The whole Euroland mess could have been avoided if this had been understood—since countries would not have abandoned their sovereign currencies, or would have insisted on a different structure of the Euro make-up. Further we would have avoided all the stupid battles over US deficits and debt limits. And would have ramped up federal spending sufficiently to get out of the great recession by spring of 2009—rather than allowing it to drag on to the present.
And if they understood how a sovereign currency operates, there would not be all this Rogoff-and-Reinhart nonsense about excessive US government borrowing.
Indeed, there is no operational procedure that allows an issuer of IOUs to borrow his/her own IOUs. If you write an IOU to your neighbor (“IOU five bucks” or “IOU a cup of sugar”) you do not go borrow your IOU from that neighbor in order to spend. It would be a nonsensical operation. If you needed more bucks or sugar you could approach a different neighbor and write another IOU—but you would not go back to your original creditor to “borrow” the IOU in order to issue it to a different neighbor.
A sovereign government does not really borrow its own currency, nor does it really even spend its tax revenue (receipts of its own currency). The best way to think about sovereign spending is “keystrokes”: the sovereign government “keystrokes” its own IOUs into existence as it spends.
I actually thought Chairman Bernanke understood this. When quizzed about where the Fed got all the dollars it used in its ($29 trillion!) bailout of Wall Street, as well as its $2+trillion Quantitative Easing, Bernanke quite accurately and honestly said: keystrokes. More recently he put it this way: (Look at his presentation beginning on page 17): http://www.scribd.com/doc/87374621/Bernanke-Lecture-Four.
“Now, you might ask the question, well, the Fed is going out and buying 2 trillion dollars of securities – how did we pay for that? And the answer is that we paid for those securities by crediting the bank accounts of the people who sold them to us, and those accounts, at the banks, showed up as reserves that the banks would hold with the Fed. So the Fed is a bank for the banks. Banks can hold deposit accounts with the Fed, essentially, and those are called reserve accounts. And so as the purchases of securities occurred, the way we paid for them was basically by increasing the amount of reserves that banks had in their accounts with the Fed.
Yep, simple keystrokes. Something the Fed can never run out of. Whether the bailout of Wall Street or the QE was a good idea is another matter entirely.
However, more recently, the Chairman weighed in on Treasury deficits. Apparently he has completely forgotten anything he ever understood about sovereign currency:
“Having a large and increasing level of government debt relative to national income runs the risk of serious economic consequences. Over the longer term, the current trajectory of federal debt threatens to crowd out private capital formation and thus reduce productivity growth. To the extent that increasing debt is financed by borrowing from abroad, a growing share of our future income would be devoted to interest payments on foreign-held federal debt. High levels of debt also impair the ability of policymakers to respond effectively to future economic shocks and other adverse events. Even the prospect of unsustainable deficits has costs, including an increased possibility of a sudden fiscal crisis. As we have seen in a number of countries recently, interest rates can soar quickly if investors lose confidence in the ability of a government to manage its fiscal policy. Although historical experience and economic theory do not indicate the exact threshold at which the perceived risks associated with the U.S. public debt would increase markedly, we can be sure that, without corrective action, our fiscal trajectory will move the nation ever closer to that point.”
http://federalreserve.gov/newsevents/testimony/bernanke20120202a.htm
Uh…NO! Completely wrong.
With regard to the observation that a “number of countries” have seen interest rates soar “if investors lose confidence”, that is obviously a reference to Euroland. However, even Paul Krugman (who, as I’ve argued, doesn’t fully understand money) recognizes that Euroland’s problems are caused by abandonment of sovereign currencies in favor of the Euro. Each individual member nation effectively became a user of the Euro—much like a US household, firm, or state government. Ability to spend is thus subject to markets and the ECB’s tolerance—which in turn is determined by German voters’ willingness to bail-out periphery countries. Don’t bet on that! Germany will not be as charitable as were the other 49 states when New York got in trouble back in the early 1970s. After all, New Yorkers sort of speak the same language shared by most Americans. But the rest of America told New York to take a hike.
So what’s the problem with Bernanke’s claims?
As a fellow economist, I can say it is quite embarrassing to read the quote from Bernanke above. You can understand that our rightwing wingnuts and goldbugs make similar comments—they are not well-trained in monetary economics. (OK, yes, I know, I’m going to receive a lot of their comments—watch for them below.)
But Ben Bernanke happens to be the flipping Chair of the Federal Reserve! And he’s a well-respected academic economist. Yet his apparent (mis)understanding of monetary economics is stuck in the simplest 19th century expositions.
Doesn’t he realize that his organization—the Fed—sets the overnight interest rate in the nearly monthly FOMC meetings? What does he think they are doing when they meet for two long days?
The base interest rate is set by a vote of the FOMC. Period. It is not set by markets. It is not determined by the government’s “borrowing requirement”. Sovereign currency-issuing government budget deficits place no upward pressure on interest rates. Ever.
