Bernanke - We are the agent of the Treasury

Here is a transcript of a section of Ben Bernanke's testimony to the Joint Economic Committee on May 22 in response to a question by Sen. Pat Toomey about how the Fed would have dealt with the effect of hitting the debt ceiling.

(1:34:25) Sen Toomey: So clearly there were plans regarding how to deal with processing of Fed payments, for instance, and other things. Could you give us a sense of what those plans consist of and what you can tell us of those plans?

(1:34:39) Ch. Bernanke: Well, my memory won't be complete, but we looked at our systems and our ability to make payments to principal and interest holders. For the most part we found that we were able to do that with a few possible exceptions - people holding savings bonds and few things that are not as easily connected to the system. We also had some discussion of the kind of policy we would have with banks - with discount window lending would we accept a defaulted treasury - all kinds of things that were contingency planning if this were to happen. What we did not do was directly engage the private sector for any contingency planning. We were mostly looking at our internal systems and our ability to address whatever directions - we are the agent, of course, of the Treasury and it's our job to do whatever they tell us to do. We were just working through our capacity both as an agent and managing the payment system and also as a bank supervisor to deal with a possible default if the debt ceiling was not raised.

h/t to Stephen Kelton for the original tweet 

There are a couple of other gems in this testimony as well

(0:39:50) Ch. Bernanke: Well first let me say, of course, Congress sets the mandate for the Federal Reserve and so Congress has the right, of course, to set the mandate any way it likes.

(1:15:17) Ch. Bernanke: The Fed is doing what Congress told it to do, which is doing our best to promote maximum employment and price stability

The Consolidated Government Sector

The key analytic technique that MMT uses that sets it apart from most others, is that it uses a consolidated government sector in its analysis (although apparently the mainstream is slowly catching on). This allows it to cut through the obfuscating political constructions between the various government departments and institutions and concentrate on the essence of what is happening

This is entirely consistent with accepted accounting practice, using a technique known as group accounting - which produces consolidated financial statements (income, balance and cash) amongst a related group of entities. The international accounting standard for that is IFRS 10 'Consolidated Financial Statements' which requires that entities under common control present a consolidated set of accounts so that external users can obtain a 'true and fair view' of the actual underlying economic transactions.

The Central Bank in all sovereign jurisdictions falls under the definition of control by the Treasury - often de facto by the operation of law (Bernanke: "Our job is to do what Treasury tells us to do"), but also de jure, e.g in the Sterling area HM Treasury actually owns the entire shareholding of the Bank of England. The control model in IFRS 10 is elaborate to try and catch all those little tricks that entities use to avoid having to consolidate accounts and is worth studying to see the various 'Wizard of Oz' methods that control can be imparted even though the public face is supposedly independent.

Given the control relationship, consolidated financial statements are entirely appropriate and correct accounting which reveals the essence of the underlying transactions. Therefore in your model you should be able to swap out the detailed entities and replace them with the consolidated entity and nothing about the response should change. If it does then it is likely your model is wrong.

In Information Systems this is known as white box and black box testing. With white box you can see the internals and with black box you can't - requiring you to conform to that modules interface in your testing.

So let's look at the white box of the UK government sector

Loads going on here with flows flying every which way from both the main government entities and that's without breaking the sub departments out - the Issue and Banking department at the Bank of England, the Asset Purchase Facility and the Debt Management Office. Much is drawn from the current operations document at the Bank of England, HM Treasury's remit to the Debt Management Office but also this rather nice description of the Central government spending flows which has a very useful picture in it:

Importantly what this arrangement of accounts tells you, along with the description of the way Reserve accounts work at the Bank of England, is that spending is disconnected from the debt management operation. All entities operating at the Bank of England have an interest free overdraft available during the day to absorb flow differentials, and this effectively means that they spend first on their accounts and then back fill to the target account balance using standard asset and liability optimisation mechanisms.

Very likely some of the government spending flow out to the private sector stock accounts earlier in the day will flow back later in the day to the National Loans Fund in exchange for Treasury bills or Gilts as a completely separate transaction. Spending therefore demonstrably comes first. Moreover it is in the Debt Management Office's interest for that to be the case since it ensures there will be healthy demand at the funding auctions.

Once you apply group accounting techniques to the government sector you get the black box view - which is remarkably simple.

All the government sector does is allocate tokens to the non-government sector (often in return for some real provision to the government) and then swaps those tokens around for different tokens which attract different income flows and have different liquidity characteristics and holding criteria. The elements this simplification reveals are quite interesting. For example, if I have a young child and qualify, then that child attracts Child Benefit. If I then sell that child to the gypsies, then the gypsies start getting the Child Benefit instead. There is remarkably little difference between a Gilt and a child from the financial systems point of view - a difference in the income stream attached and a difference in liquidity, holding cost, collateral value and issuing criteria :)

With this model you can see that QE is a token exchange - Gilts for Bank Reserves. The income flow goes down - because entities holding Bank Reserves receive less government spending than entities holding Gilts. So you will get a portfolio reconfiguration - since there is less income to go around and the mix of tokens has changed. Bank Reserves have a narrow holding criteria than Gilts and therefore are likely to create offsetting commercial bank deposits that have a wider holding criteria.

