Monday, 14 April 2014

Just a few things on modern central banking

To clear up a few operational things about the modern fiat system under which we live.
First, the purpose of the CB itself is not to "print" money when the private sector "needs" it. In a freefloating nonconvertible fiat regime, money is endogenous. The CB serves simply as the scorekeeper; think of it as a massive spreadsheet with all the accounts of the government and nongovernment sector - all the pluses with all the corresponding minuses.
The term "printing money" is that operation in which new net financial assets are created. The CB cannot do this by itself; only the federal government can do it via fiscal policy (via fiscal deficits). All transactions within the private sector net to 0. Loans create deposits. Every liability has a corresponding asset.
That being said, private banks are NOT constrained by reserves. They do not loan out reserves; they are only constrained by the actual demand for credit. That's why QE isn't doing anything vis-a-vis revitalizing crediting, since households want to deleverage not to acquire new debt.
Also, the procedure of QE is not money printing.

When the Fed creates $85 billion, it uses this money to buy bonds - typically split 50/50 between US Treasuries and Mortgage Backed Securities (MBS). Here is what's important: When the Fed creates and gives $85 billion in reserves to its member banks, it removes $85 billion worth of assets (bonds) from the balance sheets of those same member banks. The result is that no new net financial assets enter the economy. This bears repeating. Every time the Fed injects $85 billion in reserves (assets) into the economy, it removes $85 billion worth of assets from the economy. This process is not a one way flow of money into the economy, as interpreted by some.

In conclusion, monetary policy doesn't impact employment, growth, and inflation the way traditional/orthodox textbooks tell you it does. Monetary policy in and of itself is a blunt instrument at best. With fiscal policy you tame inflation vis-a-vis demand shocks; not with interest rates. And as such, the natural interest rate of fiat money is 0. Fiat money is tax-driven money; it's not a commodity - it's just a tax-credit. Given its nature, a currency sovereign can never run out of it. Things like the labor force and unused resources - those are the real constrains of society; not money or credit.