macroresilience

resilience, not stability

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.

PROPOSALS

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.

BENEFITS

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

14 Responses to 'Unifying The Fiscal And Monetary Functions: A Policy Proposal'

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  1. Innovative, yes.
    And an improvement, For sure.
    But adequate?
    See Friedman’s “A Fiscal and Monetary Framework for Economic Stability”.
    Almost completely adequate.
    Have a read of this for getting the money system working for the Restofus.
    http://www.monetary.org/wp-content/uploads/2011/11/HR-2990.pdf

    Because its our money system.
    Thanks.

    joe bongiovanni

    15 Jan 13 at 7:33 pm

  2. The above article gets very near to advocating full reserve banking. In particular, Ashwin says “Rather than shackling incumbent risky banks, my proposal simply separates them from the risk-free depository and payments system.” Well that’s straight out of the full reserve book. E.g. see this work published 2010:

    http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

    Laurence Kotlikoff, also argues for the latter separation as part of his full reserve system.

    Re the lack of any need for maturity transformation, I quite agree with Ashwin. I’ve been taking the p*ss out of MT for some time. E.g. see the right hand column of my blog:

    http://ralphanomics.blogspot.co.uk/

    The only important element of full reserve not present in Ashwin’s article (though he may have meant to include it) is that anyone placing a deposit with a “risky bank” carries the downside risk. I.e. if the bank goes under, then depositors as well as shareholders and bondholders may lose out. In effect, depositors become a form of shareholder.

    Ralph Musgrave

    16 Jan 13 at 4:14 am

  3. A few questions:

    1) Is the proposal to accomodate literally any quanitity of deposits in the “public option”.

    2) If the existing quanitiy of government debt is insufficient, would more be issued? If so, what would the government spend that on? Something, or nothing?

    3) Where does a small private entity (household or small business) go for short term borrowing?

    4) In this scheme, it seems to be the case that short term public deposits are risk free but the long term savings (pensions and proceeds from life insurance etc are not). What then prevents all current long term savings from having an incentive to transfer into the public option?

    Thanks.

    scepticus

    17 Jan 13 at 11:46 am

  4. scepticus – on 1 and 2, yes the option can be unlimited. You can think of it as the ECB deposit window for banks being extended to the masses. The rate obviously will be very low – either at the CB rate or lower (some CBs pay less on deposits than their headline repo rate).
    The government could literally spend it on nothing which would be the easiest option. The current system where all deposits are implicitly insured by the state isn’t that different anyway. The state right now has a large implicit debt that is being invested in largely unproductive activities by the banks. Most small private entity borrowing is heavily collateralised anyway – in the UK for example by property owned by the small business.
    Banks still exist in this system – they just become a form of leveraged credit fund. They give deposits which are uninsured and pay much higher rates than the public option and lend in pretty much the same manner. They even have access to the CB repo window etc for liquidity.
    On 4, that wouldn’t really work because the public option doesn’t pay very much. In fact the shift in public financing away from long bonds will force them to invest in riskier instruments if they want to meet their obligations – again this is a feature, not a bug. There should be no long-term “safe” assets.

    Ashwin

    17 Jan 13 at 1:23 pm

  5. Thanks, I think I understand. Assuming the government doesn’t spend the incoming deposits then, there is still the possibility that we get a general deflation (and hence the public option depositors get a very nice real rate of return) in the event that the remaining private money creation machinery fails to generate sufficient credit. Is that correct?

    What I still don’t get/agree with is your point about long term savings. If I am a pension fund with a 20 year liability I need to match I can can match that perfectly well by just rolling over public deposits for 20 years, since the comittment is there that any amount of public option fnding will be there ad infinitum. Of course if you are assuming that long duration lending and borrowing would be at a higher rate of return than the public option then I think this conflicts with your suggestion that maturity transformation is not needed. In any case such a higher rate of return would only transpire if the private credit machinery is expanding credit and/or private money is circulating very quickly.

    So I suspect long duration investors would pile into the public option as well.

    What am I missing?

    scepticus

    17 Jan 13 at 2:52 pm

  6. Or put another way if the economy was going to contract due to unavoidable circumstances then long investors would not expect a rate of long duration return above 0 and would pile into the public deposit.

