In praise of (a little bit of) fiscal dominance

Who makes sure the long run consolidated government-central bank budget constraint balances? Is it the government? Or is it the central bank? The former gives us a Ricardian regime; the latter gives us fiscal dominance.

Most macroeconomists take a Ricardian regime as their unspoken assumption; and, if pressed, would recommend a Ricardian regime, as is required, in the long run, by central bank independence. If the central bank is to have the independence to pursue its own objectives (be it inflation targeting or whatever), the government must take long run responsibility for its own deficits, grateful for whatever profits from seigniorage revenues the central bank deigns to hand over. Worries about the "coordination of monetary and fiscal policies", heard often in Canada until the mid-1990's, were code for the desire for a Ricardian regime.

Only the pathological cases, the Zimbabwes of monetary policy, have fiscal dominance. When the soldiers need paid, and you cannot or will not raise taxes to pay them, and you cannot borrow because prospective lenders know the soldiers will still need paid tomorrow, and you won't be willing or able to raise taxes tomorrow either, you have to print money to pay them (because they are soldiers, after all), and you might as well print to pay interest on existing debt as well, while you have the paper and ink. You need never default on debts that promise to pay only what you yourself can print.

But the very helicopter money that could help us escape the current recession assumes fiscal dominance. By literally giving away money, the central bank is destroying the assets=liabilities identity of its own balance sheet. It's trashing its own net worth. Call it a money-financed transfer payment if you wish to respect proprieties, or a money-financed tax cut. But the point is the same. The seigniorage isn't handed over to the government; it goes to the people underneath the helicopter. The time-paths of future government spending and taxation stay the same. They must, if the increase in the money supply is to be permanent. And it's that very permanence, with it's implied increase in the expected future price level, that creates the higher expected rate of inflation, and/or higher expected real growth rate, which is what rescues us from the liquidity trap.

Under a Ricardian regime, an increased primary deficit today would need to be offset by an increased primary surplus sometime in the future, with an equal present value. Under fiscal dominance, a temporary increase in the primary deficit today would have no effect on future primary deficits or surpluses; the money-finance would be permanent. That would make the fiscal-cum-monetary policy multiplier much larger. It is equivalent to promising a permanent increase in the long run equilibrium price level. It is equivalent to promising to keep monetary policy loose for too long, even after the recession has passed.

Right now, a little bit of fiscal dominance is just what the doctor would order. Will it be inflationary? Of course! At least, we sure hope people believe it will be. That's the point. If the counterfactual conditional is deflation, we want a policy that delivers an increase in the actual and expected rate of inflation.

Helicopter money, that monetarist thought-experiment, assumes fiscal dominance. So does the fiscal theory of the price level, with its implicit assumption that the present value of primary surpluses is exogenous with respect to the existing level of debt. So does Neo-chartalism (at least, the latter makes more sense to me if I assume that they assume fiscal dominance, which is what I mean by an "implicit assumption").

Fiscal dominance is not an accounting statement. It is not even an economic statement. It is a political (or, at least, political-economic) statement about how the world works, or, more precisely, how people expect the world to work. If push comes to shove, and the government's tax, spend, and debt-service objectives conflict with the central bank's monetary policy objective, who has the last word? Or, rather, who do people believe will have the last word? Which one is expected to play chicken?

And that's the problem. Just how do we create the expectation of a little bit of fiscal dominance?

Comments

[JKH]

“The seigniorage isn't handed over to the government; it goes to the people underneath the helicopter.”

I’m not getting this. If you’re comparing seigniorage handed over to the government with a “helicopter drop”, then you must be comparing bonds held by the central bank versus bonds not held by the central bank, given the same government expenditure.

There’s no difference in the net cost to the government between these two choices.

The effective net seigniorage in both cases is the reduced cost of money financing instead of bond financing. The case of the central bank holding bonds is just an internal bookkeeping wash. It doesn’t say anything about the true economics.

The people getting the transfer payment are in the same position in either case, whether the money is received by helicopter or by mail.

The only “seigniorage” they’re getting is the benefit of being disproportionate recipients while being only proportionate taxpayers. But that's the same in either case.

It’s a fiscal transfer in either case, net money financed.

And the asset-liability mismatch that matters is that of the consolidated government entity, which is also the same in either case.

That's all assuming you’re comparing bonds held by the central bank versus bonds not held by the central bank, given the same government expenditure. If you’re not, your initial statement doesn’t make sense.

