The Liquidity Trap Myth and The Central Bank as a Fiscal Entity

I agree with much of what Scott Sumner says in this post about liquidity traps and monetary policy.  In essence, the idea of a “liquidity trap” is a distraction that reframes the real constraint for monetary policy.  I won’t get into the liquidity trap & IS/LM stuff again as those conversations seem to go nowhere.  But I think Scott rightly says that the real constraint for a central bank is not usually the economic environment, but the political constraints imposed on it.  Specifically, he notes that central banks are not allowed to buy anything and everything and that politicians are generally fearful of the size of a central bank’s balance sheet.  These are political constraints, not real constraints.

But that raises another interesting thought.  If the Fed could just buy anything then what differentiates it from fiscal policy?  I say not much.  And here’s where the accounting, which Sumner hates so much, comes in handy.  You see, when the Fed buys something on the open market like a US government bond it is just swapping cash for bonds.  The private sector doesn’t end up with a higher net worth.  Its balance sheet composition changes, but its net worth is the same (assuming no capital gains).  But let’s say the Fed could buy something truly worthless, like say, “Roche’s Bag-O-Dirt” (copyright, Tom Brown).  That is, what if the Fed offered $100 to anyone who could fill up a bag of dirt and deliver it to the front door of the Fed?  Well, then we’re talking about a helicopter drop because the Fed is buying a totally worthless “asset” and just handing you $100 for it.  The financial net worth of the private sector goes up by $100 and the Fed takes a bag of dirt and throws it in the incinerator.  The Fed is not merely acting as an asset swapper or a lender of last resort.  It is acting as a fiscal entity.  The key difference is that this policy of buying bags of dirt is adding net financial assets to the private sector.

Of course, this is all a moot point because the Fed can’t do that at present since it is not legally permitted.  But for all those “Monetarists” who support such a policy, well, they’re just Fiscalists masquerading as “Monetarists”.  As I’ve said before, this isn’t just a Chuck Norris effect, it’s a Bruce Lee effect.  As Bruce once said, “saying is not enough, you must do”.  And we wouldn’t want to confuse Chuck with Bruce. After all, Bruce kicked Chuck’s ass and even tore his chest hair out.  Confusing the two is a crime against humanity.


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Cullen Roche

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. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  • jaymaster

    So by this approach, wasn’t QE1 at least partially fiscal stimulus?

    The Fed bought MBS and bank debt of dubious quality (not quite dirt, but close in some cases). And the way I understand it, they paid book value for debt that had not been marked to market.

    So the MBS/debt owners got cash money at a value greater than they would have received if they sold on the open market. To my way of thinking, that’s partially helicopter drop/money for nothin.

  • SS

    Cullen mentions this in the QE primer page:

    “QE can directly alter the value of private sector assets which can have wide ranging portfolio effects. For instance, during QE1 the Fed purchased MBS that were substantially discounted thereby marking up bank balance sheet holdings substantially.”

  • Frederick

    Scott Sumner’s a fiscalist and he just doesn’t know it because he doesn’t understand accounting. LOL.

  • Kevin

    Sorry, not buying it. As a “lender of last resort” you are saying the FED is the only one willing to finance the government’s debt. Even though this debt is technically an “asset”, if no one else if willing to buy it (i.e. lend money to the government anymore), it is no different than the FED buying some dirt dug by the Keynes Ditch Digger Inc.

  • Cullen Roche

    Are you claiming that no one wants to own US govt bonds? Where is your evidence of that?

  • Stephen

    From a conceptual viewpoint I think we have a problem. The Fed action in your example changes the ‘accepted’ value of a bag of dirt ,yes? Or it does so until tit doesn’t when it turns off it’s policy. Fed policy in intervening in asset markets similarly changes the value of anything that has a value relative to the stuff that it is actually buying. Again though, only until it doesn’t.

  • Cullen Roche

    The Fed adds $100 in cash to the private sector every time it buys a bag of dirt. That’s how this would theoretically work. That’s pretty different than selling a bag of dirt to your neighbor for $100. That’s just changing the ownership of the $100. It’s not adding net financial assets. The key to the bag-o-dirt trick is the Fed firing $100 bills out the front door….

  • Kevin

    Where would rates be today had the FED not done any open market operations above normal daily activity (No “QE” anything)?

