In an earlier post, I argued that our current monetary system is close to being to a Wicksellian ‘pure credit economy’. In Hans Trautwein’s words, this is “a state of affairs in which all money is held in interest- bearing bank deposits and in which all payments are effected by means of book-keeping transfers in the banking system”. One significant way in which our current system is not quite a pure credit economy is that economic agents still retain the option to hold currency notes. This option is not very important in positive-rate environments but it denies the central bank the ability to enforce negative interest rates (which can be avoided by simply hoarding zero-interest physical notes). The dominance of interest-bearing money combined with the inability to enforce negative interest rates implies that the quantity of base money in the system is irrelevant, not just now in a ‘liquidity trap’, but at all points in the future.

The Irrelevance of The Quantity of Base Money and The Absence of The Monetarist Hot Potato

It is trivially obvious that interest-bearing money cannot be a hot potato in the monetarist sense. There is no reason to get rid of interest-bearing money balances and interest-bearing money holdings only need to be minimised if the interest rate is insufficient relative to the ‘natural’ real rates and safety premium implied in holding money. To put it simply, if interest rates are 5% and inflation is 15% then interest-bearing money will act as a hot potato and fuel inflation. But in the current environment of possibly negative natural real rates and a high demand for safety, prolonged negative real rate regimes are perfectly sustainable without triggering any ‘hot potato’ inflation. The above holds not only at the zero-bound but at all positive interest rates. If the central bank wants to sustain positive bank rates, it must either pay interest on reserves or mop up all excess reserves. In either scenario, we have no hot potato.

Interest-Bearing Money: Debt as Money

The history of interest-bearing money is essentially the history of debt as money. The modern history of transferable debt as money is exemplified by the use of bills of exchange in post-Renaissance Europe. As Philip Coggan explains:

trading systems were an early form of our modern economy, with its layers of debt and reliance on paper money. A merchant might extend credit to his customers; in turn, he would need such credit from his own suppliers, who might only have bought the goods with money borrowed from someone else. The default of one party would ripple through the system. This system was formalized in the form of bills of exchange, promissory notes offered as payment from one trader to another. The recipient might then use the bill as collateral to raise cash from a bank or other lender. The bill would be accepted at a discount, depending on a number of factors, most crucially the creditworthiness of the merchant concerned. This was, in effect, a paper money system outside the government’s control.

It is instructive to examine the evolution of this private credit economy in order to fully understand where we stand now. The rest of this section is primarily drawn from Carl Wennerlind’s excellent book ‘Casualties of Credit’. The private credit economy was an essential component of the English economy due to the perennial shortage of metallic currency. As Wennerlind notes, it wasn’t just merchants but the bulk of the English population who were participants in the credit economy. In the early days in the seventeenth century , the supply of private credit alone was nowhere near enough to make up for the scarcity of metallic currency. One reason was the limited transferability of private debt, a problem that was solved by the passage of the Promissory Notes Act of 1704 which made all debt instruments negotiable. Nevertheless, the limited elasticity of the private credit system in responding to demand from commerce remained a problem. A related and equally severe problem was fragility induced by the possibility of default. This was the Achilles heel of the private credit economy in the 17th century and it remains the case in the 21st century. Just as in the 21st century, the real systemic risk is the threat of a wave of cascading defaults brought upon by the tightly interconnected nature of private credit agreements.

The solution to this problem that we are all aware of and that has been well-documented is the growth of modern banking ultimately backstopped by central banks (usually via lender-of-last-resort actions). This architecture was initially limited by the restrictions placed upon the central bank by the metallic/gold standard, Bretton Woods etc which were finally thrown away in 1971 to construct the “perfectly elastic” monetary system that we have today. This is the logical conclusion of the process of abstracting away from the prior personal nature of “money as debt” to a decentralised impersonal system.

