Sunday, August 21, 2011

Does issuance of government securities lower inflation risk?

There has been an ongoing debate over whether bond issuance lowers inflation risk. MMT says no. Bill Mitchell addressed this in a recent post, Painstaking, dot-point summary – bond issuance doesn’t lower inflation risk.


A commenter at Bill's named Tom posted this objection,
But guys I think that you are avoiding a main problem of this topic. i.e. Billy’s claim that “bond issuance doesn’t lower inflation risk”. If you agree with this statement do you think that it wouldn't matter if all of US government debt was in the form of monetary base (100% of GDP)? Because it is a straightforward conclusion from Billy’s claim.

And guys I would like to know if you agree with Billy that it wouldnt matter if monetary base in the USA was equal to its GDP. ($15 trillion)
This is a pretty common objection that comes up wrt the MMT claim that tsys issuance is operationally unnecessary and could be eliminated. If the Fed wished to continue to set a positive overnight rate, then it could simply pay a support rate greater than or equal to the target rate. Otherwise, it could set the overnight federal funds rate to zero. Being operationally unnecessary under the present monetary system, interest on tsys constitutes a subsidy to holders. Does it serve a public purpose? If not, it seems that tys issuance should be eliminated as inefficient.

My response (edited slightly here):

What is the difference between tsys, which are essentially savings accounts at the Fed that pay interest, and reserves that pay interest if there are no tsys and the Fed pays a support rate?

In the first case, the owner of the tsys gets the interest and in the second case the bank holding the reserves gets the interest. If entity that would have owned the tsys were not a bank, then the funds would remain in a customer deposit account at no interest unless the bank paid interest on deposit accounts. Therefore, it is ublikely that the hold of the deposit account would just leave the funds in the deposit account but rather either save at interest, invest, or spend, or some combo thereof. Since this is a counterfactual, we don’t know empirically and have to speculate. (QE doesn’t add much since it is a special case.)

The most logical answer seems to be to be that an entity who would have held tsys if they were available — look at who the typical tsys holders are and extrapolate — would seek the nearest substitute or at least the most appropriate risk-weighted return wrt portfolio management in a given context. This is essentially a portfolio management issue. It is actually an issue at present since there are not enough government securities to meet global demand, which is creating demand for more securitization and expanding shadow banking.

This would mean that more funds would flow into other savings vehicles (financial investment), some funds would also likely flow into primary investment, and some into commodities and real assets, increasing price levels. There is little reason to expect increased spending on consumption. If some increases in consumption did occur, whether this would be inflationary depends on the employment rate.

If all tsys were redeemed immediately, a one-off rise in financial and real asset price level could be expected in adjustment. More likely is that the Treasury would cease issue and redeem existing tsys as they matured, which would largely cover a span of ten years. This would imply a more gradual asset price level adjustment.

The optimal solution would be that funds would shift substantially from saving to investment. The problem the world is facing at present is over-saving and under-investment. This is creating a demand for financial innovation, creating new assets classes such as commodities and farmland, and increasing the role of shadow banking and other issues that led to the GFC.

The MMT claim is that elimination of tsys would not be inflationary since there is no causal transmission mechanism from increased reserves to increased consumption. But that doesn’t mean that eliminating tsys would not make a difference in portfolio management or the financial markets. Those differences would have to be addressed.

37 comments:

PaulJ said...

The monetary base is close to GDP right now if you include all of the dollars held by foreign entities. The M2 money supply is at about $9.6 Trillion and money held by foreigners is about $5 Trillion. Equal to the National Debt (as it should be).

I suppose we can't count the foreign holdings as part of the monetary base but I'm not sure.

PaulJ said...

@Tom

"This would imply a more gradual asset price level adjustment."

Why would there be an asset price adjustment of any significance?

Tom Hickey said...

The monetary base aka high powered money (HPM) is bank reserves plus currency. USD held outside the US ("Eurodollars") aren't included.

Here's a Fed chart of the monetary base.

The reason to expect an asset price adjustment is that the non-bank funds that would have gone into tsys will go somewhere else into other asset classes rather than be consumed. That would increase demand for those assets. ~14T of increased demand in asset markets would most likely have a noticeable effect on price level.

