resilience, not stability

Archive for January, 2013

Unifying The Fiscal And Monetary Functions: A Policy Proposal

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With the emergence of interest-bearing money, the concept of ‘money supply’ is now meaningless. The obsolescence of interest-free money is not just a consequence of payment of interest on reserves by the Fed (as Steve Waldman argues). If short-tenor government bonds are liquid enough, then no one needs to hold non interest-bearing deposits for any meaningful length of time. For example, let us assume that rates are at 6%, the Fed has sold off all its QE holdings and is no longer paying interest on reserves. Therefore, bank deposits yield no interest. In such a scenario, most individuals can put most of their risk-free investments into an ETF or index fund invested in T-bills that pays say 5.80% (with 20 bps fees). In a world of such liquid risk-free investments, there is simply no need to hold cash except immediately before the need to make a payment arises.

The near-moneyness of governmentt bonds is not a new phenomenon. Preston Miller argued that this was already the case in 1983:

In the financial sector….higher interest rates make profitable the development of new financial instruments that make government bonds more like money. These instruments allow people to hold interest-bearing assets that are as risk-free and as useful in transactions as money is. In this way, the private sector effectively monetizes government debt that the Federal Reserve doesn’t, so the inflationary effects of higher deficit policies increase…..
In recent years in the United States there have developed, at money market mutual funds, demand deposit accounts that are backed by Treasury securities and, at banks, deep-discount insured certificates of deposit that are backed by Treasury securities, issued in denominations of as little as $250, and assured of purchase by a broker. In Brazil, which has run high deficits for years, Treasury bills have become very liquid: their average turnover is now less than two days.”

An institutional player doesn’t even have to sell his government bond holdings to access liquidity. He can simply repo his holdings instead. In fact the emergence of the government bond repo market in many emerging markets was driven by the private sector’s need to monetise its government bond holdings. Akçay et al illustrate how fiscal deficits led to inflation in Turkey despite the absence of monetisation because ”innovations in the form of new financial instruments are encouraged through high interest rates, and repos are typical examples of such innovations in chronic and high inflation countries. People are thus able to hold interest-bearing assets that are almost as liquid as money, and monetization is effectively done by the private financial sector instead of the government”.

Nevertheless, government bonds are only near-money and although financial institutions have easy low-cost access to them, the rest of us do not. In the remainder of this post, I will lay out how and why we can transform short-term government debt into not just near-money but money for the man on the street. This has significant benefits for every section of society and the government itself. The significant loser in this transition would be the incumbent oligopolistic players within our financial system, most notably the banks. This however is not a bug of the proposal, it is a feature.


Public Deposit and Payments Option

I have already described the essence of the public deposit option in an earlier post as “a system similar to the postal savings system where all deposits are necessarily backed by short-term treasury bills. If the current stock of T-bills is not sufficient to back the demand for such deposits, the Treasury should shift the maturity profile of its debt until the demand is met.”. The public deposit account should also include the ability to make payments (just like a normal bank account would).

Low-Cost Retail Access to Government Bonds

Government bonds must be as liquid and low-cost for retail investors to buy and sell as they are for financial institutions. The present options for retail investors to buy government bonds are not good enough. For example, TreasuryDirect requires you to transfer your bonds if you need to sell them. In the UK, the transaction costs (between 0.35% and 0.7%) are too high.


Reduced Funding Costs for the Government and Lower Public Debt

A large chunk of the present demand for long-term borrowing comes from the government(see this post for data). Unlike the private sector for whom the avoidance of refinancing risk is worth issuing long-term debt and paying up the liquidity premium, the government has no such need to indulge in long-term borrowing. The government can and should capture the safety premium that people are willing to pay for holding short-term risk-free deposits by shifting its financing to a shorter tenor. The United Kingdom is the best example of just how much governments can save by adopting this strategy. With the Bank of England owning as much as £375 bn of the national debt, the Treasury is in effect paying only 0.5% on this stock of debt. Many view this as an unwarranted monetisation of the public debt and argue that the profits being repatriated by the BoE to the Treasury will soon reverse themselves. But the Treasury could easily achieve the same economics as today by simply shifting its debt profile towards shorter-term funding. If it simply funded its entire debt by issuing bonds of less than 3-year tenor, it would fund at even less than the current BoE rate of 0.5%. There is no doubt that the appetite and demand to allow such a shift exists – the deposit base of the UK banking sector is far greater than £375 bn.