  • Cullen Roche

    Which rate? The overnight rate would be right near zero (because the Fed has paid IOER there) and long rates would probably be slightly above the rate of inflation, just like they usually are. In other words, I don’t think rates have changed much as a result of QE. It’s caused some traders to throw hissy fits at times, but those are just short-term fluctuations around a pretty rational broader trend.

  • Kevin

    I’m confused..isn’t QE a monetary policy enacted precisely to affect interest rates?

  • Cullen Roche

    Not really. QE is a monetary policy intended to create a portfolio rebalancing effect. The Fed wants to remove bonds to force people into other assets. That’s the primary transmission mechanism, which is hotly debated. QE can’t really target rates because the Fed is not targeting price, but quantity. In other words, the Fed is not setting a price like it does on the overnight rate. The Fed is just saying they’ll buy a few $100B of bonds and letting the market determine prices. And bond traders, just about ALWAYS set the price of long bonds about 1% or so above the rate of inflation to protect themselves from the risk of purchasing power loss.

  • jaymaster

    Thanks. I read that in the past, but apparently forgot about it.

    Maybe that’s why it is now “my way of thinking.” :)

  • But What Do I Know?

    Got it–the Fed can create unlimited amounts of money. But if it did, who would need its friends the bankers?

    The Fed’s masters want to monopolize money creation for themselves–this keeps the Fed largely in check. .

  • SS

    That’s what Cullen always points out. The way our system is designed is like a big bank subsidy. If the Fed or government started issuing money then it would take away from the need for banking. That’s why the banks have bought off the government. So they can control the money issuance.

    Anyone else see that article the other day about how banks are lobbying to kill credit unions?

  • John Daschbach

    Cullen, I don’t think we will ever agree on this. If you follow the mathematics of MR, then Fed balance sheet increases are loans just like a bank makes. Your asset swap ignores the basic math of the situation. Why can’t you understand this!

    Let F = Fed, P = private investor, G = government (A,L) => Asset, Liability, (c,b) => cash, bond

    F = (0,0), P1 = (1c,0) , G = (0,0) => money supply = 1

    G deficit spends. P1 swaps an asset with the government.

    F = (0,0), P1 = (1b,0), G = (1c,-1b) => money supply = 1

    Fed buys bond from P1 (note the 0c liability! The Fed is a bank by MR. It bought the bond with money that did not exist before and for which is has no liability but it does have an asset (the bond))

    F = (1b, 0c), P1 = (1c,0), G = (1c,-1b) => money supply = 2

    Look at the three transactions. P1 started with 1c, and ends up with 1c. P1 swapped 1b for 1c to return to original position. But F when from 0 to 1. G went from 0 to 0.

    The reality is that there is an increase in money. But it’s almost all in Fed reserve accounts. The net Fed balance sheet (Tsy + MSB) has increased about $2.5 T since 2008 (Tsy $0.8 T to $2.0 T and MSB 0$ to 1.3 T) and reserves have increased from $ 0.075 T to $ 2.32 T. So QE has net put about $200 B into the system (outside of reserves held at the Fed) over the entire time. So except for the $200 B, the money supply hasn’t increased. The net effect (understanding the bonds were mostly purchased from non-bank entities) is the private sector has swapped Tsy assets for Fed reserves. Banks can lend excess reserves, but they are choosing not to, and the Fed is paying about $5 B/year in IOR to banks (which tells you that the banks risk/reward analysis is that 0.25% in the hand is worth a loan in the bush).

    So at the large scale level, it has been an asset swap. Individual holders of Tsy once swapped cash for Tsy and are now swapping Tsy for cash. And the increase in reserves means the net effect has been that this cash ended up in bank reserves. So the net is that individuals are in a very similar position as they were before they bought the Tsy (ignoring the TVM gain they obviously got to induce them to sell the Tsy) which equal 0. But the Fed still holds the asset without an offsetting liability, and the Gov has the cash asset and the bond liability. As with all banking, when the Fed asset goes away the money goes away. But as long as the Fed balance sheet doesn’t contract, the money exists, and it didn’t exist before. It’s almost all held in reserve accounts so it’s not in the economy (outside the 0.25% IOR transfer).

    The trick is getting the banks to increase lending to draw down excess reserves. But the Fed has a huge hammer, the IOR.

