Table of Contents

Copyright

Next Book in the Series

Preface

Twenty Years Ago - An Italian Epiphany

Soft Currency Economics - Introduction

Statement of Purpose

Fiat Money

The Myth of the Money Multiplier

The Myth of Debt Monetization

How Fed Funds Targeting fits into Overall Monetary Policy

Mechanics of Federal Spending

Federal Government Spending, Borrowing and Debt

Interest Rate Maintenance Account (IRMA)

Fiscal Policy Options

The Gold System as a Basis for Reserves

Reserve Requirements, History, Rationale & Current Practice

The Discount: History & Operation

Failure to Meet Reserve Requirements

The Fed Funds Market

The Repurchase Agreements Market (Repos)

Matched Sales Purchases

The Fed in the Repo Market

Controlling the Fed Funds Rate

Further Discussion of Inelasticity

Lead Accounting
More on Why Lead Accounting is Unworkable – Inelasticity for Loan Demand

What if No One Buys the Debt

How the Government Spends and Borrows as Much as it Does Without Causing
Hyperinflation

Full Employment and Price Stability

Taxation

Foreign Trade

Inflation vs. Price Increase

Conclusion

Mosler Speech - Rome Debt Management Conference October 26, 2012

Other Books

Appendix for Soft Currency Economics

Bibliography for Soft Currency Economics

About the Author

 Soft Currency Economics II
WHAT EVERYONE THINKS THEY KNOW
ABOUT MONETARY POLICY IS WRONG

By Warren Mosler
All Rights Reserved. No part of this publication may be reproduced in any form or
by any means, including scanning, photocopying, or otherwise without prior
written permission of the copyright holder.

Copyright © 1996 & 2012 Valance Company, Inc.

Valance Company, Inc.

5013 Chandlers Wharf, Suite 2
Christiansted, USVI 00820
Office phone: (340) 692-7710 (fax 7715)
 Next Book in the Series
Warren Mosler; 7 Deadly Innocent Frauds of Economic Policy
 TABLE OF CONTENTS
Preface
Twenty Years Ago - An Italian Epiphany
Soft Currency Economics - Introduction
Statement of Purpose

Fiat Money

The Myth of the Money Multiplier

The Myth of Debt Monetization

How Fed Funds Targeting fits into Overall Monetary Policy

Mechanics of Federal Spending

Federal Government Spending, Borrowing and Debt

Interest Rate Maintenance Account (IRMA)

Fiscal Policy Options

The Gold System as a Basis for Reserves

Reserve Requirements, History, Rationale & Current Practice

The Discount: History & Operation

Failure to Meet Reserve Requirements

The Fed Funds Market

The Repurchase Agreements Market (Repos)

Matched Sales Purchases

The Fed in the Repo Market

Controlling the Fed Funds Rate

Further Discussion of Inelasticity

Lead Accounting

More on Why Lead Accounting is Unworkable – Inelasticity for Loan Demand

What if No One Buys the Debt

How the Government Spends and Borrows as Much as it Does Without Causing Hyperinflation

Full Employment and Price Stability

 Taxation

Foreign Trade

Inflation vs. Price Increase

Conclusion

Mosler Speech - Rome Debt Management Conference October 26, 2012

Other Recommended Books
Appendix for Soft Currency Economics
Bibliography for Soft Currency Economics
About the Author
 Preface
Soft Currency Economics was first published after the author, Warren
Mosler, founder of Illinois Income Investors (which later became the top ranking III
investment companies), triggered an Italian Epiphany in Rome in 1992. He met
with the Professor Luigi Spaventa, a senior official of the Italian Government’s
Treasury Department, to discuss why Italian government bonds were trading at a
steep discount to Italian corporate bonds. At the time, the discount existed
because the perception was that Italy, not the large Italian corporations, was more
likely to default on its debt. This was contrary to Mosler’s understanding of fiat
currencies. He was convinced that a sovereign with its own free trading currency
could never default unless it was the government's decision to default.

Mosler had Spaventa validate and confirm his thinking that the market had
the pricing all wrong. This lead to very successful trades for Mosler, what he
referred to a “free 2%” return, and at the same time educated Spaventa that Italy
(this was prior to the Euro) could not go bankrupt unless it wanted to, and thus
Italy did not have to succumb to the pressure from the IMF to implement austerity
programs.

The Italian Epiphany subsequently led to the publication of Soft Currency

Economics in 1996. The book became the cornerstone for a heterodox economic
theory that is today known as Modern Monetary Theory or MMT. The book
explains how the monetary system and banks really operate in contrast to what is
taught in most of today’s textbooks.

It is often said that history repeats itself. Twenty years after the Italian
Epiphany, Italy is once again experiencing financial difficulties and there is once
again a discussion of the potential for default. One major difference exists today
compared to the early 1990s and that is the monetary system that existed in the
1990s no longer applies. Today, Italy no longer has its own free trading fiat
currency that it can issue to pay government expenditures. Instead, Italy now has
to borrow Euros to fund expenditures and it is the European Central Bank (ECB),
not the Italian Central Bank, which can provide the economic remedy.

At the Debt Public Management conference in Rome on October 26, 2012

which included Mario Draghi (head of the ECB), Mosler proposed the following
three strategies to address the problems in many the European economies:

1. A tax credit bond, which is a bond that in the case of nonpayment can
be used directly for the payment of taxes;

2. An ECB guarantee of national government debt and an expansion of

Maastricht limits to perhaps 7% of GDP to trigger an immediate surge
of sales; and/or
 3. For the ECB to make ‘cash’ distributions to the member nations on a
per capita basis of perhaps 10% of euro zone GDP annually.

This re-publication of Soft Currency Economics has two new additions. It

includes Mosler’s personal recollection of his Italian Epiphany as well as the
speech he presented at the Debt Public Management conference.

Russell Huntley, Editor

 Twenty Years Ago - An Italian Epiphany
Circumstances in the early 1990’s led me to an understanding of the actual
functioning of a currency. Back then, it was the government of Italy, rather than
the United States, which was in crisis. Professor Rudi Dornbusch, an influential
academic economist at MIT, insisted that Italy was on the verge of default because
their debt-to-GDP ratio exceeded 110% and the lira interest rate was higher than
the Italian growth rate.

Things were so bad that Italian Government Securities denominated in lira

yielded about 2% more than the cost of borrowing the lira from the banks. The
perceived risk of owning Italian government bonds was so high that you could buy
Italian government securities at about 14%, and borrow the lira to pay for them
from the banks at only about 12% for the full term of the securities. This was a
free lunch of 2%, raw meat for any bond desk like mine, apart from just one thing;
the perceived risk of default by the Italian government. There was easy money to
be made, but only if you knew for sure that the Italian government wouldn’t
default.

The “Free Lunch” possibility totally preoccupied me. The reward for turning
this into a risk free spread was immense. So I started brainstorming the issue with
my partners. We knew no nation had ever defaulted on its own currency when it
was not legally convertible into gold or anything else. There was a time when
nations issued securities that were convertible into gold. That era, however, ended
for good in 1971 when President Nixon took us off the gold standard
internationally (the same year I got my BA from U-Conn) and we entered the era of
floating exchange rates and non-convertible currencies.

While some people still think that the America dollar is backed by the gold
in Fort Knox, which is not the case. If you take a $10 bill to the Treasury
Department and demand gold for it, they won’t give it to you because they simply
are not legally allowed to do so, even if they wanted to. They will give you two $5
bills or ten $1 bills, but forget about getting any gold.

Historically, government defaults came only with the likes of gold standards,
fixed exchange rates, external currency debt, and indexed domestic debt. But why
was that? The answer generally given was “because they can always print the
money.” Fair enough, but there were no defaults (lots of inflation but no defaults)
and no one ever did “print the money,” so I needed a better reason before
committing millions of our investors funds.

A few days later when talking to our research analyst, Tom Shulke, it came
to me. I said, “Tom, if we buy securities from the Fed or Treasury, functionally
there is no difference. We send the funds to the same place (the Federal Reserve)
and we own the same thing, a Treasury security, which is nothing more than
account at the Fed that pays interest.”
 So functionally it has to all be the same. Yet presumably the Treasury sells
securities to fund expenditures, while when the Fed sells securities, it’s a “reserve
drain” to “offset operating factors” and manage the fed funds rate. Yet they have to
be functionally the same - it’s all just a glorified reserve drain! Many of my
colleagues in the world of hedge fund management were intrigued by the profit
potential that might exist in the 2% free lunch that the Government of Italy was
offering us. Maurice Samuels, then a portfolio manager at Harvard Management,
immediately got on board, and set up meetings for us in Rome with officials of the
Italian government to discuss these issues.

Maurice and I were soon on a plane to Rome. Shortly after landing, we were
meeting with Professor Luigi Spaventa, a senior official of the Italian Government’s
Treasury Department. (I recall telling Maurice to duck as we entered the room. He
looked up and started to laugh. The opening was maybe twenty feet high. “That’s
so you could enter this room in Roman times carrying a spear,” he replied.)
Professor Spaventa was sitting behind an elegant desk. He was wearing a three-
piece suit, and smoking one of those curled pipes. The image of the great English
economist John Maynard Keynes, whose work was at the center of much economic
policy discussion for so many years, came to mind. Professor Spaventa was Italian,
but he spoke English with a British accent, furthering the Keynesian imagery.

After we exchanged greetings, I opened with a question that got right to the
core of the reason for our trip. “Professor Spaventa, this is a rhetorical question,
but why is Italy issuing Treasury securities? Is it to get lira to spend, or is it to
prevent the lira interbank rate falling to zero from your target rate of 12%?” I could
tell that Professor Spaventa was at first puzzled by the questions. He was probably
expecting us to question when we would get our withholding tax back. The Italian
Treasury Department was way behind on making their payments. They had only
two people assigned to the task of remitting the withheld funds to foreign holders
of Italian bonds, and one of these two was a woman on maternity leave.

Professor Spaventa took a minute to collect his thoughts. When he

answered my question, he revealed an understanding of monetary operations we
had rarely seen from Treasury officials in any country. “No,” he replied. “The
interbank rate would only fall to 1⁄2%, NOT 0%, as we pay 1⁄2% interest on
reserves.” His insightful response was everything we had hoped for. Here was a
Finance Minister who actually understood monetary operations and reserve
accounting! (Note also that only recently has the U.S. Fed been allowed to pay
interest on reserves as a tool for hitting their interest rate target).

I said nothing, giving him more time to consider the question. A few seconds
later he jumped up out of his seat proclaiming “Yes! And the International
Monetary Fund is making us act pro cyclical!” My question had led to the
realization that the IMF was making the Italian Government tighten policy due to a
default risk that did not exist.

Our meeting, originally planned to last for only twenty minutes, went on for
two hours. The good Professor began inviting his associates in nearby offices to
join us to hear the good news, and instantly the cappuccino was flowing like
water. The dark cloud of default had been lifted. This was time for celebration!

A week later, an announcement came out of the Italian Ministry of Finance

regarding all Italian government bonds - “No extraordinary measures will be taken.
All payments will be made on time.” We and our clients were later told we were the
largest holders of Italian lira denominated bonds outside of Italy, and managed a
pretty good few years with that position.

Italy did not default, nor was there ever any solvency risk. Insolvency is
never an issue with non-convertible currency and floating exchange rates. We
knew that, and now the Italian Government also understood this and was unlikely
to “do something stupid,” such as proclaiming a default when there was no actual
financial reason to do so. Over the next few years, our funds and happy clients
made well over $100 million in profits on these transactions, and we may have
saved the Italian Government as well. The awareness of how currencies function
operationally inspired this book and hopefully will soon save the world from itself.

As I continued to consider the ramifications of government solvency not

being an issue, the ongoing debate over the U.S. budget deficit was raging. It was
the early 1990’s, and the recession had driven the deficit up to 5% of GDP (deficits
are traditionally thought of as a percent of GDP when comparing one nation with
another, and one year to another, to adjust for the different sized economies).

