Archive for May, 2013

Does Steady GDP Growth “Prove” that Market Monetarists Are Right About Ineffective Fiscal Policy and Foolish Keynesianism?

May 31st, 2013 5 comments

You’re seeing a lot of crowing these days from the likes of Scott Sumner, David Beckworth, Lars Christensen, et al., claiming that fiscal austerity has obviously had no effect on GDP growth.

“Look!” they say: “Even with the sequester and all the other government spending cuts, growth in 2013 has been the same as 2012! The notion that government spending affects GDP growth (“Keynesianism”) is obviously false and stupid.”

As Scott says in a recent post:

The left predicts fiscal austerity will slow the recovery, and yet both GDP and jobs are actually a bit ahead of the 2012 pace so far this year.

This is specious reasoning.

1. The “left” prediction has been that “fiscal austerity will will slow the recovery” relative to what it would be otherwise, not relative to 2012, or Q1 2012. Scott, not the lefties, chose 2012 as the benchmark. But I know they know: when you compare 2012 to 2013, ceteris is not paribus.

Look at the four highlighted numbers here, showing growth/decline in the two GDP-component numbers that dominate our economy:

Chained 2005 $, %, AR Q1’13 (2nd Estimate) Q1’13 (Advance) Q4’12 Q3’12 Q1 Y/Y 2012 2011 2010
Gross Domestic Product 2.4 2.5 0.4 3.1 1.8 2.2 1.8 2.4
 Inventory Effect 0.6 1.0 -1.5 0.7 -0.1 0.2 -0.2 1.5
Final Sales 1.8 1.5 1.9 2.4 1.9 2.1 2.0 0.9
 Foreign Trade Effect -0.2 -0.5 0.3 0.4 0.2 0.1 0.2 -0.4
Domestic Final Sales 1.9 1.9 1.5 1.9 1.7 1.9 1.8 1.3
Demand Components
Personal Consumption 3.4 3.2 1.8 1.6 2.1 1.9 2.5 1.8
Business Fixed Investment 2.2 2.1 13.1 -1.8 4.1 8.0 8.6 0.7
Residential Investment 12.0 12.6 17.5 13.6 12.8 12.1 -1.4 -3.1
Government Spending -4.9 -4.1 -7.0 3.9 -2.3 -1.7 -3.1 0.6
Chain-Type Price Index
GDP 1.1 1.2 1.0 2.7 1.6 1.8 2.1 1.3
Personal Consumption Expenditures 1.0 0.9 1.6 1.6 1.2 1.8 2.4 1.9
   PCE less Food & Energy 1.2 1.2 1.0 1.1 1.3 1.7 1.4 1.5

Haver Analytics

Personal consumption growth (roughly 70% of the economy) is way up. Shouldn’t we expect 2013 to be kicking 2012’s anemic little butt? You gotta ask: If government spending (20% of GDP) weren’t such a drag, would we (finally) be experiencing robust growth? (Business investment growth also dropped, but 1. it remained positive, still adding to growth, and 2. it’s only 10% of the economy. Residential investment is less than 5%.)

See here, from one far better-credentialed than I:

All else being equal, growth in 2013 should be better than 2012, because the headwinds holding it back are diminishing,” said Michelle Girard, chief economist of RBS. “The impact of the fiscal drag isn’t things getting worse, it’s the absence of things getting much better.”

2.  The market monetarists’ whole theory is that fiscal policy doesn’t matter (nor, apparently, does anything else) because the Fed will always offset it with monetary policy. So according to their theory, the steady GDP growth is because the Fed has offset the fiscal drag.

But: the Fed has made basically zero changes to policy or guidance since its big announcement on December 12 ($85 billion in Treasury/MBS purchases until unemployment’s below 6.5% or inflation’s at 2.5%), except to state unequivocally that “fiscal policy is restraining economic growth.”

