Money, Government and Banking
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| MMT 101 |
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The MMT fundamentals, as explained by you and the other Wiki editors Introduction Modern Money Systems The Real Economy Money, Government and Banking The Role of Government Deficits Full Employment along with Price Stability |
Summary
This article deals with operational details of how the government interacts monetarily with the banking system and the non-government sector. The central bank is though of as part of the government for simplicity.
The government is the only entity that can create the definitive currency – "base money" (bank reserves plus physical currency), constituting the "monetary base".
Private sector credit markets levers on the monetary base, creating financial assets and liabilities. This is thought of as "horizontal" activity. Privately created financial assets are claims on base money. They are always created together with a corresponding liability. This means that the result is neither an increase or a decrease of net financial assets.
A good example is when a bank lends money to a customer. A loan contract is set up, and becomes a liability for the borrower and an asset for the bank. The net result is zero. Also, a bank deposit (new bank money) is created. For the bank this is an liability, and for the customer an asset. Again, the net is zero.
Banks use "bank reserves" to settle their daily transactions. A bank can acquire reserves by attracting new deposits, or borrowing in the interbank lending market. The Central Bank interacts on the interbank lending market to maintain its target interest rate. If, at the end of the day, there is a shortage of reserves in the interbank lending market as a whole, the central bank must step in and lend the needed reserves, acting as a lender of last resort.
Many countries impose reserve requirements on their banks (although some do not). Reserve requirements is an artefact of the old gold standard and are irrelevant in the current monetary system. They do not reduce bank risk. Nor do they comprise a buffer that can be drawn on when there is a run on a bank. Banks are instead prevented from lending excessively using capital requirements, under the Basel regulatory framework.
It is important to note that, contrary to popular belief, changes in bank reserves do not drive changes in the bank money supply. It is the other way around. If a credit worthy loan seeking bank customer turns up, banks will create a loan and deposit independently of current reserve positions. Reserve shortages are then resolved after the fact in the interbank lending market.
Only government taxing and spending change the net financial assets in the economy. The original source of all base money in the economy is necessarily the government. This currency (base money) creation takes place outside the commercial banking system, and is called "vertical".
The Government
For simplicity, one can think of the central bank as being part of the consolidated government sector (along with the Treasury etc). This is a basic MMT starting point. In the analysis, the balance sheet of the central bank and the rest of the government is merged into one.
One can thereby temporarily disregard the many intra-governmental accounting details of the central bank and the rest of the government. This removes complexity, and facilitates understanding of the essential relationship between the government sector as a whole and the non-government sector, and how net financial assets enter and exit the economy of the latter. This simplicity leads to many insights, all of which remain valid when more detail is added to the model[1].
The Monetary Base
The credit market in an economy deals with financial assets. Bank loans are extended, deposit accounts are managed and various other financial assets are bought and sold. This activity takes place on top of a small foundation of "base money" called the "monetary base". It is said that credit market activity "leverages" on the monetary base.
The government is the monopoly issuer of base money (sometimes also called "high powered money"). The monetary base is comprised of bank reserves and the physical currency (cash) in circulation. Bank reserves are banks' holdings of base money in accounts with their central bank, and banks' reserves of vault cash.
Base money is the "definitive" money of the economy. If the currency is "unpegged" (pegged neither to gold nor a foreign currency), the government has no obligation to convert it on demand to some other form of money or value.
- Base money – the "definitive" money:
- Physical currency (cash) in circulation
- Bank reserves
Financial assets created in the non-government sector are different. They can never be base money per se, but claims on base money. There is an implicit assumption that they can be converted to base money at maturity. For example, regular bank deposit accounts do not hold actual base money but claims on it – sometimes called "bank money", "credit money" or "deposit money". The claim is resolved whenever the bank money is used, for example when it is withdrawn by the deposit holder as physical currency.
