12 February 2011

Modern Monetary Theory: The Sophistry of the US Dollar

soph·is·try (s f -str ). n. pl. soph·is·tries. 1. Plausible but fallacious argumentation. 2. A plausible but misleading or fallacious argument.

This is a very well written and important piece by Mr. Cullen Roche at his site Pragmatic Capitalism.   It does a good job of capturing the essence of modern monetary theory that I like to think of as post-Nixonian fiat, gaining its realization and fruition in Reaganomics and the Greenspan Fed.

Sophistry does not refer to the author or his argument who I assume believes exactly what he is saying, and of which reasonable people can make what they will.  And he is certainly not alone in his thinking.  More recently thought leaders have said the very same thing, and sometimes couched as an attack on anything else to stand up to the value-is-whatever-we-say-it-is crew of central planners and their financial engineers. 

I have done him the courtesy of including the entire piece with a link, with my comments in italics along the way.  I dislike it when someone 'cherry picks' something I have written, setting up a silly strawman argument and a false premise, and then attacking it often in a clumsy manner.  And I think this argument of Mr. Roche is well said, and worth considering seriously.  He might be right. 

But I do not think so.  I think his reason jumps the tracks at a key juncture and runs into the weeds thereafter. I fear this is a system that requires an exponentially greater reach of control and misdirection to keep working as in a late stage ponzi scheme.  And that is what makes it especially dangerous, because it must at some point silence all dissent, and promote its provisions and arrangements amongst the unwilling, or fail.

So as I said, he does a very good job of explaining it well, and many intelligent and people with weighty credentials and position seem to agree.  But many of these same people also said they ardently believed in the efficient market theory and the benefits of deregulation, and we see how quickly that belief system has collapsed under the weight of the financial crisis, although its remnant echoes are continually reappearing in various places and policies.  Old ideas die more slowly than old soldiers, especially when they continue to enrich a powerful status quo.

Rather, the sophistry is in the evolving nature of US dollar and its role as the world's reserve currency, and too often the discussions that surround it.   Perhaps rationalization would be a better word, but sophistry captures the intent of it I think.

As you may recall, the basis for the unilateral departure of the US from the Bretton Woods regime and the gold standard under Nixon was that the full faith and credit of the US Treasury, with an independent Fed as guardian of the realm, would force the Dollar to act as though it were still externally constrained, as in the case of a gold standard.   As Greenspan said, the dollar works as long as it acts as though it were on a gold standard.

This is why, as I recall, the Fed is prohibited by statute and custom from buying debt directly from the Treasury.  It must first pass through the public markets at auction, in the belief that market discipline will prevent excess money creation by legitimate price discovery and higher interest rates as required.

It might be useful to consider at this time a different definition for monetization, that is not the archaic 'printing of money.'  Monetization might best be described as those actions which consciously misprice the decreasing value and prospects of money, normally a currency, and by corollary the associated risk and returns.  As you can see this includes the debasement of specie money through various means, but also the more modern method of egregiously tinkering with interest rates beyond merely policy rate adjustments.

As I have pointed out previously, to circumvent market discipline merely requires a Fed with the will to do it, and a few complicit primary dealer banks to play along with it.  This can work well as long as no one with sufficient sovereign standing calls them on it, or the people who are the users of the currency rise up en masse against it.  This is convenient arrangement amongst regulators and market fixers is merely an impasse, and is not sustainable in a floating exchange rate system.  The arrangement requires ever increasing duplicity and threat of force. After these many years, the dollar is now literally hanging on to its value with its reserve currency nails.

