The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the Quantity Theory of Money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.
— J.M. Keyes, Open Letter to President Roosevelt, 1937
The Non-Financial Sector controls its own allocation of Deposits and Bonds
Let’s call “Deposits” all zero-day claims held by the non-financial sector on the financial sector.
When the financial sector expands its balance sheet by granting a loan, transactionally, the creation of the loan creates an additional deposit.
But the the owners of the additional deposit are not required to keep the deposit, they can purchase bonds. If the bond is another non-financial bond, then there is still an excess deposit, so another bond is purchased, etc. The release mechanism for this process is that, on the margin, the non-financial sector (slightly) bids down the price of bonds relative to deposits and the financial sector supplies an additional bond, satisfing the excess demand for bonds and reducing the excess supply of deposits.
The role of the financial sector is to bridge the gap between the types of assets that the non-financial sector wishes to hold and the types of liabilities that the non-financial sector wants to incur.
Although, transactionally, loans create deposits — in equilibrium, the loan can result in the creation of a bond liability rather than a deposit liability.
Therefore for a given level of savings and interest rates, the non-financial sector holds the proportion of bonds and deposits it desires at all times, and quantities generally adjust more quickly than rates, because the sensitivity of savings demands to interest rates is substantially less than the sensitivity of bond supply to interest rates.
Finance is a buffer between bond suppliers and bond consumers, adjusting its own net bond position to bridge the gap between supply and demand, so that households always hold the proportion of bonds to deposits that they demand.
Government Asset Swaps Are Ineffectual
Suppose the central bank intervenes in an attempt to adjust the portfolio holdings households by purchasing a treasury. By offering an attractive bid, the CB is able to purchase the bond, but as the non-financial sector was already holding its desired proportion of bonds to deposits, households will demand the same premium from the central bank as the premium that the financial sector demands for supplying them with an additional bond.
The swing supplier will set the premium, and that premium will (generally) be small if the elasticity assumptions hold.
In that case, the household sector has an additional deposit claim on the banks, which is backed by an increase in cash, and after it purchases the financial sector bond, the household sector restores its portfolio allocation to the desired level. The financial sector ends up with more cash and less (net) bonds.
It is as if the central bank is conducting a portfolio swap with the financial sector.
The central bank is pushing on a string, by neither increasing the quantity of deposits nor decreasing the quantity of bonds held by the non-financial sector.
But there is nothing special about the central bank — the same is true if the foreign sector, or the government sector, or any sector buys and sells bonds. They are all simultaneously engaging in portfolio swaps with the financial sector, whose balance sheet adjusts to bridge the gap between assets demanded and assets supplied.
Households may desire more savings, but Central Bank portfolio swaps cannot supply them with more savings. All that the asset swaps do is supply the private sector as a whole with a different allocation of savings, but asset swaps fail to force the non-financial sector to hold a different allocation of savings. The government can neither supply the non-financial sector with (materially) more deposits, nor can it supply this sector with more bonds by means of open market operations. As long as the interest-elasticity of the supply of bonds exceeds the interest-elasticity of household savings demands, all CB OMO operations are asset swaps with the financial sector. Government’s monetary policy influence begins and ends with interest rate management, not quantity management.
Follow the Instrument
The above argument relies on the financial sector’s net bond position to adjust in such a way as to allow household bond holdings to be determined independent of outside intervention. We are not arguing that household bond and deposit allocations are constant across time, but that holding the overall savings levels, preferences, and interest rates fixed, the allocations will not change as a result of intervention from other sectors.
We should be able to find evidence of this in the flow Flow of Funds.
Define 8 sectors:
- “Households” = household + nonprofits
- Pension/Insurance/Funds = government retirement funds, pension funds, insurance, closed ended funds, ETFs, mutual funds
- Non-Financial Business
- Finance = Commercial Banks, money market mutual funds, Savings & Loans, Thrifts, ABS Issuers, REITs, Finance Companies, Funding Corps, Brokers & Dealers
- Government = state and local government, Federal Government, GSEs
- Rest of World
- Monetary Authority
- Non-financial business