Gloom and doom were everywhere. News anchor David Brinkley suggested
that the nation needed to declare bankruptcy and get it over with. Ross Perot’s
popularity was on the rise with his fiscal responsibility theme. Perot actually
became one of the most successful 3rd party candidates in history by promising to
balance the budget. (His rising popularity was cut short only when he claimed the
Viet Cong were stalking his daughter’s wedding in Texas.)

With my new understanding, I was keenly aware of the risks to the welfare
of our nation. I knew that the larger federal deficits was what was fixing the
broken economy, but I watched helplessly as our mainstream leaders and the
entire media clamored for fiscal responsibility (lower deficits) and were prolonging
the agony.

It was then that I began conceiving the academic paper that would become
Soft Currency Economics. I discussed it with my previous boss, Ned Janotta, at
William Blair.

He suggested I talk to Donald Rumsfeld (his college roommate, close friend

and business associate), who personally knew many of the country’s leading
economists, about getting it published. Shortly after, I got together with “Rummy”
for an hour during his only opening that week. We met in the steam room of the
Chicago Racquet Club and discussed fiscal and monetary policy. He sent me to Art
Laffer who took on the project in 1994 and assigned Mark McNary to co-author,
research and edit. Soft Currency Economics, which follows was published in 1996.
 Soft Currency Economics - Introduction
In the midst of great abundance our leaders promote privation. We are told
that national health care is unaffordable, while hospital beds are empty. We are
told that we cannot afford to hire more teachers, while many teachers are
unemployed. And we are told that we cannot afford to give away school lunches,
while surplus food goes to waste.

When people and physical capital are employed productively, government

spending that shifts those resources to alternative use forces a trade-off. For
example, if thousands of young men and women were conscripted into the armed
forces the country would receive the benefit of a stronger military force. However, if
the new soldiers had been home builders, the nation may suffer a shortage of new
homes. This trade-off may reduce the general welfare of the nation if Americans
place a greater value on new homes than additional military protection. If,
however, the new military manpower comes not from home builders but from
individuals who were unemployed, there is no trade-off. The real cost of
conscripting home builders for military service is high; the real cost of employing
the unemployed is negligible.

The essence of the political process is coming to terms with the inherent
trade-offs we face in a world of limited resources and unlimited wants. The idea
that people can improve their lives by depriving themselves of surplus goods and
services contradicts both common sense and any respectable economic theory.
When there are widespread unemployed resources as there are today in the United
States, the trade-off costs are often minimal, yet mistakenly deemed unaffordable.

When a member of Congress reviews a list of legislative proposals, he

currently determines affordability based on how much revenue the federal
government wishes to raise, either through taxes or spending cuts. Money is
considered an economic resource. Budget deficits and the federal debt have been
the focal point of fiscal policy, not real economic costs and benefits. The prevailing
view of federal spending as reckless, disastrous and irresponsible, simply because
it increases the deficit, prevails.

Interest groups from both ends of the political spectrum have rallied around
various plans designed to reduce the deficit. Popular opinion takes for granted that
a balanced budget yields net economic benefits only to be exceeded by paying off
the debt. The Clinton administration claims a lower 1994 deficit as one of its
highest achievements. All new programs must be paid for with either tax revenue
or spending cuts. Revenue neutral has become synonymous with fiscal
responsibility.

The deficit doves and deficit hawks who debate the consequences of fiscal
policy both accept traditional perceptions of federal borrowing. Both sides of the
argument accept the premise that the federal government borrows money to fund
expenditures. They differ only in their analysis of the deficit's effects. For example,
doves may argue that since the budget does not discern between capital
investment and consumption expenditures, the deficit is overstated. Or, that since
we are primarily borrowing from ourselves, the burden is overstated. But even if
policy makers are convinced that the current deficit is a relatively minor problem,
the possibility that a certain fiscal policy initiative might inadvertently result in a
high deficit, or that we may owe the money to foreigners, imposes a high risk. It is
believed that federal deficits undermine the financial integrity of the nation.

Policy makers have been grossly misled by an obsolete and non-applicable

fiscal and monetary understanding. Consequently, we face continued economic
under-performance.
Statement of Purpose
The purpose of this work is to clearly demonstrate, through pure force of
logic, that much of the public debate on many of today's economic issues is
invalid, often going so far as to confuse costs with benefits. This is not an effort to
change the financial system. It is an effort to provide insight into the fiat monetary
system, a very effective system that is currently in place.

The validity of the current thinking about the federal budget deficit and the
federal debt will be challenged in a way that supersedes both the hawks and the
doves. Once we realize that the deficit can present no financial risk, it will be
evident that spending programs should be evaluated on their real economic
benefits, and weighed against their real economic costs. Similarly, a meaningful
analysis of tax changes evaluates their impact on the economy, not the impact on
the deficit. It will also be shown that taxed advantaged savings incentives are
creating a need for deficit spending.

The discussion will begin with an explanation of fiat money, and outline key
elements of the operation of the banking system. The following points will be
brought into focus:

Monetary policy sets the price of money, which only indirectly

determines the quantity. It will be shown that the overnight interest rate is
the primary tool of monetary policy. The Federal Reserve sets the overnight
interest rate, the price of money, by adding and draining reserves.
Government spending, taxation, and borrowing can also add and drain
reserves from the banking system and, therefore, are part of that process.

The money multiplier concept is backwards. Changes in the money

supply cause changes in bank reserves and the monetary base, not vice
versa.

Debt monetization cannot and does not take place.

The imperative behind federal borrowing is to drain excess reserves

from the banking system, to support the overnight interest rate. It is not to
fund untaxed spending. Untaxed government spending (deficit spending)
as a matter of course creates an equal amount of excess reserves in the
banking system. Government borrowing is a reserve drain, which
functions to support the fed funds rate mandated by the Federal Reserve
Board of Governors.

The federal debt is actually an interest rate maintenance account

(IRMA).

Fiscal policy determines the amount of new money directly created by

the federal government. Briefly, deficit spending is the direct creation of
new money. When the federal government spends and then borrows, a
deposit in the form of a treasury security is created. The national debt is
essentially equal to all of the new money directly created by fiscal policy.

Options over spending, taxation, and borrowing, however, are not

limited by the process itself but by the desirability of the economic
outcomes. The amount and nature of federal spending as well as the
structure of the tax code and interest rate maintenance (borrowing) have
major economic ramifications. The decision of how much money to borrow
and how much to tax can be based on the economic effect of varying the
mix, and need not focus solely on the mix itself (such as balancing the
budget).

Finally, the conclusion will incorporate five additional discussions

What if no one buys the debt?

o How the government manages to spend as much as it does and not

cause hyper-inflation.

o Full employment AND price stability.

o Taxation and a discussion of foreign trade.

Fiat Money
Historically, there have been three categories of money: commodity, credit,
and fiat. Commodity money consists of some durable material of intrinsic value,
typically gold or silver coin, which has some value other than as a medium of
exchange. Gold and silver have industrial uses as well as an esthetic value as
jewelry. Credit money refers to the liability of some individual or firm, usually a
checkable bank deposit. Fiat money is a tax credit not backed by any tangible
asset.

In 1971 the Nixon administration abandoned the gold standard and adopted
a fiat monetary system, substantially altering what looked like the same currency.
Under a fiat monetary system, money is an accepted medium of exchange only
because the government requires it for tax payments.

Government fiat money necessarily means that federal spending need not be
based on revenue. The federal government has no more money at its disposal
when the federal budget is in surplus, than when the budget is in deficit. Total
federal expense is whatever the federal government chooses it to be. There is no
inherent financial limit. The amount of federal spending, taxing and borrowing
influence inflation, interest rates, capital formation, and other real economic
phenomena, but the amount of money available to the federal government is
independent of tax revenues and independent of federal debt. Consequently, the
concept of a federal trust fund under a fiat monetary system is an anachronism.
The government is no more able to spend money when there is a trust fund than
when no such fund exists. The only financial constraints, under a fiat monetary
system, are self-imposed.

The concept of fiat money can be illuminated by a simple model: Assume a

world of a parent and several children. One day the parent announces that the
children may earn business cards by completing various household chores. At this
point the children won't care a bit about accumulating their parent's business
cards because the cards are virtually worthless. But when the parent also
announces that any child who wants to eat and live in the house must pay the
parent, say, 200 business cards each month, the cards are instantly given value
and chores begin to get done. Value has been given to the business cards by
requiring them to be used to fulfill a tax obligation. Taxes function to create the
demand for federal expenditures of fiat money, not to raise revenue per se. In fact,
a tax will create a demand for at LEAST that amount of federal spending. A
balanced budget is, from inception, the MINIMUM that can be spent, without a
continuous deflation. The children will likely desire to earn a few more cards than
they need for the immediate tax bill, so the parent can expect to run a deficit as a
matter of course.

To illustrate the nature of federal debt under a fiat monetary system, the
model of family currency can be taken a step further. Suppose the parent offers to
pay overnight interest on the outstanding business cards (payable in more
business cards). The children might want to hold on to some cards to use among
themselves for convenience. Extra cards not needed overnight for inter-sibling
transactions would probably be deposited with the parent. That is, the parent
would have borrowed back some of the business cards from the children. The
business card deposits are the national debt that the parent owes.

The reason for the borrowing is to support a minimum overnight lending

rate by giving the holders of the business cards a place to earn interest. The parent
might decide to pay (support) a high rate of interest to encourage saving.
Conversely, a low rate may discourage saving. In any case, the amount of cards
lent to the parent each night will generally equal the number of cards the parent
has spent, but not taxed - the parent's deficit. Notice that the parent is not
borrowing to fund expenditures, and that offering to pay interest (funding the
deficit) does not reduce the wealth (measured by the number of cards) of each
child.

In the U. S., the 12 members of the Federal Open Market Committee decide
on the overnight interest rate. That, along with what Congress decides to spend,
tax, and borrow (that is, pay interest on the untaxed spending), determines the
value of the money and, in general, regulates the economy.

Federal borrowing and taxation were once part of the process of managing
the Treasury's gold reserves. Unfortunately, discussions about monetary
economics and the U. S. banking system still rely on many of the relationships
observed and understood during the time when the U. S. monetary regime
operated under a gold standard, a system in which arguably the government was
required to tax or borrow sufficient revenue to fund government spending. Some of
the old models are still useful in accurately explaining the mechanics of the
banking system. Others have outlived their usefulness and have led to misleading
constructs. Two such vestiges of the gold standard are the role of bank reserves
(including the money multiplier) and the concept of monetization. An examination
of the workings of the market for bank reserves reveals the essential concepts.
(Additional monetary history and a more detailed explanation are provided in the
appendix).
 The Fed defines the method that banks are required to use in computing
deposits and reserve requirements. The period which a depository institution's
average daily reserves must meet or exceed its specified required reserves is called
the reserve maintenance period. The period in which the deposits on which
reserves are based are measured is the reserve computation period. The reserve
accounting method was amended in 1968 and again in 1984 but neither change
altered the Fed's role in the market for reserves.

Before 1968 banks were required to meet reserve requirements

contemporaneously: reserves for a week had to equal the required percentage for
that week. Banks estimated what their average deposits would be for the week and
applied the appropriate required reserve ratio to determine their reserve
requirement. The reserve requirement was an obligation each bank was legally
required to meet. Bank reserves and deposits, of course, continually change as
funds are deposited and withdrawn which confounded the bank manager's task of
managing reserve balances. Because neither the average deposits for a week nor
the average amount of required reserves could be known with any degree of
certainty until after the close of the last day it was "like trying to hit a moving
target with a shaky rifle." Therefore, in September 1968, lagged reserve accounting
(LRA) replaced contemporaneous reserve accounting (CRA). Under LRA the reserve
maintenance period was seven days ending each Wednesday (see Figure 1).
Required reserves for a maintenance period were based on the average daily
reservable deposits in the reserve computation period ending on a Wednesday two
weeks earlier. The total amount of required reserves for each bank and for the
banking system as a whole was known in advance. Actual reserves could vary, but
at least the target was stable.

