Understanding the Modern Monetary System – Part 2

This is part 2 of our series on Understanding the Modern Monetary System.  This section is one of the longest and most difficult to conquer so take your time with it.  If you get eager and want to download the hard copy with all 6 sections please see here.  If you missed part 1 please see here.

Part II – The Basic Operations of Fiat Monetary Systems 

The Autonomous Currency Issuer

The sovereign government of the USA includes the Treasury and the central bank and together these domestic monetary authorities form an autonomous currency issuer. In modern fiat money systems the government as the legitimate representation of the people writes the rules of the game. The term “autonomous currency issuer” is a shorthand way to denote the ability of policymakers to determine macro policies and development strategies. Macro policy is the term that economists use to denote simultaneous reference to fiscal and monetary policy. That the activities of the government sector can be considered on a consolidated basis does not mean that the Treasury and the central bank are similar agents; indeed, it is important to understand the distinct roles of fiscal and monetary policy.

The existing monetary system in the USA is one where the Federal Reserve issues most public sector supplied money in the form of Federal Reserve Notes (paper cash) and bank reserves. The Treasury issues coins and Special Drawing Rights. The “outside money” moniker refers to the portion of money issued by the public sector and held by the private sector: it is money originating outside of the private sector. The term “outside money” is what economists call “high powered money” or “base money”. By definition base money excludes the Treasury’s cash holdings and deposits held in its two accounts at the Federal Reserve. The Treasury also has deposit accounts held at private banks in so-called Tax and Loan accounts. That the Treasury’s deposits held at the Fed and at private banks are not counted in any “official” money supply aggregate does not mean that these money-items are in any way unimportant. Understanding the different means through which the Treasury obtains deposits before and in order to finance spending is the most crucial aspect of fiscal policy.

The US Federal Reserve System was established by a legislative act of parliament in 1913. Those who believe that the US Federal Reserve is an independent entity to the Treasury and to Congress fail to differentiate the master (Congress) from the servant (all the entities subject to the sovereign laws established by Congress). The domestic monetary authorities do different tasks though there is coordination on many policymaking issues. When approaching the subject of an autonomous currency issuer it is appropriate to view the Federal Reserve as a currency issuer. The US Fed finances all of its activities by net/new money creation, that is, ex nihilo money creation, “out of thin air”. It is appropriate to view the Treasury as a user of monies issued by the central bank and private banks. The US Congress has chosen to make the Treasury a currency user in the modern era that was not always the case in US history.

In practice the US Treasury finances all of its spending by first collecting fiscal receipts. Some of these fiscal receipts are funded by taxpayers and others by way of bond sales to a variety of agents. That the Treasury is a currency user does not mean that it need be revenue-constrained though one would not get this actuality from the words of our politicians or the mainstream media or even most economists.  There is a broad myth that the government has a true solvency constraint similar to that of a household, business or state government, all of whom are currency users. 

It’s important to understand that the Federal Reserve and private banks can always be relied on to provide financing for the Treasury with the mechanics working via borrowing operations. Yes, the existing US monetary system is one where “banks” can be harnessed as agents for the federal government.  But make no mistake; although these banks can be harnessed as agents of the government at times (as in the role of market maker for Treasury Bond auctions) they are indeed private for profit seeking entities serving private shareholders.  These interests are not always in-line with that of the Federal Reserve, the Treasury, Congress or public purpose.

There are a number of legal obligations on the “primary dealers” (i.e. a select group of private banks) not least of which is to offer bids at Treasury bond auctions.¹  So the US Treasury will always find a buyer for its bonds; and, if there is weak demand from private banks, non-bank private agents and/or foreign agents for T-bonds, the central bank can always buy them in the open market. The US Fed is a bank and has a potentially unlimited capacity to buy T-bonds (or any other asset in the economy) with ex nihilo money creation. So it is misguided to worry too much if at all about the US Treasury ever going bankrupt on its fiat dollar-denominated debts: it never need do so and if it were that would be due to political wrangling. Usually the US Congress postures on whether or not to raise the “debt ceiling” of the federal government and then acts sensibly.