Now maybe the market monetarists want to argue that the December 12 announcement was pre-emptive, proleptically adjusting for the sequester etc. that hadn’t even been legislated yet. In which case their theory would be correct. But that’s suggesting a remarkably prescient reaction function by the Fed, one that I don’t think even market monetarists would want to lay claim to.

Cross-posted at Angry Bear.

Why Libs and Cons Should All Love Milton Friedman’s Corporate Tax Proposal

May 30th, 2013 4 comments

I’m constantly astounded that nobody on the left or the right ever mentions Milton Friedman’s proposal for taxes on corporate profits.

On page 174 of (my edition of) Friedman’s libertarian bible Capitalism and Freedom, he proposes what seems a simple and sensible plan (transcription here):

…the abolition of the corporate income tax, … with the requirement that corporations be required to attribute their income to stockholders, and that stockholders be required to include such sums on their tax returns.

In other words, treat C-corp profits like S-Corp (pass-through) profits. Shareholders (they’re the “owners,” right?) pay taxes on them whether or not they’re distributed as dividends. Corporations would pay zero taxes on profits.

If corporations want to distribute enough in dividends to cover their shareholders’ tax bills, fine. That’s between the shareholders and the corporation.

I suggest: announce that this change will take place five or ten years hence, and let the capital markets adapt in the meantime.

Friedman doesn’t say anything about tax rates. I’d suggest taxing profits at the regular income rate or higher. (Pace the incoherent notion that taxing income from financial investments prevents people from making financial investments; what else are they gonna do with the money, stuff it in a mattress?)

Conservatives should love this proposal not only because it emanates from their godhead, but because it eliminates double taxation (profits taxed at the corporate level, then again when they’re distributed as dividends).

Liberals should love this proposal (despite its source) because it places the tax burden directly on “owners,” and it taxes corporate earnings at the same unsubsidized rate as labor earnings.

Everyone should love this proposal because it eradicates the whole public and private apparatus of corporate tax collection, and removes multiple preferential tax treatments that distort markets and keeps tax accountants, lawyers, and regulation-arbitragers burning the oil.


In and of itself, this proposal does nothing to address the international tax dodging that is such a problem with corporate profits.

There would still remain the question of capital gains and how/if they should be taxed, which I will leave to another post.

But I will mention here, once again, that the corporate interest deduction should be eradicated (along with the mortgage interest deduction). There’s no reason for taxpayers to subsidize debt financing in preference to equity financing. QTC, in fact.

Cross-posted at Angry Bear.

“Public” Debt and Safe Assets: A View from Space

May 28th, 2013 2 comments

In my ongoing efforts to clarify national-accounting-speak (for myself and others), I’d like to take a stab at some language that is often used ambiguously: the notion of “public” debt. (See also Thinking About the Fed.)

If you don’t think anyone is confused by that term, understand: in “public debt,” “public” means government. In “debt held by the public,” “public” means non-government.

I’m prompted to tackle this by a statement from Adair Turner in this very interesting discussion over at VoxEU. (Hat tip/further discussion: Simon Wren.)

If Japan had used [helicopter money], it would now have some mix of a higher real GDP level, a higher price level, and lower public debt to GDP.

I think the last phrase in this statement (“lower public debt”) is potentially confusing, and I’d like to explain why.

The meaning of “public debt” depends on the accounting/balance-sheet view you’re adopting. Each is a perfectly valid accounting construct; each depicts the situation differently. Some views may be more useful than others in sussing out how things work/are working.

1. The view from the Treasury balance sheet, with 1. government trust funds (Social Security, etc.) and 2. the Fed viewed as external entities. Generally referred to as “gross public debt.” The treasury bonds/bills held by those external entities are liabilities of Treasury. It must pay interest, and eventually principal, to those entities. (Though those payments flow right back to Treasury, and/or don’t flow out, depending on how you describe the “flow of funds.”)

2. The view from the “unified” balance sheet. Generally called “debt held by the public.” This consolidates the Treasury and trust-fund balances (viz: the “unified budget“) into a single “government” balance sheet. Treasury’s debt/liability to those funds is internal to government (one department just owes another), so they vanish from this consolidated view. “Government” liabilities consist only of bills/bonds held by external entities.