Figure 1 - The Lagged Reserve Accounting System, 1968-1984

In 1984 the Board of Governors of the Federal Reserve System reinstated

CRA. The reserve accounting period is now two weeks (see Figure 2). Reserves on
the last day of the accounting period are one-fourteenth of the total to be averaged.
For example, if a bank borrowed $7 billion for one day it would currently add 1/14
of $7 billion, or $500 million, to the average level of reserves for the maintenance
period. Although this system is called contemporaneous it is, in practice, a lagged
system because there is still a two-day lag: reserve periods end on Wednesday but
deposit periods end on the preceding Monday. Thus even under CRA the banking
system is faced with a fixed reserve requirement as it nears the end of each
accounting period.

The 1984 adoption of CRA occurred as federal officials, economists, and

bankers debated whether shortening the reserve accounting lag could give the Fed
control of reserve balances. The change was consciously designed to give the Fed
direct control over reserves and changes in deposits. Federal Reserve Chairman
Volcker favored the change to CRA in the mistaken belief that a shorter lag in
reserve accounting would give the Fed greater control over reserves and hence the
money supply. Chairman Volcker was mistaken. The shorter accounting lag did
not (and could not) increase the Fed's control over the money supply because
depository institutions reserve requirements are based on total deposits from the
previous accounting period. Banks for all practical purposes cannot change their
current reserve requirements.

Figure 2 - The lagged Reserve Accounting System, 1984 to present

Under both CRA and LRA the Fed must provide enough reserves to meet the
known requirements, either through open market operations or through the
discount window. If banks were left on their own to obtain more reserves no
amount of interbank lending would be able to create the necessary reserves.
Interbank lending changes the location of the reserves but the amount of reserves
in the entire banking system remains the same. For example, suppose the total
reserve requirement for the banking system was $60 billion at the close of
business today but only $55 billion of reserves were held by the entire banking
system. Unless the Fed provides the additional $5 billion in reserves, at least one
bank will fail to meet its reserve requirement. The Federal Reserve is, and can only
be, the follower, not the leader when it adjusts reserve balances in the banking
system.

The role of reserves may be widely misunderstood because it is confused

with the role of capital requirements. Capital requirements set standards for the
quality and quantity of assets which banks hold on the quality of its loans. Capital
requirements are designed to insure a minimum level of financial integrity. Reserve
requirements, on the other hand, are a means by which the Federal Reserve
controls the price of funds which banks lend. The Fed addresses the quantity and
risk of loans through capital requirements; it addresses the overnight interest rate
by setting the price of reserves.
The Myth of the Money Multiplier
Everyone who has studied money and banking has been introduced to the
concept of the money multiplier. The multiplier is a factor which links a change in
the monetary base (reserves + currency) to a change in the money supply. The
multiplier tells us what multiple of the monetary base is transformed into the
money supply (M = m x MB). Since George Washington's portrait first graced the
one dollar bill students have listened to the same explanation of the process. No
matter what the legally required reserve ratio was, the standard example always
assumed 10 percent so that the math was simple enough for college professors.
What joy must have spread through the entire financial community when, on April
12, 1992, the Fed, for the first time, set the required reserve ratio at the magical
10 percent. Given the simplicity and widespread understanding of the money
multiplier it is a shame that the myth must be laid to rest. The truth is the
opposite of the textbook model.

In the real world, banks make loans independent of reserve

positions, and then during the next accounting period, they
borrow any needed reserves. The imperatives of the
accounting system, as previously discussed, require the Fed
to lend to the banks whatever they need.

Bank managers generally neither know nor care about the aggregate level of
reserves in the banking system. Bank lending decisions are affected by the price of
reserves, not by reserve positions. If the spread between the rate of return on an
asset and the fed funds rate is wide enough, even a bank deficient in reserves will
purchase the asset and cover the cash needed by purchasing (borrowing) money in
the funds market. This fact is clearly demonstrated by many large banks when
they consistently purchase more money in the fed funds market than their entire
level of required reserves. These banks would actually have negative reserve levels
if not for fed funds purchases i.e. borrowing money to be held as reserves.

If the Fed should want to increase the money supply, devotees of the money
multiplier model (including numerous Nobel Prize winners) would have the Fed
purchase securities. When the Fed buys securities reserves are added to the
system. However, the money multiplier model fails to recognize that the added
reserves in excess of required reserves drive the funds rate to zero, since reserve
requirements do not change until the following accounting period. That forces the
Fed to sell securities, i.e., drain the excess reserves just added, to maintain the
funds rate above zero.

If, on the other hand, the Fed wants to decrease money supply, taking
reserves out of the system when there are no excess reserves places some banks at
risk of not meeting their reserve requirements. The Fed has no choice but to add
reserves back into the banking system, to keep the funds rate from going,
theoretically, to infinity.
 In either case, the money supply remains unchanged by the Fed's action.
The multiplier is properly thought of as simply the ratio of the money supply to the
monetary base (m = M/MB). Changes in the money supply cause changes in the
monetary base, not vice versa. The money multiplier is more accurately thought of
as a divisor (MB = M/m).

Failure to recognize the fallacy of the money-multiplier model has led even
some of the most well- respected experts astray. The following points should be
obvious, but are rarely understood:

1. The inelastic nature of the demand for bank reserves leaves

the Fed no control over the quantity of money. The Fed
controls only the price.

2. The market participants who have direct and immediate

effect on the money supply include everyone except the
Fed.
The Myth of Debt Monetization
The subject of debt monetization frequently enters discussions of monetary
policy. Debt monetization is usually referred to as a process whereby the Fed buys
government bonds directly from the Treasury. In other words, the federal
government borrows money from the Central Bank rather than the public. Debt
monetization is the process usually implied when a government is said to be
printing money. Debt monetization, all else equal, is said to increase the money
supply and can lead to severe inflation. However, fear of debt monetization is
unfounded, since the Federal Reserve does not even have the option to monetize
any of the outstanding federal debt or newly issued federal debt.

As long as the Fed has a mandate to maintain a target Fed

funds rate, the size of its purchases and sales of government
debt are not discretionary.

Once the Federal Reserve Board of Governors sets a fed funds rate, the Fed's
portfolio of government securities changes only because of the transactions that
are required to support the funds rate. The Fed's lack of control over the quantity
of reserves underscores the impossibility of debt monetization. The Fed is unable
to monetize the federal debt by purchasing government securities at will because
to do so would cause the funds rate to fall to zero. If the Fed purchased securities
directly from the Treasury and the Treasury then spent the money, its
expenditures would be excess reserves in the banking system. The Fed would be
forced to sell an equal amount of securities to support the fed funds target rate.
The Fed would act only as an intermediary. The Fed would be buying securities
from the Treasury and selling them to the public. No monetization would occur.

To monetize means to convert to money. Gold used to be monetized when

the government issued new gold certificates to purchase gold. In a broad sense,
federal debt is money, and deficit spending is the process of monetizing whatever
the government purchases. Monetizing does occur when the Fed buys foreign
currency. Purchasing foreign currency converts, or monetizes, that currency to
dollars. The Fed then offers U.S. Government securities for sale to offer the new
dollars just added to the banking system a place to earn interest. This often
misunderstood process is referred to as sterilization.
How Fed Funds Targeting fits into Overall Monetary Policy
The Federal Reserve is presumed to conduct monetary policy with the
ultimate goal of a low inflation and a monetary and financial environment
conducive to real economic growth. The Fed attempts to manage money and
interest rates to achieve its goals. It selects one or more intermediate targets,
because it believes they have significant effects on the money supply and the price
level.

Whatever the intermediate targets of monetary policy may be, the Fed's
primary instrument for implementing policy is the federal funds rate. The fed
funds rate is influenced by open market operations. It is maintained or adjusted in
order to guide the intermediate target variable. If the Fed is using a quantity rule
(i.e., trying to determine the quantity of money), the intermediate target is a
monetary aggregate such as M1 or M2. For instance, if M2 grows faster than its
target rate the Fed may raise the fed funds rate in an effort to slow the growth rate
of M2. If M2 grows too slowly the Fed may lower the fed funds rate. If the Fed
chooses to use the value of money as its intermediate target then the fed funds
target will be set based on a price level indicator such as the price of gold or the
Spot Commodities Index. Under a price rule the price of gold, for example, is
targeted within a narrow band. The Fed raises the fed funds rate when the price
exceeds its upper limit and lowers the rate when the price falls below its lower
limit in hopes that a change in the fed funds rate returns the price of gold into the
target range.

Open market operations offset changes in reserves caused by the various

factors which affect the monetary base, such as changes in Treasury deposits with
the Fed, float, changes in currency holdings, or changes in private borrowing.
Open market operations act as buffers around the target fed funds rate. The target
fed funds rate may go unchanged for months. In 1993, the target rate was held at
3 percent without a single change. In other years the rate was changed several
times.
Mechanics of Federal Spending
The federal government maintains a cash operating balance for the same
reason individuals and businesses do; current receipts seldom match
disbursements in timing and amount. The U. S. Treasury holds its working
balances in the 12 Federal Reserve Banks and pays for goods and services by
drawing down these accounts. Deposits are also held in thousands of commercial
banks and savings institutions across the country. Government accounts at
commercial banks are called Tax and Loan accounts because funds flow into them
from individual and business tax payments and proceeds from the sale of
government bonds. Banks often pay for their purchases of U. S. Treasury
securities or purchases on behalf of their customers by crediting their Tax and
Loan accounts.

The Treasury draws all of its checks from accounts at the Fed. The funds
are transferred from the Tax and Loan accounts to the Fed then drawn from the
Fed account to purchase goods and services or make transfer payments. Suppose
the Treasury intends to pay $500 million for a B-2 stealth bomber. The Treasury
transfers $500 million from its Tax and Loan accounts to its account at the Fed.
The commercial banks now have $500 million less in deposits and hence $500
million less reserves. At the Fed, reserves decrease by $500 million while Treasury
deposits have increased by $500 million. At this instant the increase in U. S.
Treasury deposits reduces reserves and the monetary base but when the Treasury
pays for the bomber the preceding process is reversed. U. S. Treasury deposits at
the Fed fall by $500 million and the defense contractor deposits the check received
from the Treasury in its bank, whose reserves rise by $500 million. Government
spending does not change the monetary base when reserves move simultaneously
in equal amounts and opposite directions.

Figures 3 and 4 compare the T-accounts of the banking system, the

Treasury and the Federal Reserve for a $500 million expenditure. Figure 3 shows
the net change for an expenditure offset by tax receipts. Figure 4 shows the net
change when the expenditure is offset by borrowing. In either case reserve
balances are left unchanged. There is no net change in the banking system when
the bomber is paid for with tax receipts. When the Treasury issues securities to
pay for the bomber, deposits in the banking system increase by $500 million. The
Federal Reserve's use of offsetting open market operations to keep the funds rate
within its prescribed range is primarily applied to changes in government deposit
balances.

Figure 3 - The Government Spends $500 million and Taxes $500 million
Figure 4 - The Government Spends $500 million and borrows $500
Federal Government Spending, Borrowing and Debt
The Fed's desire to maintain the target fed funds rate links government
spending, which adds reserves to the banking system, and government taxation
and borrowing, which drain reserves from the banking system.

Under a fiat monetary system, the government spends money

and then borrows what it does not tax, because deficit
spending, if not offset by borrowing, would cause the Fed
funds rate to fall.

