Wednesday, February 22, 2012

Money, Banks, and National Debt Unmasked - V

In this blog we discuss what constitutes the “national debt” and how we come by it. It is widely misunderstood and is not nearly as important as is, say, unemployment.
National Debt? We Don’t Need It
In the first blog of this series, we reminded ourselves that all money is debt. It follows that when money is created by either printing it on paper or with computer keystrokes, debt is issued. There is no necessity for government to issue debt again by selling Treasury bonds. No country that has a sovereign, non-convertible, floating rate currency needs to sell bonds to fund its spending and thereby create a national debt. However, old gold-standard rules, procedures, and laws stand in the way of other rational options.
If one party is in debt, another party must be a creditor and hold the corresponding asset. A government debt is a non-government asset. The national debt clock could just as well be called the private Treasury savings clock. And, the proportionate distribution of that debt to families could be called family savings. Ironically, if this reality were understood, families would ask, ”Where is our share?” They would find those Treasuries mostly in the pockets of the wealthy.

Figure 1. Our National Savings Clock

If we don’t need it and don’t like it, why do we have a national debt?
The Fed Buys and Sells Treasury Bonds to Manage Bank Reserves
In the previous blog, we learned that without some way to manage day-to-day fluctuations in reserves, the Fed would be unable to manage the FFR (Federal Funds Rate). 
Government deficit spending results in excess reserves, and government surpluses bring about reserve shortages. To drain excess reserves the Fed sells Treasury bonds from its portfolio to commercial banks. This is equivalent to Anne buying a CD (Certificate of Deposit) with excess funds in her checking account. The CD allows her to earn a bit more interest on her funds. Banks are happy to buy Treasuries for the same reason, because they get more interest when they convert their excess reserves into Treasury bonds.
The Fed responds to a government surplus by purchasing bonds from the banks, which converts their bond holdings back into reserves to remove the shortage. This does not add to the “national debt,” it’s like depositing the funds from a CD back into the checking account.
Most importantly, we notice that these bond operations for managing reserves are carried out within the banking system. There are no foreign bond buyers required. The rating services of S&P, Moody’s, or Fitch have nothing to do with internal banking operations and are irrelevant. The Fed sets the interest rates not the external markets.
These bond “purchases” and “sales” are just a matter of moving numbers around on the Fed’s spreadsheet. The New York Federal Reserve Bank is responsible for conducting these Open Market Operations. You can read all about draining reserves at the NYFed website.
Other Options are Available
Bond sales and repurchases are only one way to manage bank reserves. Some ranking Fed officials have recommended that rather than sell bonds, the Fed could just pay the target FFR on the reserves held by the banks (see here and here). This would give the Fed precise control of the FFR and would be a boon to the banks rather than the current holders of Treasuries. 
It probably won’t happen, because it would pit the rich against their banks, which might be fun for the 99% to watch. Reserves would accumulate to large numbers in the banking system with no ill effect.
Another method, employed by Japan, would be to hold the FFR at zero and let the reserves accumulate. That would also be a political problem, because many of the rich and some, who hold bond mutual funds, want to have a base of risk-free, interest bearing bonds.
Quantitative Easing
Currently unable to influence bank lending by lowering the FFR, the Fed is paying 0.25% interest on reserves, which is the FFR. The Fed has purchased bonds under the quantitative easing programs, QE1 and QE2, in a misguided effort to encourage a little inflation. All that has happened is an extraordinary increase in excess reserves as seen in Figure 2. Although some claim this is inflationary “printing” of money, we know these reserves are tucked away in the banking system and will not spill out into the economy. 
Figure 2. Accumulation of excess reserves as a result of quantitative easing. It's dramatic looking but of little significance.
Actually, the bond purchases under QE are somewhat deflationary, because interest generated by the bonds is paid back to the Treasury to the tune of $50 to $80 billion a year, rather than going into the private sector. This is interest income that was not available for spending in the private sector.
How About Passing the National Debt to Our Grandchildren?
Please do! If I leave a house and mortgage to the kids, they will have to pay off the mortgage to keep the house. If I pass on to them some Treasuries, they will have excellent, risk-free assets that pay income or can be used as collateral for a loan. 
Most of the interest the Fed will have to pay goes right back into the economy. That the interest is paid primarily to the rich is a political rather than an economic problem.
Our national debt is the result of the way government has chosen to manage excess bank reserves. The issuance of debt to manage bank reserves, is optional. 
The government’s debt, according to fundamental accounting, represents assets in the private sector, not intergenerational debt. Our grandchildren are enriched rather than burdened by those assets. 
Quantitative easing, which increases reserves, is not inflationary.
Related Reading

Thursday, February 16, 2012

Money, Banks, and National Debt Unmasked - IV

In this blog we consider money put into circulation by government spending. 

