What makes a bank a central bank? Asymmetric redeemability and the will to act as one.

Both central banks and commercial banks issue liabilities that function as media of exchange. Why do we say that it is central banks, rather than commercial banks, that determine monetary policy; setting interest rates in the short run, and inflation in the long run? What makes a bank a central bank?

It is true that central banks normally have a legal monopoly on the right to issue paper notes, but so what? We don't have to use paper money; we could use cheques or debit cards instead. If paper money disappeared, would central banks disappear, or lose their special power?

It is true that in some countries commercial banks are required to keep a certain ratio of central bank liabilities in reserve against their deposits, or choose to keep a certain ratio even if they are not legally required to do so. But what happens if they aren't legally required to do so, and don't choose to do so?

Here's the answer. Commercial banks promise to redeem their monetary liabilities for the monetary liabilities of the central bank at a fixed (or at least pre-determined) rate. Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks. This asymmetry of redeemability is what gives central banks their power over commercial banks. But a bank with that power is nevertheless not a true central bank unless it acts like one, and uses that power.

To see the power that flows from asymmetric redeemability, suppose bank A and bank B both issue paper money, but B promises to redeem its notes for A's notes at par, while A makes no such promise. Suppose interest rates are initially at 5%, and A decides it wants to lower interest rates to 4%, while B decides it wants to keep interest rates at 5%. What happens? The interest rate differential creates infinite arbitrage opportunities. Borrow A's notes from A at 4%, convert them into B's notes at par, and lend to B at 5%.

Bank B would end up accepting an infinite quantity of A's notes, which it could only lend out at 4%, while paying 5% on its deposits. It would make infinite losses. To avoid infinite losses, bank B would be forced to lower its rate to 4% too, or else suspend redeemability at par.

Now start at the beginning, with interest rates at 5%, and suppose A decides to raise the interest rate to 6%, while B tries to keep it at 5%. What happens? The arbitrage opportunity now works in the opposite direction. Borrow B's notes from B at 5%, convert them into A's notes, and then lend them to A at 6%.

Bank B would face an infinite demand to redeem it's notes, and it could only satisfy that demand by borrowing notes from A at 6%, while earning 5% on its loans. To avoid infinite losses, bank B would be forced to raise its rate to 6% too, or else suspend redeemability at par.

It's the asymmetric redeemability that gives bank A the power to set interest rates, and forces B to follow A. It's what gives A the power to act as a central bank, while the pursuit of profit (or the avoidance of infinite losses) makes B a commercial bank in A's orbit.

It makes no difference if the paper notes are ink marks on a ledger, or demand deposits recorded on a computer.

It also makes no difference if bank A is in one country, bank B is in another country, and they have different media of account, as long as B promises to redeem its notes for A's notes at some fixed rate, and A makes no such promise. In other words, a central bank that pegs its currency to another country's currency, with free convertibility, no longer has the power to set monetary policy, and isn't really a central bank (though it will look like a central bank to the commercial banks in B's country).

What about under the Gold Standard, where B promises to convert its notes into A's notes, and A promises to convert its notes into gold?

A central bank under the gold standard is like a central bank that unilaterally pegs its currency to the currency of another country; it isn't really a central bank at all (though it will look like one from the perspective of its commercial banks). And it's not a central bank in the modern sense, because it lacks the power to determine inflation rates in the long run. I am very tempted to say that the true central bankers under a gold standard are the gold miners. But gold miners might have the power to act as a central bank, but generally choose to maximise profits instead. They have the power, but lack the will to act like a central bank.

But a large gold mine, willing to lend or borrow gold at an interest rate of its choosing, could act as a central bank, if it had the will to do so.

Suppose that under the gold standard, two large firms controlled gold mining. All banks promise to redeem their paper money for gold at a fixed rate, but the gold miners make no such promise. But since gold from the two mines is identical, gold from one mine is redeemable into gold from the other mine at par. Here we have bilateral, or symmetric redeemability. This is exactly the same as France and Germany immediately before the introduction of the Euro, when both countries bilaterally agreed to the same fixed exchange rate between their currencies. What happens if one gold mine (France) sets a lower interest rate then the other gold mine (Germany)? Again we have infinite arbitrage opportunities. But now both mines (both France and Germany) will be required to redeem the other's gold (currency), and both will make losses. Whichever one has the strongest will, and the deepest pockets, and so cries "uncle" last, will become the central bank.

$1k? Nah!

Update: I'm not claiming any particular originality for these ideas. I got them from three sources (but don't want to claim that I have represented those sources accurately): a working paper from some economist in New Zealand (I think) whose name I have forgotten; conversations with Pierre Duguay, Deputy Governor Bank of Canada; and Willem Buiter's blog.

Comments

[Mike Sproul]

Nick:

If A lends at 1% under the market rate, its assets will soon be exhausted and its notes will be worthless. If A tries to borrow at 1% below the market rate, nobody will lend to it. If A lends at 1% above the market rate, nobody will borrow from it. If A offers to borrow at 1% above the market rate, its assets will again become exhausted and its notes will be worthless.

[Nick Rowe]

Mike: A doesn't need any assets at all. It just prints notes. (Unless the paper and ink costs money, which I'm ignoring).

Of course A's notes will become worthless, in the long run, if it sets an interest rate below the natural rate. That's what "choosing the rate of inflation" means. That's what I was trying to prove. But if B's notes are redeemable at par into A's notes, B's notes will be worthless too.

[edeast]

What is the limit to A's infinite ability? Can A be smaller than B?

[Too Much Fed]

"It is true that central banks normally have a legal monopoly on the right to issue paper notes, but so what? We don't have to use paper money; we could use cheques or debit cards instead."

If by paper notes and paper money you mean currency, I believe there is a big difference. I believe that cheques or debit cards are actually a form of currency denominated debt that could be defaulted on, while currency does not suffer from defaults.

[edeast]

Sorry didn't see Mike's comment. You can delete mine.

Can B break off it's agreement to convert at par though?

[Too Much Fed]

Nick said: "Of course A's notes will become worthless, in the long run, if it sets an interest rate below the natural rate. That's what "choosing the rate of inflation" means."

What if there was enough currency for everyone so that no borrowed in currency denominated debt?

[Nick Rowe]

edeast: central banks are typically smaller than commercial banks. Because of asymmetric convertibility, the tail can wag the dog. The limit on A? Still got paper? Still got ink? No limit. As long as people are willing to use a medium of exchange denominated in A's unit of account. Zimbabwe finally hit the limit. There's a lot of ruin in the currency of a nation, even not so great a nation.

Too much Fed: "default" means failure to fulfill your promise to redeem. A cannot default, because it makes no promise. B can default, because it makes a promise to redeem.

[Nick Rowe]

And currency can default, if the currency promises convertibility into something else. Fed notes (and BoC notes) make no such promise, so cannot default. That's because the Fed and BoC are central banks.

[Nick Rowe]

edeast: "Can B break off its agreement to convert at par though?" If B does this, and some people still accept B's currency and use it as a medium of exchange, then B becomes a central bank in its own right, issuing it's own currency that fluctuates relative to A's.

[Too Much Fed]

My post said: "It is true that central banks normally have a legal monopoly on the right to issue paper notes, but so what? We don't have to use paper money; we could use cheques or debit cards instead."

If by paper notes and paper money you mean currency, I believe there is a big difference. I believe that cheques or debit cards are actually a form of currency denominated debt that could be defaulted on, while currency does not suffer from defaults."

Nick's post said: "Too much Fed: "default" means failure to fulfill your promise to redeem. A cannot default, because it makes no promise. B can default, because it makes a promise to redeem."

So, that means cheques and debit cards are a "B" (defaultable), right?

[edeast]

So B is everyone willing to use the currency, is there papers on what the Zimbabwe limit was? Because I'm thinking that the currency failure would start out with people further from the initial lender. There must be some value gap between the different actors, and the value would decrease the further from the money maker.

[Too Much Fed]

Nick said: "Fed notes (and BoC notes) make no such promise, so cannot default. That's because the Fed and BoC are central banks."

So, what is the price of a central bank's currency that makes no promise to redeem?

[Nick Rowe]

What the hell time zone are you guys in??

It's late here; I'm off to bed!

[Too Much Fed]

edeast, could the limit be when so much currency is printed and devalued that no one wants to lend?

[edeast]

This commenting is crazy, I should refresh before I post.
Sorry I can check for papers tomorrow, I just wondered if you new any offhand.

[edeast]

Too Much Fed. Ya but empirically what is the tipping point? Say you are B2 and you've just lent to B3, you can always get another loan from B1. There has got to be a spread in interest rates or other value between actors. So where in the chain does the system stop. Probably at the point where the transient value of the inflationary money is less then the utility of money over barter(If there is no substitute currency). But really I have no idea.

[edeast]

But then again, you could consider barter as the market for discrete currency. So discrete currency will beat out the inflationary semi-continuous money issued by A, around the edges of the system. And I don't think it necessarily has to be hyper inflationary, just from experience growing up rural.

[Jon]

I find it curious that you omit any mention of required clearing balances---without which there would be no demand for reserve balances (in Canada, as there are no reserve requirements) and thus no linkage between the BoC policy-rate and rates in the loan-market.

[edeast]

Can I say that all actors are the same? Is a collection of personal I.O.U.s the same as a commercial bank's liabilities? Cause if not this comment won't make sense.

What are the properties of A's system's boundaries? Say two Bs ( B being members who accept the assymetric agreement) at the edge of A's system are trying to transact. Either, amount problem, or value problem.

Amount problem.
Bq wants to buy something of value $a100 from Bw, but only has $a50. Must substitute, fortunately a coincidence of interests Bq and Bw are also members of C, ( c being stocks, dogs, sexual favors, or other currency) and the substitution is made. If they are not members of any other value system, transaction doesn't take place.
The C can be just that interaction long.

Value problem.(Inflation)
Bq wants to buy something from Bw, normally Bw would oblige, however they cant seem to settle on a price. The value is $a is decreasing faster than Bw could extract value from.(?) They substitute. Bw is no longer a member of A.