The Federal Reserve does not have exclusive control of reserve balances.
Reserve balances can be affected by the Treasury itself. For example, if the
Treasury sells $100 of securities, thereby increasing the balance of its checking
account at the Fed by $100, reserves decline just as if the Fed had sold the
securities. When either government entity sells government securities reserve
balances decline. When either buys government securities (in this case the
Treasury would be retiring debt) reserves in the banking system increase. The
monetary constraints of a fed funds target dictate that the government cannot
spend money without borrowing (or taxing), nor can the government borrow (or
tax) without spending. The financial imperative is to keep the reserve market in
balance, not to acquire money to spend.
Interest Rate Maintenance Account (IRMA)
Over the course of time the total number of dollars that have been drained
from the banking system to maintain the fed funds rate is called the federal debt.
A more appropriate name would be the Interest Rate Maintenance Account (IRMA).
The IRMA is simply an accounting of the total amount of securities issued to pay
interest on untaxed money spent by the government.

Consider the rationale behind adjusting the maturities of government

securities. Since the purpose of government securities is to drain reserves from the
banking system and support an interest rate, the length, or maturity, of the
securities is irrelevant for credit and rollover purposes. In fact, the IRMA could
consist entirely of overnight deposits by member banks of the Fed, and the Fed
could support the fed funds rate by paying interest on all excess reserves. One
reason for selling long-term securities might be to support long-term interest rates.
Fiscal Policy Options
The act of government spending and concurrent taxation gives the illusion
that the two are inextricably linked. The illusion is strengthened by the analogy of
government as a business or government as a household. Businesses and
households in the private sector are limited in how much they may borrow by the
market's willingness to extend credit. They must borrow to fund expenditures.

The Federal government, on the other hand, is able to spend a

virtually unlimited amount first, adding reserves to the
banking system, and then borrow, if it wishes to conduct a
reserve drain.

Each year Congress approves a budget outlining federal expenditures.

Congress also decides how to finance those expenditures; in fiscal 1993 for
example, government expenditures were $1.5 trillion. The financing was made up
of $1.3 trillion in tax receipts and $0.2 trillion in borrowing. The total revenue
must equal total expenditures to maintain control of the fed funds rate. The
composition of the total revenue between taxes and borrowing is at the discretion
of Congress. The economic impact of varying the composition of government
financing between taxes and borrowing is worthy of much research, discussion
and debate. Unfortunately, sober discussion of the deficit’s economic implications
has been dominated by apocalyptic sermons on the evils of deficit spending per se.

Since the federal budget deficit became an issue in the early eighties the
warnings abound over the severe consequences of partaking in the supposedly
sinister practice of borrowing money from the private sector. Enough warnings
about the federal deficit have been made by Democrats, Republicans and other
patriotic Americans to fill a new wing in the Smithsonian. The following is but a
small sample:

"The national deficit is like cancer. The sooner we act to restrict it the
healthier our fiscal body will be and the more promising our future."
Senator Paul Simon (D-IL).

"...because of the manner in which our debt has been financed, we

are at great risk if interest rates rise dramatically, or even
moderately. The reason is that over 70 percent of the publicly- held
debt is financed for less than five years. That's suicide in business,
that's suicide in your personal life, and that's suicide in your
government." Ross Perot.

"Our nation's wealth is being drained drop by drop, because our

government continues to mount record deficits...The security of our
country depends on the fiscal integrity of our government, and we're
throwing it away." Senator Warren Rudman.

"...a blow to our children's living standards." The New York Times.
"...this great nation can no longer tolerate running runaway deficits
and exorbitant annual interest payments..." Senator Howell T.
Heflin, (D-AL).
The Gold System as a Basis for Reserves
The gold standard was established in the U. S. in 1834. Under a gold
standard the price of gold is set in terms of the dollar. The dollar was defined as
23.22 fine grains of gold. With 480 grains to the fine troy ounce, this was
equivalent to $20.67 per ounce. The monetary authority was then committed to
keep the mint price of gold fixed by being willing to buy or sell the gold in
unlimited amounts.

The gold standard was suspended from 1861 to 1879 due to the Civil War.
The variant which prevailed in the U. S. from 1880 to 1914 was a fractional
reserve gold coin standard. Under that standard both government issued notes
and notes issued by commercial banks (also deposits) circulated alongside gold
coins. These forms of currency were each convertible on demand into gold. Gold
reserves were held by the issuers to maintain convertibility.

In 1934 the Gold Reserve Act devalued the dollar by increasing the
monetary price of gold from $20.67 to $35.00 an ounce. The Act put the U. S. on a
limited gold bullion standard under which redemption in gold was restricted to
dollars held by foreign central banks and licensed private users.

As a domestic monetary standard, gold reserves regulated the domestic

money supply. In a fractional reserve gold standard the money supply was
determined by the monetary gold stock and the ratio of the monetary gold stock to
the total money supply which consisted of gold coins, fiduciary notes and bank
deposits. Money creation was determined by the amount of gold reserves. Bank
deposits depended on 1) the level of gold reserves held by commercial banks and
the central bank, 2) the preferences of the public for gold coins relative to other
forms of money, and 3) legal gold reserve ratios.

The primary attraction of gold as a basis for a monetary system is that its
supply is limited, or at least increases slowly, whereas fiat money is limited only by
the judgments of presumably fallible people. While the gold standard provided a
stable monetary framework during much of its reign as the prevailing world
monetary standard, the gold standard itself is not immune to problems of inflation
and deflation. For example, an increase in the gold supply brought about by a
major gold strike could increase prices and disrupt financial markets.

Under gold standard rules and regulations, gold set the ultimate barrier to
the expansion of bank reserves and the supply of Federal Reserve Notes. Gold set
the upper limit to liabilities of the Federal Reserve Banks. For example, in 1963
the note and deposit liabilities of the Federal Reserve Banks could not exceed four
times their holdings of gold certificates, a special form of currency backed 100
percent by gold actually held in the Treasury vaults at Fort Knox, Kentucky. If the
total Federal Reserve Bank liabilities were $50 billion then a least $12.5 billion of
the total would have to be in gold certificates. If the Fed were to reach the upper
limit the Fed would be unable to purchase any more government securities on
balance or to increase loans to member banks. This would mean that bank
reserves could no longer increase and would even have to shrink if the public
wished to hold more currency. In this case the upper limit in the money supply
would have been reached. If a further increase in the money supply appeared
desirable the Fed had two options. First, the Federal Reserve could lower the
banks' requirements so that with the same volume of reserves banks could lend
larger sums. Second, the Board of Governors of the Federal Reserve System could
suspend the 25 percent gold certificate reserve requirement.

The actual movement of gold into and out of the Treasury was a unique
process because of the status of gold as a monetary standard. A description of the
process of acquiring gold explains how gold certificates found their way into
Federal Reserve Banks. The term “monetize” means that the Treasury simply
creates new money when they acquire gold. When the Treasury wished to
purchase a gold brick from a gold mine they printed a gold certificate.

In the actual process of monetizing gold the Treasury buys it from a gold
mine. The gold bars are delivered to Fort Knox. The government pays by issuing a
check. The gold mine deposits the check in its commercial bank. The commercial
bank, in turn sends the check to the Federal Reserve Bank for deposit to its
reserve account there. The Reserve Bank then reduces the Treasury's balance by
the amount of the check. The original outlay by the government has increased the
gold mine's account without reducing any other private account in the commercial
banking system, and, the commercial bank has gained reserves while no other
bank has lost reserves. In effect, the Treasury's balance at the Federal Bank has
been shifted to a commercial bank. Both the money supply and commercial bank
reserves have been increased.

Note that this type of government spending which increases reserves and
the money supply is unique to the purchase of gold under a gold standard. When
the government buys anything other than gold they have to have, so to speak,
money in the bank to pay for it. The money the government spends on missiles,
cement, paper clips or the President's salary has to be raised by taxation or by
borrowing. The government, like everyone else, is prohibited from simply printing
money to pay for the things it buys. If the government assigned other commodities
the role held by gold only then would the government acquire cement or paper
clips by printing cement certificates or paper clip certificates. Everything else on
which the government spends is covered by taxes or borrowing. Therefore,
expenditures by the government from its account at the Fed are continuously
offset by receipts of taxes or borrowed funds.
Reserve Requirements, History, Rationale & Current Practice
Laws requiring banks and other depository institutions to hold a certain
fraction of their deposits in reserve, in very safe, secure, assets have been part of
the U. S. banking system since 1863, well before the establishment of the Federal
Reserve System in 1913. Prior to the existence of the Fed, reserve requirements
were thought to help ensure the liquidity of bank notes and deposits. But as bank
runs and financial panics continued periodically, it became apparent that reserve
requirements did not guarantee liquidity. The notion of reserve requirements as a
source of liquidity vanished completely upon creation of the Federal Reserve
System as lender of last resort.

Since 1913 there have been two primary roles associated with reserve
requirements: money control and a revenue source for the Treasury. The Federal
Reserve has viewed reserve requirements as a mechanism to stabilize the money
supply. The Fed has sought to set reserve requirements as part of the process of
controlling the money supply. The Fed's objective is to control the supply of
reserves. In the theory based on the gold standard an increase in the amount of
reserves provided to the banking system should be associated with an increase in
reservable deposits in an amount that is a multiple of the reserve increase. (Today,
however, banks make loans independent of their position. This critical departure
will be discussed later.)

Reserve requirements also result in an implicit tax on banks because

reserves held at the Fed do not earn interest. Therefore, reserve requirements
reduce the revenues of the member banks. The burden of a given level of reserve
requirement depends heavily on the level of nominal interest rates: the higher the
rates the greater the earnings foregone. The magnitude of the reserve tax has
varied considerably over the last several years. When the nominal interest rate
soared to over 10 percent in the early 1980s foregone interest reached $4 billion
per year. In the fourth quarter of 1992 the effective tax was at a rate of $700
million per year. Although the amount of the reserve tax has declined in recent
years as nominal interest rates have fallen the impact of the reserve tax depends
on the effective rate of taxation rather than the total amount. The higher the
effective tax rate on banks the lower the net return on loans.

As implied by basic tax theory, the higher the rate of taxation on the
production of any product the greater will be the price paid by the demanders of
that product and the lower will be the price received by the suppliers of that
product. Taxes introduce a wedge between prices paid and prices received.
Borrowers pay more and banks receive less for loans. A simple way in which the
Fed could eliminate the reserve tax on banks is to pay interest on the reserves. If
the Fed paid a market- based rate of interest on required reserve balances, the
reserve tax would essentially be eliminated as would the distortion of the tax on
resource allocation. In the past, proposals to pay interest on required reserve
balances have encountered resistance because they would reduce the earnings
remitted by the Fed to the Treasury.
 The reserve tax has always discouraged membership in the Federal Reserve
System. To reduce the burden of the tax, legislation was enacted to allow banks to
use vault cash to satisfy their reserve requirements. This change was phased-in
beginning December 1959. At the end of 1992, 56 percent of required reserve
balances were in the form of vault cash. Despite the efforts of the Federal Reserve
System the membership declined steadily. In 1959 approximately 85 percent of all
transaction deposits were at member banks. By 1980 the portion of transaction
deposits at member banks had fallen to less than 65 percent.

In response to declining membership the Fed sought changes, other than

the elimination of the reserve tax, to prevent membership attrition from further
undermining the efficacy of monetary policy. In 1980 Congress adopted legislation
to reform the reserve requirement rules. The Monetary Control Act of 1980
mandated universal reserve requirements to be set by the Federal Reserve for all
depository institutions, regardless of their membership status. The act also
simplified the reserve requirement schedule.
The Discount: History & Operation
The role of the discount window changed considerably between the founding
of the Federal Reserve in 1913 and the 1930s as open market operations gradually
replaced discount window borrowing as the primary source of Federal Reserve
credit. Then, between 1934 and 1950 the discount window fell into disuse. Since
the creation of the Fed, Regulation A has set the procedures that banks must
follow to gain access to the discount window. Reserve banks may lend to
depository institutions either through advances secured by U. S. government
securities or by discounting paper of acceptable quality such as mortgage notes,
local government securities and commercial paper. The rate on the loans from
Federal Reserve banks to depository institutions is set administratively by the Fed.
The Board of Governors initiates a discount rate and the 12 regional Federal
Reserve Banks adopt it within a two-week period. Although we speak of the
discount rate there are actually several rates depending on the collateral offered by
the borrower.

