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'FTPL says that B(t)/P(t) = EPV[S(t)], and that EPV[S(t)] is exogenous with respect to B(t)/P(t). B(t)/P(t) is the current value of the loan, and EPV[S(t)] is the expected present value of the repayments. The S(t+1)=$105 that you will give me in future is exogenous with respect to the B(t)=$100 that I gave you in the past. But if that were true, how did B(t) ever get to be positive in the first place? What idiot ever gave this government the first loan? It can't have been a loan; it must have been a gift."

When an utilitarian makes a promise I don't know for sure if he will keep it, but I can still form an expectations of the likelihood of his keeping it.

When the govt offers to sell me a bond for $100 and give me back $105 next year I don't know for sure that they won't either renege altogether on the repayment or that the real value of the $105 will be less in the future than it is now, but I can certainly have a set of expectations on it. Based on all these things I may still buy the bond if the present value to me is greater than the present value of $100.

If having bought the bond my expectations change so I think it is worth less than $100 in present value (and everyone else feels the same) then the only way I can sell it is to reduce its price so it yield increases sufficiently so that someone else wants it.

So expectations about the future real value of and return on bonds seems able to explain the current price of bonds quite well.

But where I think FTPL fails in going from there to explain the general price level. To do that it has to sneak in expectations about monetary policy. It is this monetary policy that drives changes n the price level not fiscal policy , and this is true no matter how much monetary policy may have been hijacked to meet fiscal policy ends. To my mind it is this that makes FTPL incorrect.

MF: but FTPL assumes that everyone knows (and that it is common knowledge) that FTPL is true.

"When an utilitarian makes a promise I don't know for sure if he will keep it, but I can still form an expectations of the likelihood of his keeping it."

If it were common knowledge that he is an act-utilitarian, his having promised to do A is irrelevant to the probability that he will do A. Bygones are bygones. His promise is a bygone.

"his having promised to do A is irrelevant to the probability that he will do A".

It sounds like one would conclude from this that lending $100 to an act-utilitarian (with a promise to repay) is the same as giving it to him with no strings attached.

I lend him $100 that he promises in writing to pay back next year. I know he is an act-utilitarian and will only pay me back if that meets the rules of his ethical code. I may still lend him the money if I know there is a legal framework to force the repayment. This legal framework would not help me if I had just given him the money. So the promise is relevant to my expectations (if one is allowed to bring these kind of additional factors into discussions on ethics)

(I'm now going to take my dog for walk and see if I can figure out how this relates to FTPL....).


MF: "I may still lend him the money if I know there is a legal framework to force the repayment."

True. But if he is the government, that won't work.

Nick:

"With no bonds, there is no FTPL."

American colonial currencies (1690-1750) were all backed by future tax collections, so the FTPL was applicable. Some colony had an emergency---soldiers to pay or whatever, and even though the colony had no cash on hand, the colony did have positive net worth, because of its future tax collections, or land that it owned, or toll roads it was going to build, etc.

Nowadays we add bonds: Currency is backed by bonds, which are backed by future tax collections, and the FTPL is just as applicable.

Mike: no. Because those future tax collections, and land sales, and the future payments to bond holders or currency holders, were not exogenous with respect to the past issuance of those bonds or currencies.

I sell shares to start up a new business. The people who buy the shares expect me to use the proceeds to buy assets, and to pay them dividends (or buy back shares) with the returns from those assets. Their buying the shares causes me to pay them future dividends. My assets, and earnings, and dividend payments, are not exogenous with respect to the value of the shares I sold. If I had been unable to sell shares I would have been unable to buy assets and unable to pay dividends. And even if I were able to pay dividends out of my own pocket, I certainly would not, if I hadn't sold any shares.

I think there are two issues embedded here. I think you are describing the exogeneity of EPV in a way that isn't part of the FTPL. You are acting as if the fiscal authority doesn't have a reaction function that cares about the price level, whereas the FTPL assumption is the opposite. The fiscal authority's reaction function is equivalent to the monetary authority's reaction function in a more conventional model, except that it is more complicated because it interacts with more standard fiscal considerations. The reason the government pays people back is because it doesn't want the price level to depart from its target, implicit or explicit. Sure, it is not endogenous in the narrow sense the B doesn't add assets to the government in the same way that shares add assets to the firm, but there is still an equilibrating mechanism between EPV and B/P.

I was reading your question in the previous thread as asking whether there could be such an equilibrium even given a fiscal price level reaction function, since we know the fiscal authority will never want the price level to go to zero upon the repayment of all the bonds. I have thoughts as to why i think Samuelson's S(t) = 0 or r < g is not a problem for this idea, but after reading this post I'd rather clear up the bigger point.

Last sentence was truncated:

I have thoughts as to why I think Samuelson's S(t) = 0 or r less than g is not a problem for this, but after reading this post I wanted to first address what seems to be the larger issue.