[Nick Rowe]

JKH: I'm not sure what you're not getting. Let's take a simple example. No bonds at all, either inside or outside the central bank. The government has constant real expenditures G, and constant real lump sum taxes T. And G=T so the budget is balanced at all periods, so the long-run government budget constraint is satisfied trivially. Then the central bank prints $100 and throws it out to the population, with no change in G or T either now or in future (except, of course, the $100 can be seen as a one-time transfer payment, which is like a one time negative tax). That's helicopter money.

Now consider an alternative. The central bank prints the same $100, and gives it to the government. The government buys land, which pays rents of $10 per year real. It is now impossible for T and G to stay constant forever, because that would violate the long-run government budget constraint. The government must increase G permanently by $10, or cut T permanently by $10 (or do something that have the same net present value).

[Too Much Fed]

Nick said: "Then the central bank prints $100 and throws it out to the population, with no change in G or T either now or in future (except, of course, the $100 can be seen as a one-time transfer payment, which is like a one time negative tax). That's helicopter money."

Isn't that helicopter currency? Should currency be substituted for money here?

[JKH]

Nick,

Helicopter money is a fiscal transfer that creates a government deficit for the consolidated government/central bank entity. It’s a fiscal deficit that is money financed, the same as it would be if the government had issued a bond to the central bank. The helicopter drop of currency is essentially the same as a cheque in the mail. One increases currency issued by the bank; the other increases bank reserves and deposit liabilities.

In your new example, the government spends on land investment and bank reserves increase. The central bank has “financed” the land investment with money issuance. (Actually, it has created money by spending on land).

But I don’t understand why you end up comparing helicopter money with land investment. Why not just compare a simple transfer payment with land investment? The helicopter thing is an unnecessary distraction.

[Too Much Fed]

Is there a difference if the central bank gets the treasury to print $100 in currency and if the central bank "prints" $100 in bank reserves?

[Too Much Fed]

Nick said: "Right now, a little bit of fiscal dominance is just what the doctor would order. Will it be inflationary? Of course! At least, we sure hope people believe it will be. That's the point. If the counterfactual conditional is deflation, we want a policy that delivers an increase in the actual and expected rate of inflation."

With that in mind, should prices be inflated with currency or currency denominated debt?

[Adam P]

Nick, you say "the fiscal theory of the price level, with its implicit assumption that the present value of primary surpluses is exogenous with respect to the existing level of debt."

This is simply false, there is no such implicit assumption made in the fiscal theory.

[Bill Woolsey]

Interesting theory, though I think you should always mention that the current liquidity trap is about low risk, short term nominal interest rates being near zero, and so it is about difficulties in using open market operations in low risk, short term securities that is the problem today. Creating expected inflation reduces the real interest rates on those securities, or perhaps raises the market clearing real interest rate on them through higher expected growth. Open market operations in longer term and more risky securities remain possible avenues of reducing nominal and real interest rates without creating higher expected inflation.

Why isn't this obvious? It it the habit of single interest rate macroeconomic modeling?

Also, there is the possibility of suspending currency payments. Perhaps that is just too much trouble. But then, creating excess inflation is trouble as well.

[Nick Rowe]

Damn! It just disappeared my comment! MY comment! Doesn't it know who I am??

Trying again.

Bill: what's "suspending currency payments"? I think most people worry about the sheer scale of purchases of risky assets that would be needed, at least if it were a temporary purchase.

Adam: Are you sure? To my mind, the FTPL says that the real value of government liabilities (money+bonds) is not just equal to but determined by the PV of primary surpluses. So those primary surpluses have to be exogenous.

Too much Fed: the helicopter delivers currency.

JKH: the helicopter is meant to reduce distractions. But if you find it distracting, a permanent money-financed transfer is fine.

[Adam P]

Bill, you ask: "Open market operations in longer term and more risky securities remain possible avenues of reducing nominal and real interest rates without creating higher expected inflation.

Why isn't this obvious?"

The reason it's not obvious is because it's patently false and anyone with even the slightest understanding of asset pricing would know this.

[Adam P]

Nick, yes I'm sure.

you said: "FTPL says that the real value of government liabilities (money+bonds) is not just equal to but determined by the PV of primary surpluses."

Yes. (Risk-neutral expected PV of course).

Then you said: "So those primary surpluses have to be exogenous."

No. When valuing an equity as the PV of expected-future dividends the tisk-neutral distribution of future dividends is endongenous.

What exactly is so hard about jointly determined?

[Ruth Harris]

If the central bank prints $100, it has a $100 liability on its balance sheet. What is the balancing asset entry?
If the government borrows $100 from the central bank, the central bank has a $100 asset (the government debt) and a $100 liability (the cash). The government has a $100 asset (the cash) and a $100 liability (the debt).
The government can borrow from the central bank, and the central bank can loan money to the government, increasing both their balance sheets, but I don't see how one can operate without the other. Can they?