Each Federal Reserve Bank's board of directors sets its discount rates
subject to approval of the Board of Governors. Since the 1950s the Fed's stated
policy discourages persistent reliance on borrowing. Borrowing from the discount
window is supposed to represent only a modest share of total reserves. The actual
amount of borrowed reserves is total reserves demanded by the banking system
minus the amount of unborrowed reserves provided by the Fed through open
market operations. Officially the Fed fashions the discount window as a safety
valve, a temporary source of resources when they are not readily available from
other sources. The discount window is simply a means of accommodating the
reserve requirements of the banking system - the same reserves provided through
open market operations but with a slightly different price and slightly different
packaging. Both the 1980 and 1990 versions of Regulation A state as a general
requirement that "Federal Reserve credit is not a substitute for capital." But all
along, fed policy has determined the amount of borrowing. To the extent that
immediate reserve needs are not provided through open market purchases they
must be provided through the discount window. In this context the window's role
is in meeting known reserve needs.

Throughout its history the Fed has used the discount window for much
more than its stated purpose. To accommodate Treasury financing needs in World
War I, the Reserve Banks were empowered to extend direct collateral loans to
member banks. Continuous borrowing year in and year out was not uncommon in
the 1920s. The availability of the discount window was expanded in 1932 by the
Emergency Relief and Construction Act. The act opened the discount window to
non-banks. It permitted the Reserve Banks to lend to individuals, partnerships
and corporations, with no other source of funds or notes eligible for discount at
member banks. The Act of June 19, 1934 authorized Reserve Banks to make
advances to established commercial or industrial enterprises for the purpose of
supplying working capital if the borrower was unable to attain assistance from the
usual sources. It is unclear whether the Act had any impact on the net amount of
lending. Essentially, Federal Reserve Banks were authorized to make loans on
behalf of the taxpayers. When a Federal Reserve Bank made a direct business loan
the loan created a new deposit in the banking system. The new deposit added
bank reserves which could be used to purchase government bonds from the Fed.
The net change to the banking system's balance sheet was an increase in deposits
matched by an increase in government securities. Reserve Banks continued to
make and co-finance working capital industrial loans until authorization to do so
was repealed by the Small Business Investment Act of 1958.

Since the 1980s, Federal Reserve lending to institutions with a high

probability of insolvency in the near term represents a major departure from its
historic mandate to provide loans to illiquid, but not insolvent, banks. A study
conducted at the request of the House Banking Committee collected data on all
depository institutions that borrowed funds from the discount window from
January 1, 1985 through May 10, 1991. Regulators grade banks on their
performance according to a scale of 1 to 5. The grades are based on five measures
known by the acronym CAMEL, for Capital Adequacy, Asset Quality, Management,
Earnings, and Liquidity. The Federal Reserve reported that of 530 borrowers that
failed within three years of the onset of their borrowings, 437 were classified as
most problem- ridden with a CAMEL rating of 5, the poorest rating; 51 borrowers
had the next lowest rating, CAMEL 4. At the time of failure 60 percent of the
borrowers had outstanding discount window loans. These loans were granted
almost daily to institutions with a high probability of insolvency.

The Fed's use of the discount window has expanded to cover a wide range of
reserve needs. The frequency of borrowing from the discount window has no
explicit restrictions. The banks using the discount window are not held to any
financial strength standards. The de facto criterion for eligibility for discount loans
is simply need. Experience has consistently shown that the Fed will not allow a
bank to fail when a bank requires a loan to cover its reserve requirement. The cost
of discount borrowing may vary considerably as the discount rate changes and as
administrative costs and/or penalties change. Nevertheless, the discount window
remains accessible to any bank's reserve needs.

The Fed's allocation of borrowed reserves as a percent of total reserves has

been less than 1 percent since 1986. Since 1950 borrowed reserves have
fluctuated from near zero to as high as 6-1/2 percent of total reserves. The bank
failures during the mid-eighties heightened the public's awareness of discount
window borrowing as a sign, accurate or not, of fiscal weakness. Banks have
become more hesitant to go to the window so as to not damage their reputation.
Failure to Meet Reserve Requirements
Another form of borrowed reserves occurs when a bank has a reserve
deficiency. If a bank fails to meet its reserve requirement it is subject to a reserve-
deficiency charge. Reserve banks are authorized to assess charges at a rate of 2%
above the discount rate. Thus, the Fed provides a third minor source of reserves
for banks unable to acquire the required level of reserves from the fed funds
market or the discount window.
The Fed Funds Market
The Fed funds market is a means by which banks can obtain funds from
other banks or nonbank lenders such as U. S. government agencies, savings and
loan associations, mutual savings banks, or an agency or branch of a foreign
bank. Federal funds are unsecured bank loans. Federal funds do not belong to the
federal government as the name might suggest. Fed funds are not subject to
reserve requirements; they are, in effect, reserves traded among financial
institutions.

Member banks have reserves in the Fed which are also known as
immediately available funds since they can be transferred almost instantaneously
over Fedwire. Fedwire is the Federal Reserve's system that electronically transfers
funds and securities on its communications network. Money and securities are no
more than accounting data. A bank can access its account at its Reserve Bank to
transfer funds or securities to any other depository institution that has a Reserve
Bank account. When banks borrow fed funds they are actually borrowing deposits
from other banks. The transfer of fed funds increases the deposits at the
borrowing bank and reduces deposits at the lending bank. Most fed funds
borrowing is for one day; essentially these borrowings are one-day unsecured
loans.

Banks could obtain funds by selling Treasury bills, either outright or as

reverse repos, but for one day or a few days such sales are less convenient and
slightly more costly than fed funds. No matter what the method of acquiring funds,
bank reserves are simply transferred from one bank to another. Interbank reserve
transactions change the location of reserves but do not alter the total amount of
reserves held in the banking system.

Banks may obtain funds in the fed funds market to maintain their reserve
requirement. They have lines of credit with each other to enact direct transfers of
funds. Banks have been known to borrow fed funds continuously and in excess of
their reserve requirement when it is profitable to do so. Banks may borrow beyond
their reserve requirement and lend the borrowed funds at higher rates than the
cost of borrowing. The difference between a bank's cost of money and the return
on loans determines its willingness to lend. The cost of money defines the cost of
loans, and thus the demand for loans.
The Repurchase Agreements Market (Repos)
The transfer of funds is also facilitated by the market for repurchase
agreements (the repo market). Banks use repurchase agreements (RPs) to obtain
short-term funds or as a means of investing funds on a very short-term basis.
Banks are the temporary recipients of funds; other banks or the Fed may supply
funds. RPs are quite flexible; they can be issued for one day or they may be
continuing contracts. In an overnight repurchase agreement, a security, such as a
U. S. Treasury bill, is purchased from a bank which agrees to repurchase the
security at the same price plus interest the next day. In effect the 'buyer' is making
a loan to the bank.

Repurchase agreements may also be made by corporations or individuals.

For example, a large corporation such as General Motors may have some idle
funds in its bank account, say, $1 million, which it would like to lend overnight.
GM uses this excess $1 million to buy Treasury bills from a bank which agrees to
repurchase them the next morning at a price slightly higher than GM's purchase
price. The effect of this agreement is that GM makes a loan of $1 million to the
bank and holds $1 million of the bank's Treasury bills until the bank repurchases
the bills to pay off the loan. Commercial banks often provide corporate depositors
with sweep accounts which automatically invest deposits in overnight RPs.
Although the checking account does not legally pay interest, in effect the
corporation is receiving interest on balances that are available for writing checks.

Since 1969 repurchase agreements have developed into an important source

of funds for banks. The volume of RPs exceeds $140 billion. The interest on RPs is
not determined by the interest on the Treasury bill used as collateral but rather by
the interest in the market for repos which is closely associated with the fed funds
rate. Since repos have collateral and federal funds do not, the repo rate is
generally a little lower than the fed funds rate.

While the trading has its eye on the funds rate the actual open market
transactions are made in the repo market. The Fed is thereby able to manage the
fed funds rate within a reasonably narrow band.
Matched Sales Purchases
Matched-sale purchase transactions (MSPs) have been used since 1966.
MSPs, also known as reverse RPs, allow the Fed to sell securities (Borrow money)
with an agreement to repurchase them (pay off the loan) within a short time. The
use of MSPs is preferred to direct sales followed later by purchases because of the
temporary nature of the market for reserves. For example, an increase in the float
that temporarily increases reserves may result when transportation facilities are
halted by a snowstorm. The excess reserves may be temporarily reduced by MSPs.
The Fed in the Repo Market
Occasionally the Fed conducts open market operations by carrying out
straight forward purchases or sales of securities, but these outright transactions
are rare. At the New York Fed's trading desk where open market operations are
executed, the desk executes outright security transactions only when it perceives a
permanent change in reserve needs. In 1992 the desk entered the market to buy
securities outright only six times.

Ordinarily, the New York Fed's trading desk arranges self-reversing

transactions to meet temporary reserve needs. The great bulk of the purchases are
done under repurchase agreements in the repo market. While most of the Fed's
security sales are executed by MSPs (also known as reverse repos), with the Fed
pledging to buy these securities back at a particular time. When the funds rate
rises above the desired level more reserves for the banking system are needed. The
Fed uses repos to buy securities, adding reserves to the system until the funds
rate falls back to the desired level. When the funds rate dips below the prescribed
rate the Fed sells securities with reverse repos, which drain reserves from the
banking system, until the funds rate climb to the target rate. The Fed uses the
repo market to manage the daily level of reserves in the banking system because
open market operations are intended to affect reserves for only a very short time.
Repo transactions enable the Fed to offset the many market fluctuations which
change the amount of reserves. The Fed does not need to know the exact nature of
a monetary disturbance, by watching the fed funds rate the Fed knows when to
offset any shock in the money market with open market operations.

The desk's activity is shown graphically in Figures 5 and 6 Fed economist

Joshua Feinman tracked daily transactions of the open market desk from June
1988 through December 1990.

Figure 5 - Probabilities of the Open Market Desk Daily Transactions June 1998 to December 1990

Figure 6 depicts the likelihood of the desk's use of RPs and MSPs in the repo
market. The graph also plots the probability that the desk will abstain from
participating in the market.

Figure 6 - Likelihood that the Fed’s Desk uses Repurchase and Reverse Repos
 Figures 5 and 6 also shows the probability of the desk's use of RPs and
MSPs based upon the average reserve need of the banking system. Note the slight
bias of the no transaction line. The desk is somewhat more willing to allow a
reserve deficiency to persist than an equal amount of reserve excess. The presence
of the discount window as a source of reserves accounts for the desk's slightly
smaller aversion to reserve deficiency versus reserve excess.

Using the fed funds rate as its daily guide the Fed uses open market
operations continuously to stabilize the funds rate. In theory and in practice the
trading desk has an easy task. Once the desired fed funds rate has been
determined, conducting offsetting open market operations is as simple as driving a
car within the bounds of a straight, clearly marked lane. When the vehicle starts to
drift a minor adjustment is made to correct its path, if the vehicle drifts in the
opposite direction the driver uses the opposite correction.
Controlling the Fed Funds Rate
The supply of reserves consists of three parts: vault currency, reserves
supplied through fed open market transactions, and loans from the Fed's discount
window (Figure 7).