Mattay said...

Tom said:

"The problem the world is facing at present is over-saving and under-investment. This is creating a demand for financial innovation, creating new assets classes such as commodities and farmland, and increasing the role of shadow banking and other issues that led to the GFC."

OK, I am quite confused. What is the relation between this and the identity that Savings = Investment? Are you using different definitions of saving or investment, or what is going on?

Part of the problem may be that I am not totally clear on exactly what counts as "savings" in national income accounting.

Nathan Tankus said...

first this is a very enlightening post. i never really thought through the profolio change effects of discontinuing issuance of treasuries. i would like to say that risky asset values may rise as a result of removing treasuries but this would be attenuated if demand for risk-free assets (currency and treasury bills) was inelastic. current holders of treasuries would just shift into dollars (or fdic insured interest bearing instruments).

Tom Hickey said...

Mattay, I should not have used "saving" and "investment." These are ambiguous terms and out of context they are unclear. No wonder you are confused.

What I was referring to is that instead of directing funds to productive investment where it is needed to create employment and incomes, funds that are neither consumed nor productively invested are used to seek rent through commitment to financial instruments. This is known as "financial investment" and "speculation," which are different from productive (primary) investment. It is "money chasing money."

Demand for savings vehicles paying above average return wrt perceived risk lead to financial engineering and innovation, which produced the structured products that imploded and resulted in the crisis that is still playing itself out.

Productive (primary) investment is spending by firms to enhance return, i.e., on plant and equipment and inventory primarily.

For a good analysis of the economic meaning of saving and investment, see Investment Makes Saving Possible, a post by Andy Harless. There are couple of comments by Warren in the comments section, too.

Nathan Tankus said...

mattey said... "OK, I am quite confused. What is the relation between this and the identity that Savings = Investment? Are you using different definitions of saving or investment, or what is going on?"

in a closed model (even a three country model) everything must come from, and go, somewhere. the savings=investment identity comes from a model without a foreign sector and without government. in an open economy (still closed model) model with government the identity changes to this:
savings= investment+ government spending - government taxation + cash transfers to other countries (in order to purchase foreign goods, assets or investments)- cash transfers from other countries (in order to purchase domestic goods, assets or investments)

otherwise known as s= I+(g-t)+(x-m)


this post is arguing that corporations chronically under-invest (in physical capital and workers) which means that output doesn't grow as fast as it should and potential real wealth is being destroyed. the flipside of this is that corporations are net savers when traditionally they are net borrowers, which has a deflationary effect on the income of other sectors and subsequently prices.

JKH said...

Mitchell's analysis is wrong, or at least incomplete, when he says the following:

“What would happen if there were bond sales? All that happens is that the bank’s reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending.”

That assumes that banks are always the end buyers of bonds, which is quite false.

So more analysis of banking system liability effects is necessary, given that both bank reserves and deposits are usually reduced together (e.g. the case when banks act as brokering intermediaries for end buyers).

Don’t know why he persists with that error, which I’ve pointed out previously. Must be ingrained in his book draft, I guess.

Mattay said...

Tom - I am glad you did use "saving" and "investment" in a way that confused me! As a result, I spent some time researching saving and investment and improved my understanding (good Nick Rowe post and subsequent discussion between him and Scott Fullwiler). Thank you also for the link to the (really awesome) Andy Harless post.

Question:

I'm trying to compare my intuitive understandings of "saving" and "investment" to the national accounting identity definitions.

When I, on a personal microeconomic level, decide I want to "save" money, I almost always buy either a stock or a bond. When I do that, I'm always buying on the secondary market - from another person who already held the stock or the bond.

I think that in terms of national income accounting, that would be counted as "consumption" rather than "investment," right? Because by buying a financial asset, I am merely exchanging money to another person, who gives me the asset in exchange. None of that does anything to increase real investment (help build a factor, repair ware and tear on machinery, etc.)

If I have that right, then what you are saying is that within the private sector as a whole, there is too much trading back and forth of financial assets - as you say, too much "money chasing money." And in real terms (or in terms of the accounting identity), that's not actually saving/investment. We have an entire sector of the economy (the financial sector) which is devoted to this sort of consumption. ?