  • Cullen Roche

    You’re consolidating fiscal and monetary policy which is the reason why you’re misunderstanding how this all works. Of course, if you consolidate fiscal and monetary policy into the same thing then it looks like the Fed is funding the govt. I could also draw up a totally ridiculous example about how my purchase of apple stock on the NYSE “funds” Apples IPO from 199X. It would show the same basic flow of funds from a primary market funding operation to a totally separate secondary market transaction. The Fed does not buy on the primary market when the govt sells its debt so consolidating the two is misleading and wrong. In fact, the Fed is not permitted to do so for this precise reason even though there’s an army of fearmongering writers out there in the blogosphere bungling this stuff left and right thereby confusing everyone. QE is implemented via secondary market transactions. They’re not primary market transactions. You’re making a very basic mistake in your analysis by consolidating a secondary market transaction into the primary market transaction.

    Just imagine a budget surplus with QE. Would you call that a loan? Of course not. The budget surplus example proves that QE is not necessarily “monetization” or a “loan” or even necessarily related at all to fiscal policy. I don’t know why people insist on consolidating them when they’re two separate policies.

  • Tom Brown

    Very funny Cullen… I never knew that Bruce took on Chuck! Somebody should have asked about that here:

  • Geoff

    What keeps the Fed in check, at least at present, is the limited amount of financial assets that are available to swap for cash/reserves. The Fed (and the banks) can create “money” but they can’t create NFA’s, at least at present.

    I’m not sure, but I think the distinction between monetary and fiscal policy is whether NFA’s were created or not.

  • Tom Brown
  • Johnny Evers

    But don’t you think that if a primary dealer buys a bond on Monday, then sells it to the Fed on Tuesday so it can use the proceeds to buy a new bond on Wedneday that the primary dealer would effectively be funding the government.
    The fact that the government doesn’t *need* to do this would be irrelevant.

  • Cullen Roche

    The Dealer doesn’t “fund” the purchase by selling to the Fed. The Dealer “funds” the purchase almost always by making an intraday loan and then settling the transaction with the money markets. The fact that they on-sell the bonds to the Fed the next day misconstrues the actual process and implies that there are no other buyers for the bonds.

    Lots of people keep saying the demand for govt bonds has dried up, but is there any evidence of this? Any at all? I don’t think so. Saying the fed “funds” the spending is like saying that I fund the spending by buying a govt bond on the secondary market. Sorry, but it’s just not right.

  • MRist

    Cullen, can we create a MR slogan? I like Mosler’s:

    “The funds to pay tax come from government spending”

    Can MR use:

    “The funds to pay taxes come from the banking oligopoly”


  • Cullen Roche

    Hmmm. I prefer “economics without politics” or something that focuses on the idea that we’re trying to do economics by focusing on facts and not politics….

  • Hoffa

    Good post!

  • Morgan Warstler

    Cross posted

    Imagine that the CB bought no treasuries ever.

    Either bc is encourages govt to take on debt, or make govt. debt cheaper, or bc the govt is running in balance, etc.

    But then to remove any discretion over what to buy, it used a random number generator to buy and sell single shares of stock.

    And to piss off the Wall Street guys, it forced the traders to rebate their sales commissions on Fed purchases at the end of the month.

    And to further piss off traders, it ran faster than the fastest HFT platform.

    That’s not in any way Fiscal policy right?

    Meaning when we think of Fiscal policy, we tend to imagine discretion and cronyism, (the lucky dirt salesman) and if instead the machine was random, the effect would be purely to lift all publicly traded companies equally, no?

    Its not exactly like buying a broad index either bc it would randomly buy single shares of crashing stock.

    It’s a technically an easy thing to build. The Fed’s just sitting on a black box full of shares it owns, and it randomly grabs one and sells it, or select one from the market to buy to stick into box….

    So could the Fed effectively pull market caps and GDP into line? Increasing the wealth effect or decreasing monthly as the transmission mechanism for staying on NGDP’s level target?

    I assume I’m wrong here, but I don’t know why.

    What I like about it is it uses the FEAR you mention, it actually makes the political constraints tighter. People would freak if the Fed kept buying an ever larger share of public markets, SO the Fed would…

    spend lots of telling Congress they need REAL GROWTH.

    The government could borrow as inexpensively, since the fed isn’t buying, and that would force the government to concern itself with making sure private sector was having an easy time running.

  • LVG

    This Sadowski guy resorts to ad hominems when he can’t counter your point:

    “Roche is a dirt-bag, er, I mean “Roche’s bag-o-dirt” is catchier than “Sproulian Purchase” or “Lever”.”