But crucially: those external entities include the Fed. In this view, the Fed is part of “the public,” and its bond holdings are “government” liabilities. “Government” owes money to the Fed. (This again nothwithstanding the fact that interest and principal flows from Treasury to the Fed flow right back to Treasury.)

3. The view from a fully consolidated “government” balance sheet, including Treasury, the trust funds, and the Fed. Debt consists of bonds/bills held by parties external to that “government.” There is no common name for this construct, and you rarely if ever see the situation depicted this way.

4. The view including GSEs (Fannie/Freddie). The Fed is buying $40 billion/month in mortgage-backed securities from these entities. They owe the Fed money, just like Treasury owes money to the trust funds. Those entities are quite arguably part of “government” (Treasury will always cover their liabilities, though perhaps using Fed machinations as the vehicle), so it’s not crazy to view this as another instance of “government owing money to itself.” If you consolidate these entities into the “government” balance sheet, “debt held by the public” includes truly non-government entities’ holdings of Treasury and GSE bonds/bills. As with #3 (but more so), you never see the situation depicted from this view.

Back to Turner’s statement: From view #2 (“government” is Treasury but not the central bank), if Japan had taxed less and issued bonds/borrowed instead the direct result would be higher “government” debt to GDP compared to a normal tax-and-spend approach. It owes all that money to an external entity: the CB. This would only be ameliorated to the extent that second-order effects — policy-induced NGDP increases — resulted in higher tax revenues.

But from View #3 (government including the CB), “public debt” would be less. Instead of taxing or borrowing money from the true non-government “public,” with the CB buying the bonds Treasury is effectively borrowing from the CB. Again: it’s just government owing money to itself.

Personally I’d like to see a lot more thinking and analysis from the perspective of View #4. In particular I’d like to see flow analysis from that perspective, showing the net Net NET flow of additional treasuries/GSEs into the private market after Fed “retirements” (under the theory that a smaller net incoming supply of additional financial assets will result in higher financial-asset prices). See for instance this Citi graph, which both Cullen Roche and Izabella Kaminska (no mean monetary thinkers) consider to be especially enlightening:

I would also suggest with some trepidation that their emphasis on “safe” assets might be misplaced, that the effects that are of interest might simply result from a reduced “supply” of financial assets, period. Which is why QE raises both bond and stock prices. But only while QE continues.

Cross-posted at Angry Bear.

Just What Exactly Do You Mean by “Money,” Buster? #23

May 25th, 2013 2 comments

I was poking around at the very interesting Divisia measures of money, and came up with the following chart.

Update: Spreadsheet error in original graph. Result: this has little to impart. Never mind. Thanks to Mark Sadowski for pointing it out.

Screen shot 2013-05-26 at 9.09.10 AM

Which has me, once again, asking monetarists the question in the title of this post. For instance: are Treasuries money? How moneyish are they? We have two presumably valid measures here telling wildly different stories in MV=PY World. What’s your story?

The numbers in this chart are purely arbitrary (Divisia measures are just indexes, here divided into GDP, which is in dollars); it’s about the relative changes.

Cross-posted at Angry Bear.

Quantitative Easing: Like “trying to kill James Bond with a shark”

May 24th, 2013 5 comments

This line by Matt McOsker, in a comment on one of my recent posts, now reigns as the best line of the year in my personal pantheon.

QE’s only direct effect is on the financial sector. It only affects the real sector — where people work to produce, buy, and sell real goods, and produce surplus in the process — through second- and third- (+) order carry-on effects of quite uncertain and contestable mechanism and efficacy.

I’m with Steve Randy Waldman: if you want to kill James Bond, just shoot him with a gun, already!

Cross-posted at Angry Bear.