Although this stock, bond, oil futures, and (gulp) credit default swap trading is really just consumption and does not increase real investment, it can spawn something else - asset price bubbles. Let's take a stock (XOM) as an example. Market asset prices for XOM are set by a low volume (relative to the total number of shares) of trading per day. Nonetheless, everyone who owns XOM values it based on the daily market price, on the grounds that they could, in theory sell their XOM at that moment for roughly that price. However, it is most definitely NOT the case that everyone who owns XOM could sell it at that moment for roughly that price. So there's one of those "wealth effects" of the sort that Bernanke is so keen on.

And then, of course, the asset price bubble collapses under the weight of its own leverage. And rather than get bullet trains or the energy source of the future, which we might get through real saving and investment, we end up with nothing.

OK, the above may be obvious, but it helped me to walk through it. Also, sorry for going so far off the main topic of your post.

Mattay said...

Nathan Tankus -

Thank you. That confirms what I took away from the Nick Rowe post/comments.

Mattay said...

Tom - I am glad you did use "saving" and "investment" in a way that confused me! As a result, I spent some time researching saving and investment and improved my understanding (good Nick Rowe post and subsequent discussion between him and Scott Fullwiler). Thank you also for the link to the (really awesome) Andy Harless post.

Question: I'm trying to compare my intuitive understandings of "saving" and "investment" to the national accounting identity definitions.

When I, on a personal microeconomic level, decide I want to "save" money, I almost always buy either a stock or a bond. When I do that, I'm always buying on the secondary market - from another person who already held the stock or the bond.

I think that in terms of national income accounting, that would be counted as "consumption" rather than "investment," right? Because by buying a financial asset, I am merely exchanging money to another person, who gives me the asset in exchange. None of that does anything to increase real investment (help build a factor, repair ware and tear on machinery, etc.)

If I have that right, then what you are saying is that within the private sector as a whole, there is too much trading back and forth of financial assets - as you say, too much "money chasing money." And in real terms (or in terms of the accounting identity), that's not actually saving/investment. We have an entire sector of the economy (the financial sector) which is devoted to this sort of consumption. ?

Although this stock, bond, oil futures, and (gulp) credit default swap trading is really just consumption and does not increase real investment, it can spawn something else - asset price bubbles.

Let's take a stock (XOM) as an example. Market asset prices for XOM are set by a low volume (relative to the total number of shares) of trading per day. Nonetheless, everyone who owns XOM values it based on the daily market price, on the grounds that they could, in theory sell their XOM at that moment for roughly that price.

However, it is most definitely NOT the case that everyone who owns XOM could sell it at that moment for roughly that price. So there's one of those "wealth effects" of the sort that Bernanke is so keen on. And eventually, the asset price bubble collapses under the weight of its own leverage...

OK, the above may be obvious, but it helped me to walk through it. Also, sorry for going so far off the main topic of your post.

Tom Hickey said...

Hi JkH,

I asked Scott Fullwiler about it, and here is his response via email:

"JKH is right.  I said the same thing in "what if the govt just prints money"
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1731625

"I would rewrite that one a bit now if I were doing it again (focusing less on leveraging/repo-ing Treasuries or at least complementing it with ability to liquidate Treasuries), but most of what I would say there I already said in the coin seigniorage posts.  It would also be better to separate out the bond buyer and the recipient of govt spending than do it as I did there showing just the net effects, but it doesn't change the overall conclusions at all (actually makes them stronger)."

Tom Hickey said...

What I learned from this:

Unless one is an economist interacting with other economists, dont use the terms "saving" and "investment." ( Even though I know this, I did so inadvertently in the original comment that was the basis for this post.)

Treat these terms like MMT economists treat "money," that is, specify exactly what you mean since, like money, saving and investment mean different things to different people, even though they have technical definitions in economics.

Not only do they mean different things to different people, it is easy to confuse the meanings in one's own mind inadvertently, even though one knows better. Imprecision in expression is confusing for one's own thinking as well in communicating with others.

Note to self: Always best to be precise. "Say what you mean, and mean what you say."

Tom Hickey said...

"Thank you also for the link to the (really awesome) Andy Harless post."