The detail is important to understand how the government sector works internally and to understand the actual operations. But it is very easy to end up in a situation where you struggle to see the wood for the trees. Hence why the consolidated government sector is an important modelling tool.

The Sterling Hierarchy of Money

I thought it might be useful to draw up a picture of how the monetary hierarchy works - using Sterling as an example. So here it is:

This is a model of the clearing system and it uses the 'tri-party' model of transactions. Every transaction involves at least two entities and a payment institution. If you pay your garage for a service then the monetary side of the transaction goes via the bank. Even if you pay in cash the garage will bank that cash at some point.

But there are a couple of important points here. The first is that a transaction can cause a cascade of payments through the hierarchy depending upon whereabouts everybody is, and that causes the balance sheets of all the intermediary institutions to change. When you go up and down the hierarchy balance sheets tend to expand and shrink.

Let's run through a use case - the payment of benefits to an individual with an account at a Credit Union. Let's say the Partner's Credit Union which happens to have a clearing account at the Co-op bank in Liverpool.

The first thing that happens is that the Department of Work and Pensions (DWP) uses the Government Banking Service to instruct either Citibank or Royal Bank of Scotland (RBS) to make a payment to the Credit union account.  Let's say Citibank. So in the DWP accounts of Citibank are debited with the payment, and so is Citibank's reserve account at the Bank of England (BoE). That reduces the size of Citibank's balance sheet.

The payment ends up at the Co-op bank which receives a credit to its reserve account at BoE. It then credits the account of the Credit union at the local branch. This increases the size of the Co-op balance sheet.

The credit union notes the payment into its clearing account. It increases the amount in the bank in its accounts and also increases the amount in the credit union deposit account of the particular customer. Again the balance sheet of the credit union expands.

HM Treasury clears with Citibank via the 'Exchequer Pyramid' which sweeps money backwards and forwards between the operational transaction accounts at Citibank and the Consolidated Loan account held at the Bank of England. So in this case Citibank will receive a credit to its reserve account at BOE, and it then credits that to the DWP accounts - expanding Citibank balance sheet once more.

At the Bank of England side there is a debit to the Consolidated Loan account to offset the outgoing payment. The Debt Management Office of HM Treasury records the outgoing payments in its accounts and uses that data as part of its swap management operation to decide which Treasury Bills and Gilts to issue into the market. Importantly though the two flows are not directly connected. Payment and swap flows happen separately (along with the receipt flow from taxation) and the Consolidated Loan account acts as a stock buffer between those flows.

So in summary the accounting transactions are:

• Debt Management Office: DR Government Expenditure, CR Consolidated Loan
• Bank of England: DR Consolidated Loan, CR Citibank Reserve
• Citibank: DR Citibank Reserve, CR DWP Account
• Citibank: DR DWP Account, CR Citibank Reserve
• Bank of England: DR Citibank Reserve, CR Co-op Bank Reserve
• Co-op: DR Co-op Reserve, CR Partners Credit Union Clearing Account
• Partners Credit Union: DR Co-op bank account, CR: Customer's deposit account

The net effect of all that is that Co-op bank and the Credit Union both get an increase in the size of their assets and liabilities. And that's because the Credit Union is a secondary financial institution. 

Making banks work

I think it is probably time to outline how I would reconfigure the banking sector in the UK.

To do that first you have to understand what a bank is and what the point of them are from the perspective of an economic system. For this I refer to Minsky's work on What Banks Should Do.

And that is very simple - promote the capital development of the economy.

About the only reason we should pay bankers to do anything is if they can demonstrate the skill of underwriting capital projects against a prospective income stream.

In simple terms this means somebody going into a bank with a proposal that requires a certain amount of money. The bank staff considers whether the prospective income stream proposed to repay that money is adequate to repay the loan and pay the wages and costs of the bank - including a reasonable return to whatever risk capital underpins the bank.

Note that there is no asset collateral involved in this process.

This underwriting process is of great benefit to all of us as it helps to ensure that we all have jobs and output. And that is why the state stands behind the banking business - helping to make sure that the cost of lending is low - in the hope of promoting that process.

The other reason might be less clear. Banking helps prevent the concentration of equity in society. If I want to start a business and the bank won't lend, then I have to find a rich person and sell them most of my business to get the money necessary to get it going. That turns me from an entrepreneur with ownership into an unpaid lackey dancing to the tune of the Vulture Capitalist class. As Felix Dennis puts it in How To Make Money

All Faustian pacts in the raising of start-up capital should be avoided ... No founder of a business who surrenders control in exchange for capital is ever likely to retrieve control of their business. Their financial destiny is in the hands of others and the entrepreneur has lost their way on the narrow road.

