In my last post, I argued that bank reserves, if they pay interest, are essentially a form of government debt. They’re issued by a different institution and have a different maturity than most government debt, but in their essential nature, they’re just a special case of government debt.
In that post, I was agnostic about whether bank reserves should be considered “money.” If bank reserves are government debt, then, to be consistent, we should either consider all government debt to be money or consider bank reserves to be something other than money. In particular, Ben Bernanke’s use of the phrase “printing money” is consistent if you consider all government debt to be money, in which case QE2 only exchanges zero-maturity money for high-maturity money whereas QE1 exchanges money for private sector assets. If you take the second option, however, then neither QE1 nor QE2 was “printing money.”
I want to explore that second option, which seems pretty reasonable in terms of the way I learned liquidity preference theory in school. In the simplest version of liquidity preference theory, money (1) pays no interest and (2) is controlled by policymakers. Obviously bank reserves no longer meet the first criterion, and bank deposits (as we learned painfully during the policy experiment of the early 1980’s) do not meet the second criterion. I’m increasingly coming to believe that the most reasonable definition of “money” is simply “cash” (negotiable central bank notes plus coins).
But the Fed does not attempt to control the supply of cash. Banks can withdraw reserves from the Fed, or deposit them, whenever they choose, and the Fed will normally compensate for aggregate net withdrawals or deposits by adjusting the total level of reserves to bring it back to where it was before the net withdrawals or deposits took place. Moreover, the amount of cash outstanding, as determined by the demand for cash, is not a significant factor in the setting of Fed policy. If “money” simply means cash, then the Fed’s “monetary policy” is unlimited accommodation. And moreover, nobody cares, or should care, about how this policy is going. For practical purposes, there is no such thing as monetary policy.
The Fed does do something active, and they call it monetary policy. But what is it really? The Fed does several things that usually come under the heading of monetary policy, but they can all be reasonably classified as something else. For one thing, it manages the level of bank reserves through open market operations. But this is really government finance policy, not monetary policy: it consists of substituting zero-maturity government debt (bank reserves) for higher maturity government debt (Treasury securities), or vice versa.
The Fed also sets the interest rate on reserves. This is also government finance policy. Suppose that, instead of auctioning off fixed quantities of securities, the Treasury were to sell as much as it could at a given interest rate and leave any excess cash in a vault. If we’re talking about, say, one-month T-bills, which have only slightly higher maturity than bank reserves, then the effect would be essentially the same as when the Fed sets the interest rate on reserves. (In particular, imagine that, starting from today’s near-zero interest rates, the Treasury were to start selling T-bills with a fixed 1% yield. That would be just like an increase on the interest rate on reserves, except that others besides banks could participate. That difference is really irrelevant except for the arbitrage opportunity provided to banks when the IOR rate exceeds the T-bill rate. If the IOR rate were to rise, banks – being in competition with one another for funds – would have an incentive to let others participate indirectly.)
Granted, this doesn’t work in reverse: the Treasury needs to borrow a certain minimum amount to finance its expenditures, so it can’t set an arbitrarily low interest rate. But it doesn’t work in reverse for bank reserves either. If the Fed sets the IOR rate far below the T-bill rate, it becomes irrelevant: banks will simply hold, for emergency purposes, a tiny amount of reserves over and above what is required, and the rest of their reserve assets they will hold as T-bills, which can easily be sold or repoed for federal funds if necessary.
The Fed also sets the reserve requirement, thereby compelling a demand for reserves, but this is not monetary policy either; it is regulatory policy. There is a regulation that requires banks to hold a certain quantity (set by the Fed) of zero-maturity government debt (reserves). There are other regulations that effectively require banks to hold certain quantities of more broadly defined safe assets to satisfy capital requirements. All these regulations create an increased demand for government debt; it’s only the maturity of the debt that is different. To the extent that such policies are used for macroeconomic demand management, they are essentially a form of taxation: the Fed can pay a lower rate of IOR than it otherwise would because it is compelling banks to hold reserves instead of using the money for profitable activities; it could achieve the same effect by raising IOR until those activities are no longer profitable (in risk-adjusted opportunity cost terms) and taxing the banks an amount equal to the difference in the interest they pay. To the extent that regulatory policy is used for macroeconomic demand management, it is just a form of fiscal policy.
Finally, the Fed lends (or purchases the assets from those who have lent) to the private sector, via its discount window, via various emergency programs in times of crisis, and in particular via QE1. But this isn’t monetary policy; it’s fiscal policy. It’s no different than what the TARP did: an exchange of government debt for private debt. Anything the Fed does through such programs could also be done by the Treasury, which could issue T-bills to obtain funding, and it would surely be considered fiscal policy. The Fed issues bank reserves instead of T-bills: a slight difference of maturity, not a fundamental difference of substance.
