Skip navigation

Monthly Archives: November 2011

One of the great questions puzzling  mainstream, neo-liberal economists and market pundits has been the low rates on Japanese bonds for the past 20 years despite extroardinarily high debt to GDP ratios.  One consistent theme of the market pundits has been that the bond markets were going to turn on Japan any minute, borrowing costs would soar and there would be a flight from Japanese bonds.

Hasn’t happened, and with a debt to GDP ratio of nearly 200% and multiple downgrades from the ratings agencies of their debt, Japanese bonds have the lowest yields in the world, with 10 year bonds yielding just over 1%.

Paul Krugman took up this theme in July, puzzling over the divergence between Japanese and Italian Bonds:

“A question (to which I don’t have the full answer): why are the interest rates on Italian and Japanese debt so different? As of right now, 10-year Japanese bonds are yielding 1.09%; 10-year Italian bonds 5.76%.

…I actually don’t have a firm view. But it seems to be an important puzzle to resolve.”

Now, with Italian debt yields soaring due to lack of investor interest, Krugman has finally found the answer:

“What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of third-world countries that have to borrow in someone else’s currency, with all the loss of flexibility that implies. In particular, since euro-area countries can’t print money even in an emergency, they’re subject to funding disruptions in a way that nations that kept their own currencies aren’t — and the result is what you see right now. America, which borrows in dollars, doesn’t have that problem.

Currency sovereignty matters.  The US is sovereign, and can always pay its debts.  At least, that’s what the markets are saying.

Warren Buffett also commented on this situation this past weekend:  ”Never give up the ability to print your own currency.”

So the academics and the investors understand this…how about the politicians?  Well, here’s Mitt (who would be king) Romney in a Republican Presidential debate:  ”This is a time to worry about America.  We see what’s happening in Italy.  What’s happening in Greece.  That’s where we’re headed if we don’t change our course.”  Oh, well.  I guess the Politicians are always the last to know.


Essentially, bank reserves are an IOU of the Central Bank to the commercial banking system.

As Wikipedia notes, they are deposits held by banks in accounts at the Central Bank (The Fed), plus currency that is held in the bank’s vault.

Reserves differ, however, from overall deposits.  The level of overall deposits in the system is typically much larger than the level of reserves.  This leads to a problem, however, because banks must use reserves when settling payments with other banks but often don’t have enough reserves on hand to settle large payments or outflows of money.

The Federal Reserve in the US solves this problem by flooding the system with reserves during the business day and then taking them back out at night.  Removing the reserves at night allows the Fed to hit its targeted interest rate on short term loans, either between banks or between the Fed and the banking system.

Here is a quote from the Federal Reserve paper  ”Divorcing money from monetary policy“:

 … reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.



The Quantity theory of money is the idea that an increasing money supply (& particularly base money–cash and reserves supplied by the Fed) has a direct relationship with prices.

The idea is used by some to suggest that Government spending is useless because it will only increase prices.  The other way it is used is by suggesting that the Federal Reserve buying assets from the private sector (Treasuries, Mortgage backed securities, etc) will be inflationary because banks will use the increased reserves to lend more, leading to additional credit and therefore increased prices.

Both of these ideas are false.

Over the past couple of years, base money in the economy has more than doubled, increasing the cries of talking heads that massive inflation is coming.  But as yet, we’ve not had (much)  inflation.

As usual, I’ll leave the technical work to others, see here and here.

A simple example should suffice.  Let’s say you are a car manufacturer who got caught in the downturn with a little too much inventory.  Typically you like to keep about 50 cars on hand to give consumers some choice in style and price.  But when the downturn hit, your inventory doubled to 100 cars.  Now a few years in from the crisis and you’ve managed to work your inventory down to about 70 cars.  The monetary base has doubled, government spending has increased but you still have excess inventory on your lot, so increasing prices is a non-starter.

The reason for this is two-fold:  1.  Just because banks have extra reserves on hand, doesn’t mean they are going to lend more money.  If they can’t find qualified borrowers, or if people are already indebted and don’t want to borrow, then banks can’t or won’t lend.  2.  If too many people are trying to save their incomes, then the velocity of money through the economy slows down and less is spent on goods and services and just ends up in savings accounts or paying down existing debt.

The bottom line is that inflation is ultimately and everywhere a capacity issue.  If there is little excess capacity in the economy, prices will increase.  If there is too much slack among goods and services, it doesn’t matter how much money or liquidity the Government pumps into the economy, prices won’t increase.  

With 9.0% unemployment and incomes decreasing, significant inflation is nowhere in sight.



Anyone can create a debt.  I could create DavidDollars and try to trade them for stuff.  The trick is getting people to accept them, which is considerably more challenging.

All money is debt.  And what a dollar is, is a tax credit.  You save dollars because you can pay your taxes with them.  It’s also convenient as a medium of exchange, since others will also save them and accept them.

But only the Government could issue tax credits as a liability.   Yes, banks can create banking deposits which trade at par with Government liabilities, but that doesn’t mean Government can’t spend without borrowing first.  The idea that “everything the government has it gets from someone else first…” belongs in the dustbin of history.

It’s completely absurd to suggest that only private banks issue can tax credits which the Government (whose liability it is)  must then borrow at interest.