[Nick Rowe]

Ruth: "If the central bank prints $100, it has a $100 liability on its balance sheet. What is the balancing asset entry?"

The balancing entry is a $100 drop in the central bank's net worth. It would be exactly the same as if one of the bank's computers, worth $100, broke and became worthless. If the bank had $0 net worth before the helicopter, its net worth would now be negative. The central bank having a negative net worth on its balance sheet is not a problem at all, unless it ever wanted to reduce the supply of money in future.

One of the good points of the helicopter metaphor is that it forces us to realise that the central bank's balance sheet is not in fact a constraint on what it does (unless it runs out of assets altogether and wants to reduce the money supply).

Now, in practice the central bank rarely gives away stuff. Normally it buys something in return for the money. It's the government that normally gives away stuff (and takes it away, in taxes). But when the Bank of Canada throws a conference, it is giving away stuff, but this has so little effect on its net worth, that all it means is a slightly smaller annual donation of profits from the Bank to the government. (Of course, the conference might result in more skillful monetary policy in future, but the ability to do skillful monetary policy does not appear on the asset side of its balance sheet.)

Sometimes, accounting conventions DO act as an improper constraint on our thinking.

[Mike Sproul]

Ruth Harris:

When the central bank prints $100, the balancing asset entry will be the $100 IOU of whoever borrowed the $100, or $100 worth of bonds purchased with the $100, or $100 worth of office furniture bought by the fed with the $100, etc. If the $100 is helicopter-dropped, then the central bank's net worth will fall by $100. If net worth is already zero, then the dollars issued by the central bank will lose value in proportion as the central bank's assets outrun its liabilities.

Central banks and governments can operate without each other. The Mexican Central bank can issue pesos while buying nothing but bonds issued by IBM. And the US government can borrow from Chinese citizens without ever dealing with the Federal reserve.

[Mike Sproul]

Ruth Harris:

"assets outrun its liabilities" should have said "liabilities outrun its assets"

Nick Rowe:

If the assets of any private company were worth even 1% less than its liabilities, then speculators would short the company's stock and profit as the stock fell. If the central bank's assets were worth 1% less than its assets, then speculators would short the currency and profit as the currency fell.

[Bill Woolsey]

Nick:

A currency suspension is when banks don't redeem deposits with currency. It was standard operating procedures during financial panics in the U.S. in the 19th century.

Without redeemablity into zero interest currency, nominal interest rates can be negative. Once out of the liquidity trap, currency redeemability can be resumed.

Expectations of suspension (and resumption at par) may result in currency runs. This suggests that resumption should not be at par, but rather at a discount reflecting the negative interest rate on deposits.

Expectations that a liquidity trap will result in a suspension can prevent it from happening, particularly if the reason for the trap is low credit demand because of expectations of lower real income.

I believe that hand-to-hand currency will eventually disappear and be replaced by electronic payments. The zero nominal bound will disappear at that point. Suspensions are disruptive, but if you think about it in the context of an institution (paper money) that is going away anyway, it is less of a worry.

[Bill Woolsey]

AdamP:

Asset prices depend on supply and demand.

That is one thing, and I think the first thing to know about asset pricing.

So, how is it that a central bank cannot reduce longer term and higher risk assets by purchasing them?

What are you assuming about the elasticity of supply and demand?

[JP Koning]

Excellent article, in particular... "Fiscal dominance is not an accounting statement. It is not even an economic statement. It is a political (or, at least, political-economic) statement about how the world works, or, more precisely, how people expect the world to work."

In Praise (of a little bit) of fiscal dominance is just another way of saying In Praise of (a little less) central banking independence, right Nick? I'm not sure if the short term gain of giving up independence outweighs the long term problems that less independence might create. I'm not a big fan of central banking, but I always admired central bankers' long and hard fought battle to distance themselves from the government treasury (take, for instance, the 1951 Fed-Treasury Accord).

And I definitely agree with you that a good understanding of central banking requires not just economics and accounting, but also politics. That's why I'm always quoting to you from the Federal Reserve Act and the Bank of Canada Act! Laws are the result of politics. I think almost everyone ignores the actual constituting articles of central banks and the language therein.

My main beef with neo-chartalism, for instance, is it that it arbitrarily aggregates the Fed (central bank) and Treasury (executive branch) together, sacrificing all the important political/legal aspects that define that relationship. While this may make the accounting easier, such a way of regarding monetary institutions will never allow for the interesting questions you ask above about independence. Indeed, as you say (I just re-read your piece), neo chartalists automatically assume pure fiscal dominance (ie no independence). Any reading of laws and central bank acts will show this assumption to be a gross simplification.