[original anon]

I think you're missing entirely it with this "asymmetric redeemability" thing. This is just a fancy and not terribly accurate way of portraying an agency relationship, whereby the commercial banks act as distribution agents for the central bank's notes.

The central bank always forces the commercial banks to keep reserves with it. ALWAYS. The question is the level. The fact that the required level is zero in Canada is irrelevant. Banks are not allowed to keep negative balances for long. They must keep zero balances. That's much different than saying they're not required to keep balances. So the forced reserve balance is what makes a central bank central. This is common sense, since the central bank is the commercial banks' banker. That's what central bank means. And that’s what makes a central bank central.

The currency distribution function is just a sideshow. The central bank could just as easily set up its own branch system and require retail customers to get their notes there. Customers would pay for the notes with cheques written on the commercial banks, cheques which the CB would clear against the reserves of the commercial banks, since it is part of that clearing system.

Much more important than the distribution function is the fact that currency is a CB liability. And to understand why that is the case, you have to understand post Keynesian economics and Chartalism, and the forced relationship between taxation and CB fiat money issuance. I’m not going to get into that here.

Sorry, you're way off here.

[original anon]

Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks.

This asymmetry perception is not real; it is only due to the existing note distribution agency relationship. A central bank with a branch system would redeem its own monetary liability (central bank notes) by issuing another (cheque on the central bank). When the customer takes that cheque to a commercial bank, it converts the central bank liability (cheque) to a monetary liability of the commercial bank, because the commercial bank gives its own deposit in exchange for cheque. Therefore, the central bank has effectively redeemed its own liability for a commercial bank liability. (The commercial bank then exchanges the cheque with the CB for a reserve credit.)

Don't confuse stocks with flows in the agency relationship. The flow relationship is what characterizes the central bank role. Stocks of notes held by the banks are just inventories.

[Mike Sproul]

Nick:

"A doesn't need any assets at all. It just prints notes."

1) Name a bank, central or otherwise, that has ever issued notes (of positive value) without holding assets against them.
2) If the public, for some reason, desires 20% fewer notes, what will your zero-asset central bank use to buy back those notes?
3) Since A gets a free lunch in your zero-asset world, what prevents other banks from issuing rival notes, getting a piece of that free lunch, reducing the demand for A's notes, and ultimately driving their value to zero?
4) If A's notes have no backing, what happens when private banks issue derivative moneys, each of which is convertible into A's notes (or something of equivalent value). Those banks can even operate offshore, where there is no reserve requirement. As the offshore bank issues 1 unit of derivative money, it puts itself in a short position in A's notes, at the same time that it reduces the demand for (and value of) A's notes. The offshore bank profits as A's notes fall to zero value.

[JP Koning]

Central bank monopolies extend far beyond the issuance of paper notes. They can force banks to be members and abide by their rules. For instance, rules might include the requirement for a certain reserve balance, or the necessity of holding deposits for clearing/settlement purposes.

It is their ability to count on compulsion and threats of penalty that makes them "central". Remove the government granted monopoly and you'd have a few private clearinghouses taking over the role once played by the central bank, and probably doing a much better job of things.

[original anon]

Good comment by JP Koning.

[Adam P]

All good comments but beside the point. What makes the BoC paper special is that it is recognized by the government as government debt and as legal tender.

Commercial bank notes have a similar relationship to BoC notes as an ADR on BHP Billiton has to an actual BHP share. The ADR may pay the same dividend but that dividend doesn't come from BHP (it comes from the ADR issuer) and BHP doesn't recognize the ADR as an ownership share and doesn't give the ADR holder any votes at the AGM. An intermediary is free to issue as many ADRs on BHP stock as they can sell but need to have enough money to pay the dividends (which explains why they usually fully hedge with the underlying stock). If the intermediary issues to many ADRs and can't pay the dividend then the ADR value falls relative to the value of a BHP share. You don't observe that very often because they are usually fully hedged but the principle remains.

By the same token you don't often see the difference between commercial bank issued money and BoC money but sometimes you do (when a bank gets run).

[Adam P]

Actually I take back the "beside the point" remark. JP Koning's comment is also right on the money, so to speak.

[www.facebook.com/profile.php?id=611985302]

Koning's point that Central Banks have power beyond money (there's that power thing again) is a good one, but anyone who is willing to claim that it's likely that unregulated banks will do anything better than a government controlled bank has not been living on this planet for the past year.

Or perhaps the the question is: Better for who? Evidence suggests the answer is: Not me.

[Nick Rowe]

Lots of good comments.

Too much Fed: "So, that means cheques and debit cards are a "B" (defaultable), right?" In practice, yes. We can imagine central banks issuing chequeing accounts and debit cards, but I don't think they do (at least not for ordinary people or firms).

"So, what is the price of a central bank's currency that makes no promise to redeem?" Price in terms of goods? For the US and Canada, $1 buys you about 3/4 of a cheap cup of coffee, so that's the price of $1.

Jon: "I find it curious that you omit any mention of required clearing balances---without which there would be no demand for reserve balances (in Canada, as there are no reserve requirements) and thus no linkage between the BoC policy-rate and rates in the loan-market."

The "standard" approach to explaining how central banks control the money supply is via the formula M = [(1+c)/(r+c)]B (if I've remembered it right), where c is the currency ratio, r the reserve ratio, M the money supply, and B the supply of central bank money.

Yes, if c or r are non-zero, and pinned down by something, you can use this approach to explain why a bank is a central bank. It's a sufficient condition, if you like. But I'm arguing it's not a necessary condition for a bank to be a central bank, and that central banks could still control monetary policy even in the limit where c and r approached zero, or were of indeterminate value. I'm arguing that asymmetric redeemability is what ultimately gives central banks control over monetary policy, even if reserves and currency vanished.

edeast: "Can I say that all actors are the same? Is a collection of personal I.O.U.s the same as a commercial bank's liabilities? Cause if not this comment won't make sense." If people had sufficient trust in your IOUs that they circulated as a medium of exchange, then they are money, and you are a (commercial) bank. But in practice this very rarely happens.

original anon: you and I have accounts at the commercial banks, and the commercial banks have accounts at the central bank. The central bank is the bankers' bank. That is part of what being a central bank has meant, historically. But will it always be the case? And more importantly, is it necessary that the central bank be the bankers' bank in order for central banks to be able to control monetary policy (interest rates and inflation)? If my argument is correct, it is not necessary. Asymmetric redeemability (plus will) is sufficient.

original anon @8.58. You lost me on this comment. "Therefore, the central bank has effectively redeemed its own liability for a commercial bank liability. (The commercial bank then exchanges the cheque with the CB for a reserve credit.)" I would disagree. It is the commercial bank that redeemed the CB liability for a commercial bank liability. The CB had no obligation to do so.

Mike: Good questions, and I would love to get into an argument about the backing theory of money, and the possibility of currency competition. But that would deserve a thread (or two) of its own. I want to stick to the narrower question here.

JP: Central banks may indeed have other legal controls over commercial banks. But are these legal controls necessary for central banks' power to control monetary policy? I am arguing that they aren't. Asymmetric redeemability (plus will) is sufficient.

Adam P: " What makes the BoC paper special is that it is recognized by the government as government debt and as legal tender." I disagree on this, but again it would take me too off-topic. The questions of why the central bank notes have value, are used as media of exchange, and why the commercial banks choose to peg to the CB notes, are all interesting questions, but I ignore them here. I just assume they do.

But I really like your ADR analogy, I think. I think it supports my argument. Even if the ADR market were much bigger than the true BHP market. But the BHP tail will still wag the ADR dog.

[Adam P]

But Nick, we've already agreed that central bank notes are not the only medium of exchange. Commercial bank debt (checks, credit cards etc.) are also used as the medium of exchange.

The question is, why does all inside money have to backed by central bank notes or reserves? And the reason is that only central bank debt is legal tender.

The fact that inside money is generally fractionally backed is important but immaterial in trying get at what defines a central bank. (I'd imagine that dividends make it unprofitable to issue ADRs with fractional backing.)

[original anon]

All you’ve demonstrated is the existence of an agency function whereby commercial banks hold central bank liabilities in inventory for distribution. They act as distributors and redemption agents. There are better ways of demonstrating the centrality of a central bank than illustrating its principal role in a principal agent relationship. You haven’t demonstrated a unique asymmetry – it’s one that exists in any principal agent relationship. It really shows nothing about what’s central to central banking. It only shows what’s central to a principal agent relationship.

[Andrew F]

I don't think it's dividends on ADRs that make fractional backing unattractive, per se. It's the risk of capital appreciation. To hedge that risk they would either need to buy massive quantities of call options (expensive), or fully back the ADR.

It shouldn't be hard for a bank to beat the return of a dividend on a stock. Many large companies have dividends yielding lower than 2.5%.

[Mike Sproul]

Nick:
"I would love to get into an argument about the backing theory of money, and the possibility of currency competition. But that would deserve a thread (or two) of its own."

Good idea Nick. Whenever you're ready, I'll be lying in wait.

[Adam P]

Nick, I think the problem everyone is having is here:

"Here's the answer. Commercial banks promise to redeem their monetary liabilities for the monetary liabilities of the central bank at a fixed (or at least pre-determined) rate. Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks."

The statement is true but only begs the question of why do commercial banks promise to redeem their liabilities for central bank liabilities? This question you haven't answered. JP's comment and mine are trying to answer this question.

What you say subsequently, drawing out the implications of the asymetric redeemability I think everyone is agreeing with.

[edeast]

Adamp; In your description how does the intermediary make money? Sounds like a ponzi scheme. The ADR intermediate has to collect dividends from the BHP, because the ADR represents, a receipt for real stock.

I have questions about adding the government to the model, ala chartalism du anon originale, and the legal tender laws of adamP.

I think it deals with this assumption... "B promises to redeem its notes for A's notes at par."
Why would an agent agree to that?

