How can the Fed unlimited QE be deflationary?

[Spekulatius]

https://www.bloomberg.com/opinion/articles/2020-06-02/jpmorgan-s-bond-chief-has-no-time-for-fed-haters

 

That’s always the answer you get when you ask a barber if you need a haircut.

[Munger_Disciple]

A good op-ed piece in Bloomberg by Bill Dudley, former President of the Federal Reserve Bank of NY:

 

https://www.bloomberg.com/opinion/articles/2020-06-22/fed-s-balance-sheet-heads-to-10-trillion-to-support-u-s-economy

 

Dudley's description of the inner workings of the Fed parallels the posts by wabuffo. He seems to imply that despite the rapid expansion of the Fed balance sheet, it can control the inflation by raising the interest rate paid on bank reserves. Does this mean the Fed will drive the ST treasury bond yields to 0% while at the same time raise the rate paid on bank reserves to control inflation if needed? Seems weird.

 

[wabuffo]

Dudley writes in a clear manner about the Fed's monetary operations.  Here's another article he wrote in January after people were claiming the Fed's resuming repo operations and expanding its balance sheet was leading to a stock bubble at the end of 2019.

 

https://www.bloomberg.com/opinion/articles/2020-01-29/fed-s-repo-response-isn-t-fueling-the-stock-market

“…when the Fed buys T-bills and increases the amount of reserves in the banking system, that liquidity can’t go elsewhere.  It can move from bank to bank as households and businesses shift where they hold their bank balances.  The only exception is if bank customers decide to increase their holdings of currency.  But if they do that, that reduces the amount of excess reserves in the banking system.

 

If one always remembers the quote above from Dudley every time some TV talking head blames the Fed's growing balance for one problem or another, one will experience less confusion about monetary policy.

 

wabuffo

[Munger_Disciple]

Dudley writes in a clear manner about the Fed's monetary operations. ....

.

.

If one always remembers the quote above from Dudley every time some TV talking head blames the Fed's growing balance for one problem or another, one will experience less confusion about monetary policy.

 

wabuffo

 

+1

[wabuffo]

I wanted to revisit this thread to outline a recent simple real-world example that illustrates how US monetary operations work.  It took place during Q2, 2020 and involves MetaBank (ticker: CASH) and the recent spending by the US Treasury under the CARES Act – specifically, the Economic Impact Payment (EIP) program.  This program sent money directly to all US individuals who qualified either via direct deposit, check, or in some cases, pre-paid debit cards.  The US Treasury engaged MetaBank (a US leader in prepaid debit cards) in the debit card creation and distribution part of the program.

 

Specifically, the US Treasury transferred to MetaBank $6.42B so they can create and issue 3.6 million prepaid debit cards to individuals across the US.  MetaBank is a small bank with only $5.8B in total assets and $4.0B in deposits – so adding $6.4B to that asset and deposit base really expands its balance sheet. What would be a rounding error to JPMorgan Chase or Bank of America is a “pig in a python” to MetaBank.  You can see it in the quickie table I drew up based on quarter-end balance sheet data from MetaBank’s regulatory filings (Quarterly Call Reports) for March and June quarter-ends. Of note, look at what happened to MetaBank's cash assets - almost all of which are bank reserves ("Balances due from Federal Reserve (F.R.) Banks").

 

       

 

These quarter-end amounts understate how much MetaBank’s balance sheet probably expanded at the exact moment the total funds were transferred.  If one adds the entire $6.42B to the total asset balance at the end of March, MetaBank's total assets would’ve reached $12.3B at that point in time.

   

Now let’s follow this funds flow through the US Monetary System via the Federal Reserve’s payment system (click on table below to expand to full size view - amounts are in $000s USD).  Step 1, the US Treasury issues a payment order to its “bank” (the Federal Reserve) to deposit $6.42B at MetaBank.  The next step (Step 2) is that the Federal Reserve shifts reserve balances from the US Treasury’s General Account to MetaBank’s reserve account.  This transfer of reserves at the Fed creates both a new asset for MetaBank and a new deposit liability electronically in Step 3.  The final step 4 is for MetaBank to issue the 3.6m prepaid debit cards to individuals, thus creating new financial assets for all of these debit card holders.  Of course, as these debit card holders spend their balances, the banks that represent merchants who are receiving those funds settle with MetaBank and the Federal Reserve starts shifting funds from MetaBank's reserve account to the other banks' reserve accounts (eg, JPM, BAC, WFC, USB, Citi, etc...).  MetaBank's reserve balance at the Fed is then reduced by those amounts presented for payment at the Fed by the other banks.