[Don the libertarian Democrat]

"JKH: the helicopter is meant to reduce distractions. But if you find it distracting, a permanent money-financed transfer is fine."

That's it. Like a lion-tamer with a lion. Get the beast to focus on the chair. One thing at a time. It's all about expectations. Don't complicate them. Simplify them. It's nothing to do with anything called "reality", but believability.

"Most macroeconomists take a Ricardian regime as their unspoken assumption"

Philosophical Analysis is all about making the unspoken explicit or a tautology, something that needs to be assumed.

"Fiscal dominance is not an accounting statement. It is not even an economic statement. It is a political (or, at least, political-economic) statement about how the world works, or, more precisely, how people expect the world to work. If push comes to shove, and the government's tax, spend, and debt-service objectives conflict with the central bank's monetary policy objective, who has the last word? Or, rather, who do people believe will have the last word? Which one is expected to play chicken?"

That's why the Chicago Plan of 1933 recommended QE + a Reinforcing Stimulus. It's much better to use both barrels. Also, that's the point of Friedman's "A monetary and fiscal framework for economic stability". To get a plan in place that constrains the political choices available, or, at least enough to produce believability.

[Adam P]

Bill,

you said that the CB could reduce real interest rates by purchasing longer term or risky assets. this is false, to the extent they change the prices of those assets it is by taking risks out of the private sector asset portfolio and thus changing market risk premia.

This can certainly be stimulative but the transimission mechanism is different and in particular it amounts to the CB directing capital allocation through their choice of what to buy, that's a business that they don't really want to be in.

[Bill Woolsey]

Adam P,

Thank you for the clarification.

I understand that the central bank is impacting risk premia (and the term structure of interest rates) when it purchases longer term and riskier securities.

I call that reducing the nominal and real interest rates. The short and riskless ones stay near zero, the longer term and riskier ones fall, the average level of real and nominal interest rates fall. Apparently, this violates some linguistic convention you follow. Does it have to do with what "the" interest rate is supposed to mean?

I suppose that there would be some change in the tranmission mechanism. Isn't the point to replace a failed transmission mechanism with one that works?

That central banks may not want to get into purchasing longer term and riskier may be true. I think they should because it is better than the alternatives.

Job one is to maintain the nominal target which should be a growth path for nominal expenditure. If this can be done withtout impacting risk premia or the term structure of interest rates--fine. If purchasing longer term or higher risk securities is necessary, then do it. If that involves too much risk, then suspend currency payments and let short term, lower risk interest rates turn negative. The expectation that these things will be done if necessary to keep nominal expenditure on its growth path will make these "drastic" actions unnecessary under most conditions.

[Nick Rowe]

JP: Thanks!
"In Praise (of a little bit) of fiscal dominance is just another way of saying In Praise of (a little less) central banking independence, right Nick?"

Right, unfortunately. But there might be a way to square the circle, if the bank could commit to financing a limited amount of deficits. Can't get my head around any concrete proposal.

"I'm not sure if the short term gain of giving up independence outweighs the long term problems that less independence might create."

Nor am I.

And all this is indeed why I stuck that "little bit" in the title. I'm torn.

I would focus less than you though on what the law says, and more on what the practice is, and what people believe/expect the practice to be. It's the unwritten monetary constitution that matters. (Isn't that a Bagehot reference?)

[Adam P]

Bill it's not a linguistic issue. The reason that it's important to understand that the CB needs to impact risk premia is that there are severe limits on its ability to do this through buying assets in the secondary market.

After all, suppose (to take a simple example) that the only bonds available where 1 period nominal discount bonds (face value 1). Fix expected inflation at zero and assume agents are risk-neutral. The CB can't impose an EQUILIBRIUM price greater than 1. The CB CAN announce that it will buy such bonds for price 1.05 but this doesn't change the equilibrium price, the bank simply ends up owning all outstanding bonds.

Now take the same example with the bonnd being a REAL (indexed) bond. The CB can't impose an equilibrium price greater than 1 in this case either (due to the assumptions of market risk-neutrality and zero expected inflation). Buying all the bonds won't change this fact and thus the CB can't push the equilibrium real rate arbitrarily lower just by buying bonds or other assets.

Now apply the same lesson to longer term bonds (real or nominal). If expected inflation is zero and agents are risk neutral then there is a minimum on longer term real rates (also zero in this example).