Less documented but equally important are the attempts to improve the supply and safety of the credit economy via collateral. The idea is simple - assets can be used as security to back the credit, thus improving the supply as well as the safety of credit. There were many recommendations as to what constitutes eligible collateral in the 17th and 18th century but by far the most popular suggestion was land. It is worth quoting Wennerlind on this subject (who in turn quotes William Potter):

Potter also offered a proposal for a land bank, which was remarkably similar to that of Culpeper. Since “Credit grounded upon the best security is the same thing with Money,” the key was to establish a bank that used a different asset than precious metals as security backing the credit money. Since land was considered the most concrete and stable commodity at the time, there could be no better security than land to induce people to part with their commodities in exchange. By mortgaging land, which “would serve as well and better for such a pawn,” the land bank created a credit currency that would have “as true intrinsick value, as Gold and Silver”

Others, such as Hugh Chamberlen advocated a general storehouse of goods that would serve as collateral. Nevertheless, none of these ideas were adopted in 17th/18th century England for good reasons - none of these choices for collateral were liquid enough or permanent enough for the purpose. To a modern investor, government bonds are the obvious answer to this dilemma. But in 17th century Europe, government debt was neither liquid nor safe. However, a series of institutional changes after the ‘Glorious Revolution’ in 1688 changed all this (see North and Weingast 1989 for details). With the setting up of the Bank of England, British government bonds began to resemble the “risk-free” counterparts of the modern world by the mid-18th century. It is obvious how the ability of the new more representative English Parliament to credibly commit to repay its debts enabled England to fund itself at a much lower cost. What is less appreciated is the fillip that the institution of a liquid, comparatively safe government bond market gave to the private credit economy. As Baskin and Miranti note, these government obligations could be used to collateralise private borrowing in a manner that is uncannily similar to the modern-day term repo contract.

The Hot Potato Constraint in a Credit Economy

What does all this have to do with the modern monetary system? In the modern pure fiat-currency economy (i.e. not the Eurozone), interest-bearing deposits, interest-bearing central bank reserves and interest-bearing government debt are all equivalent in that they are all nominally safe state obligations unencumbered by restraints such as a gold standard. Any shift in liabilities between central bank reserves, deposits and debt engineered by the central bank is only relevant for its interest-rate impact. There is nothing in this process that can be even remotely termed as  “money printing”. The inflation tax and any “hot potato” effect are dependent not on the absolute levels of inflation but the real interest rate offered on each tenor of these government obligations.

To the extent that any activity of the state approaches money printing, it is the act of deficit spending. Even this does not necessarily entail inflation - the central bank can force a contraction in the private credit economy by a sufficient rate-hike to counter any fiscal stance. Again there is no inflation tax and no possibility of hyperinflation as long as interest rates across the government obligation curve compensate sufficiently for inflation. Each fiscal stance has a separate sustainable level of inflation and interest rates that constitutes a short-term equilibrium. When a loose fiscal stance breaks out into excessive inflation and the risk of hyperinflation, it is usually the result of this rate hike being inadequate for fear of a collapse in the private economy.

Rather than talk in the abstract, it is easier to elaborate on the above framework with a few relevant and timely examples.

Permanence of QE is irrelevant

Gavyn Davies gives us the conventional argument as to why the perceived temporary nature of QE matters in preventing out-of-control inflation:

Fiscal policy, in theory at least, is set separately by the government, and the budget deficit is covered by selling bonds. The central bank then comes along and buys some of these bonds, in order to reduce long-term interest rates. It views this, purely and simply, as an unconventional arm of monetary policy. The bonds are explicitly intended to be parked only temporarily at the central bank, and they will be sold back into the private sector when monetary policy needs to be tightened. Therefore, in the long term, the amount of government debt held by the public is not reduced by QE, and all of the restraining effects of the bond sales in the long run will still occur. The government’s long-run fiscal arithmetic is not impacted.

As I have illustrated above, QE in a world of interest-bearing money is simply an adjustment in the maturity profile of government debt. But that is not all. In a credit economy where government bonds are a repoable safe asset, the bond-holder can simply repo his bonds for cash if he so chooses. Just as the East India Company could access cash on the back of their government bond holdings in the 18th century, any pension fund, insurer or bank can do the same today. This illustrates why the reversal of QE, if and when it happens, will have no impact on economy-wide access to cash/purchasing power.