If I read the literature correctly, the price level P(t) is a ratio with an expected value between about 1.4 to 5 or more, depending upon the total of bond debt (based on U.S. data). P(t) is a function of the tax rate.

Correct?

To answer my own question, "NO, Not correct."

I went to Barro (1979) "On the Determination of the Public Debt". In this paper, P(t) would be the price level potentially used as a target. Presumably, the price level P would be near 1.0.

Taxes are part of the equation which uses P so if we wished to solve for P, taxes would be one of the data variables. Thus, P(t) would be a function of taxes and other variables.

Correct?

I will have to think about your logic some moe, but any fiat currency has a value based on faith in the government. Of course, once private sector agents enmesh themselves in contracts denominated in nominal currency amounts, the currency starts to get a value independent of whatever the government does.

But the FTPL is consistent with the rest of the DSGE mathematical framework. Why should the government be bound by some hypothetical intertemporal governmental budget constraint? That makes even less sense than the FTPL.

But if you object to the FTPL, the obvious solution is to jettion the DSGE mathematical framework as it has a degenerate solution. That may be what you intend, but you seem to be aiming your fire at the FTPL only.

Go back and re-read the chapters in Reinhart and Rogoff on the theory of sovereign debt and default. The question of why anyone should ever believe that they will be paid back by government is certainly a valid one to ask, and there is considerable literature on it.

"The whole point about bonds is that future payments to bondholders are not exogenous with respect to past loans. FTPL says they are exogenous....

FTPL says that B(t)/P(t) = EPV [S(t)], and that EPV [S(t)] is exogenous with respect toj B(t)/P(t)."

I don't think this is right. And Cochrane says different in his paper.

You are assuming that FTPL says that all deficits and debt come into being as the result of exogenous surplus shocks.

So you are assuming that exogenous surplus shocks are a necessary and sufficient condition for the creation of deficits and debt.

I think what it says instead is that surplus shocks are sufficient to adjust the value of outstanding debt

But the issuance of new debt creates a corresponding surplus expectation. That initial surplus expectation is created endogenously as a result of debt issuance.

In fact Cochrane is quite explicit on this point. He says that the appropriate function of government Treasury is to issue debt where the real value of debt is matched by a corresponding surplus expectation with the same real value - and that the government should communicate that expectation.

Surplus shocks are analogous to marked to market shocks on outstanding financial assets.

Issuance of debt balanced with surplus expectations is analogous to balance of starting book value with market value at issuance.

Dr. Rowe,

What relevance do your various blog posts on FTPL have to Canada?

The Canadian government is the sovereign issuer of the Loonie. It cannot go bankrupt. It can pay any future obligation that it wishes to pay. This is the case whether it is paying the admirable Mounties their salaries, buying a Bombardier jet, or repaying a bond. Furthermore, while it should always repay any bond when it is due, there is no reason for it to pay back all outstanding bonds.

I've been trying to figure out what "the budget constraint" means. As near as I can tell, the budget constraint as you use it means that the Canadian Ministry of Finance, the government's left pocket, has imposed a rule upon itself that its expenditures must match its income from taxes and borrowing. But this restriction upon the Canadian government's left pocket does not mean that there is a limited supply of Loonies found only in its left pocket available for Canada's public purposes. The Canadian government has a right pocket, known as the Bank of Canada. The Bank of Canada creates whatever amount of Loonies Canada requires.

The Bank of Canada does not have to get its Loonies from anyone or any place. A clerk or officer sits at her computer, and tap, tap, tap, puts money in private bank accounts (or takes them out). The cost of production is her salary, the computer and her desk, and the building where she works.

In your earlier blog posts in this series, you portray the Bank of Canada and the Ministry of Finance as possibly working at cross-purposes. Why would the government fail to co-ordinate its right pocket and its left?

I realize that in parliamentary systems, the "government" often means those members of Parliament given portfolios by the governing party; that is, cabinet ministers managing departments. The Bank of Canada, however, is part of the Canadian government broadly speaking even though its leaders are more likely to be technocrats rather than politicians. The Bank's Board of Governors, indeed its Executive Committee, has a representative of the Cabinet as an ex offico member. Why wouldn't they co-operate for the benefit of Canada?

"I will have to think about your logic some moe, but any fiat currency has a value based on faith in the government."

Not true. Imagine a stateless society in which there is a Bank of Rothbard, which issues a currency in which people denominate their goods & services (including debts) and which (contrary to what poor Murray would want) is not tied to gold or any other sort of reserve. It's a fiat currency, but the relevant fiat is not that of the government, but the private agents who choose to use it as the unit of account.