Now, apply the lesson allowing for risk averse agents. If the risk premium doesn't change due to the central bank purchases (the most likely case if it just buys longer term government bonds) then there is a STRICTLY POSITIVE minimum on the longer term real rates that can be imposed without generating infaltion expectations. This is the case no matter how much the CB buys.

Finally notice that the equilibrium price of longer-term assets are already equal to the relevant risk-free interest rate plus the relevant risk-premium. Thus, your statement that longer term real rates can be reduced is in general false, in the sense that the CB ability to reduce these rates is severly limited. You seemed to imply that it could lower them as much as it wants.

Just buying assets in the secondary market, without reducing risk premia, doesn't neccessarily stimulate investment, the CB needs to buy assets that insure the right private sector risks. This is not easy and furthermore the CB is essentially in the business of directing capital allocation when it does this. In general that's an undesirable situation.

[Adam P]

And one last point, I agree with you that the present situation requires the CB to buy risky assets. My point is that we need to understand in great deal how this should work in order for it to have the desired effects.

Blanket statements that all the CB needs to do is buy enough assets aren't very helpful. It's just not that easy. What is easy is to for someone to criticise the Fed without having an alternative solution that's any good (thinking Sumner here).

Once one thinks carefully and realizes how hard this is to get right and how much uncertainty the CB faces in determining what will be the real effects of it's actions you see that actually Bernanke is doing about the best job possible and simple minded criticism (again meaning Sumner) of what he's doing is counter productive.

[winterspeak]

CB does not need to buy risky assets. It can lend unsecured to member banks at the discount window. CB activities simply change the form of extant financial assets, not the quantity. And the problem is that the private sector has insufficient NFA equity as is trying to get more via unemployment.

I also love to read stories about how a helicopter drop is monetary policy! That truly is the last refuge of monetarist scoundrels ; )

[Nick Rowe]

Winterspeak: strictly, a helicopter is monetary+fiscal policy, under standard definitions.

[winterspeak]

Help me with the standard definitions.

The last economist I was having this conversation with said the standard definition of monetary policy was "changing the quantity of the money supply". I said that was brilliant, as fiscal policy changes the quantity of the money supply with every spending and taxation event, and therefore monetary policy had redefined itself to encompass all of fiscal policy!

[Ruth Harris]

Nick Rowe:
When a central bank prints money it goes into some entity's account, and that entity must provide something in return, that goes on the asset side.
But thanks for your comment - it pointed out something I hadn't thought of, and that is that central banks operate with very small capital reserves (which would be their equity, I think). The Bank of Canada has $140 million of capital on a $75 billion dollar balance sheet.(http://boclab.com/en/about/pdf/boc_balancesheet1009.pdf)
The Federal Reserve doesn't use the same categories, but it has somewhere around $110 billion of Other (non-liability entries) on a $2.3 trillion dollar balance sheet.

Mike Sproul: In September 2008, GM had a $60 billion dollar shareholder's deficit on a $110 billion dollar balance sheet (see their 10Q filings on their website.) I always wondered why they didn't have to declare bankruptcy.

[JP Koning]

"One of the good points of the helicopter metaphor is that it forces us to realise that the central bank's balance sheet is not in fact a constraint on what it does (unless it runs out of assets altogether and wants to reduce the money supply)."

Nick, I don't agree with you on this one. You're thinking like an economist, which is great, but ignores the other side of the elephant. From the perspective of the practitioner working in financial industry, central bank balance sheets are important, now more than ever. Currency traders look at the Fed's balance sheet, compare it to that of the ECB, SNB, BoC, etc and make respective decisions based on the the comparison. I've never heard so many brokers/traders/clients talking about central bank balance sheets. For instance, many are worried about the potential repercussions of Maiden Lane I-III on the Fed's balance sheet and a writeoff of said assets.

If you don't believe me, do a Google blog search on "Federal Reserve balance sheet", or surf over to Seeking Alpha and see the reems of ink being spilt on the issue. All these perceptions are important becuase they affect the currency holding choices of traders. Do you think they are wrong in their perception? Or that trader's concern with balance sheets has no effect on currency values?

A Nick Rowe-governed central bank that thinks it can treat its balance sheet like it doesn't matter (by issuing helicopter money) WILL be disciplined by currency traders. The value of its currency will fall as these traders switch to better run currencies. Let this go on for too long and you risk having the silent majority of your clients - normal people who don't care about balance sheets - spontaneously jump to a new medium of exchange when the existing one's perpetual decline becomes too much of a hassle to bear. ie. Zimbabwe.

Once that happens you'll realise that your central bank's balance sheet is in fact a constraint on what your bank does - because by then your central bank won't exist anymore.