How The Great Moderation Destroyed the Fed’s Credibility

May 22nd, 2013 2 comments

Much ado is made of the Fed’s “credibility,” which is dog-whistle-speak for its ability, willingness, and decided inclination to jump all over any (expected or imagined) whiff of that horrifying threat — inflation! — especially the most terrifying bogeyman, “wage inflation.”

You won’t, on the other hand, find “credibility” discussed when people speak of the Fed’s inevitably weak-kneed inclination to raise inflation (expectations).

So after thirty years of diligently establishing its reputation for credibility, the Fed has no credibility. They announce on December 12 that they’ll allow inflation to go as high as 2.5% (shock! awe!). And what happens to inflation expectations?

Screen shot 2013-05-22 at 8.13.29 AM

Yes, it was a limp-wristed “promise”: they would only allow that irresponsibly dangerous hyperinflationary jump to 2.5% if unemployment remained above 6.5%. (Pick a mandate, any mandate. You know which one they’ll choose.)

So after three decades of diligently protecting responsible creditors from the manifest evils of inflation, and imposing responsibility on feckless, impatient entrepreneurial, risk-taking borrowers, nobody believes for an internet minute that the Fed can or will address the unemployment side of their mandate — that it has the wherewithal to do so, or the inclination if it did.

Got credibility?

Cross-posted at Angry Bear.

Rules? In Knife Fight?!

May 21st, 2013 Comments off

Allan Marks, in a comment on a Krugman post, reminds me of one of my favorite scenes in filmdom.

Krugman’s complaining that he doesn’t understand the rules that his detractors are arguing by, and Marks suggests he watch this (55 seconds; hit refresh if you don’t see it below):

Is anyone else wishing our esteemed President knew the rules for knife fights?

Cross-posted at Angry Bear.


Fed’s Dudley Agrees: QE is Not About the Reserves, or “Printing Money”

May 21st, 2013 7 comments

Or: “Dudley Makes Mock of the Monetarists.”

In my post The Fed is not “Printing Money.” It’s Retiring Bonds and Issuing Reserves, I said:

…when the Fed gives the banks reserves and retires bonds, it’s taking on market risk/reward, replacing it with absolutely nonvolatile, risk/reward-free assets (at least in nominal terms). It’s removing leverage and volatility from the banking system.


The banking system doesn’t “take money” out of total reserves, or reduce those reserves, to fund loans.

And now I find this in a speech today at the Japan Society by FRBNY President and CEO William Dudley (HT Matthew Klein). Emphasis mine:

asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet.  This pushes down risk premia, and prompts private sector investors to move into riskier assets.  As a result, financial market conditions ease, supporting wealth and aggregate demand.  The fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct — not the goal — of these actions.

Or to put it another way: when you increase M in MV = PY, the most likely result — the result you have to assume by default absent some convincing story about real-economy incentives, causes, and effects —  is a purely arithmetic decline in V (cf. Dudley’s “byproduct”), with zero effect on P or Y.

This is doubly true if by M you mean the Monetary Base (as do monetarists, inconsistently but often) — the only measure of money that includes reserve balances. Increasing the quantity of reserve balances (hence the monetary base) does not magically increase either P or Y.

Cross-posted at Angry Bear.

The Fed Is not Printing Money: Two Updates

May 17th, 2013 79 comments

I’d like to reply to one confusion and one set of pushbacks on yesterday’s post:

Currency and Reserve Balances

I buried one fact: banks can reduce total Fed reserve balances by withdrawing currency — physical cash — from their Fed reserve accounts. I only gestured toward this in a parenthetical and a link. It’s a trivial point for this discussion, but it raises confusion. This is the other thing (besides bonds) that the Fed issues and retires in return for reserve balances. As with bonds, it’s purely an exchange between banks and the Fed (though it’s driven by customers’ cash needs).

Banks actually have nominal control over this. The Fed has to issue currency to them (retiring reserves in exchange) when they ask for it, and they have to retire currency (issuing reserve balances) when banks send it back.