Hat tip to JKH for that. I had read Andy's post some time ago and had it filed, but JKH brought it up again in the discussion at Nick's and reminded me of it.

Ralph Musgrave said...

Milton Friedman advocated eliminating Tsys (p.250, para starting “Under the proposal..”) here:

http://nb.vse.cz/~BARTONP/mae911/friedman.pdf

Warren Mosler advoates the same here (2nd last para):

http://www.huffingtonpost.com/warren-mosler/proposals-for-the-banking_b_432105.html

Tom Hickey said...

Mattay, a simple way to think about saving and investment in the economic sense is to think of consumption as purchase of consumer goods output. What is sold equals what is purchased.

What is not consumed out of income in a period is "saved." (definition)

What is produced that is not a consumer good is a capital good. The funds spent on capital goods are investment.

As Nathan said, in a closed economy, since what bought for consumption is equal to what is sold for consumption, then the remainder of income is saving and the remainder of production is investment. Since Y (income) equals GDP (product), S = I. (Since consumption, saving and investment are flows, this is over a specific period.)

If not all consumer goods produced in a period are purchased for consumption, then they go into inventory, and inventory is counted as investment. Some inventory is produced in one period and expected to be sold in a subsequent period. This is planned investment.

But inventory that is not sold that was expected to be sold is unplanned inventory. If unplanned inventory accumulates, then firms either cut prices to liquidiate it, or else cut back production while it is liquidated at the desired price.

Note: The accounting is a lot more complicated than this, but it is not necessary to know the specifics of what counts as saving and investment in this technical sense to understand the basic ideas. The accounting is determined by accounting standards, which define the categories perhaps differently than may seem intuitive. Residential RE counts as investment in the economic sense.

So, generally speaking, if funds are capitalized by a firm for production, this is investment. If funds are not consumed out of household income, i.e., used to purchase consumer goods, those funds are saved by the household.

Therefore, much of what is ordinarily called "investment" is actually saving rather than investing in the sense of firm spending on capital goods instead of consumables. For example, when shares are purchased on an exchange, this is often called "investing" in the firm. But the firm itself get none of the proceeds from the sale of the shares, which goes to the previous owner of the shares.

What happens is a change of ownership of the equity shares that resulted from the primary investment that capitalized the firm. It is not consumption for the purchaser of the shares, either, since the shares are not consumption goods. So their purchase is saving of a financial asset for the purchaser.

There is no net increase, since it is the exchange of one financial asset (shares) for another (payment in the unit of account). Ownership of these assets changes, but not the composition of the assets in aggregate. The amount of shares and currency stays the same, and aggregation is unconcerned with individual ownership.

William Hummel has a short summary on saving and investment here that clarifies the difference between individual saving and saving in aggregate. This is often a source of confusion.

Anonymous said...

Most economists believe that the “maturity transformation” performed by banks is a valuable public service. Well, that’s what debt monetization is, maturity transformation!

This is a good argument to hammer on because it doesn’t require believing in any MMT theories. It’s just pointing out an inconsistency in the mainstream view. Monetization by banks = good! Monetization by government = bad?

Max

GLH said...

Mr. Hickey: Is Andy Harless an economist you read regularly?

Mario said...

@JKH

I would imagine that billy knows this, he's just trying to simplify an already confusing topic for most people to understand.

The point is an important technicality but doesn't change the overall thesis.

@Tom

this is a kick ass post man. Great job!

It's also great to see tons of new people posting on the blog here and at universe. GREAT STUFF!!!

Tom Hickey said...

@ JKH
Here is more from Scott F.

Here's the relevant part from the QE3-Treasury Style post (small edit made in the third point in brackets [ ] ):

7.  Non-bank sellers of the bonds purchased by the Treasury now have deposits earning essentially 0%.  Again, this is not inflationary.  There are three points to make in explaining why.

First, sellers of bonds were always able to sell their securities for deposits with or without the Treasury’s intervention given that there are around 20 dealers posting bids at all times.  Anyone holding a treasury security and desiring to sell it in order to spend more out of current income can do so easily; holders of Treasury securities are never constrained in spending by the fact that they hold the security instead of a deposit.  Further, dealers finance purchases of securities from both the private sector and the Treasury by borrowing in the repo market—that is, via credit creation using securities as collateral.  This means there is no “taking money from one person to give it to another” zero sum game when bonds are issued (banks can similarly purchase securities by taking an overdraft in reserve accounts and clearing it at the end of the day in the federal funds market), as what in fact happens is that the existence of the security actually enables more credit creation and are known to regularly facilitate credit creation in money markets that are a multiple of face value.  Removing the security from circulation eliminates the ability for it to be leveraged many times over in money markets.