Safe Short-Term Deposits Without Deposit Insurance

In the system outlined above, there would be no deposit insurance i.e. all investments/deposits except for the “public option” will be explicitly risky and unprotected. The public benefits from a safe deposit, investment and payments option without the taxpayer being put on the hook for the costs of deposit insurance.

Improved Retail Investment Options

There is a significant retail demand for government bonds that is not being met at the moment. For example, Belgians lent €520 per resident to its own government when the Belgian government sold €5.7 bn of 5-year bonds at a rate significantly below the market rate in 2011. The reason was not patriotism but simply the fact that even this below-market risk-free rate represented a significant premium over the rates that ordinary Belgians could access through a risky bank savings account.

Firewall Between The Deposit/Payments System and Risky Banking

Rather than shackling incumbent risky banks, my proposal simply separates them from the risk-free depository and payments system.The public deposit option will also eliminate the rents currently being earned by the banks and shadow banking entities such as money-market mutual funds. The liquidity premium that is currently being captured by TBTF oligopolies will be captured by the state itself.

The obvious objection to this plan is: but what about maturity transformation? As I have shown in previous posts, the data is clear that modern economies no longer need maturity transformation. Household long-term savings (which includes pensions and life insurance) are more than sufficient to meet the long-term borrowing needs of the corporate and the household sector in both the United States and Europe.

My proposal does not nationalise our financial system. It simply extends the privileges enjoyed by financial institutions and corporates to the rest of us. Financial institutions and corporations have long enjoyed the benefits of interest-bearing money and the use of government debt as money. The first known instance may be the East India Company who could repo their government bond holdings for cash with the Bank of England (see footnote 20 in this paper). Unfortunately not much has changed between then and now. As is typical of the neo-liberal era, the classes demand an increased supply of interest-bearing safe assets for themselves while restricting the masses to putting their money in interest-free bank deposits.


Note: Parts of the above post have been rehashed from earlier posts and comments on Steve Waldman’s post linked above.

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Written by Ashwin Parameswaran

January 15th, 2013 at 5:26 pm

Posted in Monetary Policy

On The Folly of Inflation Targeting In A World Of Interest Bearing Money

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One of the little known facts of the history of monetary policy is that until 1994, the Fed did not actually announce interest rate decisions. Market participants had to infer rate changes from the Fed’s open market operations. This is just one example of how so many things we take to be natural and obvious are, in reality, relatively recent phenomena. In less than twenty years, the Fed has transitioned from near-opacity to an almost obsessive transparency. Another example of a relatively recent monetary policy doctrine that is now unquestioned is the doctrine of inflation targeting. The essential idea of inflation targeting is that people and firms should not have to think about the level and volatility of inflation when they make economic decisions. Inflation must therefore be kept at low and stable levels so that the long-run costs of unpredictable and uncertain inflation are minimised. As Mervyn King notes, inflation targeting has always been about improving the “credibility and predictability of monetary policy”.

However, in a world where money earns interest, minimising the uncertainty of macroeconomic policy does not equate to minimising the volatility of inflation. When all money bears interest, all that matters for those who hold money or bonds is the real interest rate earned on money and bonds. Given the fiscal stance and state of private credit growth, central banks should manage the real rate of interest such that rentiers do not capture a free lunch (i.e. real rates should not be too high) and there is no risk of a hot-potato/credit-bubble cycle (i.e. real rates should not be too low).

Money does not bear interest today because central banks pay interest on reserves. The primary reason why we live in a world of interest-bearing money is the gradual deregulation and innovation in financial markets over the last thirty years that triggered a shift from money to near-money assets. Apart from minimal liquidity reserves, there is simply no need to hold significant amounts of money in one’s zero-interest current account. Individuals can hold money in money market funds or treasury ETFs. Firms and high net-worth individuals can simply hold treasury bills that are as risk-free and liquid as money is. Even treasury bonds consist of a risk-free component that can be separated from the duration-risk component and monetised via the repo market. The equivalence of money and bonds is not just a temporary “liquidity trap” phenomenon. The evolution of financial markets means that the role of interest-free money is obsolete, now and forever.

