Leaving (Modern) Money (Theory) On The Table

Paul Krugman has recently offended the Modern Monetary Theorists.

He argues that having the government create more money is more inflationary than having the government create more bonds. There is a good argument and a bad argument for his case.

The Bad Argument

The bad argument is the reserve-multiplier fallacy, otherwise known as the money supply multiplier, money multiplier, etc. In this argument, by supplying more reserves to the banking system, banks will go on a lending spree, creating as much inside money as outside money times a multiple, given by the required reserve ratio.

But people are slowing abandoning this belief (hat tip MoslerEconomics).

Don Kohn (Former FRB Vice Chair):”I know of no model that shows a transmission from bank reserves to inflation”.

Vitor Constancio (ECB Vice President): “The level of bank reserves hardly figures in banks lending decisions; the supply of credit outstanding is determined by banks’ perceptions of risk/reward trade-offs and demand for credit”.

Charlie Bean (Deputy Governor BOE): in response to a question about the famous Milton Friedman quote “Inflation is always and everywhere a monetary phenomenon”: “Inflation is not always and everywhere a monetary base phenomenon”

The main flaw here is not understanding how inside money is created. Banks lend money when it is profitable for them to do so. They do not lend money automatically as a result of an increase in aggregate reserves.

Here is a suggested replacement for the money supply multiplier:

Suppose banks must set aside $1 of capital for making $10 of loans (the amount will differ based on the risk characteristics of the loan as well, but let’s ignore that). Suppose that their funding costs for equity are 6%, and their marginal borrowing costs are 4%. In that case, what rate can they charge on a 10$ loan to break even?

10*r = 1*(.06) + 9*(.04)
r = (.06)*(1/10) + (9/10)*(.04)

And then banks will continue to lend as much as borrowers want to borrow at the break-even rate. The quantity of loans made is demand determined, and the cost of lending is set by the government. The quantity of loans made is not set by the government.

Now really you would want to include other terms in this weighted average. Suppose that banks fund themselves with 10% capital at the reserve rate plus 2%, 30% intermediate term loans at reserve rate plus 1%, 30% with short term loans at the reserve rate, and 30% with deposits at a rate of 1%.  Then the weighted average of these will determine the break-even rate. However much borrowers demand to borrow at that break even rate will be the quantity of loans made. By adjusting the reserve rate up, the government can raise the break-even rate.

Notice that nowhere do the quantities of reserves come into play — all that matters is the bank cost of funds and the quantity of loans demanded at the weighted average.

Now you can argue that the marginal cost of reserves will be determined by quantity. But it isn’t. When a bank lends or pays reserves to another bank, then total reserves remain fixed.  The banking system as a whole cannot increase or decrease the total quantity of reserves.

If there is just a small excess of reserves, then the marginal cost of reserves is driven to zero, and a small shortage of reserves drives the marginal cost of borrowing reserves to infinity.

So there is no smooth relationship between the quantity of reserves and the marginal cost of reserves. The relationship between the level of reserve interest rate and the level of reserves is trinary — there are either too few reserves, in which case the equilibrium price is infinite, too many reserves, in which case the equilibrium price is 0, or just the right amount of reserves, in which case the equilibrium price is any non-zero number.

This is why the central bank can increase the cost of reserves by withdrawing a small amount of money and adding it back a few days later. When it withdraws money, banks keep bidding up the price of reserves until the they hit the level that the CB wants, at which point it can reverse the transaction, and the same quantity of reserves is now lent out at a higher rate.

If you want to put this into a model, you can imagine that there is some quantity of reserves demanded, Q_d, which is primarily a function of the price level and technology, as banks are no longer required to hold a proportion reserves against deposits. Required reserves are basically zero in the modern world.  Q_d = f(P). The quantity of reserves supplied is determined by the central bank. and the rate of change of the reserve interest rate is proportional to the difference between the quantity of reserves demanded – the quantity of reserves supplied.

dr/dt = k(Q_d - Q_s)

If Q_d > Q_s, then the borrowing rate keeps going up. If Q_d < Q_s it keeps dropping (until it hits zero). That means that you can achieve any stable rate provided that Q_d = Q_s, by, on the margin, withdrawing a bit and then adding it back. This is a very crude model, but if I were to have to make a simple model about reserve demand,  then this would be it.

But even if Q_d < Q_s, the government can still impose fees or pay interest on reserves so that the break-even rate for lending remains high. For example, if the government paid interest on reserves of 4%, then the cost of reserves would be 4% regardless of quantity. Better yet, if the government taxed assets at 4%, then banks would need to charge more than 4% in order to break even, so the lending rates could be hiked without needing to decrease the quantity of reserves.