Second, the seller of the security now holding a deposit is earning less interest can convert the deposit to an interest earning balance.    Just as one holding a Treasury can easily sell, one holding a deposit can easily find interest earning alternatives.  Some make the argument that the security can decline in value and so this is not the same as holding a deposit, but this unwittingly supports my point here that holders of deposits aren’t necessarily doing so to spend.  Deposits don’t spend themselves, after all.
[continued below]

Tom Hickey said...

[continued from above]
Third, these operations by the Treasury create no new net financial assets for the non-government sector (and can in fact reduce its net saving by reducing interest paid on the national debt as bonds are replaced by reserve balances earning 0.25%).  Any increase in aggregate spending would thereby require the private sector to spend more out of existing income or dissaving, as opposed to additional spending out of additional income.  The commonly held view that “more money” necessarily creates spending confuses “more money” with “more income.”  QE—whether “Fed style” or “Treasury style”—creates the former via an asset swap; on the other hand, a true helicopter drop would create the latter as it raises the net financial assets of the private sector.  Again, “money” doesn’t spend itself.  Further, by definition, spending more out of existing income is a re-leveraging of private sector balance sheets [edit--actually, to be more precise, reduced net saving would be a releveraging under certain conditions, not all conditions].  This is highly unlikely in the current balance-sheet recession and is aside from the fact that QE again does nothing to facilitate more spending or credit creation beyond what is already possible without QE.  The exception is that QE may reduce interest rates, particularly if the Fed or (in this case) the Treasury sets a fixed bid and offers to purchase all bonds offered for sale at that price—though this again may not lead to more credit creation in a balance-sheet recession and has the negative effect of reducing the net interest income of the private sector.  (As an aside, a key difficulty neoclassical economists are having at the moment is they do not recognize the difference between a balance-sheet recession and their own flawed understanding of Keynes’s liquidity trap.)

JKH said...

Thanks, Tom.

I'm familiar with that material, and have no real problem with it. In fact, that is the MMT argument to deal with the issue of what the most likely effect of bond transactions is on non-bank balance sheets. My point was that Mitchell omitted reference to any effect at all, at least in the particular segment I quoted. In fact, the effect, and its appropriate interpretation, are fairly important from an MMT perspective, as explained by Scott.

Tom Hickey said...

"Is Andy Harless an economist you read regularly?"

I follow a lot of RSS feeds and only have time to read what is relevant to my current interests. The only things I read regularly are the posts of MMT economists and pertinent comments on those posts, as well as posts by others pro and contra MMT.

Another interest is in trends, so I try to get a feel for where major trends are heading and new trends developing. MMT is useful here because in examining trend one needs a baseline to work from and MMT provides one based on economics and policy recommendations.

Nathan Tankus said...

Mattay said...

Nathan Tankus -

Thank you. That confirms what I took away from the Nick Rowe post/comments.


glad i could help. on your confirming question to tom, i think you are confusing stocks and flows.

i've been working on this response for a few hours now (each point i make makes me think of a new point) so that it is much too long for me to post here
here's the link:
http://goo.gl/L8Tkv

i appreciate your confusion very much as it was very helpful in clarifying my own thinking.

Tom Hickey said...

New comment at Bill's on this.


Dave: "If I am getting this correctly then, would it be the MMT position that a lack of final end demand (because no additional NFA’s) would ultimately undermine any short term inflation from increased asset prices due to those portfolio preferences? Or, would it be correct to say that the world would simply adjust to higher asset prices (lower yields) on other savings vehicles?"

What I am suggesting is that ceasing tsy issuance makes a difference wrt asset price level cet. par. There are other differences it could make too, e.g., interest rates, therefore, cost of capital, etc. While I don't see inflation as a concern due to increased demand from increased liquidity (there is no change in non-government), there probably will be other effects cet. par. Those effects could be modulated by other policy shifts.