Indeed, he should understand that as government spends by crediting bank reserves, the pressure is DOWNWARD on the overnight rate—as banks offer excess reserves in the overnight market. That is relieved by the Fed—if it wants to—to hit its target.
The deficit CANNOT raise interest rates unless Bernanke & Co. decide to vote to raise rates. They can always “just say no”: no rate hikes in response to budget deficits.
Now, we do know that if budget deficits eventually spur the economy to recover, the FOMC will vote to raise interest rates. This is not due to market pressures that result from budget deficits. It is due to the double superstition held by the Fed that a) a growing economy tends to cause inflation and b) rate hikes reduce inflationary pressures. Now, I think both of these superstitions are false. But the bigger point is that rate hikes occur due to a vote of the FOMC—not to “market reactions” to deficits.
Further, if any “crowding out” occurs due to the rate hikes (that is, if investment falls) it is the fault of the FOMC that chooses to raise rates. So, yes, it is likely that the Fed will raise rates eventually, and it is possible this could reduce some kinds of debt-related private spending (ie “crowding out”), but all that is the desired result of Fed policy.
Now, Bernanke or his supporters might respond that all this is true enough of the overnight interest rate—but the problem is in the longer maturities since the Treasury will sell long-maturity treasuries to borrow to finance its deficit. And that then pressures long term interest rates at which investment is financed.
Again, nonsense. Treasury does not sell bonds to borrow its own currency IOUs.
Look at this in two ways.
First, let us say that as the Treasury deficit spends it does issue long maturity bonds dollar-for-dollar, and that tends to flood the market with more of such securities than the market wants. Can the Fed stop long term rates from rising?
Can anyone say “QE”? Duh! The Fed has bought up $2 trillion of such assets precisely to push down long interest rates. Is there any limit to its ability to do so? No, for exactly the reasons Bernanke says. Is there currently any crowding out of private spending due to the government’s trillion dollar deficits? Of course not. The treasuries are flowing onto the Fed’s balance sheets.
Ok, yes, I know. Our wingnuts and goldbugs are whipping up inflation hysteria—all those Fed purchases will cause hyperinflation by pumping banks full of reserves. No. The treasuries are safely locked up on the asset side of the Fed, and the reserves are safely locked up on the liability side of the Fed. They cannot get out. No bank can lend reserves except to another bank.
You can think of all these reserves as imprisoned for life—they’ll never get out. Rather, eventually as the economy recovers the Fed will sell the treasuries back to bank and will debit their reserves by the amount of the sale. Presto—the reserves will be gone. Without ever causing any Weimar hyperinflation.
Second. The operational purpose of bond sales by Treasury or Fed is to offer a higher interest earning alternative to reserves. This is not a borrowing operation. It is part of monetary policy—draining excess reserves that would cause the overnight rate to fall below the FOMC’s target. Just enough bonds are sold to accomplish that.
There is no competition for a limited supply of “loanable funds”—rather, banks have reserves created through government spending and they can choose to hold them, lend them in the fed funds market (to another bank) , or buy treasuries. That is it. There are no other alternatives. It has nothing to do with lending to private firms or households. It has nothing to do with the lending rate to firms that want to invest. The reserves are created through government spending then drained through sales of treasuries. And that is done only to prevent the overnight rate from falling to zero.
The Treasury and Fed can always “just say no”: do not sell the treasuries. Let the interest rate fall to zero. There is never any imperative to create “crowding out” by pushing up market rates—by raising the fed funds target or by selling long maturity treasuries in excess of what the market wants.
Let me close with reference to a relatively good piece by Martin Wolf, summarizing a paper by Paul McCulley and Zoltan Pozsar (formerly of the NYFed) that does get money right. Here is the link to Wolf and a quote from their paper. http://blogs.ft.com/martin-wolf-exchange/2012/04/17/fiscal-and-monetary-policy-in-a-liquidity-trap/#ixzz1sRMJH300
“Experience over the last four years (not to mention Japan’s experience over the past 20 years) has demonstrated that governments operating with a (floating) currency do not suffer a constraint on their borrowing. The reason is that the private sector does not wish to borrow, but wants to cut its debt, instead. There is no crowding out. Moreover, adjustment falls on the currency, not on the long-term rate of interest. In the case of the US, foreigners also want to lend, partly in support of their mercantilist economic policies.”
(Note Wolf says he’ll ignore MMT’s approach as it would take a whole lengthy analysis of its own. Too bad. Hopefully he’ll come back to that.) Let me just say that the McCulley-Pozsar analysis quoted above has got it right except that they seem to think this is “special case” analysis applying to a downturn where the private sector wants to cut its debt. But in truth, it applies in all situations in which a government issues the sovereign currency.
Wolf promises a Part 2. If his follow-up makes points relevant to my argument, I’ll also offer a Part 2.