And so I think a collapse of the dollar is more possible now than at any time in the past.  It is only sustained by the trauma which the decline of such a large economy would cause on the world markets and those central banks unfortunate enough to hold its debt.  This is the best case one can make to explain a hyperinflation

Pragmatic Capitalism
The Fed Is Not Monetizing U.S. Government Debt
By Cullen Roche
February 9, 2011

The Fed’s purchases of Treasuries continue to attract a huge amount of attention. Despite solid evidence that the program is failing to have any real fundamental economic impact, there are other worries about the program. None has been more apparent in recent weeks than the Fed’s supposed monetization of the US government’s debt. These fears of monetization are unfounded due to the various myths that are perpetually touted by the mainstream media, supposed experts on the US monetary system and even Fed officials. (Quite a collection of the mistaken, certainly not the hoi polloi and not so easily dismissed, but let's read on.  I have to add though that flags get raised in my mind whenever I pick up this tone in an argument early on. - Jesse)

In an article Monday, Bloomberg reported that the Fed has been buying an exorbitant proportion of the recently issued Treasury debt:
More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers’ holdings of Treasuries to the lowest since November 2009.

Why does this matter? Because it gives the appearance that the US government is directly funding itself via the Fed’s purchases. This would be nefarious if it were true and would give credence to the endless complaints about the high rate of inflation in the USA (which is currently running at a staggering 1.5%-2.25% depending on the source). Fortunately, the concerns are unfounded.  (Unfortunately they are not, but read on. - Jesse)
The issuance of bonds continues to this day due to Congressional mandate. In reality, our bond market funds nothing and serves only as a reserve drain which helps the Fed maintain its overnight target interest rate. It has nothing to do with funding the government.  (It would be interesting to test this theory.  For example, if the US were to have a failed bond auction this year. - Jesse)  When the US government wants to spend money they do not call China and ask for a line of credit. They do not count tax receipts. And they most certainly do not call the Fed to ensure that we have any money left. No, the truth is that the USA never really has nor doesn’t have any money. So the entire implication that the Fed is helping to fund US government expenditures is entirely inaccurate and anyone who implies as much is still working under the now defunct gold standard model and clearly doesn’t understand the workings of the modern monetary system. 

(This is the heart of the sophistry.  For the theory as it stood for many years was that market discipline and an independent Fed would take the place of the gold standard in placing some constraint on the value of the bond and the dollar.   Otherwise why would the Treasury simply not create the bonds to satisfy its obligations and place them on the Fed's balance sheet?  Or better yet, just issue currency and skip the interest?  Because the theory is that by using interest rates as a governing mechanism and forces the debt to be placed through an open system of auction, the efficiency in valuation of the market would act as a standard and as a restraint. - Jesse)

When the US government was working under the gold standard the US Treasury would literally print up certificates to purchase gold from the gold mines. These gold bars would be delivered to the government and the Treasury would issue a check to the miner. This new money would end up at the Federal Reserve Bank in the form of deposits. This would naturally increase the money supply. An increase in the money supply is scary for obvious reasons. So, the term debt monetization has its origins in the days of the gold standard, but persists to this day despite the fact that we are no longer on a gold standard. Not surprisingly, the term is still used today despite the fact that the US government can’t monetize its debt via Fed purchases (I elaborate below). 
(This description of the gold standard is regrettably cartoon-like, and completely ignores the role it played as a market force in international trade.  Most of the gold volume was related to the exchange of goods in trade, and not through the purchase of new supply from miners.  In a situation where a nation consumed more than it produced, the decline of its gold holdings would weaken its currency, forcing a unit devaluation vis a vis gold.  And vice versa with those countries with a mercantilist bent.  Since actual gold was changing hands, and a relatively modest increase is added each year to total supply, it was difficult to game the system.  Monetary policy in the form of devaluation was still very possible, but a bit awkward if one used actual specie instead of certificates. But it was enforceable and transparent. I am on the record as not favoring a return to the gold standard in the US at this time, because its financial system is too unstable and corrupted.  But gold and silver represent a major attraction for international trade in some manner, for the reasons outlined above.  The US dollar was purported to serve this purpose as the world's reserve currency post 1971, but it has failed in the exact manner predicted by those who said it could not work because of the vagaries of human weakness and the corruptibility of policy. - Jesse)

This issue was magnified yesterday when Richard Fisher of the Dallas Fed invoked the evil “debt monetization” term in his speech:
The FOMC collectively decided in November to temporarily undertake a program to purchase U.S. Treasuries that, when added to previous policy initiatives, roughly means we will be purchasing the equivalent of all newly issued Treasury debt through June. By this action, we have run the risk of being viewed as an accomplice to Congress’ fiscal nonfeasance. To avoid that perception, we must vigilantly protect the integrity of our delicate franchise. There are limits to what we can do on the monetary front to provide the bridge financing to fiscal sanity. The head of the European Central Bank, Jean-Claude Trichet, said it best recently while speaking in Germany: “Monetary policy responsibility cannot substitute for government irresponsibility.”