It's very tempting to naturalise certain elements of our current economic set-up. A good piece of mental hygiene in economics (even for those of us who aren't anarcho-capitalists or even close) is to do what Murray Rothbard did in "Man, Economy and State" and consider stateless societies, and then perhaps add states to the story in order to understand what difference they make. This is also similar to Marx's method of decreasing abstractions.

dlr: [I edited your comment to fix the truncation problem. You need to put a space each side of < , or else Typepad freaks out!]

Suppose (e.g.) the government tells the central bank to target 2% inflation. That determines the time path of seigniorage, and that determines the fiscal policy reaction function. In particular, if B/P were to be 1% higher, the government would need to increase EPV(S) by 1% too, if it wanted to avoid default. Given the Bank of Canada's inflation target, the fiscal policy "reaction function" is exactly the same for the Federal government as it is for a provincial government or a municipal government. It's simply an intertemporal budget constraint.

What makes the Federal government different from a provincial or municipal government? (Aside from getting the seigniorage, and being able to give the Bank of Canada orders?) Does the province of Quebec, or the municipality of Chelsea, need a correct "fiscal policy reaction function" to keep Canadian inflation at 2%? No. They need to obey their intertemporal budget constraint, in expectation, to be able to borrow.

Brian: "Of course, once private sector agents enmesh themselves in contracts denominated in nominal currency amounts, the currency starts to get a value independent of whatever the government does."

Yes. But it depends on what the central bank does. And given that the Bank of Canada is targeting 2% inflation, there is no difference whatsoever between the Federal government and a provincial or municipal government. (Except the Feds get the Bank of Canada's seigniorage profits, and can tell the Bank of Canada to stop targeting 2% inflation.)

JKH: "You are assuming that FTPL says that all deficits and debt come into being as the result of exogenous surplus shocks."

FTPL just assumes that B(t) > 0 at the initial date. I am asking: how did B(t) get to be > 0, if EPV(S) is exogenous wrt B?

LCB: "What relevance do your various blog posts on FTPL have to Canada?

The Canadian government is the sovereign issuer of the Loonie. It cannot go bankrupt."

The Bank of Canada targets 2% inflation. Given that inflation target, the Canadian government most certainly CAN go bankrupt. Because that inflation target puts a limit on how much money the Bank of Canada can print.

And even if it abandons the inflation target, it can face a bad choice between hyperinflation or default. And if it gets too bad, the amount of hyperinflation needed to prevent default might destroy the money altogether. Witness Zimbabwe.

Stop reading MMT guys. Think about the distinction between real and nominal variables.

Arnold: "The question of why anyone should ever believe that they will be paid back by government is certainly a valid one to ask, and there is considerable literature on it."

Yep. But any such theory must have the property that the EPV of total payments to bondholders is not exogenous with respect to the the total stock of bonds. (And those theories seek to explain why it is not exogenous, and not fixed at zero.)

Nick Rowe: "Stop reading MMT..."

I would rephrase that: read MMT authors carefully. The academic wing of MMT have done some pretty good analysis of the operational realities of modern governments, and they do explain how default is possible. However, as they note, those constraints are essentally artificial, like the debt ceiling in the US. For example, if the Federal government had an open-ended overdraft facility at the BoC - which is what the private banks appear to have - almost all of the involuntary default possibilities disappear. And in practice, any default is either voluntary or due to rank incompetence.

A hyperinflation could be created by extreme fiscal policy, such as the general government sector abolishing taxes. This follows from Functional Finance, which MMT inherits.

It may make sense in an academic journal, but the Bank of Canada would have a hard time juatifying driving a hyperinflation because inflation was slightly above target. In the real world, it is hard to see how an inflation target justifies causing a hyperinflation. I am sure the pitchfork waving mob would be greatly amused by neoclassical ponderings on equilibria selection.

Nick,

PV of surpluses is not exogenous when deficits are incurred and net new debt is issued. Did you read my comment?

Nick,

I do have a number of questions about what Cochrane means by a shock to the present value of real surpluses.

Specifically does it include any or all of the following:

a shock to the nominal size of an expected surplus cash flow, with a consequent effect on the real value of that cash flow

a shock to the expected price level at the time of an expected nominal surplus cash flow

a fortiori, any change in the distribution of expected nominal cash flows or expected price levels as above

a shock to the real interest rate r

Brian: "I would rephrase that: read MMT authors carefully."

Fair point. Abba Lerner, for example, is well worth the read.

"A hyperinflation could be created by extreme fiscal policy, such as the general government sector abolishing taxes. This follows from Functional Finance, which MMT inherits."

Or it could lead to default, if the Bank of Canada is not forced to bail out the government. And if the Bank of Canada did bail out the government, with zero taxes and no cut in spending, we would not be talking about just hyperinflation. We would be talking about the Canadian dollar becoming worthless. Because we would be over the top of the seignirage/inflation tax Laffer Curve. Canadians would switch to using US dollars.

