An Inability to Explain - MMT on Operative Policy Rate Targeting

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It is not easy to rapidly obtain a general understanding of the topic.

Ulrich Bindseil, Monetary Policy Implementation ...

Government Bonds - Needed for Not for Borrowing but for Policy Rate Targeting

One of the pivotal propositions of MMT is that the sovereign issuer of currency (government) neither needs taxes nor borrowing to fund its expenditures. It is able to issue its own funds by instructing the central bank to create money out of nothing. Why then does government issue government debt in the form of government bonds?

In order to dissolve the seeming paradox, MMT offers an alternative explanation of the motif that government has to issue public debt. The claim is that buying and selling government bonds serves to regulate the bellwether interest rate (the fed fund rate in the US) with which the central bank hopes to drive the overall structure of interest rates. (For the present purpose, we treat government as dictating central bank action.) If the central bank wishes to move the policy rate or if it wishes to maintain it, it uses its ability to issue and trade bonds to achieve whatever rate level it deems advisable.

MMT's Inability to Explain the Function of Government Debt

A big minus for MMT (Modern Money Theory) is its inability to explain comprehensibly and intelligibly how the central bank manages to maintain its target rate in the interbank market. MMT advertises policy rate ("Leitzins") targeting by the bank as a  central feature of the money system, but when it comes to explaining the mechanism one is being fobbed off with incomplete and cursory "explanations," often accompanied by "as is widely known" rather than a conscientious elucidation.

Typically, the attempted explanations are incomplete, presupposing information that is not spelled out. The impression one gets is that authors copy each other adding or leaving out certain aspects, and failing to spell out crucial information that the learner stands in need of.

I have never seen covered in the relevant literature what should be a not too difficult teaching task: a seamless explanation of the trading sequences that allow the central bank to force the interbank markets participants to lend at the rate desired by the central bank. Instead, what you get are partial explanations, insinuations and jumping-to-conclusions.

A Case among Many of How One is Being Fobbed Off

Consider this example:

1. The government issues a cheque for $1 million to some entity in the economy. In this case, a government contractor. 
2. The cheque is cashed, and as a result of the clearing operation, the contractor gets an increase of $1 million in her deposit account at the bank, and the bank gets an increase of $1 million at its account at the central bank. (The central bank is a bank for banks.) The deposit at the central bank is known as a “reserve” in the terminology used in the U.S. (The term is not applicable for a country like Canada that has abolished reserve requirements, but the U.S. usage is probably best known, so I will use it here.)
   All else equal, the commercial bank now has an excess of reserves. The bank will want to trade these excess reserves away in the interbank market, putting downward pressure on the interbank rate.

(Up to this point, I understand what is being argued; but I do not follow any more: assuming that the two banks mentioned in the three-step example are not identical, how does the fact that the reserves of the second bank have been reduced affect the reserves held by the first bank? How have the reserves of the first bank magically disappeared and with it the desire to"sell off" its excess reserves and thereby putting downward pressure on the target rate? 

3. Since the central government targets a specific target for the overnight rate, this downward pressure has to be resisted to keep the overnight rate on target. It could use an “open market” operation (a repo) to temporarily remove these excess reserves. However, the government can permanently remove those excess reserves by issuing a bond. For example, it could issue a $1 million in bonds. To pay for the bond, buyer’s bank will transfer $1 million to the government. (Why would there be a buyer?) The buyer’s account at her bank will be reduced by $1 million, and the bank’s account at the central bank (reserves) will also be reduced by $1 million. (This reverses the cash flows between the public and the aggregated private sector in step 1. (How does this relate to the first bank's desire to reduce excess reserves? How have the first bank's excess reserves been drained? How does it affect its trading behaviour, and how does this help maintain the desired target rate?)

To summarise:

1. Government issues cheque. (No impact on interest rates.)
2. Cheque cashed. (Excess reserves reduces interest rates.)
3. Bond issued to return reserves to desired level. (Interest rates rise back to target level.) (Point 3 is exactly what has not been explained, for God's sake!)

I have submitted the second, not so polemical part of this post to Brian Romanchuk, the author of the above quote, and host of a blog called Bond Economics. I wonder whether I get a response and what it will make me look like.

[Also, I am confused as to banks' discretion in determining their reserve positions. It appears in the above example that all deposits are reflected one-to-one in a bank's reserve account, rather than just a mandatory fraction or an amount considered prudent by the bank.]

I exempt Brian Romanchuk from my above reproach; he hast made an excellent effort at explaining the full picture in intelligible terms. Of course, he cannot be held responsible for the fact that somee of his posts appear unintelligible to those who do not know his full explanation.

Reply

I have promptly received the following reply from Brian Romanchuk - which I shall look more closely at, once I have read through his eReport: Understanding Government Finance:

In the 3 step example, the cheque (written by the government) is drawn on the government's bank, which is the central bank. The only effect of the cheque cashing on that leg of the transaction is that the Treasury's balance at the central bank is lowered; the central bank does not have reserves (which are deposits with itself).

The reduction of the balance of the Treasury at the central bank does not impact the ravage sector, as it is a purely intra-government accounting entry. (Remember that the Treasury owns the central bank, and so lending operations between the treasury and the central bank are effectively loans to itself.) Eventually, the Treasury balance has to be recharged, which is done via bond issuance.

As for your second question, I think it is largely covered by the above explanation. As to why a buyer would want to buy a bond or a Treasury bill, they almost always offer a yield pickup over deposits. In the U.S. system before 2008, banks were not paid interest on excess reserves, so it was always better to buy a Treasury bill.

If the Treasury held cash at commercial banks (which is done sometimes under differ banking system regimes; for example, the U.S. Treasury did this before the creation of the Fed Reserve system), a government cheque would just be a transfer within the private sector. In such a case, the government has to have the private sector money before it spends, like other private sector entities.

I hope this covers your questions. I should point out that I cover this in greater detail in my ebook "Understanding Government Finance" (end of commercial plug :-> ).