The US Federal Reserve can never “run out of money”. Under current laws the US federal government could run out of money if and only if the “debt limit” is not raised.  Barring extreme politics it must be acknowledged that US T-bonds are essentially default-free assets: that is how financial markets view them. Why did global capital flock to the United States after the bankruptcy of Lehman Brothers in 2008 even though it was clear only that the US financial system was sitting on a proverbial mountain of mispriced ‘sliced and diced’ toxic debt? The answer is simple: the “market” sought the safety of the State most capable of handling the most severe financial crisis since the Great Depression. That Washington acts as if the Treasury is “revenue-constrained” and “running out of money” is a perception problem: the Fed is a bank and has a limitless capacity to create money (albeit it must buy T-bonds in the open market).  

With this understanding it’s important to note that the government does not operate without constraint.  The true constraint for an autonomous currency issuer is always inflation and not solvency.  This is a crucial distinction that makes a currency issuer quite different from a currency user (like a household or business).  Of course, this does not mean the government can spend infinitely, but we will cover this topic more fully in section IV.

The Federal Reserve and How Monetary Policy Works

There’s a great deal of misunderstanding regarding the Fed’s role in the economy and how it influences various actors.  First, it’s important to understand that the Fed is an agent of the government.  It is created by act of Congress and remits 95% of its profits to the US Treasury.  So, contrary to popular opinion, the Fed is not merely an agent of the banks seeking to enrich private bankers.  The Fed is aligned with the US government and has a legislative mandate to achieve price stability and full employment (though it does not always achieve this).

The Federal Reserve serves as the banker to the US economy, often referred to as “the lender of last resort”.  It can best be thought of as a clearing agent to ensure that the system of payments in the USA is always running smoothly.  Since the Fed’s operations run primarily through the private banking system it is often seen as only benefiting banks and no one else.  But a healthy and competitive private banking system benefits us all so this goal is not necessarily misaligned with public purpose.  As the primary steward of the banking system and the payments system the Fed must ensure a healthy banking system.

The central bank is the most important bank in any economy. The US Federal Reserve is the most important central bank in the global economy because of the comparative size of the US economy in the global economy and also because the US dollar serves the role of the key international currency. In the United States the Fed has a dual mandate to promote full employment and price stability. The key policy lever in the Fed’s toolkit is its direct control over the Federal Funds Rate that is the interest rate (i.e. price of money) that private banks pay on reserves. Contrary to popular opinion, depository banks do not “lend out” or “multiply” reserve balances though they do lend money (loans create new deposits ex-nihilo) at a mark-up over the cost of reserves (with lending rates varying in respect to loan duration and the credit risks of individual borrowers).  Because most “money” in the US monetary system is credit based the changing of this spread can have a dramatic effect on the demand and supply of credit and thus the overall economy.

When economists speak of monetary policy they most often have in mind how the central bank manipulates the federal funds rate. In modern economies there is a variety of lenders in addition to private banks (e.g. money market mutual funds, hedge funds, government sponsored enterprises, issuers of asset-backed securities, etc.) and an array of credit market instruments (e.g. credit cards, mortgage finance, Treasury bonds, etc.) where the lending of money occurs over time spectrums from the short-term (overnight) to the long-term (thirty-years) and much in between. As a result there is a multiplicity of interest rates in the economy. The federal funds rate has the biggest impact on short-term interest rates with longer-term interest rates and privately related debt instrument based interest rates being determined by what the market can bear. It is important to recognize that the Fed’s influence on other rates occurs via arbitrage in other markets against the federal funds rate. The US Federal Reserve attains the federal funds target rate by engineering quantity changes in the volume of reserve balances and also by “open mouth policy”.

