Saturday, June 15, 2013

Lets get macro- Some basic Modern Money Theory (MMT) principles

The US federal government is the monopoly issuer of the dollar, and thus has the ability to spend as much as necessary to achieve full employment of real resources. All the viscous debating over debt and deficits has been entirely misplaced, and it is the under/unemployed who suffer. Fiscal responsibility from the standpoint of the currency issuer means spending until full employment- nothing less an nothing more. The only constrain is the possibility of inflation, if the government spends beyond the ability of the economy to produce real goods and services. However, this risk is about as far away as the moon right now, and our problems are entirely on the opposite end of the spectrum. Here are some explanations of our current sad situation:

A change in composition of the federal debt (ie treasuries into reserves, per Quantitative Easing purchases or vice versa) cannot reasonably be expected to cause inflation. First of all, reserves are not able to be spent any more than treasury securities can be spent. They are both held as interest bearing bank assets. Flooding the system with reserves could only possibly cause inflation by bringing the federal funds rate, and thus the base cost of borrowing, to a level low enough that “too many” loans would be made by banks. If indeed the cost of borrowing is too low, it is possible that many wasteful loans may be created, leading to pointless economic activity.

But even this statement is not correct, because bank lending is never constrained by reserve positions anyway. Due to the realities of our lagged accounting system, where banks make all the loans the can sell, and then settle their reserve positions at the end of a two week maintenance period, the Federal Reserve must always provide reserves to the system to maintain the target rate dictated by the FOMC; these reserve adds are not discretionary. The Fed will always provide reserves to the banking system, at a price, which is somewhere between its  ff target rate and the various discount window rates, which vary based on posting of collateral.  It is the spread between the price of reserves for the bank, and the most expensive loan that the bank can make, that determines lending activity at any point in time. It is possible that even a high federal funds rate, say 5%, will produce as much lending as the current level of 25 basis points (0.25%), if the demand for those loans also exceeds 5%. There may however be a psychological point where the up-front cost of funds is simply too high to allow borrowing to continue, even if real returns remain above zero.

Recent trends should tell us that the opposite is now true- the cost of borrowing is nowhere near low enough to market clear with historically weak demand. And since the supply of loanable funds is never constrained anyway, it is the price, not the quantity that is too low. A simple glance at the level of excess reserves in the banking system should make this obvious: In the 2000's, when way too much lending was going on, there were only a few billion in excess reserves sitting around, now there are trillions of excess reserves and not nearly enough lending. The problem is, as the ISLM model demonstrates, when unemployment is this high, the real cost of borrowing needed to bring it down is in fact negative. Since negative nominal rates are not traditionally feasible, higher inflation is needed to achieve the market clearing, real interest rate point, which lies somewhere below the x-axis.

First of all, that there is nothing “artificial” or “unnatural” about low interest rates; they’re low because demand is low, and the Fed is responding appropriately. If anything, the “unnatural” situation is that rates are too high, because they’re constrained by the zero lower bound (rates can’t go below zero, except for some minor technical bobbles, because people can always just hold cash).
-Paul Krugman blog post, June 5, 2013


The constraint of this “zero lower bound” has been analyzed to death by macro economists including Paul Krugman, yet no current monetary policies that I know of have been able to achieve this negative real rate. The Bank of Japan has been trying like hell to create inflation for 20 years, with absolutely no success. Rates have stayed at zero, there has been no inflation, no currency depreciation, and almost no economic growth. Just as we learned in the case of Japan—which experimented with ZIRP over the past two decades—extremely low rates take more demand out of the economy than they put in. What Dr. Krugman does not say forcefully enough is that is it only fiscal policy, ie increased government spending, that can cause the inflation he sees is necessary to achieve the market clearing negative rate. And in the case of Japan, as my friend tells me, their culture of “shame”, for lack of a better word, leads policy makers to prematurely back off from policy measures that may be correct, but take time to reach full implementation. That is why they have had so many “start and stop” stimulus packages. None of these measures have been enough spending at once to really kick start the economy. They are too cautious to begin with, and without immediate success Prime Ministers will resign, regimes will change, and no lessons are learned.

There are mountains of underutilized capacity in the US and Europe, that cannot be moved without a pull in the other direction: the demand side. Since most demand comes from consumer and government spending, these sources must be stimulated; the former through a large FICA tax cut, and the latter with large domestic spending increases. As a side note, while both policy choices are identical in their addition of reserves to the banking system, I speculate that spending increases will produce more economic activity than tax cuts. This is because government spending that is NOT in the form of transfer payments leads to economy activity in the first instance, whereas transfer payments go directly into bank accounts, where they may be spent, but not necessarily. Recent data has shown that tax cuts and transfer payments are more likely to be saved (or used to reduce dis-savings, ie debt) than spent- although this too is beneficial because increased savings/decrease in private debt can help banks, businesses, and families (the private sector) to repair their balance sheets and begin expanding credit and spending again.

Treasury bonds are the worlds safest asset, and serve as the "foundation" out of which a credit superstructure can be built. Despite what S&P might say, Tsy Securities are rated quadruple A, not triple A or anything less. The chance of default is zero. The yield is set at auction and realized at maturity, and the Fed is always engaging in its own purchases, which makes it easy to offload Tsy securities anytime you want to.

Additionally, special banks called primary dealers and special accounts called Treasury Tax and Loan Accounts must bid at treasury auctions and sell to the Fed at their offered rate during an open market purchase, as a price of being financial agents of the government.

So it is legally true that the Treasury must sell bonds to get money it its account at the Fed, because Congress has forbidden the Treasury to run overdrafts in this account. However, this restraint has no real affect. When primary dealer banks line up at closed Tsy Auctions to "lend" money to the Govt (buy T-Bonds) they are allowed to run an overdraft at the Fed (i.e. borrow reserves directly from the Fed), to effectively borrow the funds from one branch of the Govt to lend to another branch. Since part of the Federal Reserve's jobs is to ensure a stable system of payments, the Treasury, Fed, and the primary dealer banks have the necessary procedures and mechanisms to ensure that the Treasury's General Account is never short of funds for any payment. This is why no Treasury check has or will ever "bounce". 

So MMT is both functionally and normatively true. In the US, where we pledge allegiance to “one nation, indivisible”, it is the US government, and only the government, that sits atop the hierarchy of American society. This democratic government holds the unique prerogative of creating a currency and spending it into society to direct economic activity. All other economic activity stems from this government operation.



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