Another example of how bank money is a claim on base money, and how the claim is sometimes resolved, is money transactions. Final transactions in the economy take place through the exchange of base money (either cash or bank reserves). When a household makes a payment (non-cash) to a firm, the household's bank deposit account is debited and the firm's bank deposit account is credited. The transaction then "settled" between the banks by transferring bank reserves from the household's bank to the firm's bank. An electronic transfer between the two banks' reserve accounts is carried out in the interbank settlement system (managed by the central bank, the Fed in the US). The central bank changes electronic accounting entries to do this (much like changing numbers in a spreadsheet).
The Loan/Deposit Mechanism
When a bank extends a loan to a customer, a bank deposit with new bank money is created. For the bank, the new bank money is a liability since it is a deposit that the customer can then draw upon. For the customer, the bank deposit is a claim on base money, i.e. an asset. The loan contract (in which the borrower commits to pay interest and repay the principal – the bank's claim on base money) is an asset for the bank and a liability for the borrower.
The essence of this loan/deposit mechanism is that the bank lets the customer have a claim on base money that can be immediately liquidated on demand; but the bank also has a longer term claim (on the customer) of base money (which also includes interest payments as a compensation for the risk of customer default).
Looking at the non-government sector as a whole, this expands both total assets and total liabilities in the economy. The net result is however neither an increase nor a decrease of non-government net financial assets. (Of course, the use of the loan/deposit can be used to finance productive investment, which can increase real assets[2]).
Horizontal Money
Bank money creation through the loan/deposit mechanism occurs completely within the commercial banking system, without direct participation of the central bank, and is called "horizontal". The basis for all horizontally created money is always (private) debt. Horizontal financial activity can never increase or decrease non-government net financial assets; the net is always zero.
The loan/deposit leverages on the monetary base and creates an expansion of the aggregate non-government balance sheet – both aggregate assets and liabilities increase, but the net result is zero.
When a loan has been extended with a newly created deposit, the borrower will typically soon draw upon the deposit to transfer funds to somebody else (perhaps conducting a purchase). The borrower's deposit account is debited and the recipient's is credited. The deposit is now an asset for the recipient and a liability for the recipient's bank. To settle the transaction, reserves are transferred between the banks, so that the borrower's bank loses an asset, and the recipient's bank wins an asset. The net financial assets has neither increased nor decreased – the net result is still zero.
When a payment is done on the loan the borrower's deposit account is drawn down upon (so that bank money "disappears"), and the loan contract is updated (possibly implicitly) to reflect that the remainder of the loan has decreased as well. The net result is zero.
When interest payment is made to the bank, the payer's deposit money goes down and the bank’s shareholder equity goes up correspondingly. (The bank’s shareholder equity can be thought of as "the banker's own deposit account" here).
When dividends, wages and other expenses are paid out from banks, the bank's shareholder equity goes down, and the payee's deposit money goes up.
In all these cases, the net is zero. No new net financial assets have been created.
Should the borrower for some reason default on the loan, the loan contract (a liability for the borrower and an asset for the lending bank) is ultimately canceled. Since both an asset and a corresponding liability has disappeared, the net financial assets has neither increased nor decreased – again the net result is zero.
Central Bank Operations
Banks need bank reserves to settle their daily transactions with other banks and with the central bank (for example when taxes are paid). Physical currency (cash) is needed as vault cash for withdrawals.
A bank can acquire reserves by attracting deposits. If, at the end of the day, a bank is in need of more reserves, it can borrow from other banks (that may have ended up with excess reserves) in the interbank lending market, which is typically managed by the central bank. This can happen if the bank has extended new loans to customers (and more reserves are needed to meet legal reserve requirements if there are any in place), or if the bank has lost reserves due to transfers (lost deposits) or cash withdrawals.