In the previous blog, we found that bank loans create money “out of thin air” and put into circulation money that is temporary in nature. Without continuous loaning activity the money in circulation would diminish as loans were paid off, which would slow business activity and push the economy toward recession. 
Government Spending Increases Private Financial Assets
The government needs to provision itself with everything from battleships to paper clips and hire the people to operate them. Government contracts with private industry for some things and hires people from the private sector to, among other duties, sweep floors, legislate, mete out justice, and occupy the oval office. 
To pay for these provisions, government creates dollars, which we have seen are just US IOUs. Then it takes back these dollar-denominated IOUs in taxes of one form or another. If the government spends more than it taxes, it is in deficit by definition. And, there is a net flow of dollars from the government to the non-government sector. If the government is in surplus by collecting taxes in excess of spending, there is a net flow of dollars out of the non-government sector to the government sector.
Figure 1, A depiction of major economic sectors involved with money flows. What flows out of one flows into others as a matter of basic accounting.

To be clear, the non-government sector comprises domestic households and  businesses, as well as foreign countries with which we trade. Households provide the people who work in businesses and government. That is to say, households are the ultimate beneficiaries of both business activity and government spending.
Government Spending Increases Bank Reserves
OK, we still haven’t said where these dollars come from. Well, they are just created “out of thin air.” Where else can the government get dollars? No other entity can create them. This is how it is done.
The US Treasury is a bank and pays the government’s bills with checks drawn on its “reserve” account at the Federal Reserve Bank (Fed). The Fed supplies the reserves by marking up the Treasury’s balance. This action is similar to the Fed interaction with a private bank where the Fed supplied reserves to the bank for a loan as we discussed in the previous blog. 
As there is no loan involved in the case of government spending, the reserve supplied is a “free” reserve. It doesn’t go away like bank reserves do when a loan is paid off. 
Having its reserves increased, the Treasury passes the reserves to Tom’s bank, so that bank can credit Tom’s account. As Tom spends his money, those who receive his checks deposit them in their own banks. And, Tom’s checks cause transfer of his bank’s reserves to other banks. The reserves created by government spending remain in the system and just move from one bank to another as checks are cashed. Meanwhile Tom walks away with his merchandise leaving the reserves to others.
The reserves created by government deficit spending are excess reserves, because they never go away. Conversely, government surpluses result in a reserve shortage, as discussed below.
Taxes Reduce Bank Reserves
Hopefully, this idea is now easy to grasp. Taxing is just reverse spending and debits bank accounts just as spending credits bank accounts. Tax payments go to the Treasury’s reserve account at the Fed. Then the Fed uses keystrokes to take back the funds and cancel the liabilities that previously increased the Treasury’s reserves. Taxes, and only taxes, destroy reserves created by government spending.
You might well ask, “Where did the taxes go? Don’t they get saved to make government purchases?” Nowhere and no!  Taxes destroy money. And, logically, that destroyed money had already been created or it wouldn’t be there. Actually, the government has no way to save for future expenses. 
Reserve Excesses or Shortages Clobber the FFR
Both reserve excesses and shortages cause problems for the Fed.

Figure 2, An historic view of the FFR. The Fed increases the rate as inflation threatens and decreases it in recessions.

Remember, the Federal Funds Rate (FFR) is the policy variable the Fed uses, in normal times, to stimulate or discourage bank lending activity. Excess reserves caused by government deficits cannot be resolved by interbank lending. It’s like musical chairs with too many chairs. So banks offer each other lower interest rates in trying to dump their excesses. Consequently, the FFR will default to zero, unless the Fed takes corrective measures.
Exactly the opposite happens when the government is in surplus. There are not enough reserves to go around and banks will bid up the prices (interest rates) trying to meet their needs.
In these currently extraordinary times, the Fed has lost control of lending. The FFR is set to zero, and still there is only anemic bank lending. 
The government creates the money it needs to provision itself and levies taxes to get rid of money. This is a unique capability of a sovereign, unconstrained currency, with a floating exchange rate, and it offers advantages to the government in its stewardship of the currency.
Government spending creates assets in the non-government sector and increases bank reserves net of taxes, which destroy money.
To control the FFR and influence bank lending, the Fed must control the level of reserves in the banking system. That will be the subject of the next blog, the last of this series.
Related Reading

Thanks to Duane again for helpful suggestions.