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases. I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation. And I expect I will be at the forefront of the effort to trim back our Treasury holdings and tighten policy at the earliest sign that inflationary pressures are moving beyond the commodity markets and into the general price stream. I am a veteran of the Carter administration and know how easily prices can spin out of control and how cruelly markets can exact their revenge. I would not want to relive that experience.”
Fisher’s implication is that the Fed is directly helping to fund the US government’s spending. After all, if they’re buying the debt then they’re obviously funding the spending, right? Wrong. As regular readers know, the US government is never constrained in its ability to spend. Our monetary system underwent a dramatic change when Richard Nixon closed the gold window. It removed any constraint on the US government’s ability to spend. Nonetheless, the operating structure of the gold standard (issuing bonds, etc) still largely remained intact.

(The constraint is softer, and more pernicious than when the US was on a gold standard. The constraint is now the external valuation of the bond in the generic sense, and the dollar, which is a bond of zero duration. During the Carter administration, for example, the dollar was constrained by monetary inflation, the decreasing valuation placed on the bond and dollar by the rest of the world. A gold standard acts as a hard restraint, stopping the monetary authority from debasing the currency early on. Without that constraint perception make the process non-linear. Rather than a hard stop, with a transparent and visible devaluation process, the value can erode slowly over time until it reaches a tipping point, and a more precipitous slide into a collapse. The Fed is confident they can stop this based on the Volcker experience. This remains to be seen. They have no prove of it in theory because it involves human behaviour and significant, if not critical, international exogenous variables. - Jesse)

For a brief instant, Mr. Fisher appears as though he is on the verge of understanding the system he now heavily influences as a new voting member of the FOMC. Mr. Fisher says that the spending effectively comes first:

But here is the essential fact I want to emphasize and have you think about today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place….The Fed does not create government debt; Congress does.
Lights should be going off in Mr. Fisher’s head at this point as he says this. This is important because Mr. Fisher is essentially acknowledging that the Fed is not the entity that actually conducts helicopter drops. Of course, spending comes before debt issuance. It can be no other way in a monetary system such as ours. The Fed’s role in this process is purely monetary. It has nothing to do with the fiscal side. The Fed does not “print money”. Congress is the entity that prints money via deficit spending.  (And the Fed is supposedly the independent constraint on this, and of course the printing of money that occurs in the private banks and the shadow banking system. - Jesse)  And they always decide how much to spend before considering any potential constraint from taxes or bond issuance. Unlike a household or state the US government does not need money before it spends. (The Fed is the only relatively unrestrained source, as well as being the regulator, the governor if you will.  Because the US must issue a bond at some point to cover its spending. This is not a mere detail.  It is a rhetorical device to argue the timing, for it is implicit in the process of governance..  But only the Fed can expand its balance sheet ex nihilo, from nothing.  - Jesse)  From a common sense perspective, you would think that this would set alarms off in most people’s heads, however, it does not. The idea that the US government is never revenue constrained is so foreign to most people that their minds repel it. (And rightfully so, since such an outlook is a tenet of the Robert Mugabe School of Business, University of Zimbabwe - Jesse)

