|Oct22-10, 05:53 AM||#1|
Q: FED and interests.
I have a nagging question which comes probably from a misunderstanding, and I guess that the answer will point me to what exactly I do not understand. It's about monetary theory and macro economy. Here it goes.
If I understand well, the "money base" (MB) is all issued by the FED (the Central Bank). Using the fractional reserve banking system, commercial banks can issue a larger amount of M1 money (deposits, loans...).
The FED can act upon the money base by Open Market Operations, that is, by buying up federal bonds. In doing so, it issues MB-money (it "prints" money) and takes over federal bonds. It can reduce the money base (MB) by re-selling bonds, and taking up MB-money (destroying money, "burning bills").
In principle, "after all is said and done" the FED could sell all bonds again, recuperate all money, and reduce the money base to 0. (it will never do so, but one can understand that the 'balance' is right here)
However, the FED also has a discount window, where it issues loans to banks, and it charges a discount rate.
And this is where I have difficulties. Imagine that there is no money (that the FED took back all money by selling all federal bonds back again) in the money base, EXCEPT for a single bank that has taken a loan of $ 100,- at the discount window, and let us say that the discount rate is 10%
After 1 year, the bank wants to pay back. How does this bank do so ? There IS only $ 100,- in the money base, and now this poor bank is supposed to give back $ 110, - ??
|Oct22-10, 09:23 AM||#2|
Hypothetically speaking if there were no legal us tender in the world then the bank won't be able to meet it's legal obligations (because they physically can't, this is the kind of random hypothetical question i might expect in an idiosyncratic contracts exam).
Economically speaking a economy that doesn't have money at all (not just usd but any money) isn't all that interesting for us because (apart from the fact that the only economies that don't have money were the ones before money was invented i.e. a long long time ago) there is no role for monetary policy.
On a practical level this hypothetical could never exist. Even in the impossible event that there is no legal us tender in the world, presumably people in the us (or any other jurisdiction that currently use usd) would just resort to using alternative currencies e.g. japanese yen or canadian dollar etc. The opposite to an economy with money is an economy where exchange is based on barter. No one barters anymore because literally it costs to much to engage in economic activity otherwise.
|Oct22-10, 01:46 PM||#3|
The fact that the FED asks interest on a loan of base money, means that each loan results in an absolute reduction of base money. An entity that engages in a loan of base money of the FED must hence be sure that it will end up obtaining MORE base money than it borrowed. This is base money, and not "value". Base money cannot (in contrast to value) be *produced* in the economy (its only source is the FED), so in one way or another, borrowing base money from the FED must result in operations extracting base money from somewhere else in order to pay back the loan.
This is strange, no ?
|Oct22-10, 04:41 PM||#4|
Q: FED and interests.
Obviously the bank would be unable to repay the loan without additional funds. In practice, the money supply could never be reduced to 0 through open market operations. If that were the objective, though, I imagine the Fed would just stop issuing discount loans.
|Oct22-10, 05:25 PM||#5|
@talk2glenn. You're right I should've been referring to the money supply which i've i just changed (in my defence it's been a while since I've discussed these matters; my macro is a bit rusty). When I say money = money base.
@vanesch: Also I want to add that money doesn't equal wealth. Goods + services = wealth (in a narrow sense) and goods and services are created by labour + capital (in a simple model of an economy). Money is used as a proxy for goods + services. Even if all the money is taken out of the economy it doesn't mean people can't pay the interest. All it means is they have to find a different medium of exchange to do so. In your example because central bank has taken all USD out of the economy unless the central banks accepts alternative forms of payment (other than USD) the bank can't pay it back which isn't the same as they aren't capable of doing so.
I guess it's because the hypothetical is quite restrictive and specific we've found it hard to know what your real question is. I hope this answer helps anyway.
|Oct22-10, 09:12 PM||#7|
M1 includes demand deposits and things like traveler's checks.
Unlike open market operations, markets transactions do not remove M0. By definition, there is enough capital in the system to repay outstanding loans. This is accounting 101.
It's alarmist crap peddled to the lowest common denominator.
The amount on deposit plus the amount held in reserves always equals the amount of loans.
|Oct22-10, 11:29 PM||#8|
The reason is that with commercial banks, the money (also the interest) "keeps in circulation": the people who get the benefit of the bank (the wages of the personnel for instance) keep this interest in circulation and offset the "sink".
In the example, the $ 200 000,- interest on the 1 million loan is borrowed at bank B, but it goes into the hands of the employees of bank A as wages (say), and they will spend it in the economy, from which bank B will eventually get paid back.