But if you relax that assumption, then the definition changes;
"Can B break off its agreement to convert at par though?" If B does this, and some people still accept B's currency and use it as a medium of exchange, then B becomes a central bank in its own right, issuing it's own currency that fluctuates relative to A's
I think that is a tautology.

The last factor, is people accepting the currency. Chartalism suggests that there is an agent G, who will only accept A's currency. So I'm pretty sure that the people who interact with G and the people who use A's currency are close to the same set.

So does B agree to the 1:1 arrangement for access to these people? What other reasons are there?

[Nick Rowe]

Adam P @4.41 : Thanks for that comment, because it clears things up for me. I was really wondering why so many commenters seemed to be having trouble with what I posted.

I just assumed that B promised to redeem its notes (monetary liabilities) at some fixed rate (e.g. par) with A's notes. I didn't try to explain why B would do that. That's because my motivation was to explain to someone like Gary Marshall why the Bank of Canada (and not the Bank of Montreal, etc.) was in charge of monetary policy, and had power that BMO, TD etc. didn't have, even though it was much smaller, and that you couldn't see that power just by looking at their balance sheets.

So if you argued that the underlying reason for asymmetric redeemability was because A's notes are legal tender, I would (mostly) disagree with you, but even if I did fully agree with you, I wouldn't change what I wrote in the post. It's a separate, albeit interesting, question.

To my mind, the main reason why commercial banks promise to redeem their money for central bank money is custom. Path-dependent, QWERTY equilibrium, in the choice of medium of account. It's like languages; we speak the same language as people around us have been speaking. So if the people around us use the dollar as medium of account, we want to use money that is denominated in dollars, and is worth what it says it is worth in dollars. The Bank of Montreal could make up a new medium of account, and issue monetary liabilities in that new medium of account, but nobody would use them, because nobody else uses them.

Legal tender laws reinforce this QWERTY equilibrium by defining "the Canadian dollar" as "one of those bits of paper issued by the Bank of Canada. Like a legal dictionary.

On reading edeast's comment, I think it's similar, except when I say that people want to use money denominated in dollars, edeast would add that government is an important player, along with regular people, and what the government wants to use as money matters.

edeast: "I think that is a tautology." Yes, I think it sort of is.

[Nick Rowe]

Here's another way to think about the relation between central and commercial banks: if the Bank of Canada were to peg the Loonie to the US dollar, the relationship between the Fed and the BoC would be the same as the current relationship between the BoC and BMO.

[Adam P]

Well, I would have said that custom and things like liquidity drive what the government declares as legal tender but are not the defining property of anything. After all, when a country like Ecuador(?) dollarizes, the choice of USD as currency is driven by it's international liquidity but it actually becomes Ecuadorian money by legal decree.

A better example is the gold standard, the choice of gold as money was entirely driven by custom but by the time we got to the 1900's gold was legal tender even though the medium of exchange was not gold but fractionally backed notes.

One piece of evidence that legal status trumps custom is that abandoning the gold standard did not leave us with a worthless currency. The reluctance to abandon the 'golden fetters' during the depression was largely a worry that the custom was paramount but it doesn't seem that way ex-post.

[original anon]

“Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks."

Before alleging this difference, understand that the customers of the central bank are not the same as the customers of the commercial banks.

The customers of the central bank are the commercial banks themselves. The reason for this is two-fold.

First, it is due to the fact that the commercial banks are required to maintain reserves (even if the level is zero) at the central bank. This requirement is actually what makes central banks central.

Second, it is because the commercial banks have an agency function with respect to central bank note distribution and redemption. This intervenes between what otherwise might be a direct relationship between the central bank and commercial bank customers in the case of central bank notes.

When one takes into account this customer base difference, your statement quoted above is seen to be wrong. One must ensure that it pertains to a situation in which it is the commercial bank that is requesting redemption proceeds in the form of its own liability. Your statement does not pertain to such situation. In general, anybody requesting credit in terms of his own liability is requesting cancellation of that liability. This actually happens when a CB extinguishes commercial bank borrowing from the CB in return for the commercial bank presenting it with a CB liability in the form of bank reserves. So your statement is false in the context of the actual institutional arrangements that pertain between a CB and the rest of the system. And so it obviously does not capture what makes a central bank central.

To repeat from earlier, it is the fact that a central bank imposes reserve requirements on commercial banks (even if the required level is zero) that makes a central bank central.

[Nick Rowe]

Ar, you two are tough critics! (But valued commenters despite/because of that!).

Adam: I can see legal tender laws as being very important for pre-existing debts. They define what legally counts as paying the debt. But for current exchanges, sellers can presumably choose medium in which they set prices and accept for payment "sorry, but I won't accept cash for my house, but I will accept payment in bottles of whisky".

Abandoning gold convertibility did not make paper money worthless, because people had already grown accustomed to using (convertible) paper money. And had already experience temporary suspensions of convertibility. That would be my explanation. Let's try it the other way: suppose a government introduced a new paper money, without making it convertible into anything that had previously been used as money, but did declare it to be legal tender. So we have legal tender without custom. Could that work? When Cambodia introduced a new currency after the total economic collapse following the Kymer Rouge, they made it convertible into rice, I think. Presumably they didn't think "legal tender" would be enough.

original anon: sorry, but you lost me in the middle of your penultimate paragraph: "In general, anybody requesting credit in terms of his own liability is requesting cancellation of that liability. This actually happens when a CB extinguishes commercial bank borrowing from the CB in return for the commercial bank presenting it with a CB liability in the form of bank reserves." I have made several attempts to wrap my mind around those sentences (and how it shows symmetry of redeemability?) but failed each time. May be my fault.

Let me try to re-frame: I am looking for a "minimal" set of sufficient conditions for a bank to be able to control monetary policy. I am not saying that other sets of conditions (reserve requirements etc.) may not also be sufficient. I believe that condition is one-way obligation to redeem.

Are you saying that asymmetric redeemability is not a sufficient condition? Or are you saying that we do not in fact have asymmetric redeemability in Canada today (for example), so that the power of the Bank of Canada must instead rest on something else (that reserves may not fall below zero, for example)?

And I thought that in Canada commercial banks *could* have negative reserves at the Bank of Canada? Or am I muddled on the institutional rules again?

[Nick Rowe]

Adam: to put it another way, do legal tender laws really have coercive bite, or are they just a sunspot that helps people coordinate on a new monetary equilibrium, when a government introduces a new currency? Custom is the best sunspot, but announcements can work as well, I suppose.

[RebelEconomist]

I think that this discussion has become tangled because it is necessary to define what you mean by a central bank. Nick seems to be thinking in terms of controlling interest rates, whereas original anon (JKH?) emphasises the hub role in inter-bank payments settlement, and Mike Sproul is considering the nature of base money. A central bank can be some, all or none of these, and I dare say has been in history and still is in different countries.

Perhaps the most basic function of a central bank is to provide the medium of exchange (which has to be a durable store of value to some extent and is also likely to become the unit of account by convention). To do that, it can issue currency against anything of value (traditionally gold), and it need not be concerned with influencing interest rates at all.

Because currency is a substitute for short term debt, a currency issuer has some influence over short term interest rates, but this is enhanced if, instead of gold, the currency issuer trades short term debt for currency (although there were other, historical reasons, why central banks came to hold debt). Debt assets backing the currency are automatically created when the currency issuer lends currency or, equivalently, makes a commitment to supply currency on demand (ie credits a reserve account).

Because issuing zero-return currency tends to be profitable, there may potentially be more than one currency issuer, but the government may legislate in favour of one, traditionally to extract monopoly profit, but also for efficiency. Legal tender laws support this monopoly, especially when they apply to taxes, but they may even be essential if the government obliges the currency issuer to hold more government debt than might be otherwise acceptable to potential currency holders.

Though it is clearly a central role, there is no reason why the currency issuer needs to be the settler of inter-bank payments, but the banks involved typically need to hold a buffer stock of the medium of exchange to participate, which generates some demand for currency or reserves, and hence enhances the currency issuer's influence over interest rates.

So, what function or mix of functions defines the central bank for the purposes of this discussion?

[original anon]

"In general, anybody requesting credit in terms of his own liability is requesting cancellation of that liability. This actually happens when a CB extinguishes commercial bank borrowing from the CB in return for the commercial bank presenting it with a CB liability in the form of bank reserves."

Commercial bank borrows from the central bank because it is short reserves.

That increases a commercial bank liability (loan) and increases a central bank liability (reserves).

Commercial bank later recovers and recoups excess reserves sufficient to repay its loan from the central bank.

Commercial bank repays the loan with a central bank liability (reserves).

Central bank extinguishes the commercial bank liability (loan).

So as per my second sentence, the CB has extinguished a commercial bank liability by accepting a central bank liability in payment.

Returning to your original quote:

“Central banks do not promise to redeem their monetary liabilities for the monetary liabilities of the commercial banks."

The central bank in the case of loan repayment has redeemed its monetary liability because it extinguishes the reserve liability used as repayment for the loan. And it has issued a credit to the commercial bank in exchange. The form of credit it has issued is the cancellation of the monetary liability of the commercial bank (the loan). You can think of this directly as an accounting credit in the form of the commercial bank monetary liability, which when combined with the pre-existing monetary liability debit position, results in a net zero liability position. That is the actual accounting description. The accounting description also equates to a more conceptual interpretation whereby the central bank in the exchange is providing asset value to the commercial bank (in return for its payment of reserves) equivalent to the value of the monetary liability as an asset, which when combined with the pre-existing liability, nets the position to zero as an asset-liability offset.

This is the way you have to think of your sentence above when the central bank’s customer is the commercial bank rather than the commercial bank’s customer. It’s the way you have to think of the “monetary liability of the commercial bank” that is relevant to that interface. The monetary liability of the commercial bank to its own customer is completely irrelevant when talking about the relationship between the central bank and the commercial bank. The nature of that relationship again is determined by reserves and by a currency agency function.