To the extent the Fed leaves the banking system short of reserves through
open market operations, banks short of reserves try to borrow from each other and
bid up the fed funds rate. As the spread between the fed funds rate and the
discount rate widens more banks will borrow from the discount window.
Borrowing from the discount window carries some administrative costs as well as
a stigma of financial weakness. Nevertheless, as the funds rate rises higher and
higher above the discount rate more banks will go to the window. Banks are, after
all, profit making businesses and the financial incentives to borrow from the
window increase as the spread between the funds rate and the discount rate
widens.

Figure 7 - Supply and demand curve for Reserves

Figure 8 shows that when interest rates on fed funds rise above the
discount rate, depository institutions borrow from the Fed. In other words, the Fed
supplies the needed resources to the banking system by purchasing securities in
the open market or lending at the discount window. By adjusting the composition
of the reserves between borrowed and non-borrowed the Fed sets the spread
between the fed funds and the discount rate. The Fed uses open market operations
to adjust reserve balances so as to keep the banking system in a net borrowed
position. To reduce the spread between the fed funds rate and the discount rate
the Fed provides more unborrowed reserves through open market purchases. To
increase the spread the Fed provides fewer unborrowed reserves which require
banks to bid up the price of fed funds and borrow more heavily from the discount
window.

Figure 8 - Supply and Demand Curves for Reserves

 The fed funds rate is closely watched by the trading desk of the Federal
Reserve Bank of New York as the indicator of the reserve position of the banking
system. Every depository institution with a reserve requirement ends its reporting
period and must come up with its required reserves (an average for the period) by
the close of business on every other Wednesday. A perceived surplus sends the
funds rate plummeting downward; an expected shortage sends the rate shooting
upward. Perceptions sometimes shift rapidly on Wednesday afternoon, the last day
of the 14 day reserve accounting period. Figure 8 shows a case in which the
supply of reserves exceeds the demand for reserves.

Depository institutions have more non-borrowed reserves than they need

hence the funds rate would fall sharply. In April 1979, for example, the rate fell
from double-digit levels to 2 percent in one day.

Open market operations are carried out by the Federal Reserve Bank of New
York under the direction of the Federal Open Market Committee (FOMC). The
voting members of the FOMC are the seven members of the Board of Governors of
the Federal Reserve System, the President of the Federal Reserve Bank of New
York, and four of the Presidents from the other eleven Federal Reserve Banks who
serve on the FOMC on a rotational basis. The FOMC meet in Washington, D. C.
about every six weeks to assess the current economic outlook. The FOMC votes on
intermediate policy objectives and issues a directive to the trading desk manager of
open market operations in the New York Federal Reserve Bank. The directive
stipulates the target fed funds rate.
Further Discussion of Inelasticity
The fed funds rate can be very volatile because the market for reserves is
inelastic in the very short run. The banking system has no immediate way to rid
itself of excess reserves. A system-wide excess of reserves would push the funds
rate to zero. Even if banks were able to increase their volume of lending, excess
reserves would persist. Within the current accounting period each new loan
creates a deposit somewhere in the banking system, but each new loan absorbs
only a tiny fraction of the excess reserves. Furthermore, lending decisions are
generally independent of reserve needs.

With a system-wide shortage of reserves the Fed is the only source of

immediate funds. In the extreme, banks short of their reserve requirement fail if
unable to acquire the required reserves. Faced with imminent failure banks would
bid up the funds rate trying to borrow from each other. As the funds rate rose
more banks would go to the discount window. Banks may try to reduce their
reserve requirement by reducing the volume of their outstanding loans. However,
forcing the repayment of loans is an ineffective method of meeting reserve
requirements within the banking system. When a bank is deficient by, say
$10,000, a $10,000 loan may be called in to increase the amount of reserves by
$10,000. However, the loan repayment lowers the deposits in another bank. The
deficiency has merely shifted from one bank to another. Repayment of loans
reduces the reserve requirement only marginally within the banking system. A
huge reduction in the volume of outstanding loans brings about only a small
reduction in the banking systems' total reserve requirement. Reserve positions
must be settled immediately not months later. The banking system can obtain
reserves on a day-to-day basis from only one source, the Fed. Within a given
accounting period the banking system has no other practical means of reducing its
reserve requirement by a significant amount.
Lead Accounting
Out of a more desperate quest for control of total reserves emerges the
concept of lead accounting. The concept is more of an academic ideal than a
workable proposition. In a lead accounting system the maintenance period would
actually be prior to the computation period. Such a system would result in a very
restrictive and highly unstable environment. A reserve deficiency under a lead
accounting system could be more accurately labeled a deposit excess. In such a
case the banking system would have to undergo drastic changes in its loan
portfolio. A single bank may have a small degree of latitude to adjust its loan
portfolio in order to meet its reserve requirement. For example, if Bank A has a
$10 million reserve deficiency, and if it were able to force repayment of $10 million
of loans, Bank A's reserve balance would increase by the needed $10 million.
However, the loan repayment reduces the deposits in other banks by $10 million.
By calling in loans Bank A has not eliminated the reserve deficiency but merely
transferred the deficiency to other banks. When banks call loans the amount of
total deposits in the banking system declines, but the reduction of total deposits
reduces the amount of required reserves only marginally. The reserve requirement
is one- tenth of the total deposits; a large reduction in the amount of total deposits
would cause only a small reduction in the level of required reserves. The words
"call in loans" roll easily off the word processor, but what does this imply? First,
the portion of outstanding loans which are callable is small. Therefore, the U.S.
banking system does not have the immediate ability to expand or contract deposits
to meet short-term reserve requirements. Second, forcing changes in loan
portfolios through lead accounting would inflict a sever disruption and
unnecessary volatility, as individuals and firms would be forced to sell off assets to
reduce their borrowing on a day's notice, regardless of their equity or credit
standing.

The desire to implement lead reserve accounting is a rash reaction to the

Central Bank's lack of direct control of total bank reserves. It is a banking version
of the mountain moving to Mohammed. Even if lead reserve accounting were
enacted its effect would be far too disruptive to be used. The Federal Reserve's use
of lead accounting methods to control bank lending would be like a local police
force using tactical nuclear weapons to quell a domestic disturbance. In either
case, the power of the corrective action is so grossly disproportionate to the
situation that it is unusable.
More on Why Lead Accounting is Unworkable – Inelasticity for Loan
Demand
Financial intermediation has developed into a sophisticated and essential
institution in the modern economy. Lending is a practical reality of economic
growth and the demand for loans is very inelastic in the very short run. Even as
interest rates change the volume of outstanding loans adjusts on the margin,
gradually. Many loans have a fixed rate and are not affected by interest rate
changes. In the long run, loan demand and thus reserve demand, become
somewhat more elastic as individuals and businesses respond to interest rate
changes.

Many commodities share the property of short-run inelasticity. That is the

demand for these goods does not change with a change in the price of the good.
Consider, for example, a group of scuba divers' demand for air. If the divers were
down to their last few breaths of air and were unable to surface they would surely
be willing to pay any price for a tank of air. The only options for the divers are buy
more air or perish. The imaginary seller of air would be able to set any price for his
air. The quantity of air, however, depends entirely on what the divers need. Once
the divers have enough air additional air is of no value. The buyers determine the
quantity, and the seller sets the price. The inelasticity of the banking system's
demand for reserves is somewhat analogous to the inelastic demand for a scuba
divers air.

The Federal Reserve can set the price of reserves but the quantity is
determined by the banking system. The market for reserves is not perfectly
inelastic because the Fed allows some spill-over in the accounting of bank reserves
from one period to the next. This practice allows banks to smooth out some of the
volatility of their reserve positions but it does not change the inelastic nature of
the market for reserves. Efforts to force the market to accept fewer loans than are
demanded would be nearly as disruptive as forcing the divers to make do with no
air. The banking system would have to reduce their outstanding loans by forcing
customers to immediately sell off assets financed through the banking system. The
senseless dislocation of assets caused by forced disintermediation makes such an
action unthinkable. Central bankers who understand the intractable nature of the
banking system's loan portfolio recognize the necessity of lagged reserve
accounting. A sensible approach to changing the money supply employs a change
in the fed funds rate to gradually bring about the desired result.
What if No One Buys the Debt
It is not possible to adequately address every question raised by "debt
phoebes". One of the most common concerns, however, clearly illustrates the
unfounded fear that arises from confusing private borrowing with public
borrowing. The question is based on an image of Uncle Sam being turned away by
lenders and being stuck without financing.

Fear the government will be unable to sell securities overlooks the

mechanics of the process itself. The imperative of borrowing is interest rate
support. By issuing government securities, the government offers banks an
opportunity to exchange non-interest bearing reserves for interest bearing
securities. If all banks would rather earn zero interest on their assets than accept
interest payments from the government, the refusal to accept interest becomes a
de facto tax on the banking system. From the Treasury's point of view the
government's inability to attract any lenders would actually be a benefit. Imagine,
the government spends money and the banking system, in a sense, lends the
money at zero interest by refusing to accept interest on the new deposits which the
government spending created. Instead, the banking system is content to leave the
money in a non-interest bearing account at the Fed. The money is held at the Fed
either way - it has no other existence. If the money is left as excess reserves it sits
in a non-interest bearing account at the Fed. If the money is loaned to the
government by purchasing government securities it again is held at the
government's account at the Fed.
How the Government Spends and Borrows as Much as it Does
Without Causing Hyperinflation
Most people are accustomed to viewing savings from their own individual
point of view. It can be difficult to think of savings on the national level. Putting
part of one's salary into a savings account means only that an individual has not
spent all of his income. The effect of not spending as such is to reduce the demand
for consumption below what would have been if the income which is saved had
been spent. The act of saving will reduce effective demand for current production
without necessarily bringing about any compensating increase in the demand for
investment. In fact, a decrease in effective demand most likely reduces
employment and income. Attempts to increase individual savings may actually
cause a decrease in national income, a reduction in investment, and a decrease in
total national savings. One person's savings can become another's pay cut.
Savings equals investment. If investment doesn't change, one person's savings will
necessarily be matched by another's' dissaving’s. Every credit has an offsetting
debit.

As one firm's expenses are another person's income, spending equal to a

firm's expenses is necessary to purchase its output. A shortfall of consumption
results in an increase of unsold inventories. When business inventories
accumulate because of poor sales: 1) businesses may lower their production and
employment and 2) business may invest in less new capital. Businesses often
invest in order to increase their productive capacity and meet greater demand for
their goods. Chronically low demand for consumer goods and services may depress
investment and leaves businesses with over capacity and reduce investment
expenditures. Low spending can put the economy in the doldrums: low sales, low
income, low investment, and low savings.

When demand is strong and sales are high businesses normally respond by
increasing output. They may also invest in additional capital equipment.
Investment in new capacity is automatically an increase in savings. Savings rises
because workers are paid to produce capital goods they cannot buy and consume.
The only other choice left is for individuals to "invest" in capital goods, either
directly or through an intermediary. An increase in investment for whatever reason
is an increase in savings; a decrease in individual spending, however, does not
cause an increase in overall investment.

Savings equals investment, but the act of investment must

occur to have real savings.

The relationship between individual spending decisions and national income

is illustrated by assuming the flow of money is through the banking system. The
money businesses pay their workers may either be used to buy their output or
deposited in a bank. If the money is deposited in a bank, the bank has two basic
lending options. The money can be loaned to: 1) someone else who wishes to
purchase the output (including the government), or 2) to businesses who paid the
individuals in the first place for the purpose of financing the unsold output. If the
general demand for goods declines the demand for loans to finance inventories
rises. If, on the other hand, individuals spent money at a high rate the demand for
purchase loans would rise, inventories would decline and the level of loans to
finance business inventories would fall.