[winterspeak]

JP Koning: The traders are wrong. The US is a currency issuer, and has no operational limit on the amount of currency it can issue. Inflation is a potential problem, but the US has lots of tools that can combat inflation when and if that becomes an issue.

For all those normal people who will "jump to a new medium of exchange", I guess they will just go to jail on April 15th if they happen to live in the US.

Finally, it would be nice if people actually looked at the real Zimbabwe (and Japan) instead of just conjuring up the name like a talisman. Zimbabwe destroyed about 50% of its real output. Do you think this might have had some impact on the value of its currency?

[JP Koning]

Winterspeak, I think you misunderstand why I bring up Zimbabwe. We both agree that a 50% destruction of real output would hurt a nation's currency. I brought up Zimbabwe as an example of a spontaneous jump from one currency to another.

This jump wasn't inspired by government-issued edict. Rather, shopkeepers/bankers/etc got so sick and tired of the constant destruction of the currency's value that they took on the risk of jail-time when they simply ceased quoting and selling goods in Zim dollars, accepting only US dollars and rand. A central bank that ignores its balance sheet will eventually face this possibility - this is the discipline that Nick believes does not exist.

"The traders are wrong".

Wow, the hubris ;)

Well, they've been right till now. And they don't buy your claim that the Fed has the tools to fix its balance sheet. Dare you to bet against them.

[winterspeak]

JP Koning: Traders *have* been wrong on occasion. Look, I'm actually more Chicago school than the next guy, so I have a deep respect of markets, but the commentary from the financial sector on this sovereign debt stuff is simply wrong. I'm really surprised that anyone is still pushing this "markets are infallible" line.

I brought up Zimbabwe because, even if no one had jumped ship to another currency, a 50% contraction of real output would bring about hyperinflation by itself. Moreover, Zimbabwe, like every third world nation, was almost certainly running a mixed currency environment to begin with, probably with a lot of barter thrown in, AND they almost certainly had zero tax compliance.

In the US, tax compliance is excellent, and it is in US$. Until tax compliance markedly deteriorates, there will be healthy demand for US$. And, in the form of the US Gov, the Fed has every tool it needs to fix its balance sheet.

Very comfortable betting against them. I think there will be a deflation surprise next year. Apart from betting interest rates will fall on Treasuries, if you have another trading strategy I would be glad to hear it.

[winterspeak]

besides, it's not hubris at all. Every trade involves each party thinking the other party is wrong!

[Scott Fullwiler]

Regarding traders being wrong. . .

As Warren Mosler explains in the intro to his 7 innocent frauds paper, sometimes you can make boatloads of money betting against markets that don't understand sovereign currency issuers (and it's not the only time he's done it).

[JP Koning]

"And, in the form of the US Gov, the Fed has every tool it needs to fix its balance sheet."

Through what specific process? Is this generalizable to the "average" central bank?

[Bill Woolsey]

Adam P,

I think you answered my previous question. You are always assuming perfectly elastic supplies or demands at some kind of calculated price. This is possible if you assume homogeneous expectations. In the real world, the Fed can buy bonds, lower their yields, and leave new money in the hands of people who will buy newly issued bonds from firms wanting to purchase new capital goods. Only by making unrealistic assumptions do you end up with corner solutions. The Fed buys all bonds at the price of one.

Different people have different expectations. Come on.

But, it really doesn't matter whether the Fed buys newly issued bonds or not. Having them pass through the hands of some other investor hardly matters.

But you constant mixing of "but that is a bad idea," with "that is impossible" is irritating. What are the alternatives?

I would suggest first going up the maturity on T-bills, and then starting with AAA commercial paper.

Break the liquidity trap by any means necessary.

[winterspeak]

JP: No, it is only available to Govs running fiat regimes. So, no fixed fx, convertible currency, foreign denominated liabilities, etc.

So, the CB has a lot of its crap on its balance sheet. A bunch of it goes off, so what. Treasury can always fill in the gaps.

[JP Koning]

"Treasury can always fill in the gaps."

Maybe a country's Treasury can, but maybe it won't. Given a fully capitalized central bank and a similar one with no capital but a promise from the Treasury that it will be re-capitalized, a trader will discount the latter's currency. Why take the risk?

After all, finance departments and treasuries have been known to neglect their promises (remember $35 convertibility?). There are many examples of modern central banks that have left their central bank high-and-dry despite legal commitments to re-capitalize, ie. fill in the gaps.

[JP Koning]

sorry, meant to say: "There are many examples of modern Treasury departments that have left their central bank high-and-dry despite legal commitments to re-capitalize, ie. fill in the gaps."