    And Sumner thinks QE increases the net worth of the private sector:

    “Mark, He says the private sector doesn’t end up with a higher net worth? I hardly know where to begin.”

    Are these guys even more clueless on basic accounting than we think?

  • Mark A. Sadowski

    “This Sadowski guy resorts to ad hominems when he can’t counter your point”


  • LVG

    The point is that you have no idea what you’re talking about. Did you really need me to spell that out for you?

  • Mark A. Sadowski


  • Cullen Roche

    Guys, let’s keep it civil and mature. I am sorry I irritated Scott Sumner several weeks ago. I should have never commented on his site. That was stupid of me. But I agreed with much of his post here. So there’s really no reason to get combative. Thanks.

  • John Daschbach

    The consolidation is a simple accounting fact which is at the basis of MR. Your view is exactly the same as rejecting Thermodynamics. If we ignore foreign transfers of goods and money (a problem, but useful to first order) then the US economic system obeys the economic equivalent of integrating over all flows.

    Your going back to your micro views. It doesn’t matter the pathway of a transaction at the purely macro level, what matters is the integral over all flows in the system. I look at this as a chemical physicist who has worked at both the molecular level and the bulk level. If you have a problem with this, then you need to refute the accounting in the simple example I provided. It’s nearly the same as examples you have used for banking (without the government). It’s a few lines on a napkin. Look at the example and work through it. I don’t see how you can reach your view unless either the Fed can’t go from (0,0) to (1b,0c) (which MR is based upon). Or look at your view in the case the Fed holds to maturity and the Tsy retires (pays par on) the bond (with no offsetting purchase). If the Fed asset is extinguished by having the Tsy (taxpayer) pay off the bond at maturity then the earlier private dealer is not involved. P1 is still (1c,0). The government is still at (0,0) [ignoring interest payments]. But the Fed is (1c,0). Money = 2. If the Fed is viewed as a bank it writes down the asset (the money essentially goes into the infinite supply of dollars a bank has), Money = 1. There is no profit other than any TVM and interest payments during the asset holding period.

    As the simple example showed, simple subtraction removes the primary dealer from the equation. We can repeat this any number of times (P1-P2, P2-P3, P3-P4, ….).

    A budget surplus with QE is of course still a loan. That is the wrong question. The Gov can (and has under Clinton) run a budget surplus but still had debt, and the Fed had substantial holdings of Tsy (the interest income remitted to the Tsy). This is basic finance 101. Companies or people with very positive balance sheets often still take out loans. Why should it matter if the current year is a budget surplus? Is Apple’s bond offering not a loan to you? Apple has a huge budget surplus but it still took out loans (issued bonds). Ridiculous!

    Cullen, MR is a useful framework. But your level of critical thinking is often less than required for a BS, and certainly a PhD in Physics, Chemistry, and Math. Since macro economics is the attempt to apply the techniques of these fields to economics it is easy to see how mistakes are introduced. In fact one can easily argue that macro economics is purely applying these techniques when human scales make invoking the ergodic hypothesis semi-reasonable (it isn’t unless we argue for local equilibrium, but it works in that limit).

    Most people get this wrong. Shadow banking has been an issue in my understanding, so on the first really nice day in over a week here in CO (we had 18 inches of rain at our house) I worked on this during a long bicycle ride. I came up with a model and then came back and read most of the links on your page about shadow banking. Roughly my understanding of shadow banking derived during my ride was supported by the papers. But, disturbingly, most all of the papers use the deposits allow for loans in traditional banks model. In certain limits this holds (but only for some banks which are loan rich and deposit poor) but overall MR is brilliant in revealing that banks don’t need deposits to create loans. I would argue that this should be clear to anyone who looks at the excess reserve ratio, the discount window balance sheet (so small it’s immaterial), and the estimates for Fed Funds balances (miniscule compared with bank loans outstanding).

    But on the Fed balance sheet, you need to do the back of a napkin model. It’s the integral that matters. Right now the banks are holding reserves, which mostly balance the Fed balance sheet (about $200 B difference). But that money exists, created by the Fed. Together with bank lending it is still below the growth trend required for 3-5% unemployment, 3-4% growth, and 2% inflation. The Fed is “praying” that bank lending will pick up and allow them to eventually draw down the balance sheet, but by my estimates we should be $4 T higher just to meet the poor edge of those numbers.