Bond-financed or Money-financed deficits

Gavyn Davies again gives us the conventional argument:

When it runs a budget deficit, the government injects demand into the economy. By selling bonds to cover the deficit, it absorbs private savings, leaving less to be used to finance private investment. Another way of looking at this is that it raises interest rates by selling the bonds. Furthermore the private sector recognises that the bonds will one day need to be redeemed, so the expected burden of taxation in the future rises. This reduces private expenditure today. Let us call this combination of factors the “restraining effect” of bond sales.
All of this is changed if the government does not sell bonds to finance the budget deficit, but asks the central bank to print money instead. In that case, there is no absorption of private savings, no tendency for interest rates to rise, and no expected burden of future taxation. The restraining effect does not apply. Obviously, for any given budget deficit, this is likely to be much more expansionary (and potentially inflationary) than bond finance.

The ability of the private sector to repo its government bonds to access purchasing power today gives us a profound result. Whether the central bank monetises government debt or not is almost irrelevant (except from a signalling perspective) because the private sector can monetise government debt just as effectively. And when the government debt does not represent a ‘hot potato’, the private sector often does exactly that. This is not a theoretical argument. For example, Akçay et al illustrate how fiscal deficits led to inflation in Turkey despite the absence of monetisation because ” innovations in the form of new financial instruments are encouraged through high interest rates, and repos are typical examples of such innovations in chronic and high inflation countries. People are thus able to hold interest-bearing assets that are almost as liquid as money, and monetization is effectively done by the private financial sector instead of the government”. As Çavuşoğlu summarises, “The money creation process under high budget deficits can as well be characterised as an endogenous credit-money expansion rather than a monetary expansion to maximize seignorage revenue”.

Lest you assume that this only applies to developing market economies, the same argument has been made almost three decades ago by Preston Miller:

In the financial sector….higher interest rates make profitable the development of new financial instruments that make government bonds more like money. These instruments allow people to hold interest-bearing assets that are as risk-free and as useful in transactions as money is. In this way, the private sector effectively monetizes government debt that the Federal Reserve doesn’t, so the inflationary effects of higher deficit policies increase.

Even in the early 80s, Miller saw the gradual demise of non-interest bearing money:

In recent years in the United States there have developed, at money market mutual funds, demand deposit accounts that are backed by Treasury securities and, at banks, deep-discount insured certificates of deposit that are backed by Treasury securities, issued in denominations of as little as $250, and assured of purchase by a broker. In Brazil, which has run high deficits for years, Treasury bills have become very liquid: their average turnover is now less than two days.

As in the case of Turkey and as argued by Preston Miller, the private sector can monetize the deficit as effectively as the central bank can. And so long as government obligations are deemed safe, it almost certainly will. In an interest-bearing economy, the safety of these obligations have nothing to do with the absolute level of inflation and everything to do with the real rate of return on the bonds. When central banks and governments attempt to enforce an excessively negative rate of return, they play with fire and risk hyperinflation.

The Near-Permanence of (Non Hot-Potato) Government Debt

P.G.M. Dickson characterised the rise of the government bond market in London during the 18th century as the era of “debts that were permanent for the state, liquid for the individual”. In a credit economy, government debt issued in the past is simply money that has already been printed. Erasing this debt would not imply a monetary collapse but it would unleash strong deflationary forces.

Most of the developed world (ex the Eurozone) could easily maintain their current levels of government debt ad infinitum so long as the real interest rates paid on them are sufficient. And in fact it makes sense for them to do exactly that. Even without the monetisability of long-term government debt, there is a significant demand for them from many private sector holders - the pension fund and insurance industry which needs long-tenor bonds to match its liabilities to retirees, investors who need long-tenor bonds to hedge their risky assets and provide tail-risk protection. Even without taking into account the “natural” real rate of interest, there is a strong argument to be made that the average real rate of return on long-tenor government bonds should be negative. Therefore, it does not even make economic sense for governments to pay back their debt, as long as it can be serviced at a sustainable real rate.

The appropriate question to ask is not ‘What is the maximum level of government debt is that can be plausibly paid back?’. It is ‘What is the maximum level of government debt that can be plausibly serviced on a permanent basis?’. If there are any Ponzi schemes in government debt, they exist only if and when there are real limits to economic growth - working-age population growth, energy limits etc.