The present value of future real surpluses, exogenous or not, has to be derived from a promise of future nominal cash flows.There is no doubt that the latter is endogenous. FTPL doesn't necessarily contradict that.

Your argument reads like it applies to nominal Nick, but that is not the argument of FTPL.

Leaving aside the possibility of default, an FTPL government could be credibly believed as always keeping its nominal promises but in some circumstances be prepared to use its influence over monetary policy to change the real value of S(t).

It will then be people's expectations about the real value of future S(t) (and P) that will control current P. FTPL would seem to hold in such a world, the only problem being that if people had realistic expectations about future real S(t) the interest rate the govt had to pay would fully reflect expected inflation and prevent the govt succeeding in reducing the real value of S(t) in this way. An FTPL government can only succeed by fooling people into thinking that S(t) will be higher than it actually will be.


Yes, that extreme situation could lead to default before hyperinflation. But one could dial back to a less extreme situation to engineer a hyperinflation, such as having extremely sensitive indexation (such as to the American dollar), and aiming for a deficit of about 5% of GDP. You need something that leads to the deficit scaling with the price level, and which overcomes the fact that taxes are levied as a percentage of nominal activity.

Although interesting, these comments are moving too far away from your original post. However, it is unclear to me how the FTPL interacts with a more realistic specification of fiscal policy that I hint at above (tax rates versus an exogenous primary balance). It may be that the resulting theory is a triviality - pretty much any set of initial conditions is stable, as the automatic stabilisers will ultimately validate the expected value of the bond market.

"So an exogenous shock that makes S(1) increase to $105 causes B(0)/P(0) to rise to $100, and this in turn causes S(0) to fall to -$100."

Wrong causality and exogeneity,IMO.

It starts out with a nominal promise that is entirely endogenous. FTPL is real tweaking from there.

What makes the Federal government different from a provincial or municipal government? (Aside from getting the seigniorage, and being able to give the Bank of Canada orders?)

What, you're not familiar with the burgeoning MTPL literature?

I agree that neither seignorage nor the possible command of the CB are essential to the modern, post Sargent and Wallace FTPL. So what do MTPLers say?

1. The CB is passive or acts first (it doesn't need nominal target "orders" as in your example).
2. People expect Municipal Debt to be backed by the Federal Government Pari Passu with B. [People believe] It will not be allowed to technically default (as in standard FTPL for B).

3. Now the tricky part. The Municipal Authority acts last and in comparison the Fiscal Authority is passive with respect to the price level, while the CB is again passive as in FTPL. What does that even mean? Some public choice quirk results in only city politicians caring about, or able to act in care of, the price level. So the Fed first institutes its M policy, the FA institutes its B and FEPV policy, and then the MA acts with its (say) 2% inflation target in mind. It has a ton of constraints in hoping to be an effective enforcer of that equilibrium. It needs to hope that even the passive policies of the other liability issuers leave it *able* to select an equilibrium in line with its nominal target (just as the FA must hope about the CB's passive policy in standard FTPL) given that its only tool is MD (muni debt) and MEPV. There is a rather narrow class of worlds where the MA could succeed, and they are contingent upon the actual and expected nature of the passive reaction functions of the CB and FA, but it's possible and coherent. Certainly, the MA could achieve Zimbabwe in almost any story. But other cases are not as easy. Still, I could conjure passive policy expectations for both CB and FA where the equilibrium expectation for contingent M, B and EPV is constrained enough such that smaller, actively managed M and MEPV could managed to wag the dog rather precisely.

This is similar to how I think about the FTPL. It isn't degenerate or incoherent, it doesn't require an explanation for B > 0, but it requires an extremely strong set of institutional assumptions (relative to what we observe in the actual world) to work in cases outside of fiscally induced hyperinflation. And yet not nearly as strong as MTPL.

dlr: "What, you're not familiar with the burgeoning MTPL literature?"

You had me really worried there!

"Would you ever believe the promise of an Act-Utilitarian? No. An Act-Utilitarian will perform action A if and only if action A will maximise the sum of expected present and future utilities. His past act of having promised to do A is not a reason for the Act-Utilitarian to perform action A in future."

False. Breaking promises leads to lower future payoffs.

That is something that you learn on Mother's knee. :)

Min: maybe. It's not obvious. What about keeping your last promise, where there are no future payoffs? If it is known you will not keep your last promise, will you have any incentive to keep your second from last promise? And so on. Does it all unravel backwards? (Selten's chain store paradox).

"The Bank of Canada targets 2% inflation. Given that inflation target, the Canadian government most certainly CAN go bankrupt. Because that inflation target puts a limit on how much money the Bank of Canada can print.