The central bank uses monetary policy to set a narrow range for the interbank lending rate (the Fed funds rate in the US). If, at the end of the day, there is a lack of reserves in the banking system as a whole (for example due to new loans having been extended by the banks to customers), this places an immediate pressure upwards on the interbank lending rate. Conversely, banks ending up with more reserves than needed will try to lend the excess in the interbank lending market. If there is a surplus in the market as a whole this places an immediate pressure downwards on the interbank lending rate.
To maintain control of the rate, the central bank must intervene and add or remove reserves from the system. It can do so by carrying out "Open Market Operations", buying and selling government bonds or repos.[3] It can also set up an interest rate corridor system by simply announcing an interest rate (above the target rate) at which it is prepared to lend unlimited amounts to commercial banks -- and another (below the target rate) at which it is prepared to borrow unlimited amounts from commercial banks.[4]
Popular Myths and Mistakes
It is important to understand the consequences of loans/deposit mechanism, and the central bank acting as a lender of last resort.
As we have seen, when a bank loan is made a corresponding deposit is created. Popular belief is otherwise that banks take deposits, keep a fraction of them as reserves and lend the rest – "loans are made from deposits". This is just the opposite from reality, which is that loans create deposits.
Banks do not lend reserves to customers. Reserves are used for clearing purposes among banks. There are three things banks can do with excess reserves: lend them to other banks in the interbank lending market, buy government bonds, or convert them to cash.[5]
Also contrary to popular belief, banks' reserve shortages are thus resolved after the fact. A shortage of reserves does not restrain a bank from extend loans to customers. On the contrary, banks do indeed extend loans to any credit worthy customer on their doorstep even if low on reserves. Any shortages are resolved after the fact in the interbank lending market at the end of the day, with the central bank as lender of last resort if needed.
A related popular mistake is the notion of the "money multiplier". Taking a fractional reserve requirement of 10% as an example, it is believed that an increase in bank reserves enables the banks to create a ten-fold increase of bank deposits, which should then presumably stimulate spending. (Some even believe that an increase in reserves drives the increase in bank deposits.) Again, this has causality backwards. Changes in bank reserves do not matter for changes in the bank money supply – it is the other way around. Creation of new bank deposits are not constrained by reserve positions. Loans create deposits, and banks then settle any reserve shortages after the fact, using the central bank as lender of last resort if needed.[6]
Another related popular mistake is the notion of financial crowding out, saying that government deficit spending causes interest rates to increase which thus crowds out private activity. The first mistaken belief is that government borrowing is needed to fund deficit spending. A second mistaken belief is that borrowing takes away funds from a limited pool of "loanable funds" available in the economy. The reality is that government spends by issuing currency. Therefore, government deficit spending puts downward pressure on interest rates, not upward, since reserves are added to the banking system, not removed.
Yet another related dubious mainstream idea is Quantitative Easing.
Reserve Requirements
In some countries there is a legislative reserve requirement imposed, so that banks have to have reserves at least amounting to some fraction of the total deposits outstanding (Fractional Reserve Banking). Examples are Brazil, China, India, Mexico, Russia, South Africa and the US[7]. Other regimes[8] do not impose such a requirement other than that the accounts must not be in the red on a sustained basis. The US is currently considering eliminating the positive requirements.[9]
Reserve requirements are an artefact of the old gold standard and are irrelevant in the current monetary system. They do not reduce bank risk. Nor do they comprise a buffer that can be drawn on when there is a run on a bank.[9]
It is true that the price of reserves will play some role in a bank's credit department’s decision to lend funds, much like the interbank lending rate can have an effect. But the reserve position will not matter. As long as the margin between the return on the loan and the penalty rate they would have to pay to borrow from the central bank (through the "discount window" in the US) is sufficient, the bank will lend.[6]
Capital Requirements
However, there are capital requirements that do place a limit on the expansion of commercial banks' lending. Most advanced nations have fully implemented Basel I and II which define lending limits as a multiple of a bank's (risk-weighted) capital. Bank lending is thereby capital constrained under this regulatory framework.[9]
Capital relates to the solvency of a bank, while reserves relate to liquidity. A solvent bank can always raise liquidity by borrowing more reserves. A bank will not fail due to liquidity problems. The issue is solvency. Depositors with funds in excess of government insured limits need to be concerned about bank solvency (capital), not liquidity (reserves).
