Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems

by L. Randall Wray

we will examine fiscal policy for a government that issues its own currency.

We will therefore include in this chapter interest-targeting operations by the central bank.

•Budget deficits are evil, a burden on the economy except under some special circumstances (such as a deep recession).

•Government deficits drive interest rates up, crowd out the private sector, and lead to inflation.

•Government deficits leave debt for future generations; government needs to cut spending or tax more today to diminish this burden.

•Higher government deficits today imply higher taxes tomorrow, to pay interest and principle on the debt that results from deficits.

While these statements are consistent with the conventional wisdom, and while several of them are more-or-less accurate if applied to the case of a government that does not issue its ow...

•The overnight interest rate target is “exogenous”, set by the central bank, but the quantity of reserves is “endogenous”, determined by the needs and desires of private banks (with the caveat noted earlier that in the age of QE, central banks can fill banks with excess reserves and still hit an interest rate target by paying a support rate on reserves).

•For this reason, bond sales are not a borrowing operation (in the usual sense of the term) used by the sovereign government; instead they are a tool that helps the central bank to hit interest rate targets,

Let us be careful to acknowledge that these principles do not imply that government ought to spend without constraint.

And if things are for sale only in a foreign currency, then government cannot buy them directly using its own currency,

These principles also do not deny that too much spending by government would be inflationary.

Further, there can be exchange rate implications: if government spends too much, or if it sets its interest rate target too low, this might set off pressure to depreciate the currency.

in that sense, interest rate-setting and fiscal policy are “constrained” by government’s desire to influence the exchange rate or the inflation rate.

In Keynesian terms, this is simply another version of the twin statements that “spending generates income” and “investment generates saving”.

So it is pretty straightforward: the government’s deficits create the nongovernment’s surpluses.

Let us first examine a system like the one that existed in the United States until recently, in which the central bank does not pay interest on reserves – and before the Fed embarked on Quantitative Easing.

This drives the actual “market” rate below the central bank’s target rate for overnight funds.

The way that the central bank does this is by selling from its stock of Treasury bonds. That is called an open market sale (OMS). An OMS leads to a substitution of bonds for excess reserves:

Since the bank’s reserves decline by the same amount that its holdings of Treasuries are increased, this is effectively just a substitution of assets.

However, it now holds a claim on the Treasury (bonds) instead of a claim on the central bank (reserves),

It is easy to see that the same process would be triggered even if the central bank paid interest on reserves, as is now done in the United States and has been done for a long time in Canada.

While the end result is exactly as described above (Treasury spending leads to bank credits, taxes lead to debits, and budget deficits mean net credits to both demand deposits and bank reserves), it is more complicated.

The evidence that the central bank and Treasury do coordinate in this way is that central banks hit their rate targets and that Treasury checks don’t bounce.

The operational impact of bond sales is to substitute government bonds for reserves; it is like providing banks with a savings account at the central bank (government bonds) instead of a checking account (central bank reserves). This is done to relieve downward pressure on the overnight interest rate.

Since tax revenues (and some government spending) are endogenously determined by the performance of the economy, the fiscal stance is at least partially determined endogenously;

As discussed, the central bank can set the overnight rate, plus the rate on any other financial assets it stands ready to buy and sell. It can peg the 10-year government bond rate, or the 30-year bond rate.

It tried to use quantities rather than prices to hit a price target!

That is, it would announce how much it would spend buying Treasuries, hoping that would lower rates sufficiently; a much more efficient method would have been to announce it was going to buy a sufficient quantity to lower the rate on long-term Treasuries to its target (and then stand ready to buy as many as necessary).

That actually was J.M. Keynes’s recommendation, which he called “euthanasia of the rentier” – that is, set the risk free rate at zero and leave it there forever.

To put it as simply as possible: government deficit spending creates nongovernment sector saving in the form of domestic currency (cash, reserves, and Treasuries).

Rather, we should recognize that government spending conceptually comes first; it is accomplished by credits to bank accounts.

Still, as emphasized throughout this Primer, it takes two to tango, and the adjustment processes can be complex. There must be a net saving desire in the nongovernment sector, satisfied by the government’s deficit. More generally, as Keynes argued, saving is actually a two-step process: given income, how much will be saved; and then given saving, in what form will it be held.

Here we must turn to the role played by government interest-earning debt (“Treasuries”, or bills and bonds) to gain an understanding.

The attempt by the nongovernment sector to shift out of bank deposits will stop once the prices of goods, services, and assets adjust sufficiently so that all the extra deposits are willingly held.

Modern central banks operate with an overnight interest rate target, so if overnight rates are moved away from the target, the central bank responds. For example, when excess reserves cause banks to bid the actual overnight rate below the target, this triggers an open market sale of government bonds that drains excess reserves.

Banks make a portfolio decision: let’s buy something that earns a higher interest rate. First they can lend reserves in the overnight market, pushing that rate down.

Next they can buy a close substitute, Treasuries (government bonds), and then diversify into other assets.

(Note: unless they buy Treasuries from the Treasury or central bank, this simply shifts reserves among banks but doe...

They will begin to sell Treasuries. That eliminates the excess reserves and the downward pressure on interest rates.

So the answer to the second objection about inconsistency of portfolio preferences is really quite simple: asset prices/interest rates adjust to ensure that the nongovernment’s portfolio preferences are aligned with the quantity of reserves and deposits that result from government spending, and if the central bank does not want short-term interest rates to move away from its target, it intervenes in the open market.

(Note: asset prices and interest rates move in opposite directions. As the price of a bond goes up, its yield – interest rate – goes down.

Finally, the fear that government might “print money” if the supply of finance proves insufficient is exposed as unwarranted.

We can say that short-term Treasury bonds are an interest-earning alternative to bank reserves (as discussed earlier, reserves at the central bank often do not pay any interest; if they do pay interest, then government bonds are a higher-earning substitute).

When they are sold either by the central bank (open-market operations) or by the Treasury (new issues market), the effect is the same:

thus whether the bond sales are by the central bank or the Treasury they should be thought of as a monetary policy operation.

In other words, the initial impact of a budget deficit is to lower (not raise) interest rates.

If the central bank pays a support rate on reserves (pays interest on reserve deposits held by banks), then budget deficits tend to lead banks gaining reserves to bid up prices on Treasuries (as they try to substitute into higher interest bonds instead of reserves), lowering their interest rates.

This is precisely the opposite of what many believe: budget deficits push interest rates down (not up), all else equal.

If the central bank “pumps” excess reserves into the banking system and leaves them there, the overnight interest rate will fall toward zero (or toward the central bank’s support rate if it pays interest on reserves). This is what happened in Japan for more than a decade after its financial crisis and what happened in the United States when the Fed adopted “Quantitative Easing” in the aftermath of the financial crisis that began in 2007.