  • Morgan Warstler

    More importantly,

    Sadowski / Roche, I’m trying to grok why a random # generated buying as I describe above would be considered Fiscal.

    I can’t figure out why it would be.

  • Benjamin Cole

    I like the “Bag-o-Dirt” idea, but better is a national Fed-financed lottery with more winners than losers, mostly small winners…could easily piggyback on the many extant state lotteries. ..print money and give to the millions of small winners…

  • Morgan Warstler

    It seems like the Govt. could NOT borrow as inexpensively, so they could spend as much.

    And the Fed would be afraid to buy to own too much to the stock market.

    But, forget if you think those two things are good or bad, my question is:

    If the Fed was buying and selling stocks at random as their way of hitting a NGDPLT target, would that be a good or bad transmission mechanism.

    It seems like its a lot more direct than buying T-Bills.

    How would it be at respond to the banking shock in 2008?

    Would it keep us on NGDPLT target and let the banks crater / unwind?

  • Morgan Warstler

    Benji you too, what’s wrong with this stock market thing?

  • SS

    Bidding up stocks doesn’t mean the companies will produce the output necessary to validate the rise in stock prices.

  • Morgan Warstler

    I know its totally nominal.

    But the money far more quickly enters into markets hand.

    All that everybody knows if that the govt. is buying $50B in stock this month. Seller are going to taking $50B more out of market then they would have, they have to do something with that money…. hot potato.

    Target is reached, goes over a bit, Fed is going to sell $10B of its stock.

    Maybe its across all the dollar denominated stock exchanges. What’s that like $25T+

  • Geoff

    Morgan, I think the difference between fiscal and monetary policy is that fiscal adds NFA’s to the private sector whereas monetary policy does not. If so, then your random buying would not be considered fiscal as it does not add NFA’s.

  • Tom Brown

    Geoff, good answer. However, this might be something to think about. I wasn’t aware of it at the time, but apparently there was a big online debate between the MMists and the Austrians over “Cantillion Effects.” On the Austrian side was Bob Murphy and commentator Greg Ransom… and pretty much everyone I know chimed in on the MMist side. Glasner joined the fray late, but helpfully provided a lot of links:

    From what I can tell, these are supposed effects of “who gets the money” when money is injected. After a lot of wrangling, my take away was that although the denied it up and down at first saying things like “It doesn’t matter if it’s Joe or Bob who gets the money first! It really doesn’t!” … well I think they do eventually concede the implicit assumption there is that Joe and Bob are both PDs… or both national lottery winners… or whatever. It DOES in fact matter in terms of broad categorizations of sectors of the economy (that’s my read anyway… I tried to digest the whole debate by skimming quickly, so I may have missed something important there). The MMists explained away this “effect” by saying that any difference it DOES happen to make is not a monetary effect (thus keeping monetary policy pure).. instead that’s a lowly “fiscal effect” component. Haha!

    Anyway, that’s my read. Take it for what it’s worth! I’m probably wrong!

  • Morgan Warstler


    I’ll get there soon enough! :)

  • LVG

    No, the Fed buying stocks from private actors could create capital gains for some people which would be the equivalent of fiscal policy.

    This could cause stocks to deviate wildly from their fundamentals, but I don’t think Market Monetarists are too concerned with that.

  • Morgan Warstler

    you aren’t thinking macro.

    1 share of google, 1 share of rubbermaid, 1 share of ford, 1 share of random stock – billions of dollars at a time.

    ALL shareholders would EQUALLY get slightly overpaid pay slightly less for shares.

    NO moral issue.

  • Andrew P

    A more serious question is what does legality really mean in a system of checks and balances? It may be technically illegal for the Fed to buy bags of dirt for $100, but what really counts is who can actually stop them from doing it? Suppose the Fed did exactly this. No one can go to court to stop them because there are no directly injured parties who have “legal standing”. That leaves the question up to the Congress. All officials of the executive branch, judicial branch, and independent agencies can be impeached. Impeachment takes a majority of the House, but removal from office requires 2/3 of the Senate. If one of the political parties chose to protect the Fed’s fiscal dirt-buying operation, they would have the 34 Senate votes required to prevent impeachment from being successful. The Fed could continue its operation indefinitely as long as one political party was willing to stand with them.

    This analysis is also exactly why the President can do things that are technically illegal and get away with it. It also applies to foreign central banks – particularly the ECB.