But this in no way suggests that reserve balances are money. You can withdraw currency (notes) from your bank. Does that mean that your checking account contains currency? That checking deposits are currency? No.

This issue is unimportant here because it’s essentially a mechanical function. As long as it’s working properly — ATMs dispense cash and people can deposit cash — it has no effect on things. (And cash is pretty small magnitude in the total system). Banks keep enough cash on hand to handle their customers’ needs, and the Fed accomodates that. Aside from drug dealers, etc., nobody holds much physical currency.

The only reason cash would be an important consideration would be if the Fed starting paying (significant) negative interest on reserve balances — charging the banks to to hold their reserve deposits. Banks might decide to build secure warehouses and drive cash to and from the Fed, trading it for reserve balances, when they needed to fund loans or when loans got paid off. (It’s kinda tricky to fund a $400,000 mortgage with cash…)

Otherwise it’s a nonissue for this discussion. But I should have made it clear.

Whaddaya Mean by M, Buster?

People really don’t like the idea that the Fed’s not printing “money.” MV=PY adherents especially object.

Let’s look at the standard definitions. None of the monetary aggregate definitions M0 through MZM includes reserve balances. By those definitions, reserves are not money. (Ditto the divisia measures.) So by those definitions, when the Fed issues new reserves, it’s not “printing money.”

The one exception is the “Monetary Base,” or “base money.” That definition of money includes currency, coins, and reserves. Here’s a handy chart from Wikipedia:

Type of money M0 MB M1 M2 M3 MZM
Notes and coins in circulation (outside Federal Reserve Banks and the vaults of depository institutions) (currency) ✓[8] ✓ ✓ ✓ ✓ ✓
Notes and coins in bank vaults (Vault Cash) ✓
Federal Reserve Bank credit (required reserves and excess reserves not physically present in banks) ✓
Traveler’s checks of non-bank issuers ✓ ✓ ✓ ✓
Demand deposits ✓ ✓ ✓ ✓
Other checkable deposits (OCDs), which consist primarily of Negotiable Order of Withdrawal (NOW) accounts at depository institutions and credit union share draft accounts. ✓[9] ✓ ✓ ✓
Savings deposits ✓ ✓ ✓
Time deposits less than $100,000 and money-market deposit accounts for individuals ✓ ✓
Large time deposits, institutional money market funds, short-term repurchase and other larger liquid assets[10] ✓
All money market funds ✓

So fine: M in the equation of exchange means Base Money. But if you look at the data using that definition, it seems like there’s some serious explainin’ to do. Here’s the velocity of MB:

A 70+% decline since 2008? Hmm…

Cross-posted at Angry Bear.



The Fed is not “Printing Money.” It’s Retiring Bonds and Issuing Reserves.

May 15th, 2013 66 comments

Update 5/21: See two updates to this post here.

Mark Dow had a great post the other day:

There is zero correlation between the Fed printing and the money supply. Deal with it.

He points out (emphasis mine):

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.

As he says:

if you are an investor, trader or economist, understanding—and I mean really understanding, not just recycling things you overheard on a trading desk or recall from econ 101—the mechanics of monetary policy should be at the top of your checklist. With the US, Japan, the UK and maybe soon Europe all with their pedals to the monetary metal, more hinges on understanding this now than ever before.

And, as we saw this week, even many of the Titans of finance and economics have it wrong.

He’s obviously been reading Manmohan Singh and Peter Stella (S&S) over at Vox EU, who cite the very same numbers and add:

In fact, total commercial bank reserves at the Federal Reserve amounted to only $18.7 billion in 2006, less than the corresponding amount, in nominal terms, held by banks in 1951.

S&S also point out (Table 1 and Figure 1) what we’ve known for decades but many seem unwilling to admit: since WWII, reserve levels have had approximately zero correlation with inflation/price levels.

They continue:

This suggests either that there is something wrong with:

  • the theory of money neutrality;
  • the theory of the money multiplier; or
  • how money is measured.

