fractional reserve system by banks making loans. The two are fundamentally different.

          When talking about inflation, what matters is net money supply in which the fundamental nature of the dollars is irrelevant, all that matters is the total *available* quantity (beware liquidity traps).

          Yes, the Fed prints money out of thin air to swap for bonds and reinstate the PDs cash reserves but remember that a build up of those reserves in the first place meant destruction of horizontal money. If banks have lent money up to their reserve constraint then the money supply will be maximally expanded and banks will not have the capacity to purchase bonds.

          Thus, if PDs are buying bonds then it means there is deflation present in horizontal money. Banks have *not* lent to their reserve constraint and the supply of horizontal money, aka credit (which is the dominant component of money supply) is less than maximal.

          In this environment, the Fed printing up and swapping fresh vertical money into the system does not cause net inflation while the cause of credit contraction remains present (fraud in the housing sector).

          The Fed isn’t doing a great job with QE2, but it isn’t doing a bad job either. Things could be a lot, lot worse.

          US inflation remains no threat until the issue of rampant fraud in the financial system is fully resolved or a Black Swan arrives in the form of the entire world suddenly ditching the US dollar as a trading currency. Forced and rapid repatriation of Eurodollars would indeed be a hyperinflation trigger, but there’s no way the IMF would allow it.

      • Well, I agree with this operational reality of MMT – govt debt in the USA is not used for funding. But I doubt this discussion is the explanation for it. It is just the chicken and egg thing – it does not matter which was first, it just is. Before the chicken came it was a fish. Before government money came there was private money or state money or whatever. It was there. That’s all.

        InvestorX

  18. “You’re comparing Euro nations to the USA. It’s apples and oranges. They have a solvency issue. There is no such thing in the USA. If your scenario were indeed true we would be seeing very high rates of inflation in the USA. It’s not happening.”

    My point on the PIGS is not that we are in the same situation – I realize we are not. The point was that markets can completely ignore a risk and then literally change its mind virtually overnight with little advance warning. You assume inflation expectations will go from low, to medium, to high. That will give the Fed time to react. I disagree…we may well find that inflation expectations go from 2 to 4% in the span of a month or two. At that point a few things would happen: 1) inflation would become self-reinforcing, 2) the Fed would be too scared to apply the amount of tightening necessary (the “official” reasoning would go something like this: “we have an expectations problem not a money problem so why tighten?”). Voila – lost confidence in a currency and spiraling, self-reinforcing inflation with no advance warning. That is how markets work. You are way too confident that you will be able to spot problems in advance – if markets were that accommodating we’d all be retired by now.

    • ’2) the Fed would be too scared to apply the amount of tightening necessary (the “official” reasoning would go something like this: “we have an expectations problem not a money problem so why tighten?”).’

      why on earth would they struggle with this? the fed *loves* fighting inflation, it’s all they can really do anyway. they are all bankers…

  19. I’m starting to understand how the process works. Thank you. Does it really matter if the FED, TSY, or Congress is monetizing the debt? You are technically correct, but does it really matter who monetizes the debt? It WILL be inflationary in the end (after the usual lag time).

  20. Because of changes in US manufacturing, growth in foreign industry, and the low employee to profit ratio of the financial sector, the US in the foreseeable future will continue to have high unemployment. Stimulating equities will make ‘investors’ happy as they reinvest, but this is not how US industry will gain a competitive advantage. Another discovery in the US like the transistor could. Of course foreign tech students often return to their native lands to compete with us. When their universities achieve US quality, we will be worse off than today. The Fed and Treasury cannot cope with this.

  21. If what you say is true here Cullen, then why do we need QE and POMO?

    What is THAT “monetizing”?

    • Why do we need QE and POMO? Because they think it helps….THINK….We are seeing more and more people admit that QE does nothing or is having little to no effect….

      • BB doesn’t want anything to do with deflation, with the private sector debt being paid down and the continued slump in home asset values, perhaps the inflation that would have accompanied QE is offsetting the deflationary pressure.

  22. The Fed ran out of bullets (interest rate at zero), thus QE was engineered as a de facto method for monetary easing. Mr Bernake stated today that $600B of QE is equivalent to a 75 bps reduction in the Fed Funds rate. We may not be creating new dollars, but the US is essentially assuming the worthless piles of MBS and other toxic papaer laying around. Removal of these assets is another form of bailout, which is aimed to get banks lending again. This in turn will increase the propensity of lending and reduce rates in the short run.

    The issue is that real returns are hard to find nowadays. With the lack of fundamentally sound and underwritten investments coupled with increasing capital availability, it is inevitable that mis-allocations of capital will occur. The idea that the “wealth effect” will save the day is terribly misguided and will blow up in our faces.

    It’s very sad to watch this slow motion car crash.

    • “The idea that the “wealth effect” will save the day is terribly misguided and will blow up in our faces”. It’s not misguided its dishonest.

      This started with Greenspan in 1987 and in 2000 and each time they they more wealth effect. I agree it will blow up in our faces.

  23. I know this is a bit late, but I’d like to say that your point #2 is not my major concern. My major concern is that people DON’T understand the modern monetary system (#6)and that if they were made to understand how it operates, they would generally not believe in it. AND it is belief in the system that makes it work (since the basis for it is some abstract concept of social-production).
    I would suggest that is why the gold standard is being promulgated in many circles: it at least has something concrete (gold) that most people’s minds can grasp.