And even if it abandons the inflation target, it can face a bad choice between hyperinflation or default. And if it gets too bad, the amount of hyperinflation needed to prevent default might destroy the money altogether. Witness Zimbabwe.

Stop reading MMT guys. Think about the distinction between real and nominal variables."

I do not get this. Why the government cannot tax the excess inflation away and pay its bills by printing. I do not see the imminent "hyperinflation or default".

But I agree that MMT often seems to twist words unnecessarily to the extend it can be said to be wrong.

W. Peden,

If Mr Rothbard is exercising sovereign control over an area or territory, making rules that govern that territory which are backed up by force, then he is acting like a government or state.

'Anarcho-capitalism' really just means privatized states, not a 'stateless society'.

Philippe,

That's a slippery argument, and one from a very dubious premise. Anyway, the point is not to consider anarcho-capitalism as a political system, but to consider what difference a FISCAL authority makes. So if you want to regard the Bank of Rothbard as a state and replace the uses of 'state' in my posts with 'fiscal state', then fine; it's not the issue under analysis.

Jussi,

No-one denies that a government can avoid default by raising taxes!

Jussi: "I do not get this. Why the government cannot tax the excess inflation away and pay its bills by printing."

That is an MMT framing. Restate it as: "I do not get this. Why the government cannot pay its bills by taxing and stop needing to print excess money and creating excess inflation. I do not see the imminent "hyperinflation or default". "

Because it is unable or unwilling to increase taxes enough to pay its bills. And so resorts to printing excess money to pay its bills. Which causes inflation.

"That's a slippery argument, and one from a very dubious premise"

Why?

Mr Rothbard could issue paper/token currency which he would promise to accept in payment of rent, fees, tithes etc owed to him, and then use the currency to pay for goods and services. The currency would then have a 'fiscal' foundation. I'm not sure how a token currency would survive without having some sort of similar basis.

I guess I deserve it by not being to able to fill the blanks :)

Would you say then that the reserves are transformed to a sort of debt by paying on them? So the Central Bank is buying stuff (or financing the government) and paying by issuing debt? Is this a one way to control inflation without raising taxes according MM?

Nick, first this is a great article. However I have to agree with Min. You can have an "promise-keeping" equilibrium even between two act-utilitarians. If keeping promises is mutually beneficial in the long run you can count on the other side to keep its promise. True, keeping promises has nothing to do with "promising" - but I doubt it ever does even in the real world. I think that if there was a way where one country could costlessly get rid of its debt from other countries that would and should do it - given the fact that the objective of the state is to increase utility of its citizens.

Or try to think about it in a different way - what exactly is a promise? Promise is a way to invest your social capital in order to get something else. It has coercive component to it - if 3rd parties see you broke your promise they will stop exchange with you and you lose. Or you will not be invited to parties and you will have to carry some social stigma. Promise is the backbone of reciprocal altruism which is a pretty good strategy for survival as opposed to some other strategies (e.g. tit-for-tat).

Jussi: can you restate your comment? It is unclear. Maybe some words are missing.

JV: Thanks!

Two act-utilitarians actually wouldn't need to make promises to each other. Because if one promised to do A, the second would want him to do A if and only if the first wanted to do A too. (Unless they disagreed about the facts about the consequences of doing A.)

But, leaving that case aside, once an act-utilitarian starts developing a reputation for keeping promises, the act-utilitarian is already paying lip service to rule-utilitarianism.

(But, for this post, I only needed that argument about act-utilitarians and promises as an example, to make an analogy.)

Philippe,

Let's not wander off topic. I'll simply note that my example is silent on WHY anyone decides to use the Bank of Rothbard's currency as their unit of account.

The Central Bank can (and does) pay interest on (excess) reserves. So do you think the reserves can be now considered to be a form government debt (yet issued by the Central Bank)? Why not?

If yes, does this mean the Central Bank can by issuing reserves with interest attached fund the government without worrying about inflationary effects?

I guess I'm puzzled with two different worlds. One where there is no Central Bank, only banks and some short term government debt obligations. Banks clear daily imbalances through obligations. If the amount of obligations goes up there shouldn't be inflation? Enter the CB and change the obligations to reserves, the things seems to be different? Why?

Jussi: the Bank of Canada pays interest on *all* reserves, not just "excess" reserves.

(Canada has no legal reserve requirements. And "excess" reserves ought to be defined as "actual reserves minus *desired* reserves", not "actual reserves minus *required* reserves. And actual reserves are tiny. But that's me wandering off-topic.)

But it does not pay interest on currency.

"Reserves" are just currency held by commercial banks in electronic form. The difference is immaterial. Let's call currency+reserves "currency".

If the central bank pays market rates of interest on currency, it earns zero profits, and there is no seigniorage profits. That 0.25% of GDP would drop to 0%.