In such an environment, the uncertainty and the volatility that individuals and firms care about is the volatility of the real interest rate. Let me take a simple example to illustrate this point. Let us assume that you hold a significant proportion of your assets in a short-term T-bill ETF that currently yields 0% in an environment when inflation is 2%. Therefore, the real interest rate is -2% but you swallow this loss as a “safety premium” fearful that investing in risky assets inflated by monetary stimulus may result in much greater losses. Now suppose the Fed decides to adopt an inflation target of 5% instead, which it achieves by buying up private sector assets such as equities1 while still holding the Fed Funds rate at 0%. This move to 5% inflation obviously hurts your investment in T-bills but the real reason is not that inflation has gone up. The real reason is that real rates have turned even more negative from -2% to -5%.

Many economists will complain that there is no other option. But when government bonds effectively function as money, there are a multitude of other options. The 5% inflation target could be hit by instituting a significant increase in fiscal stimulus (preferably via helicopter drops) and simultaneously hiking rates to 3%. From the perspective of most firms and individuals, this option which minimises the volatility of real interest rates is by far the more predictable and less uncertain policy. Those who borrow or invest at fixed rates for longer tenors will obviously suffer more volatility but such activities are explicitly risk-taking by nature. There is no conceivable reason why the central bank or the government should subsidise such risk-taking.

Proponents of inflation-targeting sometimes point to the poor economic performance of many developing countries with high and variable inflation. But what is really at fault in many of these instances is the tendency of the fiscal and monetary authorities to inject unexpected bursts of inflation that are uncompensated for by the interest rate regime enforced by the central bank. It is the persistent erosion of purchasing power due to negative real interest rates2 that is the real source of the poor macroeconomic performance in most high-inflation regimes.

The obvious object to my argument is that there is no reason why real interest rates must be held constant – I agree. My argument is not that real rates should be held constant but simply that excessive volatility in real rates must be avoided even if it is at the expense of a more volatile inflation rate. If the economy is hit by an inflationary supply shock, then it must be met by an increase in the inflation rate and an increase in the nominal interest rate (thus keeping real rates stable) rather than a rate hike to maintain a constant inflation rate (which would simply be an unwarranted transfer of wealth to lenders). There are also limits to how negative real rates can be driven to before an inflationary spiral is triggered. As of now, we are clearly well within these limits but it is foolish to assume that the inflation target can be increased to any level while central bank rates still remain at zero. Sooner or later, increasingly negative real rates will set off a inflationary spiral and a stampede to buy up real assets instead of nominal bonds.

I am not opposed to central banks driving down real rates to counter the increased demand for safety during a liquidity crisis. But in an environment like today when junk bond prices are at all-time highs, there is no justification for maintaining artificially low real rates. To restore economic prosperity in today’s crony capitalist and stagnant economy, we need to provide direct transfers to individuals via money-financed stimulus while simultaneously hiking rates to stop the permanent bailout of incumbent banks and firms.

  1. See my earlier post ‘The Case Against Monetary Stimulus Via Asset Purchases’ for why I oppose such a policy.  ↩

  2. Negative rates may also be enforced by restrictions on the interest rate payable on deposits and similar financial market regulations.  ↩

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Written by Ashwin Parameswaran

January 7th, 2013 at 3:21 pm

Posted in Monetary Policy

New Essay

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I have written a new essay in the economics section of my new project reconciling the possibility of technological unemployment during a time of innovative stagnation titled Technological Unemployment Amidst Stagnation. Most of it is just a rehash of arguments that I have made on this blog especially in the posts Innovation, Stagnation and Unemployment and Advances in Technology and Artificial Intelligence: Implications for Education and Employment but about 25-30% of the essay is new material and the overall essay itself is written in a much simpler manner than many of my posts here.

Do let me know what you think. Thanks for reading.

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Written by Ashwin Parameswaran

January 4th, 2013 at 12:00 am

Posted in Uncategorized