For example, if asset price level rises, this could translated into increased demand through the "wealth effect." This would be most obvious if the funds were to go into the equity markets, for example. Is that a reasonable assumption. Probably not, since those who would have held governments would prefer a near substitute and that's likely not equities for most. These are the kinds of issues that need to be hashed out in addition to the inflation assumption.

Elimination of tsy issuance would certainly make some difference, and these differences need to be examined. Too often the only or biggest issue is assumed to be inflation due to increased spending. While I think that is wrong, there are other issues, too.

Mario said...

why don't you merge the Treasury and Fed balance sheets that way you've handled the primary dealers as they won't be needed anymore.

Then Treasury can still issue bonds but now only to consumers interested in savings and not as a means to spend through PD's.

Wouldn't that handle much of it?

Banks would get a support rate and since rates would be perpetually at zero, they wouldn't be able to purchase bonds in OMO other than for clearing purposes.

Isn't that right?

Mario said...

check out this post by Rogue. It's quite fitting here in this discussion b/c it's about how institutional money actually just wants a safe place for all their cash just as much as they want some type of interest, b/c FDIC is capped. Interesting b/c it questions the motives as savings versus just mere capital protections.

Maybe just lifting the cap on FDIC would do more than think?

http://rogueeconomistrants.blogspot.com/2011/08/are-most-savings-pools-looking-to-dis.html

Tom Hickey said...

Mario, the point is revise institutional arrangements so that it is obvious the government funds itself through direct issuance of currency without the need to fund itself with taxes or finance itself with borrowing in the case of deficits. There are different ways to do this, and we should debate alternatives. What you suggest here is one option. But I don't think that all MMT economists agree on a single option for various reasons.

Mario said...

oh yeah I'm not saying this is the way to do it. I'm just throwing ideas out there that are at least feasible and therefore something to consider. It's constructive brainstorming in hopes that others will follow suit and we'll get even more ideas to compare/contrast.

In this set up bonds don't need to be auctioned anymore than a bank needs to auction off savings accounts. If a person wants a bond at whatever yield is offered...sure go ahead and ask for one and the US will give it to you np. It really does become what Warren says...nothing more than a savings account. No more, no less. Totally harmless and benign. ;)

Tom Hickey said...

"Maybe just lifting the cap on FDIC would do more than think?"

The purpose of the FDIC was originally to prevent bank runs rather than to protect savings.

Should the government be guaranteeing the savings of large savers? Why? What public purpose does that serve? Jus' sayin'.

Mario said...

okay I guess that's one way of looking at it. But why not? Is there a harm in doing that?

Rogue was saying to me that he too is reticent about lifting FDIC b/c he's not sure if banks won't take it as an option to be more reckless. And I guess that's definitely a good point. What do you think?

If I recall Warren advocates full FDIC insurance no?

Tom Hickey said...

I believe that Warren advocates reforming the banking system by returning to the separation of traditional plain vanilla banking, with full FDIC insurance and banks as public/private partnerships, from the rest of the financial sector, which is on its own with no guarantees and under strict regulation limiting systemic risk. Yes, the point is to avoid moral hazard and crises that go viral.

Mario said...

sounds good to me! Sign me up! LOL

Tom Hickey said...

The basic idea is that state money creation is a public service. See US Constitution, Art 1, sec 8 and 10. Therefore, since banks participated in the money creation process (loans create deposits, and deposits necessitate reserves or currency for settlement purposes), they are properly viewed as public utilities and need to be regulated as such to keep things straight. Otherwise corruption of the money creation process and its administraton is bound to creep in.

Mario said...

agreed completely.

GLH said...

"a true helicopter drop would create the latter as it raises the net financial assets of the private sector. "
Wouldn't a true heicopeter drop have to come vie the fiscal side?

Tom Hickey said...

A true helicopter drop would have to increase non-government net financial assets, which is considered to be fiscal, therefore requiring congressional appropriation.

Under ordinary circumstances, the Fed only does monetary operations which just change the composition and term structure of NFA. However, the Fed does have the leeway legally to do a true helicopter drop, too, by purchasing private assets, for instance.