Obviously I don’t think asymmetric redeemability is a sufficient condition because I’m alleging and demonstrating that asymmetric redeemability is a false characterization. I’m proving symmetry exists because of the nature of the direct relationship between the central bank and the commercial banks. If you’re going to do symmetry comparisons about redeeming liabilities, you need to know which liabilities are being redeemed in each of the two cases that frame the symmetry comparison.

Whether or not Canadian banks can have negative reserves is irrelevant to the issue of discussing redeemability. But since you ask – no they can’t have negative reserves, to the degree that a negative end of day position (or any required accounting period position) forces them to cover that shortfall by borrowing from the central bank. The borrowing brings reserves back to zero.

Whether or not Canadian banks can have negative reserves is very relevant to the issue of monetary control. That’s what it’s all about. When the central bank wants to increase rates, it is essentially that it has the power to force the commercial banks to borrow in the event of a negative reserve position. It’s the demand for that money and the power to enforce a penalty rate that makes the central bank central.

BTW, redeemability of any sort is not a sufficient condition for monetary control. As I’ve said ad nauseum, it’s simply an agency relationship in the case of central bank note distribution by commercial banks.

The necessary mechanism is banks reserves, with accompanying rules for maintaining required balance levels (even if zero).

One might include actual note issuance as a necessary condition as well, particularly if one is a Chartalist. But that’s quite a separate issue than the distribution function for the notes and the way in which notes are distributed and redeemed. As noted, the central bank has the option if it wants of issuing currency directly to commercial bank customers. It doesn’t do this for reasons of obvious institutional economies of scale. It’s more efficient to use the commercial banks as agents.

[original anon]

"I think that this discussion has become tangled because it is necessary to define what you mean by a central bank."

But that's the whole question of the discussion. What makes a central bank central?

[RebelEconomist]

Incidentally, edeast asked about papers covering the "Zimbabwe limit" to currency issuance. The classic academic paper (not necessarily the most accessible or informative) is Cagan's "Monetary dynamics of hyperinflation".

[original anon]

"it need not be concerned with influencing interest rates at all"

I'd be interested in an example of one that isn't, present day or historic.

[David]

Wow. This is an interesting thread.

But I think I agree with most of the commenters. Asymmetric redeemability may be how the central bank executes its power, but in order to have asymmetric redeemability there has to be some other condition that prevents the other banks from unlinking their currency to the central bank.

In Nick's original example, bank B could simply unlink its currency from bank A, and then they'd both presumably be quasi-central banks (like the two gold miners/France-Germany example). In other words, why the heck would bank B want to link its currency to bank A's if it had a choice?

[original anon]

Thinking about it, I can see the remote possibility of a central bank without currency issuance (which wouldn’t preclude other forms of debt issuance by the government), but I can’t see the possibility of a central bank without reserve accounts held by the commercial banks. That’s what I’ve been arguing. If notes are issued, distribution and redemption arrangements are way down the list in importance.

[JP Koning]

I'd agree about everything you say about asymmetric redeemability (AdamP captures my views at 4:41am). But I'm more interested in the general asymmetric relationship between a central bank and private banks, a relationship which can take the form you talk about. But it can also be, say, an asymmetric reserve requirement, in which private banks must hold a certain % of government currency as reserves, but the government bank need not hold private currency as reserves.

But the point is: how does a central bank get to the point of having any sort of asymmetrical power to begin with? In my eyes that's what determines the "central" in central banking.

I think your point about custom is incorrect. It is the government's coercive power (at the point of the gun, so to say) exercised through legislation, not evolving custom, that allows it to arrive at its "sweet spot". I just consulted my Breckenridge - The Canadian Banking System 1819-1891 for some examples.

In 1870, Canadian private banks were for the first time required by law to hold one third of their reserves as government issued Dominion notes (raised in 1880 to one half). Prior to that they'd held specie, other domestic notes, foreign notes, whatever they'd wanted. Then and there you see the beginning of the asymmetrical relationship between private banks and government issuers.

In 1880, Canadian banks were required to redeem their notes in Dominion notes at the option of the payer. Prior to that, redemption need only be in gold. Again we see the growth of asymmetric power, since Dominion notes had no requirement to be redeemed in private notes. Eventually the final steps in this process would be taken to the arrive at what we have today - asymmetric redeemability.

So the minimal condition to control monetary policy, in my view, is simply coercive power and the will to use it, as this creates some form of asymmetry between private banks and government banks.

[JP Koning]

"But that's the whole question of the discussion. What makes a central bank central?"

Also, what makes central banking central?

Central banking precedes a formal central bank, at least it precedes the actual erection of one of those multi-columned central banks chartered by a highly complex central bank act. Canada had a form of central banking long before the introduction of the Bank of Canada in 1935. I would say central banking starts the moment that the first bank rule is centralized by a body with coercive power.

[edeast]

Thanks Rebel Economist.
I'll look for it.

I found a paper, yesterday. On fiat currency failure.
It includes the government in the model. And tests 4 levels of government involvement.
1. Economy using backed money.
2. Economy required to use fiat money.
3. Economy using fiat money with a gov that can create money to make purchases.
4. Economy using fiat money that has exogenous growth of money supply at the same rate as with an active government.
Comparing (1-2) reveals effect of fiat money.
Comparing (2-3) reveals impact of government spending.
Comparing (3-4) determines if difference between fiat money and active government is due to the level of the money supply.

Then they also ran their test for a limited time, at the end of which the fiat currency was worthless, to simulate "extreme civil unrest" and test whether hyperinflations are caused by the expectations the the money has a short future.

Some results, fiat money can provide stable regime but level of inflation is dependent on the horizon.
The also show how government spending destabilizes the whole system, causing hyperinflation and decreased efficiency. What they don't know is whether it is because they enter and compete in the market or the erratic way of injected money.
Also repeated experience with the horizon, causes increased inflation and decreased efficiency when approaching the horizon, but trade still takes place with the fiat currency.

[edeast]

. They define what legally counts as paying the debt. But for current exchanges, sellers can presumably choose medium in which they set prices and accept for payment "sorry, but I won't accept cash for my house, but I will accept payment in bottles of whisky".

But I think the point of legal tender laws is that you can't refuse to take the money as payment. You cannot say that I will only take whisky. And the Government has the coercive power because they enforce property rights. I think the G wants a to be widely used by it's citizens, is so that they can measure and tax economic activity. They want you to buy the whisky bottles off the other guy, and have him buy the house off of you. So they can tax each transaction.

[edeast]

error, I think the "reason" G want's A's currency to be widely used.

[edeast]

Basically they are a mob family, who want a cut of everything in exchange for protection.

[RebelEconomist]

"But that's the whole question of the discussion. What makes a central bank central?"

I think it is acting as the banks' bank that makes a central bank central, but what Nick is really asking, if I may put words on his page, is "how can a central bank control interest rates". Therein lies madness, because, my conclusion was (like Gary Marshall I think, but I have not seen him explain his argument clearly) that central banks do not have much control of interest rates. Unless, that is, they are prepared to take on pretty much the whole of one side of the market, and probably lose money in the process. I had a long debate with JKH about this on Brad Setser's blog before the financial crisis. And, when the financial crisis occurred, and the Fed tried to hold down interest rates when the market wanted to push them up, what I had expected happened - the Fed ended up massively expanding its balance sheet.

What is missing from Nick's post that would lead towards this conclusion is scale. In normal conditions, central banks are simply too small to have much influence on interest rates. Consider the classic T-account of the banking system. The stock of loans and deposits is normally at least ten times the stock of base money, typically much more. You don't need much response in the volume of deposits and loans from a change in interest rates to imply a huge change in base money.

[JKH]

Rebel,

I would never argue something as silly as the idea that central banks control interest rates.

What I’ve always argued is that central banks control the target policy rate and the actual rate trend relative to the chosen target at the time, apart from relatively immaterial deviation noise.

There have only been two operational exceptions to this in recent memory.

The first was the massive reserve injection by the Fed following the 9-11 attacks. The Fed was forced into emergency quantitative easing due to system dislocations. This dislocation was very short term and temporary.

The second is an operational glitch associated with the recent massive injection of excess reserves during the credit crisis. The Fed lost some control of the funds rate on the downside for a very specific reason. That is the fact that non-bank institutions who maintain balances at the Fed (e.g. Fannie, Freddie) are not eligible to earn interest on them. So they are willing to lend at below the funds rate. This is a simple architecture problem that the Fed has referenced frequently and plans to remedy at some point. For the time being, it is pragmatically irrelevant, since short rates are at the zero bound.

Anybody who wants to investigate this in a reasonable way can dig up a long term graph of the target rate and the effective rate. If, after looking at that, they want to deny that the Fed exercises control over the short policy rate, they’re welcome to join the flat earth society as well.

(And I hope you will recall that the ON Eurodollar rate is not the same as the policy rate.)

[RebelEconomist]

JKH,

Clearly Fed policy is not stated in terms of an overnight eurodollar rate, but I do not understand the difference between them - where does an overnight (I assume you mean today / tomorrow, rather than the spot / next day) eurodollar loan settle if not in a reserve account? While it seems that the Fed funds market is sufficiently narrow for the Fed to control normally, at the beginning of the financial crisis the Fed was obviously more interested in holding down the more economically pervasive term LIBOR rates, hence the TAF etc. How do you - or anyone else still reading - answer my T-account point, that central bank is generally too small not to be overwhelmed by the supply and demand response to a significant change in the interest rate? I would still like to get to the bottom of this conundrum.

[Nick Rowe]

original anon: "The central bank in the case of loan repayment has redeemed its monetary liability because it extinguishes the reserve liability used as repayment for the loan. And it has issued a credit to the commercial bank in exchange. The form of credit it has issued is the cancellation of the monetary liability of the commercial bank (the loan)."

I've been thinking about this. I see what you mean, but I don't think it counts as the central bank fulfilling it's promise to redeem commercial banks' liabilities at par.