    How can the demand for pre-poned and deferred consumption be matched and cleared in this system? It also seems to go against the grain of your resilience paradigm since most of the risk is collected in one place.

    scepticus

    17 Jan 13 at 2:54 pm

  7. [...] Peter Dorman, Tim Duy, Scott Fullwiler, Izabella Kaminska, Josh Hendrickson, Merijn Knibbe, Ashwin Parameswaran, Cullen Roche, Nick Rowe, Scott Sumner, and Stephen Williamson are all dorks, albeit of a more [...]

  8. “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.”

    I’m confused by this statement. If banks are earning 6% on their (riskless) assets, then deposits will certainly be paying more than 0%.

    Regarding the composition of the public debt, I recommend reading John Cochrane’s blog. He’s got a lot of good ideas for improving bond liquidity (which lowers cost), without necessarily offering services directly to the public.

    Max

    18 Jan 13 at 11:18 am

  9. scepticus – so my preferred route to generate consistent inflation if private sector credit growth is insufficient is helicopter drops. The public deposit will be available at negative real rates. In this case, rolling it over for long tenors will not be worthwhile.

    The same could also probably be done via negative rates, banning cash etc but I much prefer heli-drops to negative rates for resilience reasons.

    Max – if deposits themselves yield close to 6%, then my point simply holds even without ETFs, funds etc. A deposit that yields 6% is interest- bearing money. Thanks for the Cochrane ref – will check it out.
    My point is that the middlemen are redundant and there are significant benefits for both sides by cutting out the middleman as the Belgian example shows – significantly better deal for the investor and significantly below-market cost for the government.

    Ashwin

    18 Jan 13 at 4:37 pm

  10. Rather than helicopter drops how about having the CB buy up loads of equities and then distribute those across the population with the population required to hold them in a locked account and only able to periodically draw down net capital gains and dividends to use as spending.

    At least that gets round the problem that helicopter money would all end up back in the hands of the 1% or whatever who own all the capital assets.

    scepticus

    23 Jan 13 at 5:58 pm

  11. Problem with any intervention in asset markets is that it is biased towards incumbent firms almost by definition. In this idea we’re buying equities of incumbent firms. You could add in a proportion to fund new firms but it just gets messy and almost certainly will devolve into a crony capitalist shell-game in our current political system.

    Ashwin

    23 Jan 13 at 6:37 pm

  12. True, but in the helicopter case the incumbent firms end up with all the helicopter money anyway. Its near impossible to compete with massive fixed-cost means of production if the policy of the day provides funding for upkeep of those installations, which is what helicopter money does.

    What is the essential causality of the problem here in your view? I think you suggest the nub of it is asymmetric access to the money/credit/savings creation machine. is that correct?

    If so, does fixing that lead to a reduction in the quanitity of unrecycled profits held as financial assets? If it does not, I suspect that nothing will have been solved.

    scepticus

    23 Jan 13 at 6:46 pm

  13. The gist of the problem IMO is that we have a stability-obsessed crony capitalist economy. So heli-drops without solving the cronyism problem is obviously useless.

    I’ve written elsewhere about solving the crony capitalism problem – licensing/patents/regulatory reform etc but a big component of it is to stop supporting asset prices. A lot can be achieved simply by instituting heli-drops, hiking rates and just standing back. Given the fragile nature of the system, incumbent firms will collapse on their own while heli-drops will mitigate the consequences for the masses.

    Ashwin

    24 Jan 13 at 8:21 am

  14. I see. What is the premise by which the CB can raise rates at the short end without causing an inversion of the yield curve that would result from the crony sector tryng to hide their previously ill-gotten loot (and maybe new loot resulting from sucking up helicopter money from consumers), in government securities (any tenor would do). Obviously if the cronies can get a nice yield from said securities then that offsets the damage done to their fixed capital assets doesn’t it?

    Also, its not obvious how heli drops mitigate the pain for households laid off by collapsing incumbent firms. It may do over the long run when the pheonix rises from the ashes but in the short run households will be bankrupted.

    scepticus

    24 Jan 13 at 12:48 pm

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