So there you have it: there is no such thing as monetary policy. There is “central bank directed stabilization policy,” and, for convenience, you can refer to that as monetary policy if you want. If so, recognize that you are using the term loosely, and let’s not get into arguments about whether some particular Fed action is “really” monetary policy. None of it is really monetary policy.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Friday, December 10, 2010
Thursday, December 9, 2010
What Does “Printing Money” Mean?
When I heard Ben Bernanke on 60 Minutes Sunday, I was initially taken aback when he said that QE2 did not constitute “printing money.” Obviously it’s not physically printing money, but nobody ever uses that phrase literally. If creating bank reserves is not “printing money,” then what is? My first thought, maybe he means that the increase in base money is not expected to lead to an increase in bank deposits. But if that’s the case, why would they be doing it? It’s hard to imagine QE2 being effective without causing bank deposits to increase. Sure, they may not increase via the textbook money multiplier process, given that reserve requirements are not currently binding and reserve ratios are not expected to be stable. But that’s a cop out: the Fed is increasing bank reserves; it hopes this action will lead, by whatever process, to an increase in bank deposits. How is that not printing money?
Apparently it gets worse. I had forgotten what Bernanke said on his earlier 60 Minutes appearance, but Jon Stewart has a clip where, in reference to QE1, Bernanke essentially acknowledges that the Fed is printing money. Naturally, Jon Stewart was amused by this seeming inconsistency, as was I.
But I’ve been thinking about this a bit more, and I no longer think Bernanke’s statements are inconsistent. The problem is that the definition of the word “money” is not as clear cut as it seems. Indeed, one might argue that the whole concept of “money” is no longer useful (at least to economists) in a world where bank reserves pay interest and people pay bills with credit cards and with checks drawn on bond mutual funds.
Long, long ago, before I started graduate school, I used to think that the concept of money was fairly straightforward. There was cash (Federal Reserve notes, as well as coins), and there was money in the bank, and those were money. And OK, there were money market mutual funds, and those were “sort of” money. When I really started to think about it, I realized this framework was inadequate, especially given the concept of liquidity preference that I was trying to use, where the cost of holding liquid money was supposed to be the interest rate. (Money market funds pay interest, and they’re almost just like money, and even some bank accounts pay interest, so apparently you can hold liquid money without giving up the interest, so where’s the cost?)
At the time I had a solution: stop thinking of bank accounts and such as money and instead just think of “outside money,” money created by the central bank. This approach sort of seemed to work. If you wanted to hold “money” in this sense, you had to give up the interest, and a bank’s willingness to pay interest on deposits (no longer considered money) was influenced by the amount of actual money that the bank needed to hold in order to maintain that deposit. And policymakers actually had control over this kind of money, so the concept fit well with the simple assumption that the quantity of money is determined by policy.
But in 2008, the Fed started paying interest on bank reserves. (Some other central banks had already been doing so for a while, but, being a provincial American, I hadn’t really noticed.) To be honest, it didn’t occur to me at the time, but this change totally destroyed my concept of money. If bank reserves pay interest, then they aren’t money, because you don’t have to give up the interest in order to hold them. But surely they are money, because monetary policy consists primarily of manipulating the quantity of bank reserves. Epistemological fail!
So are bank reserves money or not? I don’t know. But here’s something to think about: what is the difference between bank reserves and Treasury securities? They both pay interest. They’re created by different institutions, but so what? They’re both ultimately obligations of the government: the interest paid on reserves comes out of the Fed’s profits which would otherwise go into the Treasury.
You might say that Treasury securities have to be paid back, while bank reserves don’t, but that’s merely a function of the banks’ willingness to hold reserves: if the banks (and their customers) want cash instead, the reserves have to be “paid back” to the banks/customers. And if Treasury security holders want to roll over their securities, then Treasury borrowing doesn’t have to be paid back. So there’s no real difference there. The maturity is different, it’s true: bank reserves have zero maturity, while Treasury securities have maturities ranging from one month to 30 years. But that’s not a fundamental difference: it just means that bank reserves are a special case, not that they’re a different kind of entity.
OK, bank reserves can be used to fulfill reserve requirements, and Treasury securities cannot, but again so what? Banks are subject to a number of regulatory requirements, which depend on various aspects of their asset structure. There’s really nothing special about the reserve requirement. Today capital requirements are closer to being a binding constraint than reserve requirements, so for most banks Treasury securities are just as good as reserves when it comes to fulfilling regulatory requirements. Maybe someday in the future banks will once again have a particular need for Fed-issued zero-maturity assets to fulfill a regulatory requirement, but I don’t see how that makes such assets a fundamentally different type. Show me junk bonds, T-bills, and bank reserves, and it seems to me that, if anything, the bonds are the fundamentally different type of asset.