Suppose the Bank of Canada issued more currency, *and at the same time increased the interest rate paid on currency so that people would be willing to hold that extra currency at the same price level as before*. Then there would be no inflation.

That is exactly how an issuer of debt behaves. If it issues more debt, it must ensure that the interest on debt is sufficient for people to want to hold the extra debt. Otherwise they won't buy it.

The difference between debt and currency is that currency is a medium of exchange. You can't sell extra debt, unless you persuade people to want to hold extra debt. You can issue extra currency, even if people don't want to hold extra currency, because each individual thinks he can just pass the extra hot potato money onto someone else, who in turn thinks he can pass it on to someone else....etc.

@Nick:

> Min: maybe. It's not obvious. What about keeping your last promise, where there are no future payoffs? If it is known you will not keep your last promise,

Governments are uniquely-positioned here, since ostensibly they're infinitely-lived agents. While I agree that nobody would lend to an Act-Utilitarian on his or her deathbed, governments do not have a foreseeable "last promise" to make.

> "Reserves" are just currency held by commercial banks in electronic form. The difference is immaterial. Let's call currency+reserves "currency".

We're veering off-topic, but I feel that there are important practical differences. Reserves earn interest while currency (currently) does not; reserves are held by secondary banks while currency is held by individuals.

While currency is freely exchangeable for reserves, that exchange must be mediated by a secondary bank. Because they have a monopoly on holding reserves and because that exchange must be at par, in effect the interest-on-reserves is not passed along to private citizens. (Note that your chequing account does not pay interest.)

In the meantime, only currency freely circulates for goods and services; bank reserves cannot (by law) be spent for consumption.

Ordinarily (in Canada) this is a distinction without difference because the interest paid on reserves is less than the (risk-adjusted) interest rate that could instead be obtained through lending those reserves out. In perverse cases (the US) where the risk-free rate is less than the IoR rate, this does not hold and reserves will not circulate.

Majro: " (Note that your chequing account does not pay interest.)"

Chequing accounts can and sometimes do pay interest. They often did when interest rates were higher. And often they pay implicit interest, because they reduce your fees if your balance is above a certain level, or give you better services.

If commercial banks are competitive, with free entry zero profit long run equilibrium, the fees minus interest on chequing accounts will equal the bank's operating costs minus interest on assets. Ignoring operating costs and fees, interest will equal interest on bank's assets, including reserves.

Nick said: ""Reserves" are just currency held by commercial banks in electronic form. The difference is immaterial. Let's call currency+reserves "currency"."

Majromax said: "We're veering off-topic, but I feel that there are important practical differences. Reserves earn interest while currency (currently) does not; reserves are held by secondary banks while currency is held by individuals.

While currency is freely exchangeable for reserves, that exchange must be mediated by a secondary bank. Because they have a monopoly on holding reserves and because that exchange must be at par, in effect the interest-on-reserves is not passed along to private citizens. (Note that your chequing account does not pay interest.)

In the meantime, only currency freely circulates for goods and services; bank reserves cannot (by law) be spent for consumption.

Ordinarily (in Canada) this is a distinction without difference because the interest paid on reserves is less than the (risk-adjusted) interest rate that could instead be obtained through lending those reserves out. In perverse cases (the US) where the risk-free rate is less than the IoR rate, this does not hold and reserves will not circulate."

I don't agree that is immaterial. I'm agreeing with Majromax that there are important practical differences. I'd call "central bank reserves" the demand deposits of the central bank.

Majromax, can demand deposits of the commercial banks freely circulate for goods and services (and financial assets too)?

I'm pretty sure I'm mostly agreeing with you that central bank reserves cannot be spent for consumption.

Nick said: "The difference between debt and currency is that currency is a medium of exchange. You can't sell extra debt, unless you persuade people to want to hold extra debt. You can issue extra currency, even if people don't want to hold extra currency, because each individual thinks he can just pass the extra hot potato money onto someone else, who in turn thinks he can pass it on to someone else....etc."

I don't agree there can be extra currency the way the system is set up now. Extra currency can reflux to the commercial banks for demand deposits. Commercial banks can then reflux the currency back to the central bank for central bank reserves.

Now what happens to the central bank reserves depends on the central bank. It may exchange the central bank reserves for assets (usually gov't bonds) or it may not.

The currency can always reflux. The central bank reserves may or may not reflux.

"Because there is no reason whatsoever that a government known with certainty to be FTPL would ever give away anything valuable to people clutching little bits of paper, simply because they were clutching those little bits of paper."

So there are no consequence at all that you can think of that would inspire an elected representative to enforce promises made by similar elected representatives?

On top of that you can't think of a rational reason for wanting a discount on futures tax obligations?

This blog post is so riddled with non sequiturs it's almost unreadable.