By now you might be thinking that this is all semantics. Who cares if the Fed isn’t helping to fund the spending? They’re still buying the bonds and the spending is occurring regardless of the Fed’s actions. Well, it’s important for several reasons:
1.  Someone who understands the modern monetary system understands that a sovereign government with monopoly supply of currency in a floating exchange rate system has no solvency issue. Therefore, it should not be treated as if it is a household, business or state. (This sounds as though it could be  the motto of the Weimar school of modern monetary economics.  What is missing is that for this to be correct that monopoly must be comprehensive, ie, there must be some force that cause the misallocation of wealth in the world from a central planning commission, and a mispricing of risk.  In other words, its necessary to be the world's reserve currency and to own the ratings agencies. Otherwise the only floating that gets done is the value of a currency printed ad infinitum down the drain.  The value of a fiat currency is tenuously based on the belief that the monetary authority will not assume it has no solvency issue because it owns a printing press and is willing to use it recklessly, that the currency retains some stable relationship to some useful goods.- Jesse).
2.  If solvency is not a concern (and here reason departs from reality, especially given the many serious instances of high inflation experienced by countries not on a gold standard since the end of World War II.  Technically Russia was not insolvent when the Soviet Empire collapsed. It merely re-issued a 'new ruble' after knocking a few zeros off the old one.  Tell the good news to those whose life savings were destroyed. - Jesse)  then clearly the concern is inflation or potential hyperinflation. But as we’ve seen over the last few years the Fed has not succeeded at creating inflation anywhere close to the historical average and certainly not dangerously high levels of inflation. To someone who understands how the modern monetary system functions it not surprising then, that the Fed has been unable to generate inflation during a balance sheet recession. (Inflation is how one measures it.  I would submit that the Fed is quite expert at generating asset inflation in things like financial assets and housing, having done it quite well a few times now.  But I would agree that this is not sustainable, for the reasons noted by Jefferson so many years ago, that this printed money is used for merely speculative as in gambling, not adding the 'mass' of the economy but merely serving as a subtle means of wealth transferal.  For fiat money is not wealth, but merely the means of allocation and transference. - Jesse)

3.  Fear mongerers want you to believe that the Fed is the evil entity that “prints money”. The truth is that the Fed can do no such thing. Only Congress can print money and it’s clear that their actions in recent years have failed to generate significant inflation. This is a sign that the government’s spending has been ineffective and misguided. Although I acknowledge that the US Congress is never constrained in its ability to spend this by no means implies that the US Congress should spend beyond its means. To do so can possibly result in malinvestment or very high inflation.  (As a general rule of thumb, name calling, also known as poisoning the well of a counter argument, often introduces and highlights the weakest points in a discussion. Having said that, in a fiat system the interest rates are a key bellwether and governing mechanism to the money supply and the expansion of credit which is the source of money. To this extent to say that the Fed is not involved is to use the same defense that the Wall Street banks used in the subprime mortgage crisis.  They did not originate the loan. They merely bundled them, helped to misprice them, and then sold them to the unsuspecting, the marks in this great con game. - Jesse)

4.  The idea that the Fed is buying government debt might imply that there are is a shortage of buyers of US debt. This is impossible as government debt issuance serves only as a reserve drain. Auctions are designed around calculated reserves and are carefully designed so as not to fail.  (There are a shortage of buyers at certain prices, so the Fed steps in to buy them in the act of mispricing of risk. - Jesse)

5.  Voting members of the FOMC do not understand the actual workings of the Federal Reserve System and the US monetary system and have played a direct role in the misguided policy response in recent years. Of course, this is nothing new. This problem has persisted throughout the entirety of the last 40 years and is largely to blame for the structural flaws in the US economy currently. (If those voting members included Greenspan and Bernanke and I would most heartily agree, but I do not think that is what Mr. Roche intends. - Jesse)

6.  The overwhelming majority of US citizens have no idea how the US monetary system actually functions and therefore are reluctant or unable to force any sort of real change. (As I recall those same citizens rose up almost en masse and besieged their Congressmen to vote against TARP.  They were ignored by the Congress which has been inundated by money from the banking lobby. The desire for change is clearly there.  What is lacking is choice, and I think it is fraud with intent. - Jesse) Those with political or monetary motivations tend to invoke fearful language that incites anger and in truth only adds to the problems in the US economy by driving the voter base to react to their emotions and not their knowledge of the system in which they reside.