I submit that bank reserves are essentially just zero-maturity government debt. You can call them “money” if you want, but the application of the term is pretty arbitrary. And if you’re going to call bank reserves money, why not call T-bills money as well? And for that matter, T-notes and T-bonds: those are just long-maturity money.
So back to Ben Bernanke. What is QE2? It’s an exchange of bank reserves for longer-maturity Treasury securities: both forms of government debt; the only substantial difference is the maturity. QE2 is not, in any important sense, “printing money” but merely a restructuring of the government’s debt.
And what was QE1? It was (largely) an exchange of bank reserves for private sector assets, essentially an exchange of government debt for private debt. It’s very important that QE1 involved “printing” substantial quantities of government debt that would not otherwise have existed. That government debt happens to be “money,” though, rather than what we usually think of as government debt. So, rather than go through a whole explanation of how bank reserves are really government debt, the simple and substantively correct way of explaining QE1 is that it constituted “printing money” in exchange for private sector assets.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Apparently it gets worse. I had forgotten what Bernanke said on his earlier 60 Minutes appearance, but Jon Stewart has a clip where, in reference to QE1, Bernanke essentially acknowledges that the Fed is printing money. Naturally, Jon Stewart was amused by this seeming inconsistency, as was I.
But I’ve been thinking about this a bit more, and I no longer think Bernanke’s statements are inconsistent. The problem is that the definition of the word “money” is not as clear cut as it seems. Indeed, one might argue that the whole concept of “money” is no longer useful (at least to economists) in a world where bank reserves pay interest and people pay bills with credit cards and with checks drawn on bond mutual funds.
Long, long ago, before I started graduate school, I used to think that the concept of money was fairly straightforward. There was cash (Federal Reserve notes, as well as coins), and there was money in the bank, and those were money. And OK, there were money market mutual funds, and those were “sort of” money. When I really started to think about it, I realized this framework was inadequate, especially given the concept of liquidity preference that I was trying to use, where the cost of holding liquid money was supposed to be the interest rate. (Money market funds pay interest, and they’re almost just like money, and even some bank accounts pay interest, so apparently you can hold liquid money without giving up the interest, so where’s the cost?)
At the time I had a solution: stop thinking of bank accounts and such as money and instead just think of “outside money,” money created by the central bank. This approach sort of seemed to work. If you wanted to hold “money” in this sense, you had to give up the interest, and a bank’s willingness to pay interest on deposits (no longer considered money) was influenced by the amount of actual money that the bank needed to hold in order to maintain that deposit. And policymakers actually had control over this kind of money, so the concept fit well with the simple assumption that the quantity of money is determined by policy.
But in 2008, the Fed started paying interest on bank reserves. (Some other central banks had already been doing so for a while, but, being a provincial American, I hadn’t really noticed.) To be honest, it didn’t occur to me at the time, but this change totally destroyed my concept of money. If bank reserves pay interest, then they aren’t money, because you don’t have to give up the interest in order to hold them. But surely they are money, because monetary policy consists primarily of manipulating the quantity of bank reserves. Epistemological fail!
So are bank reserves money or not? I don’t know. But here’s something to think about: what is the difference between bank reserves and Treasury securities? They both pay interest. They’re created by different institutions, but so what? They’re both ultimately obligations of the government: the interest paid on reserves comes out of the Fed’s profits which would otherwise go into the Treasury.
You might say that Treasury securities have to be paid back, while bank reserves don’t, but that’s merely a function of the banks’ willingness to hold reserves: if the banks (and their customers) want cash instead, the reserves have to be “paid back” to the banks/customers. And if Treasury security holders want to roll over their securities, then Treasury borrowing doesn’t have to be paid back. So there’s no real difference there. The maturity is different, it’s true: bank reserves have zero maturity, while Treasury securities have maturities ranging from one month to 30 years. But that’s not a fundamental difference: it just means that bank reserves are a special case, not that they’re a different kind of entity.
OK, bank reserves can be used to fulfill reserve requirements, and Treasury securities cannot, but again so what? Banks are subject to a number of regulatory requirements, which depend on various aspects of their asset structure. There’s really nothing special about the reserve requirement. Today capital requirements are closer to being a binding constraint than reserve requirements, so for most banks Treasury securities are just as good as reserves when it comes to fulfilling regulatory requirements. Maybe someday in the future banks will once again have a particular need for Fed-issued zero-maturity assets to fulfill a regulatory requirement, but I don’t see how that makes such assets a fundamentally different type. Show me junk bonds, T-bills, and bank reserves, and it seems to me that, if anything, the bonds are the fundamentally different type of asset.