    • All Powers that do not respect or have as it’s main objective to protect freedom and sovereign individual eventually destroys its economy. The US was unique and different in that respect until it changed course.

      Gold or no Gold does not stop the leviathan. Spain was on Gold and so was Roosevelt. Cullen often gives the example of the fact that the Federal Government is not like a family and it can not default. He is absolutely correct that’s the way it is but that does not make it right.

      A family needs to be responsible but big Government does not.

      Even if money was Gold for the leviathan it makes no difference at all since it will eventually dismiss its obligation by confiscating that gold or simply progressively dilute there gold coins. They always have paid for there wars by diluting currencies, look at Europe’s multi devaluations, even during the civil war in the US Lincoln printed valueless money,the French paid there soldiers in America (French Colony) with Gold Promissory Note “paper” but the boats never made it. We can find example from Rome to extreme Zimbabwe of various form of debasing the currencies. This is not new its reality and we need to always invest accordingly.

      Its not the Fiat Paper that is the problem its the club that controls it.

      In the past it was the Kings and there ambitious conquest an to day its the Public Serpents,the Banksters and the Crony Capitalists and elites.

      Its time for a big clean up lets hope it happens.

      • I don’t think I made my point clear enough. Gold, also, needs to be believed in if it is to be worth anything. However, gold is something you can hold in your hand, society’s production is not. My point is that most people need something substantive to believe in, especially when it’s backing one’s currency. That and because of the complexity of modern monetary policy, most people are either too ignorant to be aware of MMP or CHOOSE to ignore it. Either way, it makes for poor support for our MMP.

  24. Cullen, this thread may be ended already, but I’ll put this out there after losing sleep over it trying to figure it out. With the congressional mandate that bonds must be issued to cover a shortfall in spending, even if after the fact (PLEASE note, I’m not saying the bonds fund anything, I got that), it seems like government spending more money into existence is actually eliminated!

    Here’s my reasoning. If the gov’t spends $1 million into existence but only takes in $500K in revenue, the US Trsy is required by law to issue $500K in bonds, which are bought by the primary dealer with money already in the system. Leaving a net of ZERO plus a piece of paper that floats around the private sector saying the gov’t will pay you $500K one month, 3 months, 10, 20 years down the road.

    As long as this operational reality required by Congress is in existence, no net money is being created, only IOU’s. Seems like this is avoided by the Fed, with its button, purchasing the IOU and dumping “money” into the system.

    What’s wrong with this picture??

    sleepless rhp

    • I think nothing is wrong with the picture, MMT is wrong in counting a savings account as money. See my discussions with Cullen above.

      InvestorX

      • Sorry Cullen, but my intuition tells me that something does not seem right snd I try to find out what… I get the big picture of govt bonds not financing anything, so the only result could be inflation. But the other statements and conclusions seem to be less convincing and very tortured. Still I have learned a lot here and enjoy your other posts about markets, accounting identities, deflationary pressures, “guru” opinions etc.

  25. The United States government spends more than it takes in. Where does it get the money? It orders the U.S. Treasury to sell bonds to cover the difference. Who buys the bonds? The Federal Reserve, at least they are the biggest buyer right now. Where does the Federal Reserve get the money? They create it by book entries. That is, they debit an account called “Bonds” and credit the U.S. Treasury’s checking account. That is the way it works, and there is no getting away from the fact that it is monetizing the debt, dollar for dollar for every dollar the FED creates to buy U.S. Government obligations.

    The article is a steaming, stinking, pile….

  26. The clear light of morning sometimes obviates the question. OK, I get it now. The US trsy that is issued is not really different from a dollar bill, only the term structure is different. So, once again the only thing the Fed is doing by purchasing the trsy is changing the term structure…..

    Now, I think the term “monetization” needs to be defined more clearly. The way Cullen uses it in his original explanation, in saying: “Monetization is achieved by an act of Congress through deficit spending” equates with vertical money creation, which only Congress, NOT the FED can do. However, many people in the blogosphere (and Wikipedia) are saying that “monetization” is the conversion of “debt” to “money”. The hang up is that people would not consider conversion of a 2 year trsy to a 30 day trsy to be “monetization”. Yet, they would consider conversion of a 30 day trsy to a dollar bill to be “monetization”. Yet the only difference between the two is the term structure……..

    There is an awful lot of needless arguing going on due to confusion of terms….. Monetization has come to be associated with funding spending, which it is not.

  27. I am confused by the author’s focus on details.
    When the Fed buys government debt, how does it consumate the transaction with the seller? The Fed gets the bond and the seller gets cash. So, what is the
    source of this cash? Is it old cash, already in the Fed’s possession, or is it new cash?
    The author seems to imply that Congress is printing money via deficit spending, and that it does not really matter? What have I missed?

  28. “No, this is crucial. People are accusing the Fed of helping to fund govt spending. That is nonsensical and 100% wrong.”

    Cullen, I totally agree. I’m not saying this concept is not very important. I’m saying that confusion of defining “monetization” is making things a lot more difficult. Even your definition in your opening statement that: “Monetization is achieved by Congress’s deficit spending” is a different definition from what is commonly used, and is much more akin to money “creation” than “monetization”.

    For the majority of people (me included before starting to read your site), the exchange of US trsys for US $$ is considered “monetization of debt”. I now understand that the Fed is just changing term structure and no new “money” is being created or added to the system.