 

 

There are some important observations to make here:

1) MetaBank’s cash asset on its balance sheet is really an amount on deposit in a “checking account” at the Fed.  The reality is that this “cash asset” is a settlement balance and Meta can never withdraw it from the Fed.¹ It can only use the balance in this account at the Fed to settle payments with other banks (as prepaid cards get spent) or with the US Treasury.

2) US Treasury deficit spending creates new private sector financial assets.  Look at the debit and credits at the bottom of each organization’s balance sheet.  The Fed and MetaBank end up at zero change to their net asset position.  It is the debit card holders that have new financial assets.

3) If the US Treasury is constantly net deficit spending (spending exceeding tax receipts), then why aren’t bank reserves, in aggregate, for the entire US banking sector continuously growing to astronomical sums?  That’s because the US Treasury issues debt.  When it issues a bond, the process flow goes into reverse.  Reserve balances move from the banks to the US Treasury’s general account and the private sector receives a new asset.  This asset (unlike bank reserves) ends up in the hands of the private sector and thus is a more liquid asset and more marketable.  Thus, debt issuance by the US Treasury is a reserve maintenance activity, and not a funding activity for the Federal government.  (This fact is not well understood and tends to blow people's minds.)

4) Similarly, the Federal Reserve through its payment clearing and lending does not create new financial assets in the private sector (contrary to much of the economic commentary).  It manages the payments between banks and between the US Treasury and banks.  The Fed can also buy assets from/sell assets to the private sector.  But it always exchanges reserves for those assets when it does so.

 

This last point is important to remember when we think about the Fed.  Currently, the Fed is talking about moving to a new program of yield curve control.  This program would attempt to “pin down” long-term Treasury yields by having the Fed buy enormous amounts of US Treasury debt (possibly a majority of what's outstanding).  Right now, the Fed owns on its balance sheet approximately 20% of the total amount of US Treasury debt issued to the private sector (which is a normal amount for the Fed’s history going back forty years or so). 

 

If the Fed wants to own a majority of US Treasury debt (say 65%), it would have to increase bank reserves by another $9T or so.  This is because it would buy a Treasury bond and exchange it for a bank reserve balance.  But unlike Treasury spending, this asset swap doesn’t increase the size of US commercial bank’s total assets, it would just convert more and more of their total assets into deposits held at the Fed (and no increase in their deposit liabilities - unlike US Treasury spending).  As we’ve seen in the MetaBank example this would really distort the aggregate balance sheet of the US commercial banking sector ($11T+ of cash at the Fed vs $20T of total assets if the Fed moved to 65% from 20% ownership of US Treasury debt o/s).

 

Anyhoo - just thought the MetaBank real-life example was interesting and illustrative (and probably too Fed-geeky).

 

wabuffo

 

1 - technically, a bank can exchange reserves for bank notes and currency.

[Spekulatius]

^ Wabuffo, thanks for the illustrative example. I think we slowly come around the fact that buying treasuries will lead to more bank reserves, which isn’t really good news for banks at all (since they have a larger and larger percentage of low yielding and risk free assets on their balance sheet).

 

It would become a disaster (for banks) if we get negative interest rates, also the Fed officials so far vehemently  refuted negative interest rates  so far.

[Munger_Disciple]

wabuffo,

 

Thanks for the Meta example; it is very helpful in understanding how the Fed operates. Your posts and Bill Dudley's op-ed pieces have been quite educational to me.  Does this mean that the main risk to inflation comes from US government spending as opposed to the large Fed balance sheet?

 

MD

 

 

[KJP]

I wanted to revisit this thread to outline a recent simple real-world example that illustrates how US monetary operations work. 

 

Great post!  A few questions:

 

 

 

Thus, debt issuance by the US Treasury is a reserve maintenance activity, and not a funding activity for the Federal government.  (This fact is not well understood and tends to blow people's minds.)

 

How do assets (i.e., the account that's debited at Step 1 of your MetaBank example) get into the U.S. Treasury's Fed account to begin with?  If I understand your point later in the post, the issuance of debt by the Treasury reverses the flow and ends up crediting that Treasury account.  So why isn't that debt issuance "funding" Treasury spending?

 

This last point is important to remember when we think about the Fed.  Currently, the Fed is talking about moving to a new program of yield curve control.  This program would attempt to “pin down” long-term Treasury yields by having the Fed buy enormous amounts of US Treasury debt (possibly a majority of what's outstanding).  Right now, the Fed owns on its balance sheet approximately 20% of the total amount of US Treasury debt issued to the private sector (which is a normal amount for the Fed’s history going back forty years or so). 