The Good Argument

The good argument acknowledges the above, but points out that regardless of how the financial system is regulated, there is still only a finite amount of zero maturity assets that the public can be convinced to hold. This is a “limit to seignorage” argument. Sure, the government can pay interest on reserves and prevent excess credit growth, but in that case why not sell bonds? Well, one reason is that you don’t need to worry about the mythical “bond vigilantes”. You can raise or lower borrowing rates by adjusting the quantity of reserve interest payments or taxes levied on banks without needing to tap the market.

But the real problem with the good argument is that the public does not hold the base, the banking system holds reserves, and the public holds deposits + currency. When determining the limits of seignorage, are those limits determined by the amount of seignorage that can be extracted from supplying reserves equal to Q_d, and the public with currency equal to their currency demand — or are the limits of seignorage determined by the public’s demand for deposits + currency?

The Data

The Fed defines the money stock as MZM, or Money at Zero Maturity. The interest on money is the MZM own rate.

The first thing to notice is that the quantity of MZM held by the public is already roughly equal to the quantity of Federal Debt held by the public, and more often than not, the former exceeds the latter.

Therefore the public is already willing to hold the entire U.S. federal debt as zero maturity money, paying an absurdly low interest rate – on average, a negative real rate:

Therefore there is an inherent tension:

  • If we put on our economist hat, then government creating more money will cause inflation as people want to hold bonds and not money, so the government should primarily supply the private sector with bonds instead of money.
  • If we put on our banker’s hat, then the non-financial sector is desperate to hold more money, not bonds, and so banks provide a valuable service by supplying the private sector with deposits.

Both views cannot be true.

All seignorage income should flow to the government, not banks.

In the current system, the government is granting almost all seignorage income to  banks. That is why it cannot seize more seignorage income for itself. This is a voluntary constraint to grant gifts of seignorage income to the private sector, and have the government limit its own seignorage income to be a small fraction of the total amount.

With these gifts, the financial sector swells, so that compensation of Finance and Insurance employees is in excess of 20% of gross investment and 80% of net Investment. Even though the majority of business investment is via retained earnings and does not involve intermediation at all. It is becoming very expensive to match borrowers with lenders, if finance requires a 20% cut.

How would one go about seizing seignorage income from banks?

Option 1: Ban The Rents

One (draconian) option is to require banks to borrow from the government rather than from the private sector.

Banks would only be allowed to sell equity to the public.

The government can directly provide deposit services. The banks would borrow from the government at the policy rate, creating a deposit account that pays roughly zero. The government would borrow from the public by supplying them with the zero interest deposit account, and it would receive the policy interest income from the bank.

Now it still may be the case that households have too many deposits, and in that case the government can sell bonds, removing some of the deposits, or alternately it can hike the policy rate so that fewer deposits are created. But even in the former case, the amount of bonds that would need to be sold would be determined by the difference between the public’s demand for MZM and the total government debt. It would not be a function of the deficit at all.

In such an arrangement, as there is only outside money, only a small fraction of the deficit, and typically a negative fraction, should be funded by selling bonds. Whenever the public’s demand for deposits exceeds the (current) quantity of hard money, we should expand money-financed deficit spending so that the two are equal. Whenever the public’s demand for deposits is less than the current stock of hard money, we should either retire money (by increasing taxes) or sell bonds. Note that this model has no reserves at all — it has only deposits backed by outside money. Once money stops being gold coins, then there is no need to have a separate monetary base that is different from MZM.

Option 2: Tax The Rents Away

A less intrusive method would be to levy a tax equal to

(policy) rate*Assets - interest paid on liabilities

Where Assets on the left are any assets that are not liabilities of the central bank, and the interest payments on the right are any payments that are not to bank capital. I.e. dividends on common or preferred equity would be excluded, as would long term subordinated debt. The definition of bank capital would be up to the regulators as part of their capital adequacy requirements.

Simultaneous to that, the government would be willing to lend unconstrained to the banks at the policy rate, and it would offer longer term loans as well, so that banks would have no motivation to borrow at higher rates than the policy rate.

If banks cannot earn seignorage income from deposits, then why would they offer deposit services? There are benefits from data mining customer accounts, and selling additional services to customers. But at the same time, the government should offer basic deposit services to the public at no charge. That is a small price to pay for obtaining an income stream whose net present value is the entire federal debt.

The government, in this proposal, will continue to sell bonds to the public when deficit spending. But in such an arrangement, the taxes paid by banks correspond to a reduction in the base — a massive contraction. And this contraction would need to be offset by the central bank monetizing debt in order to keep the monetary base constant. This monetization corresponds to the full amount of seignorage income that can be extracted. If MZM is growing very rapidly, then this proposal might even force the government to deficit spend more once all the debt has been retired.