Wednesday, February 8, 2012

Money, Banks, and National Debt Unmasked - III

This blog will look at how bank loans inject dollars into the economy. Anyone, who has had a mortgage, car loan, or credit card knows something about debt. With that in mind, it may seem strange that we can’t understand national debt without knowing about banks and the mechanics of bank loans.
Banks Create Money out of “Thin Air.”
Most of the money in circulation is from bank loans. Bank money, as it is sometimes called, is issued in US dollars, but lasts only until the loan is paid off. It follows that for the economy to prosper there must be ongoing business activity requiring loans. When that activity declines, for any reason, businesses lay off workers and the possibility of recession looms.
It is perhaps more interesting to find that bank loans can create money “out of thin air.” Where do they get it? New money has to come from the only entity that can create dollars, the US government. Yes, the government is involved at the very heart of our private enterprise system; it supplies the money.

Deposits Increase a Banks Required Reserves
The Fed, our central bank, charters certain banks that subscribe to rules about capital-to-loan-ratio requirements, and regulations that allow those banks to have accounts with the Fed. The balances in those accounts are called reserves, and they are oh so very important to the banking system. 
Reserves are money that banks must have in their vaults or on deposit with the Fed to meet withdrawal demands.
We know that a bank is not a piggy bank that holds our money in a box. When Anne deposits her money in a bank account, it creates a liability for the bank, because the bank must honor immediately any cash or check withdrawals demanded by Anne. Savings accounts are not “demand” accounts as there can be a time lapse for large transactions before withdrawal. As soon as the demand is made, the bank must make that amount of reserves available in it’s reserve account at the Fed so the check will clear. 
Throughout the banking system these reserves are clearing balances to assure that our checks don’t bounce. Thanks to the Fed’s reserve management system, a check presented to any bank will be honored by any other bank anywhere in the nation.
Loans Create Bank Deposits
A loan begins with a creditworthy customer, Anne, who signs the loan note and the bank deposits the loan amount in her account at the bank. Look at the way assets and liabilities balance. Anne has the bank deposit as an asset and the loan as an equal liability. The bank has Anne’s account as a liability and her loan note as an equal asset. 
As Anne pays off the loan her liability vanishes as does the banks asset. As Anne draws down her account she diminishes her asset, as well as the bank’s liability, and reserves diminish accordingly. The reserve requirements are passed to the banks where Anne’s checks were cashed. 
There is no lasting effect on the total amount of all reserves in the banking system. If everyone cashed all their checks in one day, there would be enough deposits to cover them to the penny.
If Anne made good use of her loan, she might have acquired real assets (land, a patent, donkey and gold pan, etc.) and increased her wealth.

Banks Borrow to Meet Required Reserves
It is often thought that banks loan only what they have on deposit. That’s not the case. The Fed will make reserves available “out of thin air,” at a price, after a loan is made. In lending, banks are not reserve constrained; they are constrained by bank capital (net worth). 
Interest bank pays to depositors is close to FFR.
Banks determine their reserve requirements at the end of each day by tallying up the direct deposits and loans, which increase required reserves, and the cash withdrawals and checks presented from other banks, which reduce reserves. If they are short of reserves they must borrow the funds from banks that have excess reserves.
Interbank trading of reserves occurs in the overnight funds market at loan rates determined by the Federal Funds Rate (FFR) that the Fed controls as a matter of policy. To carry out its Congressional mandate to maximize employment and restrain inflation, the Fed tries to regulate the economy by adjusting the FFR, which is the cost of money to banks. It is expected that by raising or lowering the FFR the Fed can discourage or encourage loan activity, respectively.
Reserves that are not required for a particular day or other accounting period, usually two weeks, are considered excess. Because reserves earn little or no interest, banks like to keep them at a minimum by loaning them to banks with deficient reserves.
If a bank can not borrow reserves from other banks, it can borrow from the Fed’s “discount window” at a slightly higher rate to meet its periodic reserve requirements.
Bank loans inject money into circulation until the loan is paid off. If loans are made faster than they are retired, business activity and, along with it, the money in circulation increases. Otherwise, money in circulation and business activity decreases.