What Matters: Future Deficits and Real Rates

A policy option such as a cancellation of past debt or an announcement of helicopter drops would be relevant to the extent that it effects future deficits. Higher deficits would typically warrant a more hawkish monetary stance and it is the combination of this fiscal stance and the monetary response that determines whether the deficit regime constitutes an inflation tax on the private sector. For example, the state could institute a helicopter drop and raise interest rates at the same time to maintain real rates at acceptable levels - again the level of real rates is much more important than the absolute level of inflation. Even this hike in rates may not be required if the private sector is undergoing an endogenous delevering at the time.

Modern Repo and the Asset Price Approach to Monetary Policy

If the collateral underpinning the private credit economy was limited to government bonds, the lender-of-last-resort role of the central bank in the repo market would be trivial. However, the current scope of the repo market and similar financing arrangements (notably ABCP) extends to far riskier assets. Although the risk management in today’s repo market is far superior from an individual counterparty’s perspective ( the predominance of the overnight repo, more sophisticated margining etc ) the systemic risk of cascading defaults triggering a credit collapse has in fact spread to all asset markets.

In order to meet their stabilisation mandate, central banks have implicitly taken on a mandate to backstop and stabilise the entire spectrum of liquid asset markets. If the central banks influence anything that could be termed as money supply in the modern credit economy, they do so via their influence on asset price levels (influenced in turn through the central bank’s actions on present interest rates, future interest rate path and liquidity). In a collateral-dependent credit economy, the Greenspan Put is the logical end-point of the stabilisation processes, the modern motto of which could be summarised as: 'Focus on collateral values and the money supply will take care of itself'. Successive stabilisation leaves the economy in a condition where all economic actors have moved away from the idiosyncratic, illiquid economic risks that are the essence of an innovative, entrepreneurial economy towards the homogeneous liquid risks of a stagnant economy (detailed argument here).

In an earlier post, I noted that “The long-arc of stabilised cycles is itself a disequilibrium process (a sort of disequilibrium super-cycle) where performance in each cycle deteriorates compared to the last one – an increasing amount of stabilisation needs to be applied in each short-run cycle to achieve poorer results compared to the previous cycle.” This sentiment applies even when we look at the long-arc of stabilisation in England since the 17th century. In the 17th century, it only took a change in the laws (making debts negotiable) to prevent a collapse in the credit economy whereas now we need to prop up the entire spectrum of asset markets.

1. The section on monetary hot potatoes and high-powered money is almost completely taken from commenter ‘K’ - example here


Diego Espinosa

Ashwin, Excellent post. I would disagree on one point: the sustainability of l.t. negative real rates on government debt. I think its more likely that negative real rates spark natural feedback loops to either inflation or deflation. Picture a typical household needing to save for retirement. The prospect of l.t. negative real rates means the household must either: 1) save more out of current income to offset the loss of purchasing power; or 2) purchase inflation hedges that are likely to pay positive real returns in such an environment. The two behaviors produce polar-opposite results in terms of price level expectations; results that are likely to feedback on themselves. I think its important to note that governments don't really control real interest rates. They chase them around and try to influence them, but post debt crises, it usually takes shocks (exiting the gold standard; dramatic austerity) to bring them into line.


Ashwin As usual, excellent, and I agree. A couple of points : 1) 'Future deficits' is by itself an unclear concept. Any future year where G>T is trivially a future deficit, but the debt/GDP may be reducing nonetheless. 2) Following Mehrling (also Buiter, Brunnermeir)and is obvious from your post, the central bank's presumed function really is 'liquidity provider of last resort', which may mean 'lender of last resort' or, these days, 'market maker of last resort'. Funding liquidity crises are relatively clear but in market liquidity crises, the credit risk of the assets is hopelessly tied in with the liquidity risk. Further, for dealers, their business model itself means that solvency is hopelessly tied to liquidity. What's the way out? You seem to be suggesting that a market-maker of last resort function is fatally flawed, the final step on to a path of stabilised stagnation and systemic risk concentration. But can the liquidity put be priced properly and be separated from the asset price put, even operationally? I think that part of the problem is the asymmetric nature of the response. If a central bank stands ready to both buy AND sell repo-able bonds, at all times (with the widest bid-ask spread, providing the limits of the system so to speak), can we avoid a pure put on the asset price itself? I think this is what Mehrling suggests. This is similar to the idea that Goodhart proposes for funding liquidity - vary the channel to respond to systemic liquidity gluts and ebbs, and have a market ready at all times, not just as last resort. 3) Just as the trouble with the no-friction classical conception, I think the pure credit economy conception also runs into the 'imperfect substitutability' issue as well. Though, I agree, I'd begin with the pure credit economy as the default benchmark, and add imperfect substitutability and other constraints on top. Essentially, a Tobin-Mehrling world.