I submit that bank reserves are essentially just zero-maturity government debt. You can call them “money” if you want, but the application of the term is pretty arbitrary. And if you’re going to call bank reserves money, why not call T-bills money as well? And for that matter, T-notes and T-bonds: those are just long-maturity money.
So back to Ben Bernanke. What is QE2? It’s an exchange of bank reserves for longer-maturity Treasury securities: both forms of government debt; the only substantial difference is the maturity. QE2 is not, in any important sense, “printing money” but merely a restructuring of the government’s debt.
And what was QE1? It was (largely) an exchange of bank reserves for private sector assets, essentially an exchange of government debt for private debt. It’s very important that QE1 involved “printing” substantial quantities of government debt that would not otherwise have existed. That government debt happens to be “money,” though, rather than what we usually think of as government debt. So, rather than go through a whole explanation of how bank reserves are really government debt, the simple and substantively correct way of explaining QE1 is that it constituted “printing money” in exchange for private sector assets.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Wednesday, December 1, 2010
Profits, Interest, and Inflation
US corporate profits set a record in the third quarter. As Matthew Yglesias points out, that’s not as impressive as it sounds: profits are measured in nominal dollars, and they normally rise during times of economic expansion, so there’s nothing at all unusual about seeing them make new highs. After taking a closer look at the data, Justin Fox is even less impressed: as a fraction of the national income, domestic nonfinancial corporate profits are nowhere near a new high; the big numbers are coming from financial corporations (which are bouncing back strongly from the losses they had a few years ago) and from foreign earnings of US corporations. Kevin Drum is not quite so unimpressed, though: he looks at the data and sees domestic nonfinancial corporate profits recovering nicely in any case.
Count me with the unimpressed, but for different reasons. It’s really not appropriate, in my view, to look at profits in isolation from the rest of the national income. Profits are a form of capital income. Capital income can be roughly divided into profits and interest, depending on how the capital was financed. If we’re interested in the general profitability of business activities, rather than the narrow question of whether current stockholders are getting rich, we should be looking at total capital income. You might have noticed that interest rates are way down from where they were a few years ago, which probably means that there has been a substantial decline in the interest portion of capital income. So total capital income from domestic nonfinancial operations is almost certainly lower than it was before the recession.
It’s true that, even if capital returns are not very high, they can still be conducive to a recovery if the required return on capital has fallen. Indeed, the lowness of interest rates partly reflects attempts by the Fed to reduce the required return on capital. To that extent, we can be impressed by rising profits.
But the lowness of interest rates also reflects a decline in the expected inflation rate. This factor is not reflected in the raw profit statistics, and it does make them less impressive. In nominal terms, before the recession, corporations were expecting to see rising product prices, so, for any given nominal rate of profit, they were more likely to invest in new projects and more likely to hire. Today, product prices are not expected to rise very much, so today’s nominal profit has to “stand on its own,” as it were, as an indicator of how profitable any new project will be. So, by comparison, things are not going as well today as they might appear. As Justin Fox says, members of the domestic business community “have every right to be cranky.”
I do, however, concur with Matthew Yglesias’ conclusion that the trends are in the right direction. An increasing number of indicators suggest that things are improving, but I don’t expect the improvement to be rapid.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Count me with the unimpressed, but for different reasons. It’s really not appropriate, in my view, to look at profits in isolation from the rest of the national income. Profits are a form of capital income. Capital income can be roughly divided into profits and interest, depending on how the capital was financed. If we’re interested in the general profitability of business activities, rather than the narrow question of whether current stockholders are getting rich, we should be looking at total capital income. You might have noticed that interest rates are way down from where they were a few years ago, which probably means that there has been a substantial decline in the interest portion of capital income. So total capital income from domestic nonfinancial operations is almost certainly lower than it was before the recession.
It’s true that, even if capital returns are not very high, they can still be conducive to a recovery if the required return on capital has fallen. Indeed, the lowness of interest rates partly reflects attempts by the Fed to reduce the required return on capital. To that extent, we can be impressed by rising profits.
But the lowness of interest rates also reflects a decline in the expected inflation rate. This factor is not reflected in the raw profit statistics, and it does make them less impressive. In nominal terms, before the recession, corporations were expecting to see rising product prices, so, for any given nominal rate of profit, they were more likely to invest in new projects and more likely to hire. Today, product prices are not expected to rise very much, so today’s nominal profit has to “stand on its own,” as it were, as an indicator of how profitable any new project will be. So, by comparison, things are not going as well today as they might appear. As Justin Fox says, members of the domestic business community “have every right to be cranky.”
I do, however, concur with Matthew Yglesias’ conclusion that the trends are in the right direction. An increasing number of indicators suggest that things are improving, but I don’t expect the improvement to be rapid.
DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.
Subscribe to:
Posts (Atom)