Or, I would say, all of the above. I’d actually replace all three: there is something wrong with the (nonexistent) definition of “money.” But that’s another post.

I’m going to go even farther than Dow and say: the Fed is not printing money. (It can do that, but the result is stuff you can hold in your hand.) That’s a confusing and actually incoherent misconception. The Fed is issuing new reserves and exchanging them for bonds. Those bonds are effectively retired from the stock of assets circulating in the financial system (though perhaps only temporarily), as if they’d expired.

Reserves are not “money” in any useful sense. Or, they’re only money (whatever you mean by that word) within the Federal Reserve system. We probably just shouldn’t use the word at all here. It’s only confusing.

The key to understanding (and to avoid misunderstanding) this is to think about the banking system, not individual banks. The dynamics are totally different, because individual banks can affect their reserve positions (though under various market and regulatory constraints). The banking system can’t.

Because: Reserves only exist (can only exist) in banks’ accounts at the Federal Reserve Banks (and only members — banks plus GSEs and other large institutions like the IMF — can have accounts there). The banking system can’t remove reserves from the system by transferring them to the nonbank sector in exchange for bonds, drill presses, or toothpaste futures.

One bank can transfer reserves to the account of another entity with a Fed account, in exchange for bonds or whatever, but total reserves are (obviously) unchanged. And that exchange has no direct effect outside the Fed system. (That exchange can, does, have second-order, indirect, portfolio-rebalancing effects on the rest of the market. More below.)

And here’s the key thing: the banking system can’t lend reserves to nonbank customers by somehow transferring them to those customers’ deposit accounts (thereby reducing total reserves). They can’t “lend down” total reserves. The banking system doesn’t “take money” out of total reserves, or reduce those reserves, to fund loans.

This is why it’s so crazy to worry about those reserves eventually “flooding out into the real sector” in the form of new loans (and resultant spending), with all the hyperinflationary hysteria attached to that notion. (Equally: those reserves are not “unused cash” on the “sidelines” that the banks are “sitting on.” See Cullen Roche on this.) Reserves can’t leave the system, whether in a flood or a trickle. The banking system will lend (creating new deposits in its customers’ accounts out of thin air), if bankers think it will be profitable. But increased lending if anything forces the Fed to increase total reserves. Viz:

A bank issues a billion dollars in new loans, creating a billion dollars in deposits in its customers’ accounts. The borrowers spend the money by transferring it to sellers’ banks. When all the transactions net out at night at the Fed, the issuing bank is short on reserves that need to be transferred to the sellers’ banks (or sees that it will be short). So it borrows reserves from other banks. If reserves are tight, this pushes up the interbank lending rate. The Fed doesn’t want the interbank rate to increase, because it thinks interest rates are where they should be to fulfill its mandates. So it issues new reserves and trades them for banks’ bonds (which it retires, at least for the time being).

Short story: more lending increases total reserves. Slightly longer story: more lending forces the Fed to increase total reserves (or abandon its mandates).

In the current situation, of course, there’s no shortage of reserves. Banks are holding extraordinary quantities in excess of regulatory requirements. So the Fed instead controls the interbank lending rate within a corridor by setting the rate it pays on reserves (bottom) and the rate at which it will lend to banks (top). Read it all here from the FRBNY.

So how can the banking system reduce total reserves? Only in one significant way: by buying bonds from the Fed. Send some reserves over, and the Fed retires those, (re)issuing bonds in exchange. But of course the Fed isn’t selling these days; it’s buying.

Fed asset moves just issue and retire reserves and bonds. And those moves are purely at the discretion of the Fed (the Fed “enforces” this on the system by buying/selling at prices that individual banks will take up). So the Fed is in complete control of the level of total reserves. Again: there is no way for the banking system to turn existing reserves into deposits in its customers’ accounts. It can’t “lend down” total reserves.