 

Unless forced to do so by increases in reserve requirements, why would banks choose to sell any Treasury to the Fed that has a higher yield than the interest on its Fed reserves?  So is "yield control" simply the Fed paying a high enough price to drive all Treasury rates down to the rates it pays on reserves?  If that happens, what forces private market buyers to purchase Treasuries yielding essentially nothing?  In other words, why don't Treasury auctions fail? 

 

 

 

[Spekulatius]

This is a good podcast along Wabuffo’s lines (Interview with Cullen Roche)

https://podcasts.apple.com/us/podcast/we-study-billionaires-the-investors-podcast-network/id928933489?i=1000486090490

[wabuffo]

Does this mean that the main risk to inflation comes from US government spending...

 

Yes - this is my working theory.  In fact, inflation (and the political ramifications of that) are the only constraint to US government spending (so long as it is USDs).

 

wabuffo

[wabuffo]

How do assets (i.e., the account that's debited at Step 1 of your MetaBank example) get into the U.S. Treasury's Fed account to begin with?  If I understand your point later in the post, the issuance of debt by the Treasury reverses the flow and ends up crediting that Treasury account.  So why isn't that debt issuance "funding" Treasury spending?

 

KJP - I know this gets a bit "chicken-or-the-egg-y..." but bear with me.  The US Treasury (and the Fed) must adhere to policy decisions that are set by Congress (as it should be since they both are using "the public purse").  But these rules are political, and not economic or physical constraints.

 

If all it takes to create a deposit at MetaBank is for the US Treasury to tell the Fed to do it electronically, there's is also no reason why the US Treasury can't overdraw (go into a negative balance) at its account at the Federal Reserve.  In fact, why does it even need an account balance?  Pre-GFC, the US banking system, in aggregate and individually, could overdraw its reserve accounts so long as the system and individual banks cleared these overdrafts by sundown.  Today the banks aren't allowed to do that anymore.  It was a "rule" change, nothing more.  Another rule change was that the debt ceiling was removed last July (until 2021), so the US Treasury is no longer constrained by an upper limit on debt outstanding.  These are examples that show that many of the behaviors of the US Treasury and the Federal Reserves are due to rules.  For example, the Fed can't buy US Treasury direct and must do it from the private sector after it has been issued.

 

Imagine you are the Prez and one day, the US Treasury hits its debt limit as mandated by Congress, but also on that day, the US Treasury is down to its last $1 in the Treasury general account:

Payments on Social Security checks will fail unless you take action, because:

1) The US Treasury can't overdraw its General Account, and is down to a zero balance.

2) The US Treasury can't issue any T-bills or T-bonds because it has hit its debt limit, so it can't replenish its account at the Fed.

3) As President, you can't order the US Treasury to levy new taxes or fees, because that takes an Act of Congress. 

4) Cutting other spending won't help, because the US Treasury is already at a zero balance.

 

What do you do?  It's a ridiculous example, but I make it to show that in reality the US Treasury can spend and never issue another bond (if it were allowed to overdraw its account).  The Fed would clear payments from the US Treasury and its balance sheet would be whole because the negative balance of the US Treasury account would be offset by a very large positive balance of bank reserves being created from the Treasury spending.  Thus, the change in the Federal Reserve's liabilities would still leave it at a zero net change to its balance sheet.

 

In appearance it looks like the US Treasury issues debt to fund itself.  I'm telling you it doesn't need to.  It issues debt because if it didn't, bank reserves would grow to $20.5t instead of the $2.7t they are now.  That's why I think Treasury debt issuance is the same as reserve maintenance.  In effect, if you look at the US Treasury and the Fed together, the Federal government is offering the private sector a choice for its financial assets:

1) demand deposit at the Fed (bank reserves), or

2) time deposit elsewhere at the Fed (tie up your money for 30 days up to 30 years for a higher interest rate).

 

If Congress can repeal the US Treasury's upper limit (debt ceiling), it could also repeal its lower limit (TGA balance can't be less than zero).  Even if both rules were repealed, I'm saying that the US Treasury would still issue debt for managing the bank reserves (and not to fund its spending).

 

wabuffo

[Cigarbutt]

When "inflation" is the only restraint on government spending, you know that inflation will come, somehow, eventually. Is that desirable? Mr. William M. Martin in 1969 regretted (he said he "failed" which is uncharacteristic in these circles) not to have intervened (restrictive policy) more strongly before it was too late. Though he was aware and vocal about it before.