7.  Quantitative easing does not increase the money supply and is therefore not inflationary. (Apparently the Adjusted Monetary Base escapes his attention, in addition to the Fed's role as 'the standard in proxy' acting in lieu of an external standard such as gold or a peg to a hard currency - Jesse) Although this operation can have significant psychological impacts (such as inducing undue speculation)  (You bet your ass it does, and it is doing it right now - Jesse) QE can only work in the same manner that traditional monetary policy is implemented at the short-end of the curve. This occurs by setting a target rate and by being a willing buyer of any size at that rate. This is NOT how the current policy is designed. The current structure of QE leaves interest rates entirely controlled by the marketplace and not the Fed. Therefore, the mixed results should come as no surprise to anyone as the policy was poorly designed to begin with and is likely doing little more than contributing to excessive speculation and promoting the continued financialization of the US economy. The Fed’s implementation of such policies (such as QE) and complete misunderstanding of such policies does nothing but help create disequilibrium in the marketplace and increase the odds of future instability. (What Mr. Roche seems to be saying is that the Fed should just set rates across the curve, and chuck the marketplace.  Now THAT's bare-knuckled monetization.  It might work if the Fed could also set a price for oil, food, gold and silver, and make that stick for example.  They are trying with gold, and silver with less success, but not even that much for the others. - Jesse)

8.  Monetization is achieved by act of Congress via deficit spending and is independent of the Fed’s monetary policy. Anyone who uses the term in the context of the Fed’s contribution of government spending does not understand how the modern monetary system works. In a strict technical sense, monetization is always

(This ignores the role of private banks in creating credit which becomes money. Certainly the Congress plays a key role in the creation of money through government spending and the issuance of debt. But the private banking system plays a key role as well. And the gatekeeper for all this is the Fed.   This also ignores the Fed's new ability to buy purely private debt and mortgage obligations. Indeed, as I recall in those distant days when there was a misplaced fear that with its illusory surplus the Fed might run out of sovereign debt to buy, the Fed reassured us that it could buy debt from many other sources. They can do it, and they are doing it. - Jesse)

End Note: It is disappointing to find that these types of discussions too quickly devolve into name calling and sloganeering for one's team, to little benefit except for page clicks and crowd persuasion, which faux reasoning seems to drive too much of the financial reporting today.

Indeed, there seems to be little actual investigative reporting in general being done anymore in the states. And we are seeing far too little reasoning being done from those quarters from which we might expect better. It is too often talking head versus talking head in the staged manner of professional wrestling.  And conspicuous in this deficiency is the economics profession, which too often become a pliable mouthpiece for this or that well-heeled constituency. But it is as one might suppose it to be. There is nothing so corrosive to intellectual integrity as the cover up of a well-intentioned but artificial and inherently deceptive scheme gone badly, and one is caught in a credibility trap.  And of course a status quo based on position and privilege always has its allures.

Many people have raised a voice about the frauds at the center of the financial collapse, and we are at the point where this type of discussion does not matter overmuch; people are going to believe what they wish to believe based on self-interest and the principle of relativism and expediency. Chartalism holds wonderful rewards for those that can pull the levers, and punishment for those who step out of line. 

The problem with these sorts of central command and control constructs is that they assume that men can act with a wonderful enlightment, with the wisdom and selflessness of angels.  Unfortunately they do not often do this.  Such a system is the preferred tool of autocrats, and is inherently inimical to openness and democracy, always requiring secrecy and unilateral power.
“The Constitution is not an instrument for the government to restrain the people, it is an instrument for the people to restrain the government - lest it come to dominate our lives and our interests.” Patrick Henry
One can rationalize almost anything in the service of the power that sets all value and serves none other.  It becomes a matter of duty, of merely following orders.  As an official of another empire destined to its decline once asked, "What is truth?" and then turned and washed his hands of it, which was the expedient thing to do.  Truth is what the few say it is, when the hubris of the will to power is at its zenith. And then it consumes all, for the will to power serves none but itself.

I think there will be a tipping point, some catalyzing event which will spark an unavoidable reaction in the public, in which the people will finally stand and demand justice.  And then some change will come, for good or ill. We are seeing the early stages of that in the world today and in many places where the people are suffering.