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MMT and QE

Hi Cullen,

The way I understand it, MMT involves the central bank simply creating money for the treasury to spend. As opposed to going to the debt markets, this means the government has no interest costs if it were to be self-financed.

I was thinking though, isn't the central bank funding the treasury in a similar way when it did QE? For example, suppose that the treasury wants to spend and issues debt. The private banks create money for the treasury and take the bonds in return.

So normally the treasury would pay interest to the banks, but if the Fed buys the bonds and returns the interest to the government, isn't this effectively the creation of new money to fund government spending, but now with zero cost of funds for the government?

Hopefully what I said makes sense. I'm sure I'm missing something and sure you'll set me straight!

Hi @BC,

Honestly, I don’t think MMT people have a very good grasp on the concept of govt “funding”. They actually state that taxes don’t fund govt spending and that all govt spending is self financing. I think this is quite fundamentally wrong.

Let’s say you have a Tsy and Fed. People often say that if the Fed buys your bonds then you have “funding”. This is true to some degree. You technically have a liability buyer. But who is the marginal price setter in the economy? It’s not the govt, it’s the non-govt. After all, if the non-govt doesn’t want to hold govt issued financial assets then inflation will rise as the non-govt re-prices govt money against everything else. So, the marginal price setter is the non-govt since the govt cannot force people to hold their financial assets.

This is where MMT people tend to get things wrong. The govt relies on the non-govt to buy its liabilities and it cannot force those buyers to buy. The price at which the govt sells those assets is par minus the rate of inflation. So, let’s say the Fed directly buys $100T of T-Bonds from the Tsy thereby “financing” those bonds. And let’s also assume that inflation is raging at 50% per year. What would happen to those bonds? The prices would collapse. The Fed would try to on-sell the bonds to the non-govt and the non-govt wouldn’t accept them at $100T. Or, let’s say the Fed can’t sell the bonds because they refuse to accept the discounted market price. In that case the Treasury would simply spend the cash into the economy and the market would immediately discount its value in real terms against everything else. Ie, the cost of that funding skyrockets in any case.

The mistake people make with QE is that inflation was going to be low in either case. It’s not that the govt set the price low. It’s that the non-govt had no pricing power coming out of the GFC.

I think the mistake most economic theories make is that they work causality from the govt out to the private sector when it’s almost always the reverse. The pvt sector causes things to happen in the economy and the govt mostly just responds in ways that impact the pvt sector on the margin. MMT is one of the worst theories in this sense because it’s hugely govt centric and misleads people into thinking that the govt can steer the economic ship in any which direction it wants.

Make sense?

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

Thanks Cullen for the detailed reply.

There's a lot there, but I think I understand your reasoning. What I still don't fully grasp though (although maybe it was implied in your response and I just missed it) is to me QE seems like it already achieved the goal of monetary financing for the government.

For example, during a crisis, if we assume its another balance sheet recession then one of the proposed solutions is that the government should do fiscal stimulus by borrowing lots of money and spending it to make up for the deleveraging in the private sector. But then lets say there are a lot of critics that come out and argue against the cost of deficit spending and servicing the debt.

Wouldn't one way to silence these critics be to have the Fed simply do QE again to make the deficit spending cost-free to the government (since the Fed simply returns the interest payments to the Government)? Yes I suppose you'd then have the critics arguing that it might stoke inflation or hyperinflation, but during a recession where money supply growth is slowing or even declining might that not be exactly what they want to do (ie. create money for fiscal stimulus).

Hi @bc,

I think people get the causation wrong here. Too often they just assume that deficit spending will cause inflation when in fact inflation is usually caused by some other exogenous event and the govt prints as a response. You have to think of the monetary system in a fully endogenous sense. That is, we can all create money and financial assets. I can go create millions of dollars in new money at a bank right now if I wanted to. So the govt isn’t unique in the sense that they can create financial assets, but people tend to think that only the govt creates money so then they automatically assume that a deficit must create inflation because that’s money creation. This is totally wrong. There are many factors that play into whether new asset creation results in inflation.

Anyhow, the kicker is that the govt’s deficit need not create inflation in certain environments, especially a debt deflation like the GFC. Now, the cost of that deficit is the potential inflation it causes. So, when prices surge what is really happening is that the govt’s cost of funding is rising. In essence, the non-govt is refusing to accept govt liabilities at the same price. Whether the Fed is buying T-Bonds doesn’t really matter. All that matters is the rate of inflation as that is the real financing rate that the govt should be concerned about.

The mistake that people made in 2009 was that they assumed that the deficit would be inflationary. Keep in mind, the Fed buying the bonds had NOTHING to do with whether inflation would occur. What was really happening was the pvt sector was deflating by the tune of trillion of dollars per year and the govt was merely offsetting that. So you could say that the private sector ended up financing govt spending at a higher rate of inflation than what they might have otherwise financed it at if the govt had implemented smaller stimulus.