Let me give you another example. I can write "IOU $100 signed Nick Rowe" on a bit of paper, but nobody has promised to redeem my liabilities for anyone else's liabilities at par. I can't be sure that anyone will accept my paper and give me a loan.

Now suppose I have a $100 mortgage at BMO, and I also have $100 in my chequing account. If I write a cheque to BMO to pay off my mortgage, you might say that BMO has redeemed my liability. But this is not the same as BMO fullfilling a promise to make me a loan. All the BMO has done is to cancel two offsetting liabilities: their liability to me, and my liability to them.

I need to get my head clearer on this, so I can express what I am trying to say more clearly.

TD (or anyone) can take a cheque written on BMO and demand payment in BoC liabilities (or BoC notes). BMO has promised to fulfill any such demand. TD (or anyone) cannot take a cheque written on the BoC (or BoC notes) and demand payment in BMO liabilities. The BoC has not promised to fulfill any such demand.

Also: "Whether or not Canadian banks can have negative reserves is irrelevant to the issue of discussing redeemability. But since you ask – no they can’t have negative reserves, to the degree that a negative end of day position (or any required accounting period position) forces them to cover that shortfall by borrowing from the central bank. The borrowing brings reserves back to zero."

I can't see the difference between that and a negative reserve balance, if the borrowing is automatically extended. I can't see the difference between a line of credit, an overdraft, and a negative balance in my chequing account. It's the net position that matters.

[RebelEconomist]

Nick, original anon,

I agree that a central bank effectively redeems its liabilities when it accepts reserves to cancel a loan, but it seems to me that this is a quite limited commitment, because it is restricted to the time that the loan matures and the central bank will only pay with the debt of the reserve holder itself (rather than with the debt of a third party such as credit in an account with another bank). The relationship is still very asymmetric.

[RebelEconomist]

original anon,

You said "I'd be interested in an example of one (central bank) that isn't (concerned with controlling interest rates), present day or historic."

I don't think that the early central banks such as the Bank of England were. They basically grew out of professional lenders of specie who found that they could borrow a little cheaper if they made their debt securitised and transferrable (and therefore more liquid). Presumably, the interest rates these note issuing lenders charged were in line with the terms prevailing in a traditional market of loans between individuals, which in turn depended on the return to other opportunities to invest capital and credit risk. Eventually, one of this range of note-issuing banks emerged as the dominant one, typically because the government granted it special privileges in return for a cut of the action. In the case of the Bank of England, it specialised in lending to the government, so making its notes legal tender, and, over the years, severely curtailing the ability of the other banks to issue notes at all, allowed the BoE to fund itself more cheaply, and it was expected to pass this advantage on to the government in the rates it charged them. Apart from that, the early central banks were not concerned to influence interest rates, and certainly not for the purposes of macroeconomic control.

[original anon]

“TD (or anyone) can take a cheque written on BMO and demand payment in BoC liabilities (or BoC notes). BMO has promised to fulfill any such demand. TD (or anyone) cannot take a cheque written on the BoC (or BoC notes) and demand payment in BMO liabilities. The BoC has not promised to fulfill any such demand.”

Two preliminaries:

First, you made a general statement which I allege does not hold generally. The onus is on you to prove the truth of your general statement. The onus is on me only to prove that it isn’t true as a general statement, not that it’s generally false. Fair?

Second, notwithstanding the first, I think I can show your statement also doesn’t hold in a sense that is more general than my first example.

The key to the discussion about symmetry is to recognize that when looking at cases where the CB is counterparty to actual transactions, one must acknowledge that the CB only deals with commercial banks. That’s an asymmetry in itself. But it’s not the asymmetry you’re talking about. In fact, it’s the one that I’m talking about when I say that what makes a central bank central is the fact that it is the bankers’ bank, and that commercial banks must maintain reserve accounts with the central bank. The central bank generally doesn’t deal directly with commercial bank customers. I went on at length about this and the nature of the agency relationship in which commercial banks offer central bank liabilities to retail customers. Your statement of asymmetry isn’t consistent with the known facts of the world, because it doesn’t recognize the fact that the CB doesn’t deal with commercial bank customers as counterparties in transactions, at least not usually. You have to compare relevant counterparty markets in assessing symmetry or asymmetry. At the very least one should be more reluctant to make statements about asymmetry in markets that don’t exist, when transactional symmetry appears in the markets that do exist within the overarching asymmetric institutional structure of the counterparties to actual transactions.

So my initial example was based on the actual market between the CB and the banks. The question effectively is whether symmetry exists in the liabilities that are available to counterparties dealing in this market. And it does. I gave an example of where it does. A CB that accepts reserves in repayment of a loan then extinguishes that loan, effectively providing payment directly in the form of the commercial bank liability.

Now the question is whether that initial example can be made more general within the relevant market – which is the interbank market including the CB and the commercial banks; i.e. ex non-bank counterparties.

In review, suppose in my first example that BMO presents reserves to CB in exchange for CB extinguishing BMO’s liability (loan). CB has effectively made payment with a BMO liability in the sense that it has provided asset value to BMO in an amount equivalent to BMO’s liability. Again, this is a matter of debit-credit accounting, as well as conceptual logic.

Now let’s go wider.

What we need to prove is the case where CB, instead of paying BMO in terms of BMO’s liability, pays BMO in terms of TD’s liability.

I.e. can BMO pay reserves to CB in return for a TD liability?

But that’s exactly what happens when BMO makes an interbank loan to TD and pays for the transaction through the interbank reserve clearings. CB debits BMO for its reserves, and then credits TD with the reserves that it is due. The ONLY way that BMO can make an interbank loan to TD is to have its CB account debited by CB.

And you can be sure that CB is the one that’s actually doing the debiting. That’s the role of the banker to the banks. TD is NOT the one debiting that account. TD is only due reserves – it does not have the debiting power. BMO makes the reserve payment to CB – NOT to TD. And TD receives its reserve payment from CB – NOT from CB. That is the conceptual, logical, and legal nature of clearing arrangements and enforcement.

So the result is that CB receives payment from BMO in the form of reserves, and BMO receives payment from CB in terms of TD’s liability – because without the CB reserve market, that transaction could not take place.

So I believe that proves a symmetric relationship in the markets that exist as opposed to an asymmetric relationship in the markets that don’t. If I were claiming asymmetry between the sun and its planets, I’d suggest it was due to the fact that the planets revolved around the sun, and that there were more of them. I wouldn’t suggest it was because solar eclipses are visible on earth, but the same solar eclipses can’t be observed on the sun.

[original anon]

above:

"And TD receives its reserve payment from CB – NOT from CB"

should read:

"And TD receives its reserve payment from CB – NOT from BMO"

[original anon]

I threw in the solar eclipse analogy as bait.

Could be worth another asymmetry post in itself.

[Nick Rowe]

original anon:

Let me approach this another way. Suppose the Fed decided to peg the US dollar to the Loonie (at par), and the BoC shrugged its shoulders and said "whatever". In that case I believe that the BoC would set monetary policy for the whole of US+Canada. In an important sense, the BoC would become the central bank of the US, even though the BoC is much smaller than the Fed, and even though the Fed and US commercial banks did not use the BoC clearing house.

I want to argue that the relation between the BoC and the Fed in that hypothetical case is the same as the re;ation between the BoC and BMO, TD, etc.

Now, I have tried to say that asymmetric redeemability is what is going on when the Fed unilaterally pegs the dollar to the Loonie. I might be wrong on that. Clearly I don't understand what it means as clearly as I want to.

Your counterexamples are indeed a fair tactic, and I must be careful not to fall into the "No true Scotsman Fallacy" (changing the definition of "true Scotsman" every time someone comes up with an example where a Scotsman does something I say a true Scotsman would never do).

Modifying your helicentric analogy: we both agree that the planets revolve around the sun, because we see them doing it. When the BoC says it wants higher/lower interest rates, it nearly always gets (roughly) what it wants. But we are trying to explain why the planets revolve around the sun, when (in this case) the sun is so much smaller than the planets.

More later...

[Nick Rowe]

I wrote: "Suppose the Fed decided to peg the US dollar to the Loonie (at par), and the BoC shrugged its shoulders and said "whatever"."

In this analogy to a unilateral peg, the Fed has promised to redeem US dollars for Loonies at par, and do whatever it takes to ensure the exchange rate stays fixed. What does the Bank of Canada's "whatever" mean? The Bank of Canada replies that that is a Fed decision, and it will continue to target Canadian inflation, raising and lowering interest rates as it sees fit for Canadian purposes, ignoring any effect this might have on the exchange rate, or on how the Fed will need to respond to keep the exchange rate at par. It doesn't try to help the Fed keep the exchange rate fixed. And I've been thinking of this as meaning the BoC does not promise to redeem the Fed's liabilities.

Now, there is one exception, where the BoC does try to help BMO keep its exchange rate fixed: in the event of a run on BMO, the BoC *will* lend reserves to BMO freely. But this exception does tend to prove the rule, since we allow that in the case of a bank run on commercial banks, the BoC may temporarily lose control of monetary policy.

[RebelEconomist]

original anon,

Since you say "The ONLY way that BMO can make an interbank loan to TD is to have its CB account debited by CB", perhaps you can explain the difference between the Fed funds and eurodollar loan market I wondered about in my comment of November 01, 2009 at 04:45 PM.

Aren't there large value payment systems that do not involve the central bank - eg CHAPS in the UK?

[original anon]

“Let me approach this another way. Suppose the Fed decided to peg the US dollar to the Loonie (at par), and the BoC shrugged its shoulders and said "whatever". In that case I believe that the BoC would set monetary policy for the whole of US+Canada. In an important sense, the BoC would become the central bank of the US, even though the BoC is much smaller than the Fed, and even though the Fed and US commercial banks did not use the BoC clearing house.”