The Fed sets the FFR as a matter of policy, not through external markets.
Contrary to the common perception that reserves are loanable funds, reserves are not loaned out of the banking system; they are loaned only to other banks!
If money entered the economy only through bank loans, there would always be reserves available to meet demand. That is, reserves would equal deposits. In the next blog, we look at how government spending and taxation affect this picture.
Related Reading

Thanks to Duane and Joanne, who helped make this topic more understandable.

Friday, February 3, 2012

Money, Banks, and National Debt Unmasked - II

In a previous blog, realization that our money is both IOUs of the Fed and backed by computer spreadsheet entries might have raised some curiosity or incredulity. It might even make the arguments of certain US Congressmen and OWS protesters for a gold standard sound pretty good. That is, until we look into it a little further.
Gold Standard is Gone - Fortunately
The US was on a gold standard for a long time until President Nixon “closed the gold widow” in 1971. Since then, the US and most other countries have used a so called fiat currency, without gold backing (convertibility to gold).
A gold standard is based on a fixed price of gold by weight. The idea is that each dollar, would be backed by a fleck of gold. This puts a limit on the dollars the Fed can issue unless more gold is obtained to fill the needs of a growing economy. To obtain more gold, we must mine it, get it by exporting goods to other countries, or borrow it at some rate of interest. 
Because we engage in international trade, our trading partners would have to agree on some sort of foreign exchange formula or be on a gold standard also. Such an arrangement existed under the Bretton Woods system after World War II. Because the US had most of the gold, it had a gold standard, and other currencies were pegged to the dollar and were convertible to gold.
US currency was then constrained by the amount of gold reserves that could support it, and it had a fixed foreign exchange rate. Viet Nam war deficits led to several years of international turmoil and discontent over the operation of the existing monetary system. Then, President Nixon pulled the plug. He states his case in the following video.

Because a gold-standard currency is constrained in quantity of IOUs that can be issued and has a fixed exchange rate, it is inflexible to changes in either economic growth or international trade conditions. Consequently, a gold standard almost always collapses chaotically in a panic to cash paper money for gold after some unexpected economic event.
Fiat Currency Has Value
Unlike the gold standard, our fiat currency is unconstrained and has a floating exchange rate. There is no functional constraint on the quantity of IOUs, and international exchange rates can accommodate changes in international economic conditions. The system can flex rather than break.
Oddly, we still have laws that require the US to act as if we are still on a gold standard. So, we have goofy rules about debt ceilings and selling bonds that appear to fund government spending. We’ll get to those later in the series.
Whether gold or fiat, the value of money lies in its convertibility into hours of labor or the product thereof. We look at the following three factors that support our fiat currency.
National Productivity:
Increased productivity allows more output for the same effort or the same output with fewer workers. Thus, we either increase productivity or unemployment, and the former increases the dollar’s value. Whether the outcome is productivity or unemployment depends on the fiscal and monetary policies of government. It really is controllable even though recent experience suggests otherwise.  
Currency Stewardship
Federal stewardship of the currency is demanded by the Constitution, and Congress has charged the Fed with with containing inflation and maximizing employment. In the past 60 years inflation as measured by the Consumer Price Index has averaged less that 3.5% with some wide variations. Unemployment has been a persistent problem, that has been “solved” by accepting a 4 - 5% unemployment rate as a natural hedge against inflation. Modern Money Theorists reject this acceptable level and advocate a federal jobs program to maintain full employment and productivity.
Government must enforce taxes and require payment in US dollars to maintain demand for the currency.
Productivity, stewardship, and taxes together determine what we can buy with the dollar that forms the basis for market activity.
We should also take note that the US government is the only entity that can create the US dollar. Thus, our currency is sovereign. And as we have seen, our’s is a fiat currency that is unconstrained and has a floating exchange rate. The lack of constraint allows flexibility and policy options, and stewardship prevents reckless spending.
Other advanced countries have the same currency system. Unfortunately, countries in the Euro Zone do not have sovereign currencies. They all use the euro that can be issued only by the European Central Bank. Consequently, the EZ countries operate under a system of constraints that is a de facto gold standard. And, that is the fundamental fault underlying current EZ debt problems. 
The value of an unconstrained fiat currency with floating exchange rate outweighs that of a constrained gold standard with its fixed exchange rate. There is more to the story that will be addressed in subsequent blogs. 
Related Reading