The proposal would be functionally equivalent to the “no bonds” and “zero rate” proposals in most cases, even though the government is selling bonds and maintaining positive interest rates throughout. The result of this proposal is that instead of supplying economic rents to the financial sector, the foregone interest relinquished by households in exchange for liquidity is used to fund public works supply public benefits, rather than build mansions in Connecticut.

Leaving (Modern) Money (Theory) On The Table

17 thoughts on “Leaving (Modern) Money (Theory) On The Table

  1. I don’t know, Vimothy, you had an uncharacteristically generous reading of Krugman’s post, so why not extend the same grace to Bill?

    I understand why he wouldn’t like Krugman’s characterization of MMT. I guess any macro theory is going to have a collection of core problems that explain the business cycle, together with policy reaction functions that try to attenuate the cycle or reduce their occurrence. Krugman basically criticized the reaction function as unworkable under a different assumption of the core problem, and without properly understanding the reaction function to boot.

    1. vimothy says:

      Maybe you’re right. I like the MMT guys–all the heterodox schools add value, IMO–but I find their instant dismissal of everybody else in the field pretty tiresome. Self-parody at times. No one else understands operations! Pure fallacy. If you read Mitchell’s open letter, it basically starts, “Dear Paul, I have a PhD. In the past, other people criticised us and they were wrong too. Let me give you some advice on how to do academic research…”

      Interesting that you suggest they have a theory of a business cycle though. How does MMT explain the generic stylised facts of the business cycle?

      1. LOL, well dismissals fly fast and furious on the web. But they generate a lot of papers, too, that are interesting to read.

        I think MMT is variant on the standard PK stuff. I wouldn’t call it a business cycle per se, but a (longer) credit cycle — or at least that is the component that I am aware of. I’m not an expert.

        The argument goes like this. Nominal savings of the private sector are change in debt + NX + change in NFA. The sum of all three leads the business cycle.

        Change in debt is cyclical according to Minksy, with booms and busts. Even without Minksy, you have booms and busts due to other causes — e.g. noise traders, etc.

        Change in NFA is the policy variable to try to smooth nominal savings demands.

        That is the contribution to the credit cycle that I am aware of.

        For the change in the trade cycle, there are many heterodox theories, many of which were mainstream. Harrod’s knife-edge model, Kalecki has a model, Goodwin has a model, etc.

  2. beowulf says:

    RSJ, your option 2 is brilliant. If you take what CBO projects to be paid out from Tsy as net interest, by flipping the script, and anchoring Fed Fund rate with your bank asset tax instead of debt sales or IOR, that same amount would paid into Tsy as tax revenue.

    Of course the trick would be to design the tax as a Fed user fee for one of “any new services which the Federal Reserve System offers, including but not limited to payment services to effectuate the electronic transfer of funds”. The Fed governors could levy and adjust such a bank asset user fee at any time (and, of course, rebate the net earnings to Tsy).

    Naturally, Congress could pass the equivalent tax code measure, but its unlikely they’d leave the rate adjustable (in theory Congress could delegate to Tsy authority to adjust any tax rate as needed, but to the best of my knowledge, never does).

    Either way, your bank asset tax as an alternative to IOR or selling Treasuries is a damn good idea. Has any other country tried this or, to put it another way, as anyone else even thought of this?

    1. Thanks, Beowulf. Scott F. mentioned that others have proposed this idea. I have a hard time believing that it is not mainstream because it is so hard to think of, but rather because of the power relations involved.

      It just seems obvious that all seignorage income should be used for public purpose, rather than just high powered money.

      But even ignoring public purpose, these economic rents are highly distortionary, as the economy allocates real resources to seizing those rents instead of producing output.

      1. beowulf says:

        “I have a hard time believing that it is not mainstream because it is so hard to think of, but rather because of the power relations involved. ”

        I think that’s exactly the case, most of the people who understand banking are, well, bankers, why would they want to kill the golden goose? When someone does take an axe to said goose (like with the formation of the Australian Commonwealth Bank 100 years ago), its a sight to see.
        “The first test came when a decision was required regarding the amount of capital needed to start a bank of that kind. Under the Act, the Commonwealth had the right to sell and issue debentures totalling £1 million. Some even thought that amount of capital would be insufficient, having in mind what had happened in 1893. . . When Denison Miller heard of it, his reply was that no capital was needed…. [O]n January 20th, 1913 he made a speech declaring the new Commonwealth Bank open for business. He said:
        “‘This bank is being started without capital, as none is required at the present time, but it is backed by the entire wealth and credit of the whole of Australia.’

