1888? Whitechapel Murders, Nintendo

March 14, 2014 § Leave a comment


The Bank of England’s Quarterly Review contains a detailed description of how money creation works in the UK’s fiat money economy…

And it is controversial. It rejects conventional theories of bank lending and money creation (my emphasis):

“The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”

To be sure, numerous papers from many eminent researchers and august institutions (including the Fed, the IMF, the ECB and the Bank for International Settlements) have cast doubt upon conventional theory as an adequate explanation of money creation in a modern fiat money system. But to my knowledge this is the first time that a central bank has presented an explanation of money creation that so comprehensively departs from conventional orthodoxy…

It is of course difficult for mainstream economists to accept that the theory they have believed and taught for so many years – and upon which many models of the economy depend – is simply inadequate.  read more


Nearly all of human life has always passed far from hot baths

January 7, 2014 § Leave a comment


We are now in a position to demonstrate our proposition: the natural rate of interest is zero. First, to reiterate the argument thus far: Under a state money system with flexible exchange rates, the monetary system is tax driven. The federal government, as issuer of the currency, is not revenue constrained. Taxes do not finance spending, but taxation serves to create a notional demand for state money. Spending logically precedes tax collection, and total spending will normally exceed tax revenues. The government budget, from inception, will therefore normally be in deficit, which also allows the nongovernment sector to “net save” state money (this in fact has been observed in all state currencies).

The Natural Rate of Interest Is Zero
If spending is not revenue constrained, why does the government (conceived here as a consolidated Treasury and Central Bank) borrow (sell securities)? As spending logically precedes tax collection, the government must likewise spend sufficiently before it can borrow. Thus, government spending must also, as a point of logic, precede security sales. To cite a “real world” example, market participants recognize that when Treasury securities are paid for, increasing Treasury balances at the Fed, the Fed does “repos” on the same day; the Fed must “add” so the Treasury can get paid.

Since the currency issuer does not need to borrow its own money to spend, security sales, like taxes, must have some other purpose. That purpose in a typical state money system is to manage aggregate bank reserves and control short-term interest rates (over night interbank lending rate, or Fed funds rate in the United States).

In the contemporary economy, government “money” includes currency and central bank accounts known as member bank reserves. Government spending and lending adds reserves to the banking system. Government taxing and security sales drain (subtract) reserves from the banking system. When the government realizes a budget deficit, there is a net reserve add to the banking system. That is, government deficit spending results in net credits to member bank reserve accounts. If these net credits lead to excess reserve positions, overnight interest rates will be bid down by the member banks with excess reserves to the interest rate paid on reserves by the central bank (zero percent in the case of the USA and Japan, for example). If the central bank has a positive target for the overnight lending rate, either the central bank must pay interest on reserves or otherwise provide an interest-bearing alternative to non-interest-bearing reserve accounts. This is typically done by offering securities for sale in the open market to drain the excess reserves. Central Bank officials and traders recognize this as “offsetting operating factors,” since the sales are intended to offset the impact of the likes of fiscal policy, float, and so forth on reserves that would cause the Fed funds rate to move away from the Fed’s target rate.

Our main point is, in nations that include the USA, Japan, and others where interest is not paid on central bank reserves, the “penalty” for deficit spending and not issuing securities is not (apart from various self-imposed constraints) “bounced” government checks but a zero percent interbank rate, as in Japan today.

The overnight lending rate is the most important benchmark interest rate for many other important rates, including banks’ prime rates, mortgage rates, and consumer loan rates, and therefore the Fed funds rate serves as the “base rate” of interest in the economy. In a state money system with flexible exchange rates running a budget deficit—in other words, under the “normal” conditions or operations of the specified institutional context—without government intervention either to pay interest on reserves or to offer securities to drain excess reserves to actively support a nonzero, positive interest rate, thenatural or normal rate of interest of such a system is zero.

This analysis is supported by both recent research and experience.  read more

PHOTOGRAPH: Pixy Yijun Liao

A brothel running from a single-bed flat above a Rose Hill shop was shut down by police yesterday. Officers entered the flat to find two Brazilian women aged 33 and 40 at 4.30pm. One said she was married, the other was wearing a towel

December 20, 2013 § Leave a comment


… when you think about money it is at least a good idea to take into account that the definition you use might need to include government bonds. They are a central part of the transaction infrastructure of the U.S. economy.

And if you include government bonds as money, then you’ll see there is very little money creation going in QE. Trading bond-money for reserve-money shifts the components of the money supply but does not necessarily increase it. (If the Fed is paying a premium for the bonds, or the Fed’s buying drives the market for the bonds up, there probably is some marginal increase in the money supply.) Of course, this might have important effects but the effect cannot be explained as simply as the standard monetarist narrative would have it.

So why not consider government bonds money? Here’s how Sumner recently responded in the comment section on his blog:

And I do not consider money and bonds to be close substitutes. When I go shopping I do not agonize about whether to bring cash or T-bills to the grocery store. And bonds pay interest, cash does not. Even reserves paid no interest until 2008, when the Fed shot itself in the foot with IOR.

Frankly, I don’t know what the grocery store insertion accomplishes here. My local grocery store won’t accept bills in denominations larger than $50. Are $100 bills not money? Is the balance of my bank account not money because I have to write a check or go to an ATM to settle a transaction at my grocery store? Is all available consumer credit card indebtedness money because it could be used in grocery stores? The grocery store test is both under-inclusive and over-inclusive.