[Adam P]

No Bill, you're still wrong. You have two problems.

First, apply the same logic one investor at a time, allowing them to have different risk tolerances and different inflation expectations. The inflation expectations of each one will determine the most that that particular agent will hold bonds at, thus although in this case the central bank can change the price there is still an upper bound on that price (lower bound on the interest rate) specified by that distribution (over agents) of expectations. That upper bound may be 1, it may be more than 1 or may be less than 1. The point is that it may be too low to break the trap, especially when you consider the next point about risk premiums.

But secondly, and this is really the point you're not understanding. There is a risk premium for real investment. Even if the CB gets the real rates to zero (or below) across the entire yield curve the risk premiums may make the available investment opportunities still unattractive relative to holding cash at zero or even negative return. I'm not assuming the same risk premium for each project, each is evaluated on a risk-adjusted basis. And of course, lowering real rates should stimulate some investment, the marginal project, but the issue is to get enough investment to return to something like full employment.

Real risk premia that are high enough require the CB to get the real interest rates well below zero in order to even approach full employment and then the bound referred to in the first paragraph can bind.

(I never once said that the CB can't change prices at all by buying assets, I said this ability was severely limited if they don't change inflation expectations. You have to read and try to understand what I actually wrote.)

Now, I never said it matters if the Fed buys newly issued bonds. What I said was that (if not generating higher inflation expectations) the Fed would need to reducde REAL risk premiums, buying treasuries and AAA paper won't likely do that because it doesn't insure the risks that are generating the risk premium in the first place.

[Nick Rowe]

Ruth Harris: "When a central bank prints money it goes into some entity's account, and that entity must provide something in return, that goes on the asset side."

Suppose a central bank (or any other corporation) donates some money to charity, and gets nothing in return?

The really important asset of the Bank of Canada does not appear on its balance sheet. That's the value of its de facto monopoly profits from creating base money. Probably worth around $100 billion, ballpark, at 2% inflation. It could throw away all its other assets, as long as it kept that asset, and still function.

[winterspeak]

JP: ""There are many examples of modern Treasury departments that have left their central bank high-and-dry despite legal commitments to re-capitalize, ie. fill in the gaps."

Really? In fully fiat regimes? No sarcasm here -- I do not know of any such instances. Can you point me to some links? Thanks!

[Ruth Harris]

Nick Rowe:Suppose a central bank (or any other corporation) donates some money to charity, and gets nothing in return?

The donation increases the charity's account at the central bank (assuming it has one), which is a liability on the bank's balance sheet. There must be an offsetting entry, which would likely be a reduction in the equity portion of the central bank (on the same side as the liability) rather than an increase in the asset side.
If I donate to a charity, I donate money, which reduces my assets, and I have to reduce the equity on my personal balance sheet to reflect that. But a central bank donation would affect the liability portion of its balance sheet, not the assets.

[JP Koning]

Winterspeak, a good examples of this is the Bangko Sentral ng Pilipinas (BSP). When it was incorporated in 1993 the Philippine government was mandated to contribute 50 million pesos in capital, but it only paid P10 million, with a promise to pay the balance. To this day it has never paid its share. The 2010 budget will supposedly rectify this over the course of the next few years, but I don't need to point out that any government's planned budgets are political promises that don't need to fulfilled. 17 years of waiting for the Treasury to "fill in the gaps".

The best economist on these issues is the IMF's Peter Stella. See http://www.imf.org/external/pubs/ft/wp/2008/wp0837.pdf - he has many more examples of the above.

[JP Koning]

Ruth and Nick - regarding a central bank donation, I believe this would be credited to the goodwill category on the asset side of the central bank's balance sheet. The balancing liability would be an increase in money outstanding.

[bill woolsey]

Adam P,

When they have driven all nominal interest rates to zero, regardless of risk or term to maturity, then there is a real liquidity trap. Yes.

My point is simply that if the interest rate on low risk very short securities are near zero, that isn't a liquidity trap.

It is possible that having all interest rates of all maturities and risk classes at zero might not be sufficient to get investment equal to saving at full employment output.

But we have little evidence that this is true now.

[JP Koning]

Nick, I can't help but think you are avoiding my points.

So what if the most important asset of a central bank - its monopoly - does not appear on its balance sheet. Traders don't look at one central bank monopoly and its currency brand in isolation, but make comparisons between central bank monopolies and brands.

Central Bank X and Central Bank Y are alike in all respects, including the value of their respective monopolies, except X throws away all its interest earning assets while Y keeps them. X takes a huge hit to their capital, although still has its monopoly intact. Currency traders - weary of Y's now much-reduced capital - flee to Y's currency from X's.