“Progressive” economist Joseph Stiglitz was on the BBC this weekend talking about the Euro.  Despite having both feet firmly planted in mainstream economic theory, I often agree with what Stiglitz has to say.  He’s right about one thing here:  ”The ECB (European Central Bank) is the one institution that has the flexibility that is necessary to deal with the crisis.”  This is true, Europe needs to move to a tighter fiscal framework or it will all fall apart.

But he says something else which misses the mark:  ”Issuing bonds should be one part of the fiscal framework.”

Now this is tough, and counter to everything we’ve been taught about economics, but bonds are not a fiscal operation.  Bonds are a monetary operation.  When the ECB issues Euros, it is already a debt.  A Euro is a tax credit which is eligible to be paid by the holder for any local, state or national Euro debt.  It’s already a liability of the Central Bank and this is why Europeans are willing to hold them and save them.  T hey can pay their taxes with them, among other things.

What issuing bonds does, for the holders of Euros, is to pay them interest on their savings.  Additionally, issuing bonds allows the Central Bank to withdraw Euros out of the banking system to meet its target interest rate.  I know that’s confusing, so let me lay it out straight.

1.  The ECB issues Euros.  In doing so, Euro reserves go up in the banking system.

2.  When Euro reserves go up in the banking system, banks with excess reserves try to sell them to other banks which are short.

3.  If there is a system wide excess of reserves, the price of Euros in the bank market will drop to 0 because there are no banks which need reserves.  In this sense, the “natural rate” of interest is zero.

4.  If the ECB wants to maintain a positive interest rate, they issue bonds to drain reserves and maintain a positive interest rate.

Now, to make bonds even more useless, all the ECB has to do to make them completely redundant is offer interest to banks on their reserves.  This would serve the same function as issuing bonds, which are not necessary to fund the Euro or the Euro states.

In this case, private investors wouldn’t get no-risk interest income from the bonds, but then maybe they would take their excess Euros and do something constructive with them, like take some risk and invest them.  Regardless, Europe doesn’t need Euro-bonds.  All that does is perpetuate the myth that bonds are fiscal operations, which they’re not.

When we talk about fiscal operations, we are talking about the Government using spending and taxation to influence the economy.

Government spending adds financial assets to the private sector.   Government taxation removes financial assets from the private sector.

The alternative is monetary policy.

After the latest Federal Reserve Meeting, Chairman Ben Bernanke gave a press conference at which he said something worth commenting on.

I think the best way to address inequality is to create jobs. It gives people opportunities. It gives people a chance to earn income, gain experience and to ultimately earn more. But that’s an indirect approach that’s really the only way the Fed can address inequality per se.

I think it would be helpful if we could get assistance from some other parts of the government to work with us to help create more jobs.

I agree with this statement wholeheartedly.  And ordinarily I would be harping on the last sentence where he implores Congress to use it’s fiscal capacity to create jobs.  But I also want to note something else in that last sentence.  ”…it would be helpful if we could get assistance from some other parts of government…”

So there’s an admission there that The Fed is part of the Government of the United States.  Many people believe the Fed is a private bank.  That’s not the case, even if their board of directors is made up largely of directors from Private Banks.  In another post I will talk about looking at Government finances by looking at the combined finances of the Central Bank and the Treasury.  You have to look at them both to see the whole story.  For now it’s enough to know:  The Federal Reserve is part of the Government and statements from The Fed Director say so.


Most of the balance sheet recession hits on the bottom 80% of income earners.  Even though many in the top 20% are affected, the bottom 80% have what’s called a “high propensity to spend.”  That is, lacking very much in savings, any income they earn is immediately spent on consumption and basic living expenses with modest amounts for luxury toward the upper percentiles.  If the lowest 80% are spending more of their income on debt servicing, that is fewer goods and services they are going to buy.

In the “broken window fallacy,” a group of onlookers to a broken shop window determine that broken windows are good for economy.  They are unable to realize that a repaired window is a cost to the shopowner which results in less income for other goods, such as shoes for his children.

The broken window fallacy was written by 19th century economist Frederic Bastiat, who is often cited by Libertarians as a early Austrian (despite being a Frenchman) because he often decried protectionism and government intervention.

His most important contribution to economics was the idea that good economic decisions can only be arrived at by taking into consideration the “full picture.”  That is, the immediate consequences of an action are not sufficient, you must also take into account the subsequent reactions and further actions down the road.

The irony is that those who cite Bastiat today are unable to recognize even the most basic realities of the monetary system, including that Government liabilities are private sector savings.

The myth is that a profligate welfare system for Greek workers has resulted in the Mediterranean country’s fiscal problems. Marshall Auerback and Rob Parenteau crush that myth here.  Aside from problems with the Euro itself, the reality is that the fiscal imbalances are a result of the top 20% of Greek taxpayers paying essentially no taxes.

Here’s one of the critical paragraphs, although I highly recommend the whole thing:

” if one looks at total social spending of select Eurozone countries as a per cent of GDP through 2005 (based on OECD statistics), Greece’s spending lagged behind that of all euro countries except for Ireland, and was below the OECD average. Note also that in spite of all the commentary on early retirement in Greece, its spending on old age programs was in line with the spending in Germany and France.”

So I guess Greek Mythology lives on….