 

We can go technical (and quantitative) and look at specific transactions at the Fed’s Term Deposit Facility and all and look at the circular transactions (it is a big and complicated circle but it is a circle) but, basically, under the government debt dimension, the Fed acts as a financial intermediate (if you can live with one perspective of the chicken or egg question): The Fed borrows reserves and pays interest on them and, with the proceeds, buys government bonds. So this is considered business as usual now given the tools in the tool box but i would submit that on-balance sheet interest-bearing reserves, massive excess reserves and large-scale quantitative government security acquisitions are a 'new' phenomenon that has has been relentless for more than a decade. When the policy of paying interest on deposited reserves was 'designed', one of the main drivers, apart from 'policy effectiveness maximization', was to provide a an exit strategy (!) tool..

 

When Montesquieu described the principles behind the separation of the three powers, he had in mind that the three independent entities would cooperate and generally work together but the idea was that the checks and balances inherent to such a system would play out in certain circumstances. The independence of the Fed is a related concept. When i post things here and it's stupid (perhaps most contributions), i expect to be told so by independent contributors (i guess we could call this constructive cooperation). Why has the Fed cooperation with the Treasury resulted in a situation where it has become virtually impossible to raise rates (under the current regime)? Why are we in a situation where inflation (as a lagging indicator) is the only residual constraint on government spending?

 

Negotiations and compromises are fine and even "Accords" like in 1951 can make sense but it feels to me now like a poorly designed echo chamber. Did i succeed in skating on thin political (controversial word used in reply #60) ice here?

 

Under present and unprecedented circumstances, inflation may take a while to take hold and it's interesting to consider what it may take to get there. How will the Fed react (since reaction instead of action seems to be the motto) and adjust interest paid on reserves when (if?) market rates go negative?

[wabuffo]

How will the Fed react?

 

1) CB - unfortunately, the PhD's at the Fed have talked themselves into letting inflation run hot.  They are talking about needing to make up for years of no inflation - sort of needing a big CAGR this year to make up for a string of zero CAGR years.  So initially, I fully expect the Fed to do...nothing.

 

2) even if the Fed reacts, what would they do? Raise rates? And that solves inflation, how?  I have no faith in the Fed being able to do anything about inflation, because as we've said currency debasement is fiscally created and, therefore, needs a fiscal response. 

 

wabuffo

[Munger_Disciple]

Does this mean that the main risk to inflation comes from US government spending...

 

Yes - this is my working theory.  In fact, inflation (and the political ramifications of that) are the only constraint to US government spending (so long as it is USDs).

 

wabuffo

 

As we know, Fed is also purchasing securities other than govt bonds; corporates (including junk), short term muni debt and mortgage backed securities. It seems to me that this activity has the potential to create asset inflation/bubbles by reducing the spread between US treasuries and such securities due to an implied "fed put". I am especially bothered by the purchase of munis: suppose a municipality defaults. What recourse does the Fed have in that case to recoup the funds? 

[Cigarbutt]

^If currency debasement is a concern, there are potential ways to hedge (i also bought gold (bars) during a previous post dot-com reflationary episode) and one may even question how price stability could be achieved or optimized from a top-down approach. FWIW, in the small time spent on macro (the stuff is interesting) in proportion to the rest, i recently looked back at some notes made on margins (The Trouble with Prosperity, James Grant, chapter 1: Heirs to 1958) to help understand a technicality related to the Operation Twist performed in 1961. It is interesting to note that Mr. Grant does an amazing job at analyzing the macro concerns of the day (there's always something to worry about) but a better way to make money perhaps (despite the building inflation currents) was to look for mispriced textile operators on the decline. :)

 

Your bureaucratic inertia argument does not convince me. Circumstances were different to some degree but, in the late 70s and early 80s, Mr. Paul Volcker went against the grain, stepped on some toes, patiently built support for a rational plan, maneuvered various corridors and was eventually able to nudge the Fed money supply/base policy in the right direction. Because of the complexity of the inflation issue, perhaps it was a fluke (similar price path would have occurred) but a strong case could be made that governance made a difference as restrictive policies (and their consequences) can be explained (or at least negotiated behind closed doors). It is difficult for the 2020 Fed to discuss or consider a restrictive phase when they have not been able to extricate themselves from a uni-directional, self-imposed, quasi-permanent and pro-cyclical accommodative stance with progressively deeper easing now flirting with the zero bound (i suspect yield curve control may just be an appetizer).