To be exact, the central bank adds or deletes reserves to accommodate demand by depository banks at the target Federal Funds Rate; and does so to maintain an orderly clearing and payments system. By “open mouth policy” it is meant that the announcement of a policy change can itself help to attain the new federal funds rate target as opposed to the Federal Reserve actually engaging in operations. In some respects market participants adjust to the new interest rate level based on their assessment that the Fed would otherwise enforce the rate via open market operations (e.g. the selling or buying of securities and the conducting or unwinding of positions in ‘repo’ markets). Normally the variance in the Federal Funds Rate is minor though it can be substantial during moments of market stress such as after the collapse of Lehman Brothers in September 2008.  It’s important to note that the Federal Reserve could, in theory, control the entire yield curve of government debt.  That is, if they wanted to pin long rates at 0% there is nothing stopping them from achieving this aside from political and public backlash.  In this regard, it’s important to understand that the Fed only allows the marketplace to control long rates on US Government Bonds to the degree that the Fed permits.  In this regard the term “don’t fight the Fed” is most appropriate since the Federal Reserve can always set the price of the instruments it buys.

It is worth taking a look at the US Federal Reserve’s balance sheet in order to understand how the Fed attains the overnight Federal Funds Rate through activities mainly with depository institutions. Table 1 presents a simplified version. The reader should take note that the US Treasury has two deposit accounts at the Federal Reserve: how the Treasury obtains these deposits is crucial to understanding fiscal policy. Here let us consider how monetary policy worked prior to the payment of reserve interest in late 2008. Typically, on a short-term day-to-day basis, the central bank engages in repurchase agreements (repos) to add reserve balances and reverse repurchase agreements (reverse repos) to drain reserve balances. The Fed can also unwind repos such that a private bank must part with a reserve or unwind reserve repos such that the Fed must supply a reserve.

(Table 1 – The Fed’s Balance Sheet and Factors Affecting Reserve Balances)

Over the longer-term, and when the central bank wants to increase the size of its balance sheet and the volume of high-powered money, it typically engages in open market purchases of T-bonds. In the current crisis, especially the period from September 2008 to the end of 2010, the US Fed grew its balance sheet by purchasing a wide variety of financial assets other than T-bonds from depository and non-depository financial firms (e.g. mortgage-backed securities). In rare instances the Fed also engages in open market sales of T-bonds to remove “excess” liquidity by draining reserves in order to put upward pressures on the Federal Funds Rate.

Prior to December 2008 the US Fed’s daily management of the monetary system revolved mainly around repo and reverse repo operations, that is, with open market purchases of T-bonds used to enact more permanent changes in the volume of high-powered money. In December 2008 the Federal Reserve acquired the legislative power to pay interest on reserves and that has changed how the overnight Federal Funds Rate target is obtained and hence how monetary policy works. For those readers interested in the technical details we refer you to a paper by Marc Lavoie titled “Changes in Central Bank Procedures during the Sub-prime Crisis and Their Repercussions on Monetary Theory”.² The gist of it is that the US Fed now has an additional policy tool at its disposal and can obtain the overnight Federal Funds Rate even when the banking sector is holding large amounts of “excess” reserves.

It might help to think of the rate on reserves as the de-fact Fed Funds Rate.  The reason why this is important is simple.  Were the Fed unable to pay interest on reserves the banks would bid down the overnight rate in an effort to rid themselves of reserves.  This would put downward pressure on the Fed Funds Rate unless the Fed removed the reserves.  By paying interest on reserves the Fed is able to maintain the size of its balance sheet (thus keeping reserves in the banking system) while also keeping control of the Fed Funds Rate.  In this regard, the Fed can always be seen as manipulating the Fed Funds Rate HIGHER since reserves put downward pressure on the rate.

The Fed’s manipulation of short-term interest rates is often called a blunt policy instrument. Why? When the Fed lowers or raises interest rates it has an indiscriminate impact on economic activity. Take, for example, when the central bank wants to moderate mortgage lending. The policy option of lowering or raising the Federal Funds Rate will influence mortgage interest rates in addition to other interest rates. Monetary policy is mainly about setting short-term interest rates though it covers other areas as well including: (1) liquidity support to financial institutions to fulfill the Fed’s role as a “lender of last resort”; (2) appropriate financial regulation; and, (3) the purchase of T-bonds as required to fulfill the Fed’s role as the government’s banker.