    I don’t really think the Fed will ever go on a dirt buying binge, but I could foresee a highly political Fed chairman buying municipal bonds to bail out a bankrupt city or insolvent State.

  • Cowpoke

    “Lots of people keep saying the demand for govt bonds has dried up, but is there any evidence of this?”

    YES SIR, there Is,
    The PRICE:

  • Andrew P

    Why not simply have the Fed buy muni or State project bonds for some infrastructure, like bridges and roads? Or bonds that fund federal loans to small business? (I’ve heard the last one seriously proposed.)

  • Cullen Roche

    Traders would just front run prices bidding them up higher and higher until they were so far separated from their fundamentals that they crash. I don’t think messing with stock prices makes a lot of sense. That just encourages irrational traders to act even more irrationally.

  • Cullen Roche


    It’s not an accounting “fact”. It’s just the way you’re drawing it up. I can draw QE and bond sales up as different operations. Big deal. You’re consolidating fiscal and monetary policy in order to defend your previously erroneous claim that QE is a loan. No one I know of would claim such a thing. The Fed doesn’t describe it that way, economists don’t describe it that way and MR definitely doesn’t describe it that way. So I think you’re reaching here. It’s best to think of QE as monetary policy and bond sales as fiscal policy. Consolidating them into the same operation misconstrues what they really are.

    And no, your response to the budget surplus example doesn’t change anything. The fact is, QE could be implemented with lots of different assets in lots of different environments. And if the govt were running a budget surplus where they didn’t need to sell bonds then would you call purchases of, say, MBS QE? Or what about Japan where they’re buying REITs? Would you claim Japan is funding the past IPOs of REITs? Of course you wouldn’t. That would be totally ridiculous just like claiming your purchase of Apple shares tomorrow funds their 199X IPO. That would be highly misleading.

  • Andrew P

    If the Fed starts buying things that are technically illegal for it to buy, it is diving into the dangerous realm of politics. It is very easy for them to get into the political realm, but very hard to get out once they get in.

    I’ve seen claims that the real bailout in 2009 was not the Fed buying MBS, but the rather FASB eliminating the “mark to market” accounting for banks. By doing this, the FASB took bank insolvency and failure off the table. Do you have an estimate of the relative impact of the two actions, given that they happened at about the same time and are hard to disentangle?

  • Benjamin Cole


    Not sure what you mean, but what I mean is we have a national lottery. The winners are paid with cash printed by the Fed (okay the Bureau of Engraving, but they give the cash to the Fed and the Fed hands it out).

    But instead of huge winners, there are, say, many $125 winners, who bought $50 in tickets. You have to give your ID and SS# to collect, and and you are limited to $10,000 a year in winnings.

    Okay, moral hazard: But people risked capital to win, no one is guaranteed to win.

    in terms of mechanics, I think everything is almost already place; that is, most states already run lotteries.

    You don’t even have miles of sandbags piling up around the Fed.

    I really like my lottery idea, and I am sorry it receives so little respect. It is the Rodney Dangerfield of monetary stimulus ideas.

  • Stephen

    I don’t think I made myself clear and right now I don’t know how to explain it better than to say you seem to be looking at 1st order activity without considering 2nd order consequences of that activity.

  • Morgan Warstler

    Benji, I want to make Sumner’s futures almost exactly that:

    I want it for SMB owners though. So it’s not a lottery, its a sports book, but it accurately predicts what the market thinks, and gives the best part of the market SMBs the fast taste of bad news, so they can act first.

    For the same reason Scott wants the tax credit on the employer side, but also for distributism.

  • Johnny Evers

    It doesn’t really matter if there are other buyers for the bonds or not. The process shows that the Fed is buying bonds through a middleman.
    In your example, the middleman borrows to buy the initial bond, then closes his loan by selling the bond. He has no skin in this game at all.
    Let’s look at this example: My son has 100k in his bank account. HIs annual tuition bill of 25k come due. He pays it. I then put 25k into his bank account.
    Who is paying for him to go to college?

  • 1jump

    What about equity? Cant new net financial assets in the form of equity be created by the private sector?

  • Andrea Malagoli

    When the Fed buys mortgages, it may not be buying outright dirt, but it is buying a claim on real assets that may be worth much less than they paid for.