Capital requirements attempt to limit excessive risk-taking relative to capital, thereby reducing the likelihood of bank failures. They also constrain the size of the banks because capital is costly. Finally, they reduce the public-private partnership ratio inherent in any banking system where governments will bail out the depositors in event of failure. The higher the capital held against its assets the more the shareholders are exposed to bank failure.
Tighter capital requirements may limit some credit expansion but provide the conditions for more durable growth cycles by avoiding the speculative bubbles.[9]
Vertical Operations and Net Financial Assets
When the government spends (to firms and households), the recipient's bank deposit account is credited. New bank money has been created. The transaction is settled by reserves being added to the recipient's bank. The central bank does this by crediting the bank's reserve account in the interbank settlement system (by making changes in electronic accounting entries). For the bank, the net result is zero (the new deposit is a liability, but the new reserves is an asset). For the recipient of the payment, the new bank money is an asset, and there is no corresponding liability in the non-government sector.
The result of the government spending is therefore an increase of net financial assets in the non-government sector. [10]
Only government taxing and spending change the net financial assets in the economy. The original source of all base money in the economy is necessarily the government. This currency creation (base money) takes place outside the commercial banking system, and is called "vertical".
Conversely, when the government collects taxes, reserves are removed from the non-government sector – also a "vertical" operation. This results in a decrease of non-government net financial assets.
Government currency issuance is fundamentally different from the "horizontal" activity within the private sector, where bank loans creates bank deposits. Horizontal money (bank money) creation neither increases or decreases the non-government net financial assets – the net is always zero.
As has been discussed above, the central bank conducts Open Market Operations to maintain the interbank interest rate. By extending short term loans, the central bank can supply more reserves to the banking system. However, the amounts are small relative to government spending and taxing, and it is taken as a defensive action to add or drain reserves on a short term basis[11]:81. The borrowed reserves is an asset for the borrowing bank, but the loan is also a corresponding liability, so the mechanism does not change the non-government net financial assets.
As government spending and taxing changes the amount of reserves in the banking system, the interbank lending rate would be affected. The reason is that spending typically occurs uniformly over the year, but taxing typically occurs once per year or quarterly. Spikes in the amounts of the reserves and thereby also the interest rate would result. In order to maintain the rate at its target, interest rate maintenance operations are simultaneously performed to offset these effects.[12]
Fiscal and Monetary Policy
In essence, when the government spends and taxes, the amount of non-government net financial assets is altered (base money and government bonds). Measures are taken so that this "fiscal policy" is conducted without affecting the interest rate in the interbank lending market. The interest rate is instead controlled by "monetary policy" (conducted by the Fed on the interbank lending market) which alters the composition of base money versus government bonds.
- Fiscal policy – taxing and spending – alters the amount of non-government net financial assets (issued government bonds and base money). Conducted by the Treasury.
- Monetary policy – interest rate maintenance – only alters the composition of non-government net financial assets (i.e issued government bonds versus base money). Conducted by the central bank.
We can also say[13]:
- the Treasury spends base money into existence
- the central bank lends base money into existence
Vertical and Horizontal Operations Summarized
To summarize, thousands of private sector transactions result in deposit accounts being credited and debited, and are "settled" as bank reserves are shifted between banks.
When new loans are made, new bank money (deposits) is created. The total private sector balance sheet expands (i.e both assets and liabilities increase) – "leverage" increases.
If reserve shortages occurs in the banking system, the central bank lends new reserves in order to maintain the interbank lending rate.
The main source of new reserves – and the only source of increasing net financial assets – is however government deficit spending. When there is an excess of reserves in the banking system, the central bank drains them using some monetary policy tool or lets the interest rate drop to zero.