Have you even bothered to ask yourself questions like what does the ftpl say about what happens if you double the growth rate of M or changes the inflation target? Its monetarism. It has all the things you say make monetarism special.

Interest rate is not indicative of stance (though, you mean success) of monetary policy.

It has expectations or chuck Norris (future surpluses/seignorage).

It has hot/cold potatoes.

None of those things are nearly as explicit or identifiable in MV=PQ.

And it respects government cb accounting (as it exists in the real world) instead of "imagine..."

Nick Rowe: "What about keeping your last promise, where there are no future payoffs? If it is known you will not keep your last promise, will you have any incentive to keep your second from last promise? And so on. Does it all unravel backwards?"

This is a fairly well researched area. It matters when the end is in sight. That is one reason that I keep bringing up the eruption of the Yellowstone supervolcano. We know that it will eventually happen, and that few of the promises made just before Yellowstone blows will be kept, but we do not reason backwards from that remote possibility.

OTOH, consider the first senior care facility in the U. S. A woman in Connecticut (Hartford, IIRC) promised to care for the elderly in her home until the end of their days, for $1,000. In a way she kept that promise, but violated its spirit. The life expectancy of those in her keep was around three months. She was killing them off.

Reasoning back from a future date uncertain is problematic.

@Nick

Thanks for a thorough response.

Yet I still have a question. You wrote (currency here by your definition here reserves + currency):

"Suppose the Bank of Canada issued more currency, *and at the same time increased the interest rate paid on currency so that people would be willing to hold that extra currency at the same price level as before*. Then there would be no inflation."

and continue

"...You can't sell extra debt, unless you persuade people to want to hold extra debt. You can issue extra currency, even if people don't want to hold extra currency..."

Does putting these together mean the government and the Central Bank together can create (not sell) interest paying reserves without inflation limit to fund the government?

If yes, what limits here the real resources the government can use?

Miami: "Have you even bothered to ask yourself questions like what does the ftpl say about what happens if you double the growth rate of M or changes the inflation target?"

Yes. And answered it. See my previous post.

And you clearly have misunderstood my post.

Min: "Reasoning back from a future date uncertain is problematic."

Yep.

Jussi: "If yes, what limits here the real resources the government can use?"

Yes, of course. Increased government spending is not inflationary, unless the central bank makes it so. The limit is the government's ability to collect tax revenues to pay the interest on what it has borrowed.

@Nick

Sure, I get that part. But in my fiction the Central Bank issues debt (as interest paying reserves), pays the interest in order to monetize government spending. Here the amount of government spending cannot be limited by tax revenues as the government is fully monetized by the Central Bank and the inflation front is taken care by the interest on reserves.

What do I miss - what is the limit then?

If you are printing money to pay interest on money, the growth rate of the money supply equals the interest rate, and equals the inflation rate. Because the stock of money is growing over time. See my old post "when new money is paid as interest on old money".

@Nick

Yes, that was a good teaching post. I reread it.

But would it mean by the same token the debt issued by the Treasury is inflationary if it was taken to pay the interest? But that doesn't sound true. But then again why would it matter which entity issued the debt (interest paying reserves or Treasury debt)?

Bullshit. Monetary policy confined by existing accounting and institutional arrangements gives you the ftpl. Saying its not "true" doesn't even make sense if you believe the QTM to be true. They map directly onto each other if you remain confined to reality.

"What was really new about the FTPL compared to standard theory is that it insists that the government budget constraint, in economies where large amounts of nominal interest-bearing debt are issued, has to be treated as one of the central equations determining equilibrium and determining the price level. Once you realize that, you realize that there is a kind of a simple connection between outstanding nominal interest-bearing liabilities, taxes and the price level that's comparable to the simple connection between outstanding money balances, demand for money and the price level.
These relationships are both true. That is, it is true that in equilibrium, the total nominal value of the debt, the total real value of interest-bearing debt, has to match expectations of future tax backing for that debt. And that's true in any model.
And then at the same time, it's true, of course, that in equilibrium the real balances held by the public have to match the demand for those real balances. It can be helpful, depending on the circumstances and as a crude first approximation, to think of the price level as being determined by the ratio of the nominal quantity of money to the real demand for money. Or it can be useful to think of the price level as being the ratio of the nominal value of interest-bearing debt outstanding to the tax backing for that debt. It's hard for people who get used to thinking about it in one simple way or another to realize that in equilibrium both these ways of thinking about it are correct."

-Chris Sims

You say that's wrong but have yet to demonstrate how its wrong. Just that you don't want to live in a world like that. Whatever that means.

"So an exogenous shock that makes S(1) increase to $105 causes B(0)/P(0) to rise to $100, and this in turn causes S(0) to fall to -$100."

Nope. S(0) is about expectations, B(0) is representative of the -$100.