  • Tom Brown

    Not really, since all financial assets created within the private sector are simultaneously a debt to one party and a credit to another. In that sense they are all “inside” assets. For example, say I work for the bank and I have a deposit there with $0. They pay me $1 by crediting my deposit. Now I’ve got $1 equity and the bank has -$1 equity. If you consolidate our BSs we have $0 together.

    Now let’s say I withdraw my $1 as cash. I’m still at $1 equity. The bank replaces my $1 deposit liability on their BS by borrowing $1 from the Fed. They are still at -$1 equity, so still $0 total equity w/in the private sector.

    The only way to get non-zero financial equity in the private sector is if it comes from the outside. Say the Fed buys a bag of worthless dirt from me… or the Tsy taxes me and keeps the balance in their Fed deposit (doesn’t spend it). Either case, the private sector financial equity is no longer $0.

  • Tom Brown

    Geoff, I’m not sure about this:

    “I think the distinction between monetary and fiscal policy is whether NFA’s were created or not.”

    What about just plain taxing and spending? It doesn’t create NFAs (assuming every $ taxed is spent – but not more – no deficit spending). Is that fiscal or not?

  • Geoff

    GP, Tom. I was indeed thinking about the deficit spending (aka NFA creation) aspect of fiscal policy as opposed to simple tax and spend redistribution. The other question, which some commentators have mentioned, is capital gains. When the Fed buys securities at more than market value (like they did in QE1) does that create NFA’s or not?

    Final question. Where did our profile pictures go? I think there is something wrong with WordPress.

  • Tom Brown

    Re: profile pic & word press. Mine kept disappearing, so I gave up. I wasn’t sure this still was wordpress, but I just logged in again, and it appears that it’s a wordpress login, so I guess it is. But I don’t see anything in my profile about uploading or having a profile pic anymore. Morgan has one. So does Cullen.

    Fed buying at more than market: I say it does. The bag of dirt is the classic (but extreme) example. The seller gets an NFA where none was present before. There’s nobody in the private sector who’s a debtor regarding that NFA: only the Fed is (through the intermediary of the banks).

  • Geoff

    Agreed on the bag of dirt, which is a brand new asset. Not sure about overpaying for an existing security.

  • Tom Brown

    I don’t see why not. Say you’ve got a toxic MBS. If you were forced to “mark to market” it’d be worth half the face value. But the Fed comes in and pays face value. I guess the NFA as such never entered the books, but the books were a fiction in the first place.

    It could be more explicit. Ben calls you up and says “we’d like to purchase that $1000 bond you’ve got: we’re willing to pay $2000… but don’t tell anybody! This is illegal!”

  • Geoff

    Illegal, lol. Perhaps it depends on whether the security is so toxic that it has been written down. If it has been written down, and thus the income statement has taken a hit, then NFAs have declined. So the Fed buying would replace the lost NFAs and make the private sector whole again?

    This may be a job for one of your balance sheet creations :)

  • Tom Brown

    I could be wrong, but I think it’s more like this: Say the bank owns 1 mortgage and the borrower has stopped paying. Before the borrower stopped paying it was worth $100k. Now it’s in an indeterminant state: will the borrower start paying again? Is he already in bankruptcy court getting rid of his liabilities? If this is left to play out and the borrower never pays again, the loan itself becomes worthless. The bank can grab the house (the real asset) to attempt to make themselves whole again, but in terms of financial assets, the private sector just lost one for good: the loan: and with it, both a creditor and debtor. The private sectors financial assets still total to $0 equity.

    Now lets say during that indeterminant time the Fed buys the mortgage. No change on the books… until it’s certain that the borrower has been relieved of his liability. Now the private sector books have equity > $0. Where did it come from? Outside the system: the Fed.

  • Cullen Roche

    Sorry, I had to dump a plug-in which messed the profile pics up. It should be fixed now so you can log-in and upload what you want. You can also use and any site running it (all wordpress) will automatically link your email address to the image you upload there. That’s why Morgan’s same pic shows up on WP sites….

  • Geoff

    Makes sense, Tom. If the Fed buys the bad loan from the bank, it is effectively writing back up the asset side of the bank balance sheet. Unless you also write back up the liability side of the borrower balance sheet, his equity (i.e. the equity of the private sector) has increased. In this case, I think you are basically saying that the Fed is bailing out the borrower, which would probably be considered fiscal policy!

  • Tom Brown

    Bailing out the lender. The borrower still loses his house or worse (bankruptcy).

  • Geoff


  • Geoff

    Thanks. Done.