More importantly, Sumner begs the question: are bonds money? It’s not whether money and bonds are close substitutes but whether, when it comes to figuring out whether QE is inflationary, bonds and reserves are close substitutes and should both count as money. And with both bonds and reserves paying a bit of interest these days, and both being transactional currencies considered both safe and liquid, it seems that they are.

The upside of counting bonds in the relevant money supply is that it explains why the QE-driven enormous expansion of the Fed’s balance sheet—that is, the growth of base money—hasn’t been very inflationary. You don’t have to make up phantom, Occam’s Razor violating concepts such as “demand for reserves,” to explain this. You just notice that QE doesn’t grow the money supply by very much.  read more

PHOTOGRAPH: Andrew Shapter

It is my design to render it manifest that no one point in its composition is referrible either to accident or intuition — that the work proceeded, step by step, to its completion with the precision and rigid consequence of a mathematical problem

March 13, 2013 § Leave a comment


Modern money is is state money. Taxation today functions to create demand for state currencies in order for the money-issuing authority to purchase requisite goods and services from the private sector. Taxation, in a sense, is a vehicle for moving resources from the private to the public domain. Government spending in sovereign currency systems is not limited by the ability of the state to ‘raise’ revenue. In fact, as it will be explained below, sovereign governments face no operational financial constraints.

To fully grasp the logic of sovereign financing, one must make the analytic distinction between the government and non-government sectors. For the private sector, spending is indeed restricted by its capacity to earn revenue or to borrow. This is not the case for the public sector, which ‘finances’ its expenditures in its own money. This is a reflection of its single supplier (monopoly) status. For example, in the USA, the dollar is not a ‘limited resource of the government’. Rather it is a tax credit to the population which is confronted with a dollar-denominated tax liability. Thus government spending provides to the population that which is necessary to pay taxes (dollars). The government need not collect taxes in order to spend; rather it is the private sector, which must earn dollars to settle its tax debt. The consolidated government (including the Treasury and the central bank) is never revenue constrained in its own currency.

If the purpose of taxation is to create demand for state money, then logically and operationally, tax collections cannot occur before the government has provided that which it demands for payment of taxes. In other words, spending comes first and taxation follows later. Another way of seeing this causality is to say that government spending ‘finances’ private sector ‘tax payments’ and not vice versa. Several other implications follow.

Deficits and surpluses
Government spending supplies high-powered money to the population. If the private sector wishes to hoard some of it – a normal condition of the system – deficits necessarily result as a matter of accounting logic. Furthermore, the government cannot collect more in taxes than it has previously spent; thus balanced budgets are the theoretical minimum that can be achieved. But the private sector’s desire to net save ensures that deficits are generated. The market demand for currency, therefore, determines the size of the deficit.

In a given year, of course, surpluses are possible, but they are always limited by the amount of deficit spending in previous years. If during the accounting period government spending falls short of tax collections, private sector holdings of net financial assets necessarily decline. The implication is that surpluses always reduce private sector net savings, while deficits replenish them. It should also be noted that, when governments run surpluses, they do not ‘get’ anything because tax collections ‘destroy’ high-powered money.  read more

PHOTOGRAPH: Hans-Peter Feldmann

Now hold on. I can hear you counting. One two three four. I know you’re coming around me. What I propose is that we move out together. Count it out together. That was always the plan

February 20, 2013 § Leave a comment


So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).

Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What happens when there are bond sales? All that happens is that the bank reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.

However, the reality is that:

• Building bank reserves does not increase the ability of the banks to lend.
• The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
• Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

But it is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.  read more


Writing a novel about a man who leaves his wife and three children and goes to live alone on the other side of London to write a novel about a man who leaves his wife and three children

November 14, 2012 § Leave a comment

When the Fed buys assets, it purchases them by crediting banks with reserves. So the result of QE is that the Fed’s balance sheet grows rapidly—to, literally, trillions of dollars. At the same time, banks exchange the assets they are selling (the Treasuries and MBSs that the Fed is buying) for credits to their reserves held at the Fed. Normally, banks try to minimize reserve holdings—to what they need to cover payments clearing (banks clear accounts with one another using reserves) as well as Fed-imposed required reserve ratios. With QE, the banks have ended up with humongous quantities of excess reserves.

As we said, normally banks would not hold excess reserves voluntarily—reserves used to earn zero, so banks would try to lend them out in the fed funds market (to other banks). But in the ZIRP environment, they can’t get any return on lending reserves. Further, the Fed switched policy in the aftermath of the crisis so that it now pays a small, positive return on reserves. So the banks are holding the excess reserves and the Fed credits them with a bit of interest. They aren’t thrilled with that but there’s nothing they can do: the Fed offers them a price they cannot refuse on the Treasuries and MBSs it wants to buy, and they get stuck with the reserves.

A lot of people—including policy makers—exhort the banks to “lend out the reserves” on the notion that this would “get the economy going”. There are two problems with that. First, banks can lend reserves only to other banks—and all the other banks have exactly the same problem: too many reserves. A bank cannot lend reserves to your household or firm. You do not have an account at the Fed, so there is no operational maneuver that would allow you to borrow the reserves (when a bank lends reserves to another bank, the Fed debits the lending bank’s reserves and credits the borrowing bank’s reserves). Unless you are a bank, you cannot borrow them.

The second problem is that banks don’t need reserves in order to lend. What they need is good, willing, and credit-worthy borrowers. That is what is sadly lacking. Those who are credit-worthy are not willing; those who are willing are mostly not credit-worthy.

And we should be glad that banks are not currently lending to the uncredit-worthy. Here’s why: that’s what got us into this mess in the first place.  read more


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