 

In the last 2 to 3 years, the time spent on macro themes has increased slightly and i'll watch it and it may be an age thing, to compensate for previous recklessness. Time is precious and the key is selection and there's someone who i keep reading when the opportunity arises: Mr. Paul Kasriel. He's an economist who was at Northern Trust and who (if i understand correctly) works for fun during retirement (which should always be the way to work). He does not seem trapped by a specific ideology and recently wrote this (he feels that inflation is coming and wonders how we'll get there):

http://www.haver.com/comment/comment.html?c=200526SP2.html

Edit: non-material detail added

[Spekulatius]

^ My simple thinking at this point (based on wabuffo’s point and Cullen Roche seem to think along the same lines ) regarding inflation is to forget about the Fed and just look at what the treasury does in terms of borrowing.on that end, it doesn’t look good right now.

 

Business with power and or inflation protection bought at sensible prices should do at least OK going forward in any scenario.

[scorpioncapital]

Is it actually possible to have inflation - or at least the benefits alleged to it if everyone knows there is inflation and buys inflation protection? some say the benefit of inflation is its asymmetry. seems today people are more educated and on top of things in understanding these issues compared to the past?

[Spekulatius]

Is it actually possible to have inflation - or at least the benefits alleged to it if everyone knows there is inflation and buys inflation protection? some say the benefit of inflation is its asymmetry. seems today people are more educated and on top of things in understanding these issues compared to the past?

 

More educated? I seriously doubt that. You have to be a baby boomer to have experienced inflation and we all know that baby boomers suck. Reading a textbook doesn’t really give you the same experience, that’s for sure.

 

My grandparents were small kids during the Weimar inflation in 1922 and told me stories about people rushing to the stores to buy what they can immediately on payday because next morning, things were way more expensive.

They were playing with small money notes that were several orders or magnitude devalued (a couple of weeks old at the peak) and people were moving money in wheelbarrows.

 

I remember the 70’s and hard assets and gold later were all the rage. There was the 1979 Hunt brothers silver boom and bust. Easy money leads to a lot of misallocation of Capital but inflation does so as well.

 

Hagstroms book “Warren Buffet way” discusses how WEB was investing in inflationary setting (buy business with pricing power and low reinvestment needs) and may be worth a re-read.

 

 

[Cigarbutt]

^It's probably best to go with the flow and to buy businesses that will do at least OK under any circumstances with a margin of safety.

A self-imposed curfew on this topic has been set after this post.

 

Larger fiscal deficits will make sure all roads eventually lead to inflation but Japan has shown that an older, less productive and heavily leveraged society can have an impact on velocity as the the nominal growth of the economy is a function of money growth and velocity.

https://fred.stlouisfed.org/series/M2V

It's funny to think that the great minds of the past thought that money velocity was a constant (it was not if you look carefully at what happened in the 30s and during the low grade inflationary buildup of the post WW2 period) and, of course, nobody could have predicted what has been happening with the recent growing debt overhang.

 

For those interested in Canada (?), the nation escaped QE during the 2007-9 episode but, this time around with the communicable disease issue, the deficit is 6x larger compared to the response to the GFC and recently Canada jumped on the QE bandwagon in order to (to summarize) help prevent a bond supply indigestion.

Interesting perspective that discusses some of the issues mentioned in this thread and "what comes next" (hint:potentially a lot more):

http://behindthenumbers.ca/2020/04/08/canada-joins-the-qe-club-what-is-quantitative-easing-and-what-comes-next/

 

Recently the CDN federal government released a 168-page economic snapshot and the institutional Budget Watchdog suggested that there was no reason for drama if 1-what is happening is temporary and V-cyclical (not secular) and if interest rates stay near zero..

 

So inflation will probably creep up somehow but i bet we will see negative (perhaps deeply negative interest rates) first. The IMF, in 2019, published a nice blueprint "Enabling Deep Negative Rates to Fight Recessions: A Guide" (they also cover the potential implications for bank profitability in a footnote) and i submit that "independent" institutions may eventually rally to consider negative rates as a "GIFT" that will keep on giving.

[SharperDingaan]

Is it actually possible to have inflation - or at least the benefits alleged to it if everyone knows there is inflation and buys inflation protection? some say the benefit of inflation is its asymmetry. seems today people are more educated and on top of things in understanding these issues compared to the past?

 

More educated? I seriously doubt that. You have to be a baby boomer to have experienced inflation and we all know that baby boomers suck. Reading a textbook doesn’t really give you the same experience, that’s for sure.

 

My grandparents were small kids during the Weimar inflation in 1922 and told me stories about people rushing to the stores to buy what they can immediately on payday because next morning, things were way more expensive.