A feature of the US financial landscape after 1980 was the rising macro role of non-depository financial firms in credit allocation. The US Federal Reserve System was designed to suit an institutional setting dominated by depository institutions; consequently, the rise of the so-called “shadow banking system” has complicated the attainment of monetary policy objectives. This is exceedingly so during periods of acute market stress. As non-depository financial firms fall outside the traditional transmission belt of monetary policy this can make it difficult for the Fed to fulfill its role as a “lender of last resort” and provide direct liquidity support via balance sheet substitutions (e.g. asset swaps for reserves). All of this explains the Fed’s new lending facilities designed to provide direct liquidity support to non-depository financial firms (in exchange for a wide range of collateral).

Monetary policy is quite distinct from fiscal policy though the two do overlap and there is much coordination between the domestic monetary authorities. Consider that the US Federal Reserve’s “aggressive” interventions during the crisis, particularly after the collapse of Lehman Brothers, effectively “bailed out” financial institutions. In taking distressed assets off the balance sheets of financial businesses in such large volumes there was a fiscal component to the Fed’s actions (that did not require Congressional approval).  By supporting these firms and essentially “making a market” in illiquid assets (and even removing them from bank balance sheets) the Fed was able to keep asset prices higher than they otherwise would have been and helping make these firms more solvent than they otherwise would be.

It’s important to make a distinction between buying Treasury bonds (which are risk free assets) and private market assets (such as mortgage backed securities).  When the Fed engages in purchases of T-bonds they are swapping assets with the private sector.  I.e. there is no overall change in the net financial assets of the public sector even though these operations do create new “outside” money ex-nihilo.  Such operations when undertaken with private banks in fact change the composition of private sector financial assets (swapping reserves for T-bonds) and do not add to the supply of private bank issued money.  Fed policies such as “Quantitative Easing” are often mistakenly referred to as “money printing”, but we must be very specific in using such terminology as it can often be misleading.

Treasury’s “Symbiotic Relationship” with the Fed & Fiscal Policy

In the present era the US federal government must collect and draw on fiscal receipts before and in order to spend.  The Treasury, as a currency user, must always obtain deposits before it can spend.  We must remember that the Fed is a bank and has a potentially unlimited capacity to buy dollar-denominated debt in the open market so let’s worry a lot less about the US Treasury going bankrupt: it need not under existing laws.  Further, the government’s unique ability to harness banks as agents of government creates a unique ability to remain fully funded.

The Treasury procures revenue in two primary forms: taxes and bond sales.  When the Treasury sells bonds to cover the funding short-fall from tax receipts it runs a “budget deficit”.   Taxation is fairly self explanatory, but the Treasury’s complex relationship with the Federal Reserve and Primary Dealers is often misunderstood so it can be helpful to offer some insights on the “symbiotic relationship”.

Like commercial banks, the US Treasury has an account with the Federal Reserve that renders it a currency user.  But the US Congress has a unique relationship with the Fed that would allow the Federal Reserve to always make good on payments if necessary.  In this regard, the US government can also in some respects be viewed as a currency issuer because the political unity and symbiotic relationship with the Federal Reserve renders the possibility of default practically nil (assuming no willing default).  I.e., there is no such thing as the US Treasury not having a funding source since the Federal Reserve can always theoretically serve as the lender of last resort to the government and the Primary Dealers are required to make a market in government debt.  To understand this point we can review government bond auctions in the USA.  These auctions are carefully orchestrated events that are designed not to fail – that’s why they never do. The NY Fed describes the way in which their operations are intricately intertwined with the US Treasury:

“Staff on the Desk start each workday by gathering information about the market’s activities from a number of sources. The Fed’s traders discuss with the primary dealers how the day might unfold in the securities market and how the dealers’ task of financing their securities positions is progressing. Desk staff also talk with the large banks about their reserve needs and the banks’ plans for meeting them and with fed funds brokers about activities in that market.

