Who rules the roost?

1 October, 2012 at 13:46 | Posted in Economics | 1 Comment

According to modern monetary theorist L. Randall Wray - Professor of Economics at the University of Missouri-Kansas City and Senior Scholar at the Levy Economics Institute of Bard College, New York - it’s definitely the Fed and other central banks that set the interest rate:

The base interest rate is set by a vote of the FOMC. Period. It is not set by markets. It is not determined by the government’s “borrowing requirement”. Sovereign currency-issuing government budget deficits place no upward pressure on interest rates. Ever.

[A]s government spends by crediting bank reserves, the pressure is DOWNWARD on the overnight rate—as banks offer excess reserves in the overnight market. That is relieved by the Fed—if it wants to—to hit its target.

The deficit CANNOT raise interest rates unless Bernanke & Co. decide to vote to raise rates. They can always “just say no”: no rate hikes in response to budget deficits.

Now, we do know that if budget deficits eventually spur the economy to recover, the FOMC will vote to raise interest rates. This is not due to market pressures that result from budget deficits. It is due to the double superstition held by the Fed that a) a growing economy tends to cause inflation and b) rate hikes reduce inflationary pressures. Now, I think both of these superstitions are false. But the bigger point is that rate hikes occur due to a vote of the FOMC—not to “market reactions” to deficits.

Further, if any “crowding out” occurs due to the rate hikes (that is, if investment falls) it is the fault of the FOMC that chooses to raise rates.  So, yes, it is likely that the Fed will raise rates eventually, and it is possible this could reduce some kinds of debt-related private spending (ie “crowding out”), but all that is the desired result of Fed policy.

Now, Bernanke or his supporters might respond that all this is true enough of the overnight interest rate—but the problem is in the longer maturities since the Treasury will sell long-maturity treasuries to borrow to finance its deficit. And that then pressures long term interest rates at which investment is financed.

Again, nonsense. Treasury does not sell bonds to borrow its own currency IOUs.

Look at this in two ways.

First, let us say that as the Treasury deficit spends it does issue long maturity bonds dollar-for-dollar, and that tends to flood the market with more of such securities than the market wants. Can the Fed stop long term rates from rising?

Can anyone say “QE”? Duh! The Fed has bought up $2 trillion of such assets precisely to push down long interest rates. Is there any limit to its ability to do so? No, for exactly the reasons Bernanke says. Is there currently any crowding out of private spending due to the government’s trillion dollar deficits? Of course not. The treasuries are flowing onto the Fed’s balance sheets.

Ok, yes, I know. Our wingnuts and goldbugs are whipping up inflation hysteria—all those Fed purchases will cause hyperinflation by pumping banks full of reserves. No. The treasuries are safely locked up on the asset side of the Fed, and the reserves are safely locked up on the liability side of the Fed. They cannot get out. No bank can lend reserves except to another bank.

You can think of all these reserves as imprisoned for life—they’ll never get out. Rather, eventually as the economy recovers the Fed will sell the treasuries back to bank and will debit their reserves by the amount of the sale. Presto—the reserves will be gone. Without ever causing any Weimar hyperinflation.

Second. The operational purpose of bond sales by Treasury or Fed is to offer a higher interest earning alternative to reserves. This is not a borrowing operation. It is part of monetary policy—draining excess reserves that would cause the overnight rate to fall below the FOMC’s target. Just enough bonds are sold to accomplish that.

There is no competition for a limited supply of “loanable funds”—rather, banks have reserves created through government spending and they can choose to hold them, lend them in the fed funds market (to another bank) , or buy treasuries. That is it. There are no other alternatives. It has nothing to do with lending to private firms or households. It has nothing to do with the lending rate to firms that want to invest. The reserves are created through government spending then drained through sales of treasuries. And that is done only to prevent the overnight rate from falling to zero.

The Treasury and Fed can always “just say no”: do not sell the treasuries. Let the interest rate fall to zero. There is never any imperative to create “crowding out” by pushing up market rates—by raising the fed funds target or by selling long maturity treasuries in excess of what the market wants.

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  1. Apparently, Peter Schiff still hasn’t gotten the message… >.>


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