Asymptosis » Why Unwinding QE Won’t Matter

[...] Parameswaran nails it once again. If you want to understand how the modern financial/monetary system actually works, run [...]


Diego - I agree that governments don't control real rates, probably influence is a better word. On negative real rates, you have a point. Where i'm coming from is that the safety premium paid by the credit economy and the risk-hedging nature of govie duration can justify small negative real rates for a very long time.


Ritwik - agreed on the deficit. There are probably a few other caveats I've missed. I am suggesting that the current regime is fatally flawed. Unsurprisingly, I don't think there is any way to save this system that doesn't involve bringing back the possibility of failure. Even if they somehow provide just the liquidity put, it doesn't solve the systemic problem that the entire macroeconomy realigns to take advantage of this put. To put it bluntly, why would you lend to a small business when all that the CB accepts at the repo window are marketable securities?


What an awesome post. Amazingly interesting. Thank you!


Awesome to see you posting again. Always look forward to your insights!


No doubt QE is draining repo collateral, which tightens that market. Do you think it may also be draining bonds from market segments that do not normally provide repo collateral? If so, is the marginal analysis different?


This may be too obvious to mention, but producing government bonds (and money) doesn't require running a deficit in the usual sense. The government could purchase financial assets. So we can separate the question of whether government bonds are desirable from the question of whether public debt (net of financial assets) is desirable.


JKH - short answer is that I don't think QE is operating on any such collateral. If anything the "money supply" analysis of this extends to a vast array of private sector assets which, if the holder is so inclined, can be translated into liquidity today in this manner. Of course most of these markets locked up during the crisis as opposed to govie bond repos which didn't. My historical account is meant to show that repo-like schemes have been demanded and have existed for a very long time. For example, there are pamphleteers in the 17th century who demanded a sort of open repo window where a centralised bank provides cash against a wide pool of assets. Repo has sprung up in many developing countries solely with the purpose of enabling private sector monetisation of govt bonds in environments of rising rates. Environments such as the 20 years post WW2 where such money supply elasticity shuts down are the historical exception and of course in these exceptional periods, monetarism is actually a good approximation of the system - gold standard or not.


Max - absolutely. I do not intend to suggest that we should run high deficits. I'm merely arguing that the weight of all these past deficits, however ill-spent, has already been felt on the current price level. I'm not even suggesting that govt debt is necessary for the private credit economy. It provides excellent backing so long as the govt acts responsibly but private credit money can absolutely exist even without the state.


Ashwin " To put it bluntly, why would you lend to a small business when all that the CB accepts at the repo window are marketable securities?" Because I *know* that his true credit premium is 2% while the market thinks it's 5%. So I price it at 4% and deliver myself a profit without needing liquidity support. My liabilities don't need to circulate as money. Or, even if they do, they do because I'm high expected net-worth. So I'm a financial intermediary, but not a bank in the SRW sense.


Ritwik - the way I read the empirical evidence so far is that this sort of lending you're talking about isn't happening. There are some asset management firms who entered the business lending space in Europe over the last couple of years thanks to bank funding costs exploding but its a drop in the ocean and they'll get outcompeted as soon as bank funding costs come down. The other problem is that all these non-bank players/HNW individuals focus on the high-risk/return space, the banks pick up the pennies and its the mundane middle that gets slaughtered. I've made references to this in the past but if we have this stabilisation regime in place, it should at least be made into an open access repo window, where the CB accepts any collateral from anybody (with sufficient collateral, margin etc of course).