References
- ↑ Bill Mitchell, The consolidated government – treasury and central bank, http://bilbo.economicoutlook.net/blog/?p=11218
- ↑ "Tom Hickey on MMT". http://moslereconomics.com/2010/04/04/tom-hickey-on-mmt/. Retrieved 1 June 2011.
- ↑ https://secure.wikimedia.org/wikipedia/en/wiki/Monetary_policy
- ↑ http://www.bankofcanada.ca/monetary-policy-introduction/why-monetary-policy-matters/1-economy/
- ↑ "Paul Krugman Still Gets it Wrong: Modern Money Theory". http://www.economonitor.com/lrwray/2011/08/16/paul-krugman-still-gets-it-wrong-modern-money-theory/. Retrieved 20 August 2011.
- ↑ 6.0 6.1 Bill Mitchell, Money multiplier and other myths, http://bilbo.economicoutlook.net/blog/?p=1623
- ↑ "Reserve requirement". Wikipedia. https://secure.wikimedia.org/wikipedia/en/wiki/Reserve_requirement. Retrieved 31 May 2011.
- ↑ such as Australia, Canada, New Zeeland and Sweden "Reserve requirement". Wikipedia. https://secure.wikimedia.org/wikipedia/en/wiki/Reserve_requirement. Retrieved 31 May 2011.
- ↑ 9.0 9.1 9.2 9.3 Bill Mitchell, Lending is capital- not reserve-constrained, http://bilbo.economicoutlook.net/blog/?p=9075
- ↑ In the books, the net financial assets of the non-government sector are held as liabilities for the government. However, for a modern money regime, the amount per se of the financial liabilities is of no importance (as new financial assets can be created at will etc). What matters is non-government economical phenomenons, as inflation, deflation and unemployment.
- ↑ Wray, L. Randall (1998). Understanding Modern Money. Edward Elgar Publishing Limited. ISBN 978 1 84542 941 6.
- ↑ Taking the US as an example, to see the details the Treasury and the central bank needs to be considered as separate entities (instead of as a consolidated government), which makes it more complicated. When taxes are collected the taxpayer's deposit account is debited, and corresponding reserves are removed from the taxpayer's bank, and thereby also from the interbank lending market. This change in reserves needs to be offset, so that the interbank overnight lending interest rate is not affected. Therefore, the same amount of "money" is simultaneously added to a Treasury Tax and Loan (TT&L) account, where they count as reserves within the banking system. This is essentially a reserve maintenance operation. The TT&L accounts can be thought of as providing a buffer stock of reserves, working to even out the spikes in reserve balances (that would have otherwise occurred in the banking system due to the non-uniformity of Treasury spending and taxing). Similarly, when the Treasury is to spend more than it taxes, the US law says it must issue Treasury securities (government bonds) and sell to the public. Thereby reserves are removed from the buyer's bank's reserve account with the Fed. Again, this change in reserves is offset by simultaneously adding reserves to a TT&L account -- a reserve maintenance operation. Eventually, when the Treasury wishes to spend, reserves are first removed from a TT&L account and added to the Treasury General Account at the Fed. A check is then written to the agent receiving the spending. When it is deposited by the recipient, the Fed debits the Treasury General Account and credits the reserve account of the recipient's bank – again without changing the total amount of reserves in the interbank lending market. For more on this, see Warren Mosler: Soft Currency Economics, Stephanie Bell's (now Kelton) "Can Taxes and Bonds Finance Government Spending?", Scott Fullwiler's "Modern Monetary Theory—A Primer on the Operational Realities of the Monetary System" and Mecpoc: Operationally, Government Spending is Not Inherently Revenue Constrained. Any such Constraints Are Necessarily Self-Imposed
- ↑ L. Randall Wray - Response to comments for MMT Primer part 3 - http://neweconomicperspectives.blogspot.com/2011/06/mmp-blog-2-responses_23.html