The structural situation in the U. S. is one in which individuals are given

powerful incentives not to spend. This has allowed the government, in a sense, to
spend people's money for them. The reason that government deficit spending has
not resulted in more inflation is that it has offset a structurally reduced rate of
private spending. A large portion of personal income consists of IRA contributions,
Keoghs, life insurance reserves, pension fund income, and other money that
compounds continuously and is not spent. Similarly, a significant portion of
business income is also low velocity; it accumulates in corporate savings accounts
of various types. Dollars earned by foreign central banks are also not likely to be
spent.

The root of this paradox is the mistaken notion that savings is needed to
provide money for investment. This is not true. In the banking system, loans,
including those for business investments, create equal deposits, obviating the need
for savings as a source of money. Investment creates its own money.

Once we recognize that savings does not cause investment it follows that the
solution to high unemployment and low capacity utilization is not necessarily to
encourage more savings. In fact, taxed advantaged savings has probably caused
the private sector to desire to be a NET saver. This condition requires the public
sector to run a deficit, or face deflation.
Full Employment and Price Stability
There is a very interesting fiscal policy option that is not under
consideration, because it may result in a larger budget deficit. The Federal
government could offer a job to anyone who applies, at a fixed rate of pay, and let
the deficit float. This would result in full employment, by definition. It would also
eliminate the need for such legislation as unemployment compensation and a
minimum wage.

This new class of government employees, which could be called

supplementary, would function as an automatic stabilizer, the way unemployment
currently does. A strong economy with rising labor costs would result in
supplementary employees leaving their government jobs, as the private sector
lures them with higher wages. (The government must allow this to happen, and
not increases wages to compete.) This reduction of government expenditures is a
contractionary fiscal bias. If the economy slows, and workers are laid off from the
private sector, they will immediately assume supplementary government
employment. The resulting increase in government expenditures is an
expansionary bias. As long as the government does not change the supplementary
wage, it becomes the defining factor for the currency- the price around which free
market prices in the private sector evolve.

Once the government levies a tax, the private sector needs the
government’s money so that it can pay the tax.

A government using fiat money has pricing power that it may not
understand. The conventional understanding that the government must tax so it
can get money to spend does not apply to a fiat currency. Because the private
sector needs the government's money to meet its tax obligations, the government
can literally name its price for the money it spends. In a market economy it is only
necessary to define one price and let the market establish the rest. For this
example I am proposing to set the price of the supplementary government workers.

This is not meant to be a complete analysis. It is meant to illustrate the

point that there are fiscal options that are not under consideration because of the
fear of deficits.
Taxation
Taxation is part of the process of obtaining the resources needed by the
government. The government has an infinite amount of its fiat currency to spend.
Taxes are needed to get the private sector to trade real goods and services in
return for the fiat money it needs to pay taxes. From the government's point of
view, it is a matter of price times quantity equals revenue.

Given this, the secondary effects of taxes can now be considered before
deciding on the tax structure. A sales tax will inhibit transactions, as will an
income tax. This tendency to restrict trade and transactions is generally
considered a detriment. It reduces the tendency to realize the benefits of
specialization of labor and comparative advantage. Furthermore, transaction taxes
offer large rewards for successful evasion, and therefore require powerful
enforcement agencies and severe penalties. They also result in massive legal efforts
to transact without being subject to the taxes as defined by the law. Add this to
the cost of all of the record keeping necessary to be in compliance. All of these are
real economic costs of transactions taxes.

A real estate tax is an interesting alternative. It is much easier to enforce,

provides a more stable demand for government spending, and does not discourage
transactions. It can be made progressive, if the democracy desires.

How much money one has may be less important than how much one
spends. This not a common consideration. But having money does not consume
real resources. Nor does one person's accumulation of nominal wealth preclude
another's, since the quantity of money available is infinite. Fiat money is only a tax
credit.

Perhaps those in favor of a progressive tax system should instead be

concerned over the disproportionate consumption of real resources. Rather than
attempting to tax away one's money at source, luxury taxes could be levied to
prevent excess consumption (not to raise revenue). The success of the luxury tax
should be measured by how little money it raises.
Foreign Trade
By the tenor of recent trade discussions it is apparent that the modern
world has forgotten that exports are the cost of imports. Under a gold standard,
each transaction was more clearly defined. If one imported cars, and paid in
currency, the cars had been exchanged for gold. Cars were imported and gold was
exported. Fiat money changed this. If a nation imports cars, and pays in its own
fiat currency, cars are still imported but no commodity is exported. The holder of
that money has a very loosely defined currency. In fact, the holder of currency is
only guaranteed to be able to buy something from a willing seller at the seller's
offered price. Any country running a trade surplus is taking risk inherent in
accumulating fiat foreign currency. Real goods and services are leaving the
country running a surplus, in return for an uncertain ability to import in the
future. The importing country is getting real goods and services, and agreeing only
to later export at whatever price it pleases to other countries holding its currency.
That means that if the United States suddenly put a tax on exports, Japan's
purchasing power would be reduced.
Inflation vs. Price Increase
Little or no consideration has been given to the possibility that higher prices
may simply be the market allocating resources and not inflation.

Prices reflect the indifference levels where buyers and sellers meet. The
market mechanism allows the participants to make their purchases and sales at
any price on which they mutually agree. Market prices tend to change
continuously. If, for example, there is a freeze in Brazil, the price of coffee may go
up. The higher price accommodates the transfer of the remaining supply of coffee
from the sellers to the buyers.

Prices going up and down can be the market allocating resources, not a
problem of inflation. Inflation is the process whereby the government causes
higher prices by creating more money either directly through deficit spending, or
indirectly by lowering interest rates or otherwise encouraging borrowing. For
example, when a shortage of goods and services causes higher prices, a
government may attempt to help its constituents to buy more by giving them more
money. Of course, a shortage means that the desired products don't exist. More
money just raises the price. When that, in turn, causes the government to further
increase the money available, an inflationary spiral has been created. The
institutionalization of this process is called indexing.

Left alone, the price of coffee, gold, or just about anything may go up, down,
or sideways. Goods and services go through cycles. One year, there may be a
record harvest and the next a disaster. Oil can be in shortage one decade, and
then in surplus the next. There could, conceivably, be years, or even decades when
the CPI grows at, say, 5% without any real inflation. There may be fewer things to
go around, with the market allocating them to the highest bidder.

As the economy expands and the population increases, some items in

relatively fixed supply are bound to gain value relative to items in general supply.
Specifically, gold, waterfront property, and movie star retainers will likely increase
relative to computers, watches, and other electronics.

If the Fed should decide to manage the economy by targeting the price of
gold, they would respond to an increase in the price of gold with higher interest
rates. The purpose would be to discourage lending, thereby reducing money
creation. In effect, the Fed would try to reduce the amount of money we all have in
order to keep the price of gold down. That may then depress the demand for all
other goods and services, even though they may be in surplus. By raising rates,
the Fed is saying that there is too much money in the economy and it is causing a
problem.

Presumably there is some advantage to targeting gold, the CPI, or any other
index, rather than leaving the money alone and letting the market adjust prices.
Interest rates can be too low and lead to excess money creation relative to the
goods and services available for sale. On the other hand, higher commodity prices
may represent the normal ebbs and flows in the markets for these items.

If there are indeed price increases due to changing supply dynamics, Fed
policy of restricting money may result in a slowdown of serious proportions which
would not have occurred if they had left interest rates alone.
Conclusion
The supposed technical and financial limits imposed by the federal budget
deficit and federal debt are a vestige of commodity money. Today's fiat currency
system has no such restrictions. The concept of a financial limit to the level of
untaxed federal spending (money creation/deficit spending) is erroneous. The
former constraints imposed by the gold standard have been gone since 1971. This
is not to say that deficit spending does not have economic consequences. It is to
say that the full range of fiscal policy options should be considered and evaluated
based on their economic impacts rather than imaginary financial restraints.
Current macroeconomic policy can center on how to more fully utilize the nation's
productive resources. True overcapacity is an easy problem to solve. We can afford
to employ idle resources.

Obsolete economic models have hindered our ability to properly address real
issues. Our attention has been directed away from issues which have real
economic effects to meaningless issues of accounting. Discussions of income,
inflation, and unemployment have been overshadowed by the national debt and
deficit. The range of possible policy actions has been needlessly restricted. Errant
thinking about the federal deficit has left policy makers unwilling to discuss any
measures which might risk an increase in the amount of federal borrowing. At the
same time they are increasing savings incentives, which create further need for
those unwanted deficits.

The major economic problems facing the United States today are not
extreme. Only a misunderstanding of money and accounting prevents Americans
from achieving a higher quality of life that is readily available.
 Mosler Speech - Rome Debt Management
Conference October 26, 2012
I’ll first address what I believe is the most misunderstood question, which is
why the euro national governments debts are as high as they are. The answer
begins with the absolute fact that government debt is equal to global ‘non-
government’ accumulations of euro financial assets. For any given ‘closed sector’
the euro is a traditional case of ‘inside money’, as with a ‘giro’ or ‘clearing house.’
The only way an agent could have net euro financial assets would be for another to
be net borrowed. For every euro asset there is a euro liability. The net is always
zero.

This type of system famously can’t accommodate a net desire to save, unless
there is a provision for net financial assets to enter the sector in question. In the
case of the euro, this means the non-government sector requires government
deficit spending to satisfy its net savings desires, should there be any.
Additionally, note that all government spending is either used to pay taxes or
remains as net savings in the economy, in one form or another. And
unemployment, as defined, is the evidence that the economy does not have
sufficient euro income to pay its taxes and fulfill its net savings desires.

The answer to why national government debt is so high continues with an

investigation of the ‘savings desires’ that generate the need for net financial assets.
European institutional structure includes powerful incentives to not spend
income, and to instead accumulate financial assets. Historically these have been
called ‘demand leakages’, and include tax advantaged as well as mandatory
requirements for income to go into retirement funds, corporate reserves, as well as
actual cash in circulation. Without an equal expansion of private sector debt by
other agents spending more than their incomes, these savings desires can’t be
realized, unless governments spend more than their income.

In the years immediately before the euro, the member nations with today’s
high debts had their own currencies. As currency issuers, whether they realized it
or not, they had no solvency issues, they set their own interest rates, and they
accommodated domestic savings desires with government deficit spending, which
allowed them to sustain growth and keep unemployment relatively low.

The point here is that high deficits were offsetting the high demand leakages
built into the institutional structures. And that requirement has not gone away, as
the traditional demand leakages remain. And note that the nation with the lowest
deficit, Luxemburg, never had its own currency, and instead market forces caused
them to fund their net financial assets with net exports.

What changed with the euro, and the ‘divorces’ from the national central
banks, was the ability to fund national deficits. The euro nation’s financial
dynamics became very much like the US states. They can no longer ‘print the
money’, and are instead revenue constrained. However, the difference is that,
unlike the US states, the euro members entered the euro with the higher debt
levels incurred when they were issuers of their currencies, not constrained by
revenues, and acting to offset demand leakages as required to sustain output and
employment.

Today, the ECB is the central bank for the euro. I often call it the ‘score
keeper’ for the euro. The ECB system spends and lends euro simply by crediting
accounts. These euro don’t ‘come from’ anywhere.

They are ‘data entry’. As Chairman Bernanke responded when asked where
the hundreds of billions of dollars lent to the banks came from: ‘...we simply use
the computer to mark up the size of the account they have with the Fed.’

In fact, any central bank, operationally, can make any size payments in its
own currency. When the ECB makes a 500 million euro securities purchase, no
one asks where the euro came from, whether it was taxpayer money, or whether
the ECB somehow borrowed it from China. Central banks are not revenue
constrained in their own currency. This puts them in the unique position of being
able to act counter cyclically during a down turn in the economy.

Conversely, the euro members, like the US states, are not financially
capable of reacting counter cyclically to increased savings desires when private
sector credit expansion fails and economies slow.