Reserve forecasters at the New York Fed and at the Board of Governors in Washington, D.C., compile data on bank reserves for the previous day and make projections of factors that could affect reserves for future days. The staff also receives information from the Treasury about its balance at the Federal Reserve and assists the Treasury in managing this balance and Treasury accounts at commercial banks.

Following the discussion with the Treasury, forecasts of reserves are completed. Then, after reviewing all of the information gathered from the various sources, Desk staff develop a plan of action for the day.”

Paul Santoro of the NY Fed recently elaborated this “symbiotic” relationship:

“The U.S. Treasury and the Federal Reserve System have long enjoyed a close relationship, each helping the other to carry out certain statutory responsibilities. This relationship proved beneficial during the 2008-09 financial crisis, when the Treasury altered its cash management practices to facilitate the Fed’s dramatic expansion of credit to banks, primary dealers, and foreign central banks.

…Understanding the relationship between Federal Reserve credit policy and Treasury cash management is important because the relationship illuminates an important but sometimes unappreciated interface between the Treasury and the Fed. It also underscores the symbiotic relationship between the two institutions, in which each assists the other in fulfilling its statutory responsibilities.”

So you can see that this is all well orchestrated policy. The Fed and Treasury are working in tandem with the Primary Dealers. As mentioned, part of the agreement in becoming a Primary Dealer is to make a market in treasuries:

“The primary dealers serve, first and foremost, as trading counterparties of the Federal Reserve Bank of New York (The New York Fed) in its implementation of monetary policy. This role includes the obligations to: (i) participate consistently as counterparty to the New York Fed in its execution of open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee (FOMC); and (ii) provide the New York Fed’s trading desk with market information and analysis helpful in the formulation and implementation of monetary policy. Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account-holders.”

Therefore it is misleading to imply that the auctions might fail due to a lack of demand or some sort of funding failure. The Primary Dealers are required to make a market in government bonds. None of this means auctions can’t fail or that the US government couldn’t choose to default.  It could. But that would be political folly and misunderstanding.  Not due to a lack of funding.

This “symbiotic relationship” can be best seen in a recent US government 10 year bond auction.  This auction occurred just weeks after QE2 ended and just before the debt ceiling debacle occurred in July 2011 so one would have expected this to be a very unstable auction.  In fact, it was business as usual.  As you can see below, the US government was able to auction off $21B in 10 year notes with the Primary Dealers tendering more than 2X the entire auction.  Indirect bidders tendered almost half the auction, but were not needed at all to accomplish the reserve drain.  The bid to cover at 3.1 was extremely strong.

(Figure 1 – 10 Year Note Auction)

There can be no doubt that the domestic monetary authorities of the United States together issue an autonomous currency and that macro policies can be “afforded”. When the Treasury spends more than it collects in revenues the deficit spending also creates net financial assets (something the private banking system cannot achieve). The potential for policymakers to use the fiat monetary system at its disposal to obtain the public purpose is not limited by any inoperable financial constraints but the choices of policymakers and all that falls under the world politics.

Lastly, this understanding of “inside” and “outside” monies exposes an important difference between the government’s balance sheet and that of private sector entities.  There is no operational revenue constraint for the issuer of the currency.  There is a constraint to the extent that private sector entities can borrow and spend, however.  So the key takeaway here is that the government balance sheet is not like a household’s or a state’s balance sheet. The US government, as the issuer of currency in a floating exchange rate system can never be said to be “running out of money”.

The constraint for an autonomous currency issuer is never solvency, but rather inflation.  One role of the government is to help maintain the money supply at a level that does not impose hardship on the private sector.  The goal is always to maximize living standards of the currency users in accordance with public purpose.   While growth and living standards are ultimately a byproduct of the private sector’s ability to produce and innovate, the government can utilize its many tools to influence the composition and quantity of the currency.  It does so via managing monetary and fiscal policy in an effort to maintain a balance between the public’s desire for net financial assets and private credit.

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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