I can work with this example. And I can possibly buy into the idea that the Bank of Canada might set or at least influence monetary policy for the combination. But I can’t buy into the idea that the Bank of Canada becomes the US central bank, simply because US commercial banks would not maintain US reserve accounts with the Bank of Canada. I know what you’re saying, as “in an important sense” but I think you want to be clear on technical limits versus policy influence. There’s a difference between acknowledging that the Fed has great influence on PBOC policy, versus maintaining that the Fed is China’s central bank. The same would hold for the relationship between the Bank of Canada and the Fed in your example. That said, let me work with your example.

In asking the question “What makes a central bank central?” I think you have to maintain a logical context for the positioning of the central characteristic. As suggested above, the question makes sense in the case of the Bank of Canada relative to its position at the center of the Canadian banking system – not in the sense technically of whether the Bank of Canada can be central relative to the Fed, or vice versa. (Also see my closing paragraph below.) That said, it can be demonstrated that the central bank is central with respect to foreign exchange transactions in its own banking system, and that the same type of symmetry exists as illustrated earlier with respect to CB Canadian dollar transactions in the interbank market.

Recall my first example was the case of an exchange whereby BMO paid CB with a CB liability (reserves) in exchange for BMO paying CB with a BMO liability (loan from CB to BMO).

In the second example, BMO paid CB a CB liability (reserves) in exchange for a TD liability (loan from BMO to TD). That transaction in its entirety requires the CB reserve system.

The third example, which corresponds to the issue you raise, would be that where BMO pays CB a CB liability (reserves) in exchange for a TD liability. In this case, the TD liability is a US dollar deposit of BMO with TD. Again, that transaction in its entirety requires the CB reserve system.

Behind this transaction, the role of the relationship between the Fed and the Bank of Canada is only indirect in the symmetry story, which as described above is a symmetry story about a central bank with its own banking system – in this case, the role of the Bank of Canada relative to the Canadian banking system.

E.g. suppose as a PRELUDE to my third example, the Fed buys US dollars and sells Canadian dollars to support its US dollar peg to Canada. Thus, at the margin (i.e. ignoring a cumulative Canadian dollar reserve position), the Fed has ended up long US, short Canadian. Then suppose the Fed “squares up” its resulting FX exposure change in a follow up transaction (sooner or later) by purchasing Canadian dollars and selling US dollars. The counterparty to that transaction could well be TD in my third example, as there TD ended up “long” Canadian dollars and short US dollars (i.e. its liability to BMO).

So that’s how I would position FX transactions generally in the context of why a Canadian central bank is central relative to a Canadian banking system. I think there’s a danger of abstracting to the point of irrelevance, including artificially constructed asymmetry, if one starts mixing it up in the sense of an attempted higher analogy in the relationship between different banking systems with different centers. But I can consider it further if you want to pursue it.

[Nick Rowe]

original anon: "I think there’s a danger of abstracting to the point of irrelevance,..."

"danger"? That's an occupational hazard that academic economists love to court! We call it a feature, not a bug ;)

I think we are partly back to Rebel's question: what we mean by "central bank"?

There are two questions: 1. what do we mean by "central bank"?; 2. what causes a bank to be central (given that meaning of "central")?

I come at it as a macroeconomist, so to me the important question is: what causes the Bank of Canada to have so much more power over macroeconomic variables than the Bank of Montreal? By "central bank" I mean one that can control inflation, etc.

But I can appreciate that someone who came at it from a different angle might want to define "central bank" differently, as the "bankers' bank", for example.

And my definition is certainly weird, historically speaking, because under the gold standard, for example, there are no central banks in my meaning, though they do exist in other meanings.

Perhaps I should have titled my post: "What gives some banks (typically central banks), so much power over macro variables?"

Will return later.

[original anon]

You're going in circles here, shifting reference points at whim, with a conclusion (at this point) the same as the title of your post - you can't possibly know what you "mean" by central bank without understanding what "causes" it to be central. BTW, I meant irrelevance in the context of the rest of the discussion - a higher bar on irrelevance than irrelevance in the context of the rest of the world.

[Nick Rowe]

original anon: This was my opening paragraph:

"Both central banks and commercial banks issue liabilities that function as media of exchange. Why do we say that it is central banks, rather than commercial banks, that determine monetary policy; setting interest rates in the short run, and inflation in the long run? What makes a bank a *central* bank?"

I thought my second and third sentences implicitly defined a "central" bank as one that has power over macro variables.

Insufficiently clear, maybe. But I'm not changing reference points on a whim. I don't even need to use the word "central". "Concerning those banks which we believe and observe to have power over macro variables: what is the source of their power? And why don't other banks have that same power?"

[Nick Rowe]

Yep. I definitely wasn't clear enough about the question I was trying to answer. Another post I should re-write from scratch. Oh well.

[RebelEconomist]

Forget CHAPS; I did a bit of investigation and it seems that CHAPS only clears payments, for settlement at the Bank of England. But while I cannot name an example of a non-central bank payment settlement institution right now, I am sure that they could, and probably do, exist. All that is necessary is to establish a mutual company into which settlement members contribute some safe assets in return for a settlement balance, with settlements between members conducted in the accounts of their settlement institution. So I do not think that being the bankers' bank is necessary to control interest rates (to the extent that the monetary institution can control them of course!).

I know these are arcane issues, but I think that is precisely why understanding them might be very fruitful in terms of understanding, for example, the causes of the financial crisis. Even in a central bank, I never found anyone who really understood the whole picture - the economists avoid such details (especially as many "monetary economics" modules hardly discuss money) and the operations staff tend to have little time for theory.

[Nick Rowe]

Rebel: agreed. I find it very hard to get my head around the details myself. It's like cutting through pea soup.

[original anon]

“Yep. I definitely wasn't clear enough about the question I was trying to answer. Another post I should re-write from scratch. Oh well.”

It’s really not that difficult to describe the functions of the typical modern central bank. The Bank of Canada is a reasonable example. More importantly, and indicatively, I see little difference between the Bank of Canada and the Fed from a functional point of view (something like inflation targets is not critical to a discussion like this), or between those two and other central banks for that matter. From there, you zero in on the function that you think is central. It’s not rocket science.

The question posed in the title of your post is straightforward in that context. As I said, I think the answer is the reserve account and the clearing function that goes along with it. This mirrors the typical deposit account service that a commercial bank offers when they agree to make sure your deposits and withdrawals (cash or cheque) are reflected accurately in your balance. You were fairly clear in that you thought a specific redeemability relationship was the criterion for centrality. So we had a discussion.

I think the question is reasonably clear provided you make some reasonable assumptions about the nature of the modern central bank. If you want to go off and dispute what the typical central bank looks like, that really is a waste of time, given the similarities of institutions like the Bank of Canada, the Fed, and the others. Hell, I see nothing of note even in the Chinese central bank that makes it unqualified to be part of a “typical” modern central bank discussion. Its foreign exchange activity and its peg is just a question of degree in running an FX fund (even the Bank of Canada might consider the idea of intervention, although it doesn’t like it).

So if the question and the assumptions about what the words in the question mean are reasonably straightforward, it’s really the answer that counts.

Anyway, good discussion.

[Nick Rowe]

RebelEconomist posted this question as a comment on another post. Since I wanted to answer it, but we were all wandering off topic on that other post, I asked him to move it over here. But he's on UK time (I think), and maybe down the pub, or at tea, so I couldn't wait! So I'm re-asking it here.

"But no-one is answering what I think is a simple point. If the central bank provides 5% of the banking system assets, and wishes to, say, lower the level of interest rates by 100bps, if this results in deposits shrinking by about 2.5% and loans increasing by about 2.5%, one would think that the central bank would have to roughly double the base money supply to achieve its objective. Clearly, interest rate changes are not associated with huge changes in base money supply, so is deposit supply and loan demand inelastic, or is the central bank influencing the interest rate by means other than being the marginal player in the money market?"

I associate this way of thinking about monetary policy and interest rates with inter-war British monetary theory; and you see it today in some Austrian analyses, I think. The interest rate is determined by the supply and demand for loanable funds (both flows), and central banks's monetary policy affects interest rates by increasing the supply of loanable funds -- effectively printing a flow of money and lending it out.

Notice first how very different this way of thinking is from the Keynesian liquidity preference theory, where the interest rate is determined by the stock supply and demand for money, rather than the flow supply and demand for loanable funds. I know the ISLM can integrate liquidity preference and loanable funds, but the ISLM allows real income to adjust to make liquidity preference and loanable funds give the same answer for the rate of interest. That begs the question, since income won't increase until you get the rate of interest down and investment and consumption respond. And what happens in the very short run, before output and income have had time to adjust (it takes time to increase employment and output)?

To simplify, let's delete the banking sector initially, then bring it back in later. And delete government bonds too. There's just paper money printed by the central bank, and commercial bonds.

Initially the flow demand for commercial bonds (desired savings) equals the flow demand for commercial bonds (desired investment). And the stock demand for currency equals the stock supply. So we start in equilibrium. Now hold output and income constant, because we are in the very short run, and firms won't have time to hire more workers and increase output and income yet (we can't move along the IS curve, in other words).

What happens with a once and for all helicopter increase in the STOCK of money? Specifically, what happens to the FLOW demand and supply of loanable funds?

To be continued later, because I've got to teach public goods. But if anyone wants to have a go, go for it.

[JKH]

Nick,

As already noted, I don't plan to enter the debate further.

But fyi, the post Keynesians would say your analysis is entirely wrong in its loanable funds foundation, which applies to a fixed but not a floating rate system.

Enough said by me. I don't want to disrupt what might otherwise be an interesting discussion.

(P.S. Chartalism/MMT is effectively a branch of post Keynesianism. E.G. Australian blogger Steve Keen is a well known post Keynesian, but not a Chartalist.)

[Nick Rowe]

Oh, and assume the price level is fixed, because we are in the very short run.

JKH: The loanable funds theory works great in the long run closed economy. In the long run open economy you need to add the supply or demand for loanable funds from the rest of the world, regardless of whether nominal interest rates are fixed or flexible, because real exchange rates are flexible.

[JKH]

Nick, I hope you have the opportunity to have a healthy debate about this with the Chartalists!