Detroit Dan

Good post, with some new insights in the MMT vein. However, I'm not at all convinced by the stuff about "hot potato" interest rates and hyperinflation. Hyperinflation is invariably a byproduct of serious political issues (invasion of the Ruhr by France in Weimar Germany, confiscation of farms in Zimbabwe, international sanctions in Iran). Interest rates are trivial in comparison to these larger factors. Show me even a single example of low interest rates causing hyperinflation...


Detroit Dan - I can give you at least two examples (Weimar and Zimbabwe). For details see my last post Note that I am talking about significant negative real interest rates, not nominal rates.


Ashwin, Nice points. Although I am not sure why this "repo" argument keeps coming. Households do not repo and firms making investments also do not repo to finance working capital and to finance investment. Even if they are involved in repos, they are sophisticated enough to borrow elsewhere if the repo market wasn't developed. Also it is simply not true that governments can spend ad-infinitum. You mention Hungary and it shows exactly what the constraint is - it is one of the biggest debtors of the world and fiscal policy has a "balance of payments constraint".


Ramanan - Thanks. I'm not sure I said that government can spend ad-infinitum. Just that with the appropriate real rate paid on debt, the current debt can be treated as permanent. Your are of course correct about the BoP constraint. If you don't get the repo argument, then I clearly haven't done a good enough job explaining it. Govt debt being a repoable nominally safe asset means that it is equivalent to money for all practical purposes. If I held govt debt and wanted cash on the back of it, I could via the repo market/window. So buying govt debt with reserves has no "money supply" impact. Firms and households aren't direct participants but if loans to them are liquifiable in this manner, then banks are much more likely to lend to them. One of the changes made by the ECB last winter when they started doing longer-term repos was to allow business loans as eligible collateral which theoretically should encourage banks to increase business lending. Mortgage-backed securities have of course been repoable both in the pvt market and with the CB for a long time now.


Ashwin, "If you don’t get the repo argument, then I clearly haven’t done a good enough job explaining it. Govt debt being a repoable nominally safe asset means that it is equivalent to money for all practical purposes. If I held govt debt and wanted cash on the back of it, I could via the repo market/window. So buying govt debt with reserves has no “money supply” impact." I understand that obsessing with monetary aggregates is sad and that one is not limited by spending by the amount of money in existence and the bonds = money (a caricature only but useful one). I know all that Tobin/Kaldor arguments. However to explain this, one really doesn't need to bring in repos. If a household or an institution wants to make expenditures on goods and services, it needn't repo. There's hardly anyone actually doing it that way. Even if they do, they highly sophisticated to raise funds in the usual way and the liquidity of the repo market doesn't actually increase their ability to make expenditures. That was my point.


Ramanan Are you saying that the macroeconomy as a whole is never liquidity constrained? Think of the banking system as a sequence of dealers. Ceteris paribus, each bank is more willing to extend funds (to other banks and to the real sector) if its current assets count as good collateral. This is doubly true if the same asset can be further collateralized - rehypothecation. Repo is a way to stretch the liquidity of the system, to overcome whatever little influence the central bank extended through the reserve constraint. In a banking/financial system without repo - India for example - the world looks rather straightforward NeoKeynesian/Monetarist and even if the causation of the money multiplier is still backwards, the central bank has significantly greater control over credit. The developed world circa 1940-1980 also looked similar. In a world with repo and collateralization, this is no longer true. Also, a lot of working capital is itself a repo - the inventory provides collateral for the borrowing used to purchase it. Now if this collateral could be securitized and further act as collateral, without a doubt the cost of working capital (and other lending) would come down, assuming the same monetary/fiscal stance. I'm pretty sure a lot of structured product solutions for corporates do precisely the same thing.


Ramanan - OK we have an empirical disagreement, not a theoretical one. I'm guessing you're saying that a household/firm could just borrow unsecured from the bank anyway. All I'm saying is that instead of having to borrow unsecured at a high rate, the ability to borrow with liquid collateral at a low rate dramatically increases the actual money demanded. For the lender/bank, the various mechanisms like margining make the loan virtually risk-free and obviously the rate reflects that.