They were playing with small money notes that were several orders or magnitude devalued (a couple of weeks old at the peak) and people were moving money in wheelbarrows.

 

I remember the 70’s and hard assets and gold later were all the rage. There was the 1979 Hunt brothers silver boom and bust. Easy money leads to a lot of misallocation of Capital but inflation does so as well.

 

Hagstroms book “Warren Buffet way” discusses how WEB was investing in inflationary setting (buy business with pricing power and low reinvestment needs) and may be worth a re-read.

 

Keep in mind that for an 'experience' to remain in the public domain, it has to be traumatic, current (within a decade), and experienced simultaneously by multiple generations. As the eldest generation dies off, everyone moves up a generation, and 'experience' rapidly fades. It also warps, as you recall what inflation was like for a male/female, at an earlier life stage - NOT today's stage of life. A very large portion of the NA population has little/no inflation experience, and much of the recall is severely warped.

 

Contrast that to SA, Africa, and parts of Eastern Europe. Grandmothers investing their life savings in canned goods, for resale on the street at the days price level, a COMMON sight. And not 'back then' - every 10-20 years or so. Want to know about inflation?

Talk to immigrants from those places.

 

It is pretty hard to get inflation in a global great recession/depression - but guaranteed if the monetary authority has no choice but to print more bills: inflation remains, and the economy switches to alternative currencies. Hence, we see everything possible being done to push monetary policy to the limits (and beyond), to minimize the use of fiscal policy.

 

There is a reason why we tolerate the absurdity of negative interest rates.

Bankers willingly paying you to borrow large amounts of money from them - is rational? Really?

 

SD

 

 

 

 

 

[muscleman]

Now we have this. That's all deflationary policies huh? I guess Stan Drunkenmiller has made a really bad macro call.

 

https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600

The Federal Reserve is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades.

 

Instead, Fed officials would take a more relaxed view by allowing for periods in which inflation would run slightly above the central bank’s 2% target, to make up for past episodes in which inflation ran below the target.

 

[KJP]

 

KJP - I know this gets a bit "chicken-or-the-egg-y..." but bear with me. 

 

Thanks for the detailed response.  I believe some of the constraints are statutory, rather than merely regulatory (not sure exactly what you meant by "rules"), but, of course, even statutes can be changed.  But if we assume the current regime remains, can the Treasury's account go negative?  If not, how is that Treasury account "funded"?

 

Stepping into hypotheticals, if the Treasury account can go negative, is that any different than the Fed buying Treasury debt directly?  After all, a "negative" balance is simply a loan, even if a forced one.  And if the Fed can buy Treasury debt directly, does that cross the Rubicon into pure money-printing?  Put another way, a constraint under the existing rules seems to be the someone needs to first buy Treasury debt issuance.  If the Treasury's Fed account can go negative, that constraint is eliminated and the Treasury may spend an infinite amount of dollars without any revenue.  [i have not yet read Prof. Kelton's book, but is her thesis that this is how the monetary system actually works now, and any focus on "pre-funding" the Fed's Treasury account is a misunderstanding?]

 

 

[wabuffo]

KJP - at the risk of extending a topic that seems to be petering out in terms of interest-levels...

 

And if the Fed can buy Treasury debt directly, does that cross the Rubicon into pure money-printing?

 

You are assuming that these direct-buys of Treasuries are the Fed helping the US Treasury.  But what if history has shown that in the rare cases where they happen, it is the other way around?  What if it is the Federal Reserve that is actually the structurally weaker institution and needs occasional propping up by the US Treasury?  Go back to Sept 2008, as the mushroom clouds were going off around the financial sector.  There was this rather brief announcement by the US Treasury on Sept 17, 2008:

 

https://www.treasury.gov/press-center/press-releases/Pages/hp1144.aspx

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve.  The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

Back then, there was a real fear that the Fed was going to run out of Treasuries as it was acting as a direct lender to financial firms that were desperate to exchange bad collateral for good (US Treasuries).  At the time, the program was euphemistically known as "Treasuries for trash".  Thus this announcement was declaring that the US Treasury was issuing $585b of T-Bills directly to the Fed and in return the Fed was crediting the US Treasury with $585b in settlement balances in its General account.  The US Treasury did this to give the Fed more "ammunition".

 

We've seen this again in this crisis, where the US Treasury has added $114b in "equity" to absorb first losses from some of the new Fed lending programs that could expose the Fed to losses.

 

If the Treasury's Fed account can go negative, that constraint is eliminated and the Treasury may spend an infinite amount of dollars without any revenue.