[RebelEconomist]

Thanks Nick, I was at tea. I look forward to reading your explanation tomorrow.

If you find yourself covering the same point several times, JKH, you need a blog!

[JKH]

RebelEconomist @ 5:23 p.m.

No doubt an informed suggestion, Rebel.

And an intriguing one - thanks.

[Workhorse]

Hi Nick (this is the first time to write a comment here),

Thank you very much for the interesting discussion; it gave me a good food for thought - during my working hours (and, as a natural result, I had to work overtime!).

I think, the key to make the "CB" in your model is the commitment to exchange A's money ANYTIME AT PAR, rather than the one-way redeemability itself. For example, in the former case of the two banks model, if bank B purchases A's notes (A$) in exchange of B's notes (B$) at par, but if B re-purchases B$ at the rate of 104/105 (A$/B$), then the investors obtain only 4% yields in A$ - there is no arbitrage opportunity. The same argument applies to the latter case. B can sell A$ at par and buy it back at 106/105 (A$/B$). Again no arbitrage profit.

This implies that, I think, B's losses in the two-bank model come from the lack of interest rate parity, rather than the asymmetric redeemability. Of course, the idea of the asymmetric redeemability is still very interesting (rather than simply assuming infinite supply of money) - and I am interested in the reason why. A possible interpretation is "A is a risk-free bank and B is a risky bank", because A never want to accept B's debts as a part of A's assets while B is happy to accept A's debts infinitely. This may be an acceptable (and therefore, boring!) interpretation of the asymmetric redeemability.

Again, thank you for the interesting idea!

[Too Much Fed]

Nick's post said: "So, what is the price of a central bank's currency that makes no promise to redeem?" Price in terms of goods? For the US and Canada, $1 buys you about 3/4 of a cheap cup of coffee, so that's the price of $1."

So if the price of currency that makes no promise to redeem is price inflation/deflation of good and services, why does the fed use currency denominated debt to fight price deflation from positive productivity growth and cheap labor (assuming lower interest rates lead to more currency denominated debt)?

Here is another way to look at it. What if lower interest rates do not get excess savers to spend in the present and do not get excess debtors to go further into currency denominated debt (because they already have too much of it) to spend in the present?

[Too Much Fed]

edeast said: ". They define what legally counts as paying the debt. But for current exchanges, sellers can presumably choose medium in which they set prices and accept for payment "sorry, but I won't accept cash for my house, but I will accept payment in bottles of whisky".

But I think the point of legal tender laws is that you can't refuse to take the money as payment. You cannot say that I will only take whisky. And the Government has the coercive power because they enforce property rights. I think the G wants a to be widely used by it's citizens, is so that they can measure and tax economic activity. They want you to buy the whisky bottles off the other guy, and have him buy the house off of you. So they can tax each transaction."

Doesn't the fed have monopoly control over the amount of currency?

If debt could be paid off in whiskey, what would happen if someone started increasing whiskey production by 20% or more per year?

[RebelEconomist]

By the way, JKH, I would be interested in your explanation of the difference in credit risk between Fed funds and a eurodollar deposit, because I once had to consider it for the purposes of a contract. My counterparty suggested that cash derivatives collateral be remunerated at Fed funds, and I wondered why they preferred that to LIBOR. As I recall, there was something different to do with FDIC insurance.

[JKH]

I’m not 100 per cent sure on this, but I believe it’s because repayment settlement for overnight fed funds occurs prior to reserve account settlement on repayment of anything comparable in the Eurodollar market, where the initial transaction in both cases occurs at the same time, as per the rate comparison. The elapsed timing difference equals credit risk difference.

Please correct me if I’m wrong.

[JKH]

Whether or not my point on timing is exactly correct, another possible contributing factor is that the set of survey banks for Eurodollar quotes is a lower average credit risk group than the weighted average credit risk of the banks that by volume determine the Fed effective rate. Again, I'm not sure on that, but it seems plausible.

[JKH]

The FDIC insurance aspect may make sense as well. It's conceivable that the Fed or FDIC guarantees repayment of ON fed funds when a bank is shut down, but not settlement for comparable Euro contracts. I really don't know on that one.

[Nick Rowe]

Continued from Nov 3 1.10pm:

How can a change in the small stock of currency cause a significant change in the large supply and demand for loanable funds?

First, because the first is a stock, and the second is a flow. If the people who want to get rid of the helicopter money want to get rid of the excess stock of money instantly, by lending it out (i.e. buying commercial bonds) that creates an infinite excess flow demand for commercial bonds (an infinite excess flow supply of loanable funds). (And remember that even though each individual can get rid of currency by buying bonds, they can't do this in aggregate, so the infinite excess flow supply of loanable funds continues until the rate of interest falls and people decide to hold the extra currency instead).

Second, even if we convert the stock into a flow, by assuming that those who pick up the helicopter money try to get rid of it slowly over time, we need to think about the elasticity of demand and supply for loanable funds in the very short run, when real output, income, and price level are fixed. If Y, C, and I are all fixed in the very short run (Y=C+I in this simple model), then the demand for loanable funds from investment is fixed, and the supply of loanable funds from savings is fixed too. In other words, the supply and demand curves of loanable funds from savings and investment are perfectly interest-inelastic in the very short run. Any extra supply of loanable funds from an excess flow supply of currency can create an indefinitely large fall in the equilibrium interest rate in the very short run. Increased borrowing for increased investment, and decreased lending from decreased savings, take time to happen. And when they do happen, income increases, creating the extra savings and flow supply of loanable funds.

Now add a banking system, so currency is only a small proportion of the stock of money.

To be continued...

[Nick Rowe]

Continued from 2.58:

Forget the helicopter. Assume instead the central bank lends out the new currency, adding it to the flow supply of loanable funds, offering to supply an unlimited quantity of currency at a lowered interest rate. As we have seen, with the supply of loanable funds from savings and demand for loanable funds from investment being perfectly inelastic in the very short run, the increase in the stock of currency needed to lower the interest rate depends not on the elasticities of savings and investment, but on the interest elasticity of the demand for a stock of currency.

Now just add in what I wrote in the original post, about the infinite arbitrage opportunities opened up if the commercial banks try to keep their interest rates constant, when the central bank lowers its interest rate, and the infinite losses that commercial banks would face, given asymmetric redeemability. The commercial banks will lower interest rates too.

So even if we start out with a loanable funds theory of the rate of interest, we end up with a liquidity preference theory, in the very short run when Y is fixed.

[Nick Rowe]

Workhorse: Welcome, and thanks!

I agree with your comment. For my argument to work, it is not enough for the commercial banks to promise to redeem their liabilities at par today. They must promise to do so in future as well. (Or, the rate, if not par, must be fixed. Or if not fixed, at least pre-determined to adjust at some particular rate, like a crawling peg. Definitely not flexible exchange rates between the commercial and central banks' monetary liabilities.

[Nick Rowe]

Too much Fed: the question at issue here is to explain how it is that central banks can raise or lower interest rates. The extent to which interest rates affect aggregate demand is a separate question, that I don't want to get into here.

[Too Much Fed]

Nick said: "Now add a banking system, so currency is only a small proportion of the stock of money."

Let's call that "stock of money" the fungible money supply, the money supply that can purchase either financial assets or goods and servies.

If currency is only a small proportion of the fungible money supply, what is the large proportion?

[Too Much Fed]

Nick said: "If the people who want to get rid of the helicopter money want to get rid of the excess stock of money instantly, by lending it out (i.e. buying commercial bonds) that creates an infinite excess flow demand for commercial bonds (an infinite excess flow supply of loanable funds)."

What if the helicopter money is bank reserves?

If not bank reserves but currency, why give it to the lenders (your statement above leads me to that assumption)?

I think I need a definition of helicopter money.

[Too Much Fed]

Nick said: "What happens with a once and for all helicopter increase in the STOCK of money? Specifically, what happens to the FLOW demand and supply of loanable funds?"

If by STOCK of money, you mean the fungible money supply, then I don't believe there is an exact, direct relationship.

Once again, I need a definition of helicopter increase and who gets the drop.

[Nick Rowe]

Helicopter money: the central banker prints some currency, loads it into a helicopter, and flies around the country throwing it out for people to pick up.

[RebelEconomist]

Ha! Would I be right in suspecting that you are having trouble explaining how central banks set interest rates Nick? After some perambulation around the difference between loanable funds and liquidity preference flow / stock ideas (which I am not sure matters in the context of an overnight loan market), and a dead end (helicopter money; this is so rare as to be practically irrelevant since, as Mike Sproul says, central banks supply base money by trading it for another asset such as a loan), you eventually say that commercial banks will follow the central bank because they know that its ability to supply base money is infinite and that therefore they would face infinite losses if they did not adjust their rates in line. That is the point that Gary Marshall tries to make - to get interest rates down by supplying base money, the central bank has to be ready to supply such a large amount of base money that they would generate an intolerable rate of inflation. And you picked the slightly easier case where the central bank's objective was to ease, in which its infinite capacity to trade money for debt (assuming that it will not be deterred by the inflationary consequences) is not in question.

By the way, more respected analysts than Gary Marshall and I have noted this conundrum. The clearest statement of it by a famous name that I know of is Ben Friedman's "The future of monetary policy: the central bank as an army with only a signal corps" (originally published as NBER WP 7420) - it is sufficient to read the first half-dozen pages or so.

[RebelEconomist]

All good suggestions, JKH. Some other ideas that I had written in the margin of page 87 of my copy of Meulendyke ("US Monetary Policy and Financial Markets") are:
(1) Fed funds payment settles later in the day (ie similar to your first point, but at the opening of the transaction).
(2) The ranking of such a deposit in the creditor hierarchy.
(3) No FDIC fee is payable on a Fed funds deposit, which Meulendyke argues would mean that Fed funds trades above other deposits (not sure I agree).
In the end, I never was able to get to the bottom of it; I think I just insisted on treasury collateral!

Such issues illustrate the level of detail that is needed to understand how monetary policy works. In this case, the more experienced back office staff are probably better placed to know than either the economists or the dealers.