Ritwik, I disagree that an economy like India looks New Keynesian or Monetarist. Money is naturally endogenous and not because of innovations in the financial system. Rehypothecation doesn't make a system which behaved like a money multiplier world into a world where it is not. As for collateral, yes lending is collateralized but my point was regarding the special market called the repo market. If I borrow from the bank and keep some collateral, one doesn't talk of this being a repo even though the loan was collateralized. Repo is a technical term.


Should have added: Rehypothecation doesn’t make a system which behaved like a money multiplier world into a world where it is not because there was none to begin with.


"To the extent that any activity of the state approaches money printing, it is the act of deficit spending. Even this does not necessarily entail inflation" Inflation is an increase in the money supply which is trivially measured. So of course deficit spending if inflationary. Even if you consider the government is attempting to counteract private credit contraction can you really with a straight face tell me that going from 29 trillion to 30 trillion isn't inflation? Your whole piece is nonsense if you simply realize that the government allowed banks to over-leverage thus increasing the money supply far past the sustainable equilibrium. Private credit contraction is the market fixing this by repricing risk. Government interference in the market is completely unnecessary and is in fact preventing the market from pricing risk effectively thus completely unsustainably distorting the economy. What needs to be discussed is not government intervention, but what the economy would like with appropriately priced risk. People need an equilibrium economy so that they can live their lives without the destructive changes that are now occurring worldwide.


Ashwin, As usual a brilliant post. The Turkish case mentioned above where high deficits led to inflation despite the absence of government debt monetisation provides indeed an excellent illustration of your point. However I was wondering whether one should not also refer symmetrically to other examples such as the current situation in Brazil where there is a high level of inflation despite the absence of public deficits AND the absence of clear evidence of monetisaiton of government debt... Shouldn't we therefore refer to public AND private deficits or even more to aggregate credit growth in combinaton with real interest rates as the combination that matters?


Francisco - so yes private credit growth matters and can cause low double-digit inflation even without govt deficits. But usually such a regime still maintains slightly negative or higher real interest rates in which case there is no "hot potato"-ness to the regime. So long as credit growth is robust which can be a long time, 8% inflation and 9% rates is a perfectly sustainable and dare I say a completely harmless regime. I don't know what period of Brazilian inflation you're referring to but the last decade has largely seen positive real rates, in fact higher real rates than most of the world. The commodity boom may also have something to do with these real rates but I'm no expert on Brazil.


Yes. As you emphasize in your post there is no inflation tax and no possibility of hyperinflation as long as interest rates across the government obligation curve compensate sufficiently for inflation. The point I was trying to make is that you point out latter in your post that what matters is the combination of real interest rates with future deficits. However one could extend the reasoning by saying that what matters is the combination of real rates with credit growth instead of limiting ourselves to injection of aggregate demand by means of public deficits alone. Would you agree with that?


Francisco - Absolutely. I agree. In this post and the last one I've essentially ignored the private credit aspect except when it is a sort of arbitrage reaction to negative real rates. My main point was a sort of reaction to all the articles I've been reading recently on permanent vs temporary QE and monetisation and whether the BoE repatriates profits to the Treasury which people think is important and which really doesn't matter.


Hey Ashwin, long time no see. I like that you have have stated definitevely that the private sector monetises government debt, which is a theme I have been wriring about for some years. In fact below is a link to my asking Bill Mitchell that exact question. Anyway, about negative nominal rates (NNR). I disagree that existence of paper cash is a hard constraint since if NNR were introduced according to your view cash woukd simply cease to circulate because it would all be hoarded, and since there is so little of it compared to the broader shadow economy it ought not to have much effect, as long as natural rates were negative anyway. It may even be sufficient for the CB to declare that the zero bound is no longer a bound. One might expect that then the market ought to evolve towards a situation in which it clears at zero more often that not, though your suggsted regime of regular and non systemic bank-death would be a required part of this mix. Interesting that your thoughts have converged with mine over time. I wonder when you'll start talking about thermodynamics and entropy maximisation...