 

Even though the US left the gold standard in 1971, I think the old concepts when the US dollar was subordinated to gold have refused to die - even if they are no longer applicable.  Through trial and error, we are finding that since severing the link to gold, the US Treasury has more fiscal capacity than we previously thought.  Dick Cheney turned out to be an armchair Nobel economist when he said "deficits don't matter" - even if his utterance may have been a cynical exhortation to Congress to pass the Bush tax cuts in the early aughts.

 

The reality is if you look at the Fed and the US Treasury on a consolidated basis - their three forms of private sector financial assets are all debts in that they are liabilities of their consolidated balance sheet (currency in circulation, bank reserves, Treasury debt). 

 

What is cash?  It is a Federal Government IOU.  In fact, here is a UK 20 pound note.  These banknotes have a smiling Queen Elizabeth saying "I promise to pay bearer on demand the sum of twenty pounds".  It sure sounds like some form of IOU.  It seems like one could present a 20 pound note to the Queen, and she will give you a ...hmm...uhh... a shiny and new 20 pound note in exchange.  8)

 

 

If one accepts that currency and banknotes are IOUs, then why is US Treasury Debt the only one of the three forms of Federal government liabilities that we consider debt?  We think of money as a unit of account but what if it is really government debt?

 

Why are they IOUs?  Because banknotes are basically scrip that the private sector must obtain in order to extinguish its Federal tax (and fee) obligations that are imposed on the private sector by the government. The Federal government must operate in a deficit with the private sector so as to allow the private sector to accumulate the government's money to pay its taxes.  Once the cycle starts, it becomes a flywheel that almost makes the original premise secondary (i.e., that the government's money is really a sort of "tax anticipation note payable"). 

 

Recently when States like California and Illinois got into financial trouble they would issue IOUs to suppliers.  These IOUs were accepted locally because attached to these IOUs was a provision where the IOUs could be used to extinguish State govt tax and fee liabilities.  Thus, not only were they accepted, but they also achieved some limited local circulation in commercial transactions with banks, for example.  There are other historical examples. During the War of 1812, a cash-strapped (and gold-strapped) US government issued short-term US Treasury debt that paid a low nominal interest rate (but could also be used to extinguish tax liabilities).  These notes circulated widely and some even continued to circulate well past their redemption date (and thus no longer paid any interest).  They continued to circulate because they became a form of banknote (money) as they could be presented to the Federal government for payment of taxes or tariffs owed.

 

I think this forms the basis of MMT's theoretical framework and I am generally sympathetic to it.  My problem with MMT is that it has been embraced largely by the left and thus it is hard to separate its explanatory features from its prescriptive (Green New Deal, Guaranteed Employment, etc).  It also refuses to reconcile the opposing forces of fiscal capacity expansion versus currency debasement or give a nod to the economic benefits of low taxes and sound money.  MMT-adherents tend to ignore the currency debasement part even when the evidence piles up (eg., gold).

 

wabuffo

[Vish_ram]

The real concern I’ve is that we are using the Fed (monetary tools) to put a bandaid on structural issues (Curtailing growth in entitlement spending & others).

 

It is sickening to see that we cannot balance the books in a booming economy (until Jan 2020). Giving tax cuts without offsetting spending is just pernicious.

 

A couple of things that Trump has done is a step in the right direction - fixing trade agreements, preventing IP theft, bringing back US manufacturing etc. Both the parties have killed the middle class. If middle class is alive and well ,we would have good tax revenues and we may not have to use Fed’s credit card.

 

Let me flip the question: IF Fed had a limited QE, what would happen?

This would be even more deflationary. Treasury would have to borrow from public’s savings & from foreigners. They would demand higher interest rate. THe amount of T’s borrowing would significantly drop. They have to make painful cuts in social security, medicare, military spending etc. This would start a vicious cycle of deflation.

If Treasury is willing to issue at higher interest rate, then they have to borrow more to just pay the interest.

 

The economic output would drop further, reducing tax receipts. This further pushes us to more deflation.

 

Just like legislators fail to do their job in enacting laws without ambiguity pass the buck to Supreme courts, they are using Fed to fix structural issues. No wonder they have the lowest approval ratings.

 

[Castanza]

KJP - at the risk of extending a topic that seems to be petering out in terms of interest-levels...

 

And if the Fed can buy Treasury debt directly, does that cross the Rubicon into pure money-printing?