I hope all that makes sense.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

Cullen, at first glance what BC said about similarity between "govt's self financing in MMT term" and QE sounds quite true and it strikes me as well. Both of them expose how govt is able to create money by issuing financial assets on itself without depending on non-govt sector. But then, I tried to understand your argument also the logic behind it. I think there are 4 main keywords here that should be paid attention: liability counterparty, asset price, inflation, and market-based system.

In order to grasp full understanding about the whole concept, I will break down into each piece of your detailed explanation.

Let’s say you have a Tsy and Fed. People often say that if the Fed buys your bonds then you have “funding”. This is true to some degree. You technically have a liability buyer. But who is the marginal price setter in the economy? It’s not the govt, it’s the non-govt. After all, if the non-govt doesn’t want to hold govt issued financial assets then inflation will rise as the non-govt re-prices govt money against everything else. So, the marginal price setter is the non-govt since the govt cannot force people to hold their financial assets.

Two questions.
1. Does above explain why CB can't buy Tsy bonds directly in primary market because the initial prices must be set first by market ?
2. Does above also explain why in QE, CB has to buy any financial assets which already circulate in secondary market since the initial prices are already established by market ?

Both of them expose how govt is able to create money by issuing financial assets on itself without depending on non-govt sector.

This is the erroneous point I am really trying to drive home here. The govt absolutely positively DOES rely on the non-govt. Think of it this way. Instead of issuing bonds the Tsy just prints up $100T in cash and puts it out front. Does that money need to be "funded"? At what price?

The key point here is that you only have "funding" in an endogenous money system when someone is willing to accept your liabilities. That's what it means to be able to create money. If you can create money endogenously then you have funding. I can create money so long as a bank is willing to accept my liabilities and create a new loan. It takes two to tango.

The govt isn't unique in this sense. So, when they print up that $100T they still rely on people to accept it. But what's the cost of that funding? The cost is the rate of inflation. Clearly, printing $100T in cash would probably cause some inflation. So, what will happen there is the non-govt will take that cash, bid up other goods and that will make it more expensive for the govt to finance future spending. What might have cost $1 for the govt to buy last year will now cost them $2. That is a decline in their purchasing power whether they can print money or not. In other words, their funding agents have re-priced their money LOWER in value just like issuing excessive stock could dilute the value of existing shares.

This is why I argue that MMT is wrong when they say the govt doesn't rely on funding. They are implicitly arguing that the govt doesn't need the non-govt to accept their money. This is very wrong and I am convinced they don't understand why it's wrong.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

Back to my questions.

Let’s say you have a Tsy and Fed. People often say that if the Fed buys your bonds then you have “funding”. This is true to some degree. You technically have a liability buyer. But who is the marginal price setter in the economy? It’s not the govt, it’s the non-govt. After all, if the non-govt doesn’t want to hold govt issued financial assets then inflation will rise as the non-govt re-prices govt money against everything else. So, the marginal price setter is the non-govt since the govt cannot force people to hold their financial assets.

1. Does above explain why CB can't buy Tsy bonds directly in primary market because the initial prices must be set first by market ?
2. Does above also explain why in QE, CB has to buy any financial assets which already circulate in secondary market since the initial prices are already established by market ?

Hi @kevlar,

1. Yes, from the people I’ve talked to at the US Tsy that is precisely the reason. They are trying to obtain a market signal for the demand for bonds. They still require Primary Dealers to buy bonds, but they’re letting the PD’s set the price thereby sending a signal to the govt about demand.

2. The Fed is only allowed to buy govt guaranteed assets. That is not true in all govts. The BOJ can buy virtually anything I believe. In the USA this seems to be a political constraint only where Congress set the rules so that the Fed couldn’t have the risk of principal losses in their asset holdings.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche

Hi Cullen,

Thanks for the detailed answer. Just to make sure I understand, let me re-ask my question in a simpler way:

1) Every time the Fed purchases a government bond due to QE, this is effectively an interest-free loan to government, correct?

2) It would follow that the downside is not the interest that the government incurs, but inflation, correct?

Hi @bc,

1. Yes, you can think of it like that. Or more technically, the Fed is buying the bond and essentially refinancing the asset at whatever the new interest cost is (in this case it’s the interest on reserves since the banks are earning that instead of a non-bank earning the T-bond rate).

2. The govt never has trouble paying interest since it can simply print money. So yes, the cost of funding for the govt is always the rate of inflation. Importantly, the govt is unique (not because it doesn’t need funding), but because it has hugely diverse high quality income streams so this means the govt faces virtually no credit constraint which means their ability to borrow is unparalleled when compared to other entities in the economy.

"Pragmatic Capitalism is the best website on the Internet. Just trust me. Please?" - Cullen Roche