When the Fed issues and retires bonds and reserves, it’s not “printing money,” so it’s not playing some kind of simplistic MV=PY game. It’s adjusting the balance of the banking system’s portfolio (“forcing” it to change exchange bonds for reserves) — and by extension, affecting the mutually interacting portfolio preferences of all market players (via interest-rate/yield-curve effects, and also, more psychologically, by imparting the optimistic notion that there’s adult supervision — that this frat party won’t turn into Animal House).

In other words, it’s a much deeper game than many monetarists would have you believe. It’s especially deep because neither the Fed nor the markets understand it properly. Certainly the Fed governors have strong disagreements about how it works. (Arguably, nobody understands, very much including me. There are many interacting understandings and reaction functions out there, many based on complete misunderstandings of the system dynamics. But I think we’re getting closer these days, with the slow but increasingly widespread and accelerating dismissal of silly notions like the money multiplier.)

Dow explains these portfolio effects and reaction functions very nicely:

…why is the Fed doing QE in the first place?

By keeping rates low well out the yield curve and providing comfort that the Fed will be there to fight the risk of recession and deflation…we start feeling better about putting our getting our money back out of the mattress and putting it back to work.

…it is the indirect psychological effects from Fed support and the low cost of capital—not the popularly imagined injection of Fed liquidity into stock markets—that have gotten investors to mobilize their idle cash from money market accounts, increase margin, and take financial risk. It is our money, not the Fed’s, that’s driving this rally. Ironically, if we all understood monetary policy better, the Fed’s policies would be working far less well. Thank God for small favors.

The other, more mechanical, implication is that financial sector lending is neither nourished nor constrained by base money growth. … The main determinant of credit growth, therefore, really just boils down to risk appetite: whether banks and shadow banks want to lend and whether others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share?

These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around—in large part because of what Econ 101 misguidedly taught us about the primacy of price, incentives and rational behavior.

I certainly make no claim to a deep understanding of those portfolio effects. (If I had such an understanding, I’d be far richer than I am.) But I do have some thoughts I’d like to share.

• When the Fed issues reserves and retires bonds, it’s 1. reducing the net flow of newly-issued (treasury and GSE-mortgage) bonds into the market, or even causing a net reduction. And if the latter is true, it’s 2. reducing the total stock of bonds available for trading in the market.

Since the flow of new bonds is obviously much smaller than the outstanding stock, you would expect flow effects of Fed actions to have much greater immediate influence on bond markets than stock effects.But it’s unclear what their long-term effects might be. A steady flow reduction, on the other hand, will eventually have cumulative effects on the total stock — again with uncertain future effects.

Jake Tepper, quoted in this post by Cullen Roche (read the comments too), gives us this:

…The fed is going to purchase $85 billion of treasuries and mortgages a month. So over 500 billion in six months…. the net issuance [by Treasury] versus refunding is a little over 100. That means we have 400 billion, 400 billion that has to be made up.

Whatever “made up” means. But Tepper’s also ignoring the Fed’s other big buys: mortgage-backed securities issued by government-sponsored enterprises (Fannie, Freddie). I would like to see as long a time series as possible of the following:

Net MBS issuance by GSEs (issuance – retirement)


Net Treasury issuance (new issues – retirement)


Net Fed ”retirement”

Also have to include Fed repos, I think? But maybe trivial over the long term.

In other words: net Net NET consolidated flow of new bond issuance to the private sector by Treasury, Fed, and the GSE gods.

Then: that measure as a percent of GDP? Of total Treasury/GSE bonds outstanding? Total Credit Market Debt Outstanding (TCMDO)? Other measures to compare it to?

• Contrary to what you often hear, even today when reserves and bonds are paying nearly equivalent interest rates, they are not equivalent assets. Because: bonds have expiration dates, and variable market prices/interest rates. So bonds carry market/interest-rate risk and reward for their holders — the potential for cap gains and losses. Reserves don’t.