So the only thing you need to do when you borrow a million $, is to make sure that you will be able to *create value* for $ 200 000,- by the time you need to pay it back + interests. This creation of value will "suck in" enough money (say, from the bank employees, because you sell them pizzas) again to "close the circle". So the story as such is wrong, for commercial banks and commercial loans.
However, and this is how I came upon this problem for me, it DOES seem right if you think of loans by the FED, because the interest you pay to the FED is not circling around anymore, it is effectively destroyed.
Now, indeed, as long as the government issues bonds, the FED can create money by buying them. So it seems that you need a budget deficit in order for this interest not to be diminishing base money.
Mmmm, so in fact, if that's true (if the FED will buy bonds by exactly the same amount as you pay interests to the FED) the money base will remain intact, and you can see these interests in fact as a kind of taxes you pay to the government.
Yes, this might be the solution to my difficulty:
- you pay interests to the FED, and hence "destroy" base money
- the FED buys bonds for exactly the same amount and "creates" base money
- the government can have a deficit (issuing bonds) for exactly the same amount
you could have paid directly your interests as taxes to the government.
Does that sound about right ?
|Oct25-10, 10:04 PM||#9|
Money isn't only created by the Fed. As you mentioned, with the fractional reserve system, there is a money multiplier so that money borrowed from the Fed (and you're borrowing whether you sell bonds or borrow from the discount window) can be re-loaned and those loans will earn higher interest than the discount rate (they have to, or the bank wouldn't make it's money back and then what you're imagining could theoretically happen). Every dollar the Fed injects become $1.10, or whatever, but the point is there ends up being more money than just what the Fed directly prints.
Even if the Fed took all M1 out of circulation (which it can't because the total amount of bonds it owns to sell is only like $700 billion, far less than the amount of M1 in circulation), M2 and M3 assets can still be converted into M1.
|Oct26-10, 06:25 PM||#10|
MS = (1/RR)*M0, where RR is the Reserve Requirement, M0 is the amount of cash in the system.
If M0 = 0, then by definition the MS also equals 0. The Federal Reserve cannot remove all the cash from the system without reducing M1, M2, and M3 to 0 as well. The Fed also has sufficient bonds to do this, again because by definition the number of outstanding bonds owned by the fed is always equal to the amount of M0 (currency) in circulation (assets equal liabilities).
You can understand this through a simple thought experiment.
A bank does not have sufficient cash on hand to repay its obligations to the Fed. To meet those obligations, it must liquidate (or undo) its outstanding loans. The borrows must in turn liquidate their loans, and so on through the system.
|Oct27-10, 08:13 AM||#11|
You can't create intrinsic wealth or value through the mere process of creating and using fiat money and conversely you don't really destroy intrinsic wealth or value by withdrawing use of fiat money. All you really need to get out from fiat money is that one of it's uses is as a nominal proxy for real goods and services because it's more efficient to use than a bartering system (there are huge efficiency gains from using the fiat system).
It's interesting that the story you've referred to is a famous one (as you say in anti-kapitalist circles anyway). Personally I haven't heard those arguments before until this forum. If I give my forthright opinion on the matter laid out in the article that was linked or any other form of the same argument I find it logically fallacious because it fails to distinguish between real and nominal values. Real values are what matters.
*I use efficiency, real, and nominal in the economic sense.
EDIT: For emphasis, I will use the example of fed conducting monetary policy by injecting funds into the economy. The fact that they are 'printing' billions and billions of dollars doesn't mean real wealth has just been created out of thin air. All it means is the amount of money (i.e. nominal value) in the economy has increased but (all else being constant) the amount of real goods and services is the same. That is, nominal values have changed but the real values haven't.
|Oct29-10, 06:25 AM||#12|
I wanted to find out whether there was a "leak" in these flows with FED loans. Turns out there IS actually a leak, UNLESS the government issues bonds at the same rate as the interest that is paid back on the FED loans AND the FED buys these bonds (in other words, injects exactly the same amount of base money as it took out). The point is that the one who "gets to spend it" is the government.
So I *think* the issue I had is solved by this:
there is conservation of base money when there are FED loans when:
- the FED takes (and hence destroys) the money corresponding to the interest rate on the loans
- the state issues bonds equal to this amount (hence can balance a deficit of exactly this amount)
- the FED buys those bonds and issues an equal amount of base money
As total amount of base money is conserved in the combination of these 3 operations, there are no inflationary pressures due to this operation, and the state is to spend an amount of money equal to the interests paid to the FED without compensating this with taxes, and without creating debt.