Only the ECB can, as I like to say, ‘write the check’ to allow for the provision
of the net financial assets demanded by the institutional structure, as evidenced
by the rate of unemployment and the output gap in general.

Given the state of private sector credit and net export potential, the euro
zone currently needs even higher levels of government deficit spending than
otherwise to sustain growth and employment. And only the ECB can write that
check. And yes, I realize the political difficulties this implies, the most pressing
issue being that of moral hazard.

Given the necessity of more national government debt and with only the
ECB ultimately capable of writing the check, I’ll now discuss policy options for
closing the output gap, and their associated risks.

A simple ECB guarantee of national government debt and an expansion of

Maastricht limits to perhaps 7% of GDP would trigger an immediate surge of sales,
output, employment, and general prosperity.

However, without adequate enforcement of limits, it would also surely

trigger an inflationary race to the bottom, as the nation managing to run the
largest deficits would benefit the most in real terms. So the challenge is to allow
the right level of fiscal expansion to accommodate the demand leakages of the
independent member nations, but without the direct central fiscal control of a
currency union like the US.
 Tax credit bonds are another option. These are bonds that have the same
characteristics of today’s sovereign debt, but in the case of non-payment (there is
no default condition) these fully transferrable bonds can be used for payment of
taxes to the government of issue. This means that taxpayers of other members will
never be asked to pay any other member’s obligations, which I presume would
have wide political appeal.

A third option is for the ECB to make ‘cash’ distributions to the member
nations on a per capita basis of perhaps 10% of euro zone GDP annually. This
would begin a systematic reduction of member deficits towards zero over a multi-
year period. It would also have to include strict spending limits to regulate
aggregate demand. To that end, the ECB could withhold payment to violators,
which is far easier to do than imposing and collecting fines, as is the case today.

Twenty years ago I was in Rome at the finance ministry meeting with
Professor Luigi Spaventa, along with my colleague Maurice Samuels of Harvard
Management. Those, too, were dark days for Italy. Debt was over 100% of GDP,
interest rates over 12%, the global economy was weak, and Professor Rudi
Dornbusch had been making the rounds proclaiming that Italian default was
certain. I asked Professor Spaventa, rhetorically, why Italy was issuing CCT’s and
BTP’s. Was it to fund expenditures, or was it because if the treasury spent the lira,
and did not issue securities, and the Bank of Italy did not sell securities, the
overnight rate would fall to 0? There was a long pause before Professor Spaventa
answered ‘no, rates would only fall to ½% as we pay interest on reserves’
indicating full and sudden understanding that there was no default risk. He then
immediately rose with an attack on IMF conditionality. A great weight had been
lifted. The next week it was announced ‘no extraordinary measures would be taken
- all payments will be met on time” and the debt crisis receded.

Solving that debt crisis was relatively easy, as in fact there was no debt
crisis. Today the situation is both more serious and more complex. The economic
problem is that deficits are too small, while the political understanding is that
deficits are too large. And the consequential ECB funding with conditionality
translates into lower rates and higher unemployment.

Note that I have made no mention of interest rates or monetary policy in

general. My 40 years of experience as an insider in monetary operations tells me
they matter very little for growth and employment. And for nations with high
deficits, I’ve come to expect high rates from the CB to function to promote inflation
from both the interest income channels, and through the general cost structure of
the economy.

I will conclude with very brief word on inflation. Just like the dollar, yen,
and pound, the euro is a simple public monopoly. And any monopolist is
necessarily price setter, not price taker.
 Furthermore, a monopolist sets two prices. First is what Marshall called the
‘own rate’ which is how the monopolist’s thing exchanges for itself. For a currency
that is the interest rate set by the CB.

The second is how that thing exchanges for other goods and services. For a
currency we call that the price level. I say it this way - the price level is necessarily
a function of prices paid by the government of issue when it spends, and/or
collateral demanded when it lends.

What this means for the euro zone is that inflation control ultimately comes
down to limiting government spending by limiting selected prices member nations
are allowed to pay when they spend.

Like central banking, it’s about price, and not quantity.

Thank you.
 Other Recommended Books

Warren Mosler, The 7 Deadly Innocent Frauds of Economic Policy.

Randall Wray, Modern Money Theory
Randall Wray, Understanding Modern Money
William Black, The Best way to Rob a bank is to Own One
 Appendix for Soft Currency Economics
Charts used in Soft Currency Economics

Error: Reference source not found

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Figure 3 - The Government Spends $500 million and Taxes $500 million
Figure 4 - The Government Spends $500 million and borrows $500
Figure 5 - Probabilities of the Open Market Desk Daily Transactions June 1998 to December 1990
Figure 6 - Likelihood that the Fed’s Desk uses Repurchase and Reverse Repos
Figure 7 - Supply and demand curve for Reserves
Figure 8 - Supply and Demand Curves for Reserves
 Bibliography for Soft Currency Economics
Auerbach, Robert D.,Money, Banking, and Financial Markets, 2nd Ed., MacMillian, 1985.

Berstein, Peter L.,A Primer on Money, Banking, and Gold, Vintage Books, 1965.

Board of Governors of the Federal Reserve System,The Federal Reserve System: Purposes and
Functions, 7th Ed. (The Board 1984).

Bryant, Ralph C.,"Controlling Money", The Brookings Institution, 1983.

Cosimano, Thomas F. and John B. Van Huyck,"Dynamic Monetary Control and Interest Rate
Stabilization",Journal of Monetary Economics 23, 1989, pp. 53-63.

Dillard, Dudley, The Economics of John Maynard Keynes, The Theory of a Monetary Economy,
(New York: Prentice-Hall, 1948).

Feige, Edgar L., Robert McGee, "Money Supply Control and Lagged Reserve Accounting",
Journal of Money, Credit, and Banking, Vol. 9 (November 1977), pp. 536-551.

Feinman, Joshua N., "Reserve Requirements: History, Current Practice, and Potential Reform",
Federal Reserve Bulletin, June 1993, pp. 569-589.

Feinman, Joshua N., "Estimating the Open Market Desk's Daily Reaction Fraction", Journal of
Money, Credit, and Banking, Vol. 25, No 2 (May 1993).

Henning, Charles N., Pigott, William, Scott, Robert Haney, Financial Markets and the Economy,
4th Ed., Prentice-Hall, 1984.

Knodell, Jane, "Open Market Operations: Evolution and Significance", Journal of Economic
Issues, (June 1987), pp. 691-699.

Laurent, Robert D., "Lagged Reserve Accounting and the Fed's New Operating Procedure",
Economic Perspectives, Federal Reserve Bank of Chicago, Midyear 1982, pp. 32-44.

Manypenny, Gerald D. and Bermudez, Michael L., "The Federal Reserve Banks as Fiscal Agents
and Depositories of the United States", Federal Reserve Bulletin, October, 1992.

Mayer, Thomas, Duesenberry, James S., Aliber, Robert Z., Money, Banking, and the Economy,
2nd Ed., W.W. Norton & Company, 1984.
McDonough, William, et al, "Desk Activity for the Open Market Account", Federal Reserve Bank
of New York, Quarterly Review, Spring 1992-93, pp. 109-114.

Meulendyke, Ann-Marie, "Reserve Requirements and the Discount Window in Recent

Decades", Federal Reserve Bank of New York, Quarterly Review, Vol. 17 (Autumn 1992).

Meyer, Lawerence H., Editor, "Improving Money Stock Control", Center for the Study of
American Business, (Boston: Kluwer-Nijhoff Publishing, 1983).

Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, 3rd Ed., Harper
Collins, 1992.

Pierce, David A.,"Money Supply Control: Reserves as the Instrument Under Lagged
Accounting”, The Journal of Finance, Vol. XXXI, No. 3 (June 1976) pp. 845-852.

Rosenbaum, Mary Susan, "Contemporaneous Reserve Accounting: The New System and Its
Implications for Monetary Policy", Economic Review, Federal Reserve Bank of Atlanta (April
1984), pp. 46-57.

Roth, Howard L., "Federal Reserve Open Market Techniques", Economic Review, Federal
Reserve Bank of Kansas City (March 1986).

Timberlake, Richard H., "Institutional Evolution of Federal Reserve Hegemony", Cato Journal,
Vol. 5, No. 3 (Winter 1986).
 About the Author
What others are saying about Warren Mosler:

“One of the brightest minds in finance.” CNBC (6/11/10)

“Warren Mosler is one of the most original and clear-eyed participants

in today’s debates over economic policy.” JAMES GALBRAITH, FORMER
EXECUTIVE DIRECTOR, JOINT ECONOMIC COMMITTEE AND PROFESSOR, THE UNIVERSITY OF
TEXAS – AUSTIN

“I can say without hesitation that Warren Mosler has had the most profound
impact on our understanding of modern money and government budgets of
anyone I know or know of, including Nobel Prize winners, Central Bank
Directors, Ministers of Finance and full professors at Ivy League
Universities. It is no exaggeration to say that his ideas concerning economic
theory and policy are responsible for the most exciting new paradigm in
economics in the last 30 years - perhaps longer - and he has inspired more
economists to turn their attention to the real world of economic policy than
any other single individual.” DR. MATTHEW FORSTATER, PROFESSOR OF ECONOMICS,
UNIVERSITY OF MISSOURI - KANSAS CITY

“Warren is one of the rare individuals who understand money and finance
and how the Treasury and the Fed really work. He receives information from
industry experts from all over the world.” WILLIAM K. BLACK, ASSOCIATE
PROFESSOR OF ECONOMICS & LAW, UNIVERSITY OF MISSOURI - KANSAS CITY

“He [Warren Mosler] represents a rare combination: someone who combines

an exceptional knowledge of finance with the wisdom and compassion
required to get us an array of policies that will bring us back to sustainable
full employment.” MARSHALL AUERBACK, GLOBAL PORTFOLIO STRATEGIST, RAB
CAPITAL AND FELLOW, ECONOMISTS FOR PEACE & SECURITY

-------------------------

Warren Mosler is a world renowned financier, economist and entrepreneur.

For Mosler, life has always been about the intellectual challenge of reducing
seemingly complex phenomena to their simplest terms in the chase for the “elegant
solution”.

As a financier, Mosler is the co-founder of Illinois Income Investors (III), a

family of leveraged fixed income investment funds. He developed numerous
successful strategies that utilized US Government securities, mortgage backed
securities, LIBOR swaps and LIBOR caps, and financial markets in a market
neutral, zero duration strategy. Mosler originated the ‘mortgage swap’ in 1986 and
orchestrated the largest futures delivery to date (over $20 billion notional) in
Japan in 1996. He is also the inventor of a swap futures contract currently in
operation (in a muted form) by a major exchange. III was rated number by MAR in
risk adjusted returns for the prior 10 years in 1997 when he returned control over
to his partners.

Warren Mosler is currently the Present of Valance Co, Inc. located in St.
Croix in the US Virgin Islands, where he resides. Mosler is also Chairman and
majority shareholder of Consulier Engineering (CSLR), President and founder of
Mosler Automotive, which manufactures the MT900 sports car in Riviera Beach,
Florida; Co-Founder and Distinguished Research Associate of The Center for Full
Employment And Price Stability at the University of Missouri in Kansas City;
Senior Associate Fellow, Cambridge Center for Economic and Public Policy,
Downing College, Cambridge, UK; and Associate Fellow, University of Newcastle,
Australia.

As an economist, Mosler has been about designing economic programs to

achieve full employment and price stability in the United States. After the
economic crash in 2008, Mosler proposed economic programs to help reduce
unemployment and improve the economy through the stimulation of aggregate
demand. These included temporary elimination of the payroll tax, a pro-rata
funding for states and a guaranteed job program. In 2010, at the request of
Independent Party, he ran for the Connecticut Senate seat on these issues. He
finished third, but in many ways he won, because the Administration picked up
and implement a payroll tax cut. He is currently running for Congress.