As you can read in this must-read 2009 paper from the Bank of International Settlements, reserves are the Final Settlement Medium. They’re what it comes down to every night when all the day’s bank transactions are consolidated, netted out, transferred, and resolved. A dollar of reserves is always worth a dollar. There’s no possibility of capital gains or losses on reserve holdings. Reserves are inexorably nominal. (Even more so than $100 bills, which are worth less relative to reserves if they’re sitting in a Columbian drug-dealer’s suitcase.)

So when the Fed gives the banks reserves and retires bonds, it’s taking on market risk/reward, replacing it with absolutely nonvolatile, risk/reward-free assets (at least in nominal terms). It’s removing leverage and volatility from the banking system. (MMTers might well ask why our government system requires the injection of that volatility in the first place, when the Treasury could simply be issuing “dollar bills” with no expiration dates or interest payments, instead of treasury bills. [Or consols.] But that’s an aside.)

• I have to address notions like this one from Lee Adler, in a comment on Dow’s post:

The correlation between Fed and other central bank money printing with market behavior is clear and direct.

Yeah: while the Fed is on a bond-buying spree, it buoys bond prices and depresses yields. Especially when bond yields are historically low, market players shift their portfolio preferences from bonds to equities in a “reach for yield,” so equities go up too. (This presumably yields a wealth effect of [rich] people spending more — perhaps the only transmission mechanism to the real economy for Fed balance-sheet changes.)

This says exactly nothing about those balance-sheet moves as an impact on the stock of “money,” or inflation. It just says that while Fed asset purchases/sales are ongoing (and expected to continue), they will raise or lower the value of financial assets. It’s either orthagonal to Dow’s assertions, or  in fact demonstrates exactly what he’s saying about psychological effects.

• It doesn’t make sense to say that the Fed is “monetizing” the debt (because reserves aren’t money). If you think in terms of consolidated Treasury/Fed net issuance/retirement of government bonds, it’s retiring debt — removing bonds from the market and absorbing them into the Treasury/Fed complex. The bonds still exist, of course, and the Treasury still pays interest — to the Fed, which kicks it right back to Treasury. But as far as the markets are concerned, those bonds are essentially dead and gone (at least for now).

It seems that the Fed could simply burn a whole pile of those bonds, no? It would have no effect on flows, aside from the rather pointless interest flows back and forth between Treasury and Fed. And it would only affect the stock of “dead” bonds — ones that have been retired into the Fed. (The notion’s been discussed by people as diverse as Ron Paul and Mervyn King — Paul with the misconception that this would be “declaring bankrupcy,” and King with the misapprehension that it would be “monetizing the debt.”)

• It’s not at all clear what the flow effect would once the had Fed stopped net-buying bonds, while Treasury and the GSEs continued issuing new bonds in excess of retirements. Financial asset prices might stay at their then current levels. Who knows.

• The question, of course, is whether the Fed will ever sell all those bonds back to the market (thereby reducing reserve holdings). The average maturity of the Fed’s bond holdings is >10 years, so they’ll naturally expire and disappear, but only slowly. We’ve entered a brave new monetary world, in which central banks exert themselves not just through reserve management/interbank lending rates, but through balance-sheet expansion and contraction. (See the two “schemes” in the BIS paper linked above.) I don’t know if anyone knows what to expect in that regard. The Fed’s certainly talking about reducing its bond purchases in the future, which will affect net bond flows into/from the market, but it’s not at all clear whether it will ever shrink its balance sheet to pre-crisis levels (in absolute terms or relative to other measures), thereby reducing banks’ reserve holdings to those earlier levels.

• The $10-trillion question: If the Fed did sell off all its bond holdings in an effort to get back those halcyon days when banks didn’t hold any excess reserves — so the Fed could control the interbank rate with small open-market operations — what in the hell would happen? Whether slowly or quickly, bond prices would fall as the sales continued, yields would rise (compared to a counterfactual in which the Fed wasn’t selling off their holdings). Markets would shift their portfolio preferences from stocks to bonds, so equity prices would fall along with bond prices. Disastre?

Again, I don’t think anybody knows.

Cross-posted at Angry Bear.