[JKH]

I don't know how many times I have to say this, but the central bank does not "set interest rates".

It sets the target policy rate and guides the market rate that corresponds to it through reserve management.

Friedman doesn't address the mechanism. He probably doesn't know about it or understand it, like most economists who have no knowledge of reserve accounting and operations.

[JKH]

BTW, Nick, when I informed Mosler by comment that you were planning on a post "attacking Chartalism", he said something to the effect "It can't be attacked. It's accounting." Which is very much to the point on the policy interest rate issue, as part of MMT/Chartalism.

[Nick Rowe]

Rebel: Central banks do helicopter money a lot. Whenever a central bank gives its seigniorage profits to the government (and they do this all the time), and whenever the government uses those profits to finance a deficit (and they do this all the time), the helicopters are flying. The people who work in central banks never see the helicopters, of course, because they are too close to the action to see the woods for the trees. They also don't see the vacuum cleaner bond market operation, when government and central banks work together to vacuum bonds out of people's pockets. All central bankers ever see is the combined results of those two operations, and they call it an "open market operation".

Whenever a central bank increases the supply of currency, of course the long run result will be a price level that is equi-proportionately higher than it would be otherwise. And all real things (including the rate of interest) will be the same as they would be otherwise. That's the standard Quantity Theory/Neutrality of Money result. What we seek to understand is how central bank printing of currency can have such powerful effects: on interest rates in the very short run; on interest rates and output in the short run, and on the price level in the long run.

[JKH]

The following is a note put out by Goldman Sachs, posted on Mosler’s site. In the main article, the first paragraph is Chartalism. The rest is standard post Keynesianism. The micro and macro analytical framework for all of it is mostly about understanding bank reserve accounting.

“Since March I have been arguing that the world was a better place than people thought. I am now shifting my core view, which still might take several months to develop in the marketplace.

Skipping to the Conclusions

1. Deflation will be the surprise theme of 2010, when Congress will go into a pre-election deadlock; elections have only underscored this is the public direction

2. Excess Reserves will neither generate new lending nor generate inflation; actually, the quantity of reserves (M0) basically has no real economic effect

3. ZIRP and QE actually CONTRIBUTE to the deflation mostly by depriving the spending public of much-needed coupon income

4. When Federal Tax Rates increase in 2011 this problem will become even more severe

5. The overall level of public indebtedness (vs GDP) will not put upward pressure on yields in this backdrop and there will be a reckoning in the high-rates/‘deficit hawk’ community

6. Strong possibility that QE will actually be upsized next year rather than ended when the Fed observes these effects (and this might actually make things WORSE)

The Explanation (a Journey)

It seemed fairly intuitive and obvious for thousands of years that the Earth was at rest and the Sun moving around it. Likewise, it has ’seemed’ that the Fed controls the money supply, balances the economy by setting interest rates and fixing reserves which power bank lending, that more ‘Fed’ money means less buying power per dollar (inflation), that the federal government needs to borrow this same money from The People in order to be able to spend, and that it needs to grow its way out of its debt burden or risks fiscal insolvency. I have, in just a fortnight, been COMPLETELY disabused of all these well-entrenched notions. Starting from the beginning, here is how I now think it works:

1. The first dollar is created when Treasury gives it to someone in exchange for something - ammo, a bridge, labor. It is a coupon. In exchange for your bridge, here is something you - or anyone you trade it with - can give me back to cover your taxes. In the mean time, it goes from person A to person B, gets deposited in a bank, which then deposits it at the Fed, which then records the whole thing in a giant spreadsheet. Liability: One overnight reserve/demand deposit/tax coupon. Asset: IOU from Treasury general account. Tax day comes, Person A pulls his deposit, ‘cashes in’ the coupon, the Treasury scraps it, and POOF, everything is back to even.

2. For various reasons (either a gold-standard relic or a conscious power restraint, depending who you ask), we ‘make’ the Treasury cover its ‘shortfall’ at the Fed and SWAP one type of tax-coupon (a deposit or reserve) for another by selling a Treasury note. Either the Fed (in the absence of enough reserves – we’ll get to this) or a Bank (to earn risk-free interest) or Person A (who sets a price for his need to save) is ‘forced’ out his demand deposit dollar and into a treasury note at the auction clearing price. What about the fact that treasuries aren’t fungible like currency? On an overnight basis, that doesn’t really constrain anyone’s behavior. A reserve or a deposit means you get your money back the next day. Same thing with a treasury. Functionally it’s cash and won’t influence your decision to buy a car. Likewise for the bank. In the overnight duration example, it does NOT affect their term lending decisions if they have more reserves and few overnight bills, or more bills and fewer reserves. It’s even possible to imagine a world (W.J.Bryan’s dream) where the Fed, with its scorekeeping spreadsheet, combines the line-items we call treasuries and reserves.

3. Total “public sector dissavings is equal to private sector savings (plus overseas holdings)” as a matter of accounting identity. This really means that the only money available to buy treasuries came from government itself (here I am being a bit loose combining Tres+Fed), from its own tax coupons. If there aren’t enough ready coupons at settlement time for those Treasuries, the Fed MUST ‘supply’ them by doing a repo (trading deposits/coupons for a treasury by purchasing one themselves at least temporarily). They don’t really have a choice in the matter, however, because if the reserves in the banking system didn’t cover it, overnight rates would go to the moon. So in setting interest rates they MUST do a recording on their spreadsheet and the Fedwire and shift around some reserve-coupons (usable as cash) for treasury-coupons (usable for savings but functionally identical).

4. Thus ‘monetizing the deficit’ is actually just the Fed’s daily recordkeeping combined with its interest rate targetting, just ‘keeping the score in balance.’ However, duration is real, as only overnight bills are usable as currency, and because people (and pensions!) need savings, they need to be able to pay taxes or trade tax-coupons for goods when they retire, and so there is a price for long-term money known as interest rates. The Fed CAN affect this by settings rates and by shifting between overnight reserves, longer-term treasuries, and cash in circulation. When the Fed does a term repo or a coupon sale, they shift around the banking and private sector’s duration, trading overnight coupons for longer-term ones as needed to keep the balance in order.

5. But all this activity doesn’t influence the real economy or even the amount of money out there. The amount of money out there dictates the recordkeeping that the Fed must do.

6. This is where QE comes in to play. In QE, aside from its usual recordkeeping activities, the Fed converts treasuries into overnight reserves, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it ‘needed’ to do all along. Again, they force people out of treasuries and into cash and reserves.

7. The private sector is net saving, by definition. It has saved everything the Treasury ever spent, in cash and in treasuries and in deposits. In fact, Treasuries outstanding plus cash in circulation plus reserves are just the tangible record of the cumulative deficit spending, also by IDENTITY.

8. So when QE is going on, there is some combination of savers getting fewer coupons – which constrains their aggregate demand just like a lower social security check would, and banks being forced out of duration instruments and into cash reserves. I do not think this makes them ‘lend more’ – their lending decision was not a function of their ‘cash flow’ but rather a function of their capital and the opportunities out there (even when you judge a bank’s asset/equity capital ratio, there is no duration in accounting, so a reserve asset and a treasury asset both ‘cost’ the same). If they had the capital and the opportunities, they would keep lending and ‘force’ the Fed to give them the cash (via coupon passes and repos, which we then wouldn’t call QE but rather ‘preventing overnight rates from going to infinity’). As far as I can tell, excess reserves is a meaningless operational overhang that has no impact on the economy or prices. The Fed is actually powering rates (cost of money) not supply (amount of money) which is coming from everyone else in the economy (Tres spending and private loan demand).

9. I’ll grant there is a psychological component to inflation phenomenon, as well as a preponderance of ignorance about what reserves are, and that might result in some type of inflationary event in another universe, but not in the one we are in where interest rates are low and taxes are going up and the demand for savings is therefore rising rather than falling.

10. One can now retell history through this better lens. Big surpluses in ‘97-’01, then a big tax cut in ‘03. Big surpluses in ‘27-’30, then a huge deficit in ‘40-’41. Was an aging Japanese public ’shocked’ into its savings rate or is that savings just the record of the recessionary deficit spending that came after ‘97? It will be interesting to watch what happens there as the demographic story forces households to live moreso off JGB income - will this force the BOJ to push rates higher or will they never ‘get it’ and force the deflation deeper?

11. There are, as always mitigating factors. Unlike in the Japan example, a huge chunk of US fixed income is held abroad, so lower rates are depriving less exported coupon income which is actually a benefit. There is of course some benefit from lower private sector borrowing rates as well - MEW, lower startup costs for new capital investment, etc. Also, even if one denies that higher debt/gdp ratios are what weakened it (rather than China’s decisions - again something unavailable to Japan), the dollar IS weaker now which is inflationary. But this is all more than offset, I think, by ppl’s expectation that higher taxes are coming, and that’s hugely deflationary and curbs aggregate demand via multiple channels.

12. Additionally, there seems to be a finite amount of political capital that can be spent via the deficit, and that amount seems to be rapidly running out. See https://portal.gs.com/gs/portal/home/fdh/?st=1&d=8055164 . The period of deficit stimulus is mostly behind us. Instead, people are depending upon ZIRP and the Fed to stimulate the economy, and in fact there is marginal, and possible negative, stimulation coming from that channel. The Fed is taking away the social security checks knowns as ‘coupon interest.’

13. Finally, there is a huge caveat that I can’t get around, which is whether we are measuring inflation correctly. It happens that I don’t think we are – strange effects like declining inventory will provide upward pressure and lagged-accounting for rents providing downward pressure in the CPI. This is an unfortunate, untradeable fact about the universe that I think will be offset by other indicators (Core PCE) sending a better signal. But this is part of the reason this whole story will take time to develop in the marketplace. As a massive importer of goods and exporter of debts we are not quite Japan, but the path of misunderstanding is remarkably similar.”

* Credit due Warren Mosler and moslereconomics.com for guiding my logic.

J.J. Lando"