        “In those few simple words was the charter of the Bank, and the creed of Denison Miller, which he never tired of reciting… Slowly it began to dawn on the private banks that they may have harbored a viper. They had been so intent on the risks of having to contend with bank socialisation that they didn’t realise they had much more to fear from competition by an orthodox banker, with the resources of the country behind him.”

  3. Sergei says:

    RSJ, interesting and it is not a coincidence that credit assets of the banking system are rougly equal to MZM since loans create deposits (some definitional issues aside). However it also means that the banking system as a whole can not get rid of those deposits. Then the government jumps in and via budget deficits provides additional deposits which can be somewhat absorbed by central bank policies though this relationship is obviously exogenous to the central bank.

    Then, what banks try to do is to partly squeeze maturity transformation out of themselves. This is where money market funds, etc jump in and pick up the “bill”. This is done via vanilla swap transactions. So “deposit” in a money market fund is “invested” into a bank bond and so a liability of one bank indirectly becomes an asset of another with some fee charged in between. However the amount of deposits does not change because the banking system is the settlement vehicle for all antities in the economy. Non-bank bonds are irrelevant for this process since they represent an asset swap between two non-banking entities.

    I am still somewhat failing to appreciate the whole picture but it looks to me like it is impossible to limit the maturity transformation done with the banking system. And the only way to “nationalize” private gains derived from the sovereign yield curve steepness is to directly tax them.

    Or am I missing anything?

    1. Sergei says:

      And as a consequence it means that as long as credit assets of the banking system exceed sovereign marketable debt, there will be enough of MZM to purchase this debt in its short-term form, e.g. not longer than 3m t-bills.

      An alternative solution would be to separate the payment system from the commercial banking system.

    2. Sergei,

      I don’t think that the credit assets of the banking system are directly related to MZM per se.

      Loans may create deposits, in the transactional sense, but in the equilibrium sense, loans are as likely to create bonds, as households do not keep the deposits but exchange them for other claims on the financial sector. That is how the non-financial sector is able to rid itself of unwanted deposits. I will dig up some old data that makes this relationship clearer.

      “It looks to me like it is impossible to limit the maturity transformation done with the banking system. And the only way to “nationalize” private gains derived from the sovereign yield curve steepness is to directly tax them.”

      I agree. We should be taxing them. I’m bothered by paying them interest on reserves. I don’t think there is anything wrong with maturity transformation per se — it’s just not properly taxed.

      1. Sergei says:

        Yes, reference to MZM was ambiguous and most likely irrelevant.

        However the point I wanted to make is that even if households purchase non-bank bonds (except govt for obvious reasons) the amount of demand deposits in the banking system does not change. It just shuffles these deposits around as it does with any other deposit. So roughly every bank in the system has its “fair” share of demand deposits defined by its market share. Daily volatility and business model aside, nothing can change this fact. So one can pretend that Basel 3 tries to limit maturity transformation of banks however all that Basel 3 achieves in this sense is that banks pay more fees to the non-banking sector to “incentivice” it to purchase bank bonds.

        However, if we move to the asset set of the balance sheet, then we see that given increasing costs banks will lose even more asset origination to the non-banking financial system. And so the only “profitable” asset origination of which will stay in the banking domain is retail.

        Overall, the way I see it is that Basel 3 is forcing even greater inter- and cross-dependencies in the financial system making it even more fragile than ever before.

        If what I wrote above makes sense, then I am getting almost scared 🙂

      2. Sergei says:

        There are two additional factors influencing the volume of loans versus the volume of demand deposits in the banking system. These are i) bank profits which reduce the volume of demand deposits relative to the volume of loans and ii) client defaults which reduce the volume of loans relative to the volume of deposits. Well, actually these two factors are just two sides of the same coin 🙂

        Then there is budget deficit but the existing institutional structure assumes that these deposits are fully recycled into bonds.

        Finally, one unknown variable remains and that is central bank and its OMO. However both budget and CB deal with another type of deposits, namely bank reserves, which commercial banks can not create.

  4. Nathanael says:

    This is an EXCELLENT piece. Thank you. This matches exactly what I have said for a while, but with more detail.

    What you may be missing is that the reason for the current situation is historical. Banks had most of, or even all, the seignorage income, *and* the power to control the money supply, for a startlingly long time in the US. The Greenback Party pushed to take both powers away from them and give those powers to the government. They lost. In the end, a “bargain with the devil” was made, the Federal Reserve Act, in which the government took control of the money supply away from the banks, but the banks retained the seignorage income.

    Indeed, the banks should have the seignorage income taken away from them. But do people understand this well enough to do it? The Greenback Party did, but they couldn’t get it through Congress due to the power of the bankers.

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