Traders discipline X's balance sheet antics by drastically reducing the value of its money liabilities. X's fails in its function as the provider of a stable unit of purchasing power to its citizens.

[JP Koning]

Whoops: "Currency traders - weary of X's now much-reduced capital - flee to Y's currency from X's."

[Nick Rowe]

JP: Guilty! I was avoiding your points. I was having too much fun watching you and Winterspeak argue it out, wondering which side to come down on ;)

I like your latest example though. It clarifies things. But suppose there is a third country, Z, which is exactly like Y, except the government of Z throws away the same amount of assets as the central bank did in country X.

If you believe in fiscal dominance, then X and Z are the same, and traders will respond the same way.

If you believe in independent central banks, and Ricardian Equivalence, then Y and Z are the same.

I think the truth maybe lies somewhere between.

[Nick Rowe]

Ruth and JP: however you want to handle the charitable donation on the accounts, just handle helicopter money the same way!

My basic point: you can't use accounting identities to prove that helicopter money is impossible! And it is a fundamental misunderstanding of accounting (or rather, meta-accounting) to think that you can. And it also shows how accounting, if we are not careful, can distort our thinking.

[JP Koning]

"I think the truth maybe lies somewhere between."

Me too. The world seems much more complex than our theories.

I'd agree with your point about Z, as long as it implies that central bank Z had no government bonds on its balance sheet. Because if it did have a few gov't bonds, and government Z throws away assets, gov't Z's bonds will collapse in value, and central bank Z will take a hit to its capital.

On second thought, I guess that the definition of 100% independence implies no government bonds on the central bank balance sheet, and therefore your point about Z makes sense.

[Ruth Harris]

Re: Helicopter money
My point is that the central bank has to have an asset on its books to balance the money it creates, and that asset will be a liability on some other entity's balance sheet. Usually the government's, backed by the government's power to tax.
So I'm not sure a government can throw away its assets.

[David Heigham]

Me, I have anways favoured blimps over helicopters. Money from government always tends to drop in lumps (so you need to consider who gets it when working out what is likley to happen). The helicopter scatters it with unrealistic equity.

That apart, Nick is talking about a consistent way of creating beneficial self-fulfilling expectations. You cannot do that with strict Ricardian expectations about a government that does not directly act to increase future disposable income. But if he expects the actions of the government to increase the PNV of future income by more than the cost of these actions; surely a citizen called Ricardo will now save less than proportionately because he will expect an increase in future taxable capacity?

In the general case, I think that a necessary condition for fiscal dominance to be desirable is confidence that the government will spend the extra money so as to increase expected future economic output above the future economic output expected without the government action. That is to say,(since expectations tend to be self realising) it depends as much on our state of hope or despair for the economy without the government action as upon what we think government action will achieve.

[Nick Rowe]

Ruth: How does it go? "Are you now, or have you ever been, a member of any organisation of accountants?" Because what you are saying sounds like the product of a mind that is so dominated by an accountant's way of thinking, that you say things that would not make any sense at all, otherwise. You illustrate perfectly the dangers of accounting.

"My point is that the central bank has to have an asset on its books to balance the money it creates..." No it doesn't, if it gives away money for free.

"...and that asset will be a liability on some other entity's balance sheet." Not necessarily. It might be a computer, or bricks and mortar, or gold, or land.

"So I'm not sure a government can throw away its assets." !!!

What if the government takes all its trucks, computers, desks, etc., and just throws them in the garbage? Or gives them to its cronies?

[Nick Rowe]

David: "In the general case, I think that a necessary condition for fiscal dominance to be desirable is confidence that the government will spend the extra money so as to increase expected future economic output above the future economic output expected without the government action."

There's some truth in what you say here. A few months ago, I did a post on Ricardian Equivalence making what I think might be a similar point. Fiscal policy will be more powerful if people expect the government spending will be on useful investment that will raise people's future disposable income. But I think that's a very different point from the one I'm making here, which is that fiscal policy will be more powerful if people expect a future increase in the money supply rather than higher future taxes.

[winterspeak]

Ruth: If a Govt gives away money, then I would book it as a negative equity entry on the Govt books, so it's a negative entry on the liability side. This is deficit spending, it happens all the time, the sum of all past actions is the "national debt" and it equals the amount of NFA equity the Govt sector has paid-in to the non-Govt sector. This is why I sometimes refer to is as "paid-out equity" but that has its own issues.

You always need to have the balance sheets balance, but the balance sheet for a currency issuer naturally should look extremely different than a balance sheet for a currency user. The required negative equity position may be the most unusual difference though.