The point about private sector monetising debt is common knowledge in most EM countries - Turkey, India being excellent examples. The evidence is most obvious in Turkey as highlighted in the paper I linked to. Significant negative nominal rates will ensure that the only money out there are paper notes. You, I and everyone else will convert all their money to notes and store it in a safe somewhere. The deposit will be the hot potato but with a "free lunch" option of converting into notes which obviously everyone will take. My preferred solution is to give everyone a free deposit account at the CB, access to a public payments system and then ban paper notes. I have no doubt that entropy matters. Its just that my knowledge of physics doesn't allow me to say anything smart about it! I'm sure I'll get there but it'll take a while...

Liminal Hack

Ashwin, I'm not sure that paper notes represent the dominant dynamic constraint here. Like I said there is not enough of them for everyone to convert, and particularly for very large sums there is a big problem. I'd imagine a warehouse full of notes, with various 'paper claims' on those notes. The paper claims circulate, and the paper notes sit there, no different to gold or fine wine storage. The paper claims would attract a discount as a result of insurance and over-subscription. This is because paper notes can't be sent down a wire and thus have no real liquidity in large quantity. I agree with the notion of individuals being granted a risk free account at the CB though, at some low-ish nominal limit such as $100K.

Liminal Hack

Regarding physics, my observation is simply that the is not much difference in principle between the circular flow of money and related material, and the flow of heat, kinetic and chemical energy in the atmosphere/geosphere. The latter is governed by gradients, mixing, forcing and thermodynamics and the evidence would seem to be that the economy is subject to similar constraints giving rise to similar types of far from equilibrium complexities and responses. I don't think that one needs to be either a physicist or a financial professional in order to test these notions. Certainly I'm neither.


Your assumption that printed notes are somehow limited in supply is incorrect. If everyone goes to the bank and demands printed notes in lieu of their electronic deposits, the CB ( or whoever they've delegated printing duties to) has to print all the notes needed to meet this demand. The inconvenience of holding notes is why small negative rates don't matter much but at some negative rate, it becomes worth my while to store notes like I store wine.

Liminal Hack

I don't think the CB has any standing commitment to convert electronic broad money into paper notes on demand. Technically circulating paper cash is counted in M4 in the UK at least. Even if retail depositors all withdrew their cash I don't see how payroll, payment of utility bills etc could reasonably or cheaply be conducted in cash. But regardless of this point, I think there is another rather important question here. I think you may be assuming that under a negative nominal rate regime, the yield curve would be upward sloping, and hence one would need large negative short rate to get a low or negative long duration rate. Whereas I think the reality would be an inverted nominal yield curve, because NNR is only going to coincide with deflation. This makes sense if bank depositors are subjected to your 'controlled burn' scenario for example. In these circumstances, there will be a premium for long term risk free assets (govvies basically) that don't suffer from this risk. Under those circumstances, we'd have a small negative short rate, say -0.5 to -1%, with the longer end of the curve dipping significantly deeper into negative territory. It makes no sense for an upward sloping yield curve to exist in an NNR environment. So cash hoarding ought not to be a problem.


I think we're talking past each other. Let me just finally say that I'm not the first one to make this point. Willem Buiter has done a lot of research on ways to avoid the zero bound - this post may be useful


Ashwin How does the Indian pvt system monetise govt debt? Are you referring to the FD accounts? I always thought India's monetary system was one which was reasonably distant from peak credit elasticity.


Ritwik - On India being fairly distant from peak credit elasticity, I agree. And given the fairly modest fiscal deficits run by the Indian govt (compared to say the old Turkish experience) it's hard to disentangle exactly how much of the inflation is fiscal and how much is pvt sector endogenous. One way of thinking about my point (which in hindsight I should have included in the post): when govt bonds are money-like, there is really no scenario where govt bond rates shoot up dramatically with the CB rate being held constant (without money market chaos). The expectations-arbitrage relationship of the govie yield curve is too strong for that to happen. Dramatic gestures like the CB stopping its explicit monetisation like the RBI has done over the last decade are largely symbolic gestures. The only recent historic example I know of where the inverse held was post-WW2 US economy. Banks held large amounts of govt bonds, were reserve-starved and the Fed had complete control. As Leijonhufvud noticed, this was the heyday of monetarism.

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