 

You are assuming that these direct-buys of Treasuries are the Fed helping the US Treasury.  But what if history has shown that in the rare cases where they happen, it is the other way around?  What if it is the Federal Reserve that is actually the structurally weaker institution and needs occasional propping up by the US Treasury?  Go back to Sept 2008, as the mushroom clouds were going off around the financial sector.  There was this rather brief announcement by the US Treasury on Sept 17, 2008:

 

https://www.treasury.gov/press-center/press-releases/Pages/hp1144.aspx

The Treasury Department announced today the initiation of a temporary Supplementary Financing Program at the request of the Federal Reserve.  The program will consist of a series of Treasury bills, apart from Treasury's current borrowing program, which will provide cash for use in the Federal Reserve initiatives.

Back then, there was a real fear that the Fed was going to run out of Treasuries as it was acting as a direct lender to financial firms that were desperate to exchange bad collateral for good (US Treasuries).  At the time, the program was euphemistically known as "Treasuries for trash".  Thus this announcement was declaring that the US Treasury was issuing $585b of T-Bills directly to the Fed and in return the Fed was crediting the US Treasury with $585b in settlement balances in its General account.  The US Treasury did this to give the Fed more "ammunition".

 

We've seen this again in this crisis, where the US Treasury has added $114b in "equity" to absorb first losses from some of the new Fed lending programs that could expose the Fed to losses.

 

If the Treasury's Fed account can go negative, that constraint is eliminated and the Treasury may spend an infinite amount of dollars without any revenue.

 

Even though the US left the gold standard in 1971, I think the old concepts when the US dollar was subordinated to gold have refused to die - even if they are no longer applicable.  Through trial and error, we are finding that since severing the link to gold, the US Treasury has more fiscal capacity than we previously thought.  Dick Cheney turned out to be an armchair Nobel economist when he said "deficits don't matter" - even if his utterance may have been a cynical exhortation to Congress to pass the Bush tax cuts in the early aughts.

 

The reality is if you look at the Fed and the US Treasury on a consolidated basis - their three forms of private sector financial assets are all debts in that they are liabilities of their consolidated balance sheet (currency in circulation, bank reserves, Treasury debt). 

 

What is cash?  It is a Federal Government IOU.  In fact, here is a UK 20 pound note.  These banknotes have a smiling Queen Elizabeth saying "I promise to pay bearer on demand the sum of twenty pounds".  It sure sounds like some form of IOU.  It seems like one could present a 20 pound note to the Queen, and she will give you a ...hmm...uhh... a shiny and new 20 pound note in exchange.  8)

 

 

If one accepts that currency and banknotes are IOUs, then why is US Treasury Debt the only one of the three forms of Federal government liabilities that we consider debt?  We think of money as a unit of account but what if it is really government debt?

 

Why are they IOUs?  Because banknotes are basically scrip that the private sector must obtain in order to extinguish its Federal tax (and fee) obligations that are imposed on the private sector by the government. The Federal government must operate in a deficit with the private sector so as to allow the private sector to accumulate the government's money to pay its taxes.  Once the cycle starts, it becomes a flywheel that almost makes the original premise secondary (i.e., that the government's money is really a sort of "tax anticipation note payable"). 

 

Recently when States like California and Illinois got into financial trouble they would issue IOUs to suppliers.  These IOUs were accepted locally because attached to these IOUs was a provision where the IOUs could be used to extinguish State govt tax and fee liabilities.  Thus, not only were they accepted, but they also achieved some limited local circulation in commercial transactions with banks, for example.  There are other historical examples. During the War of 1812, a cash-strapped (and gold-strapped) US government issued short-term US Treasury debt that paid a low nominal interest rate (but could also be used to extinguish tax liabilities).  These notes circulated widely and some even continued to circulate well past their redemption date (and thus no long paid any interest).  They continued to circulate because they became a form of banknote (money) as they could be presented to the Federal government for payment of taxes or tariffs owed.

 

I think this forms the basis of MMT's theoretical framework and I am generally sympathetic to it.  My problem with MMT is that it has been embraced largely by the left and thus it is hard to separate its explanatory features from its prescriptive (Green New Deal, Guaranteed Employment, etc).  It also refuses to reconcile the opposing forces of fiscal capacity expansion versus currency debasement or give a nod to the economic benefits of low taxes and sound money.  MMT-adherents tend to ignore the currency debasement part even when the evidence piles up (eg., gold).

 

wabuffo

 

Thanks for sharing your thoughts and explanations throughout this thread wabuffo. Was wondering if you have any books or resources you recommend to become better versed in this area? You clearly have spent a lot of time on this topic.

 

thanks