So it is AS IF you paid your interests on your FED loans DIRECTLY as a tax to the state.
I wanted to hear some comments on that - I have the impression it is correct.
|Oct29-10, 08:42 AM||#13|
vanesch I'm still not sure what you mean so I just want to clear a couple of things up with my interpretation of your post and hopefully you can help clarify a few things I don't quite understand.
- Suppose there is no legal tender in the economy. The FED lends out $100 (principal) to person A on the promise that it will be paid back with interest of say 10% (i.e. $10) in a year's time (that is A has to pay Fed back at year end of $110). So at start of year 0 the money base equals $100. At end of year 0 the money base is -$10.
- At start of year 1, the government issues $10 bond. The Fed immediately buys that $10 bond (ie injects $10 into money base). Net result from this transaction is money base is 0.
- Assuming Fed was charging govt. the same interest, at end of year 1 government has to pay back $11 even though the money base is 0. So end of year 1 the money base is -$11.
- This process can be repeated infinitely.
From this example you conclude that:
- 'the one who "gets to spend it" is the government';
- 'there are no inflationary pressures due to this operation' (I understand why there might not be inflation since there is no money in the economy or negative money but I don't understand why inflation is relevant in this economy);
- 'the state is to spend an amount of money equal to the interests paid to the FED without compensating this with taxes, and without creating debt. So it is AS IF you paid your interests on your FED loans DIRECTLY as a tax to the state.'
I think you may have a set of perfectly reasonable arguments but I'm not sure I understand what they are yet and I want to clarify the things I don't get.
|Nov2-10, 02:53 AM||#14|
Let us, for the moment, assume that bonds bought by the FED are "put in the safe forever" and never come out anymore, nor should the gov. pay any interest to the FED for the bonds in their safe.
Government spending is equal to T + dD + dM0
T = taxes
dD = debt increase
dM0 = money base increase by the open market operations of the FED.
If T and dD = 0 in our example, the government can still spend dM0, equal to $10,- here.
What I meant was, this operation doesn't bring any money IN or OUT of circulation after all. As much is destroyed as there has been created.
|Nov5-10, 12:27 AM||#15|
The convention in economics is to denote flows like G, investment (I), consumption (C) etc. in real terms but denominated in nominal values (See here national income identity).
|Nov5-10, 06:59 AM||#16|
I thought it was only whenever the FED decided to sell bonds again to the public by taking in (M0) money, that the government was to pay these bonds ; in other words, the FED selling bonds to the public comes down to the state taking in taxes and burning the money (back into thin air).
As long as the gov. bonds are in the FED's safe, it is as if they never existed, and as if the government had printed money.
I thought that that was the fundamental principle of the open market operations: printing money and destroying money in the money base - only they do it via an intermediate piece of paper called a government bond.
I thought it went like this (hypothetical thought experiment):
The government has earned, say $ 100 billion in taxes.
The government issues $ 50 billion in bonds.
The government has now 150 billion to spend.
(this is your equation: G = 150 b = T + dD = 100 b + 50 b)
However, the FED buys up 40 billion of these newly issued bonds.
This means that there are only 10 billion bonds in private circulation (so this is the ACTUAL debt increase dD of the gov), and has issued 40 billion of new dollars (d M0).
So the original 50 b is decomposed in 10 b actual debt increase (dD) and 40 b money base increase (dM0).
This is the *monetary* flow. Not the flow of actual value, where there is no such thing as issuing "base value" out of thin air, I agree there. But I'm interested in the flow of money here, not of value.
|Nov5-10, 02:01 PM||#17|
Treasury bonds held by the Fed still earn interest (payable by the Treasury to the bond holder) and have a maturity date, and indeed for practical intents and purposes the Treasury cannot differentiate between bonds held by the Fed and bonds held by the market. The only exception of note is central bank profits - if the Fed is revenue positive at the end of the year, the earnings are transferred to the Treasury.
When the central bank buys bonds on the open market, it is typically (but not necessarily) buying them from private bond holders, and not from the Treasury directly. Vise versa, when the Treasury issues bonds, it is typically selling them to private investors, and not to the Fed directly. This independence is critical to the apparent stability of the currency; if the Board bought Treasury's directly, it would radically devalue the dollar (the implication being the Treasury cannot find willing buyers on the open market).
The government has no control over the money supply; the Reserve Board has that power as an independent authority. The Treasury only has legal power to destroy damaged currency, to be replaced with new, a supply-neutral activity.
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