"So an exogenous shock that makes S(1) increase to $105 causes B(0)/P(0) to rise to $100, and this in turn causes S(0) to fall to -$100."

No, S(0) is $105. Its about expectations. The -$100 is represented by B(0).

Sorry for the double post.

Jussi: if you issue new debt to pay interest on old debt, and keep on doing it forever, you are running a ponzi scheme. Is that ponzi scheme sustainable? If it's not sustainable, it must lead either to default, or else you raise taxes and stop doing it. With currency it is sustainable, because people will hold currency even if the real rate of return on currency is very negative (there's inflation). Plus, we measure prices in terms of currency, not in bonds. (Currency is the unit of account.) So if people expect default on bonds, bond prices drop relative to currency, but the central bank does not need to let the price of currency drop relative to goods (inflation).

Miami: "You say that's wrong but have yet to demonstrate how its wrong. Just that you don't want to live in a world like that. Whatever that means."

I live in a world (called "Canada") where a central bank adjusts the supply of money to the demand for money to ensure inflation remains at 2%, and where the federal government adjusts expected future fiscal policy to match the total stock of bonds outstanding, to prevent default, given that policy of the Bank of Canada. I can imagine a different world (Zimbabwe), where the central bank adjusts the supply of money, and inflation, to prevent default on bonds, taking expected future fiscal policy as given. But I don't live in a world like that, nor do I want to.

Miami: let me try it this way.

Chris Sims, in that passage you quote, forgets that bonds can default, and that (fiat) currency cannot default. Currency is alpha, bonds are beta, because bonds are a promise to pay currency, not vice versa. And we define "inflation" as a falling price of currency against goods, not a falling price of bonds against goods.

The central bank that issues currency can, if it wishes, adjust the supply of currency to the demand for currency, to prevent the price of currency falling against goods. If it does that, the issuer of bonds has a choice: either adjust future taxes to prevent risk of default; or else allow the risk of default to increase, and let the price of bonds fall against currency, and against goods.

It is only if the central bank adjusts the supply of currency to prevent default on bonds, that expected future taxes influence the price of currency against goods.

"Inflation" means "the price of currency is falling against goods".

If an issuer of currency promises (say) 2% inflation, then "currency default" means "inflation above 2%".

An issuer of bonds promises to pay currency. A "bond default" means the price of bonds falls against currency.

Who prevents a bond default? Is it the issuer of bonds, or the issuer of currency?

If it is the issuer of currency, then the issuer of currency may need to let currency default (let inflation rise above 2%) to prevent a bond default.

But in sensible countries, with inflation targeting (or similar) central banks, it is the issuer of bonds who prevents bond default, by adjusting expected future taxes and spending to ensure it doesn't happen.

@Nick

Thanks once again - being patience and all.

I have to still keep commenting as I would really like to understand why I seem to fail (am I the only one?) to get the money/debt relationship. I guess it is a lot about seeing how indifferent banks are between reserves and short term government debt, even in the event of liquidity crisis. And knowing the reserves can only be held by banks and government entities (or the likes) anyway.

I'm not sure whether you were rhetoric or not? As I see it both currency and debt are liabilities of the government in the broad sense. I guess it is hard to default the currency without bonds but I think it is possible. Of course the governments usually default bonds only. But both can be defaulted in practice and it is not sensible to default either, so not sure it is a great theoretical argument (or is it, why?). Money certainly carries liquidity premium usually (but look Germany today). But these smell to me more like difference in scale than in kind? Plus piling debt over debt seems to often bolster confidence in bonds (all major economies in the current on going crisis).

I guess my question is whether Treasury debt is sustainable if new debt is issued to pay interest on old debt? Does this depend on any qualifications like if the banks are forced to use only Treasury notes (and so no other reserves) to clear daily imbalances? Or debt issued is only a promise to return reserves tomorrow, like 1-day Treasury bill?

You could say the central bank adjusts the number of bonds outstanding or money its the same coin just different sides.

I'm not sold on your alpha/beta distinction, especially given the fact that the rate on bonds was lower in the US than that on reserves for a period of the crisis maybe even still at times. If reserves were alpha that shouldn't happen, should it? Money is a beta saving vehicle. Its a stop gap not an asset people hold for any other reason than liquidity.

I think you've stretched the definition of default too far. Rising bond yields is not the same thing as defaulting and you know that. Currency default is inflation above target? What do you call it when its below target?

I know you see a MASSIVE distinction between the ftpl and the QTM but I don't and I've read all your posts and still don't see the distinction you're trying to articulate. Most likely that is due to a poverty in my understanding of both theories but if it were obvious I think you would have been able to show that by now. As someone from the concrete steppes it was refreshing to see expectations and interest rates as a poor indicator of the stance of monetary policy, represented mathematically. If it looks like a duck.

Thanks for your time and patience, I'm a big fan of your blog posts.

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