Several of the proposals to narrow banking propose to restrict bank lending far further than is necessary or socially sensible - putting up the cost of lending far too high.

Lending

When I was 17 and was looking to start my first business I went to see an old grizzled business advisor. And about the first thing he said was that British Banks don't do their job. That job is the distribution of new state backed money to those who can make use of it to develop the capital of the country. The problem of getting lending to businesses has been around for a very long time.

The lending banks we need are the ones that can lend development capital effectively and stick to doing just that. If we are to have private lending banks, then they need to be able to make a decent profit doing development capital lending.

The way I would narrow banks is to offer them an incentive - an unlimited cost free overdraft at the Bank of England. 0% funding costs. In return they must drop all the side businesses and just do capital development lending on an uncollateralised basis - probably in the form of simple overdrafts. In other words they become an agency businesses delivering state money to those that require it.

I'm not even sure a capital buffer is required here. Losing your lending licence if your underwriting isn't that good should be sufficient incentive to run a tight ship. Backing off the entire thing to the central bank reduces the barriers to entry in lending - making self-employed, highly dispersed and, importantly, locally focussed underwriters a possibility (the 'Provi Model').

Any lending businesses that doesn't want to take the oath, then has to fully fund their lending on a maturity matched basis Zopa style. No deposit insurance, no access to the Bank of England, and losses absorbed by those doing the lending. This then becomes the fate of the shadow banking system - the building societies and money funds.

So that sets state funded lending against fully match-funded lending in competitive tension. State funding will likely be conservative but actually injects extra net financial assets into the non-government sector economy. Fully funded lending is just patient man helping impatient man for a fee in return for the risk.

Now narrowing banking in any way will put the cost of lending up markedly - particularly if you de-collateralise to get away from asset bubble spirals. With the current level of loans that is likely to cause fun and games. So you have to get the total amount of lending down at the same time as the narrowing is put in place.

Probably the quickest way to do that is via a debt jubilee, where everybody gets a set amount of money from the state to set against a loan. That way loan amounts, property values and the level of lending all go down at the same time, and those currently without loans get the cash as compensation for loss of asset value.

So with complete disintermediation by the central bank you can have several models - from a fully nationalised state bank with employed underwriters, through the 'Provi Model' where you have self-employed lenders and collectors, to the normal bank with employed bank managers.

The amount of state money injected is limited by demand - as determined by a highly distributed set of underwriters locally on the ground varying interest rates to suit local conditions and their own profitability vs the competition from fully match funded lenders.

That is a flexible system that can respond rapidly to changes in circumstances and is infinitely superior to a cabal of the elite sat in luxurious surroundings in London trying to work out how much the economy requires by applying the Wisdom of Solomon that they don't really have.

A National Bank Transaction System

The retail bank transaction system is the circulation of our economy - interruptions can prove dangerous and perhaps fatal.  As Cypriots recently found, most of us can only operate for a few days without access to a cash-point or online banking transaction service.  

Transaction banking services are a national dependency, just as our body depends on the circulation system to pump blood around the system.  This dependency is currently held entirely within the hands of privately-owned, dubiously managed, mixed-market banking organisations.  Any threat to their monopolies or their bonuses, and the transaction banking system gets it.  The Government, fearing a Cypriot-style crisis or queues at the Northern Rock, capitulates, and Osborne goes to Brussels to argue for bigger banker bonuses.

Even the wildest free-marketeers would hesitate to place our entire road network in private hands, so banking transactions should be protected in the same way.

There is no such thing as 'cash in the bank' if you're beyond the central bank's deposit insurance limit (note I didn't say "state's insurance limit" - only the central bank can provide reliable deposit insurance). At that point you're a risk investor in the bank as many in Cyprus have recently found out.

The transaction system is clearly being used as a hostage by the banks to get whatever they want out of the government and the central bank. Do as we say or we shoot the transaction system!

The transaction system has to continue to function in the event of a bank failure.  Funds held in transactional accounts should be unaffected by that bank failure. The bank illusion of money in the vault has to be replaced with the reality of money in the vault. It can never be allowed to be shattered otherwise you get a sudden shift in expectations at best and cascade failure of businesses at worst.

But that can't be done by simply propping up banks no matter how ridiculous they behave. Capitalism without losses is like Catholicism without hell-fire. It no longer works as a concept. Bad lenders have to be allowed to fail.

Additionally the transaction system is a massive cost overhead to banks and they hate it. Every bank has a unique system, they are fundamental incompatible and that means the duplication between banks is colossal. I've done quite a bit of work on bank transaction systems over the years and the scale dis-economies are quite spectacular. And so they follow management fads - like outsourcing and offshoring - that do little more that shuffle the costs around the business. The recent failure of the RBS transaction system is a case in point.

The banks can do things together. APACS (now UKPA) and LINK show what can be done with mutual co-operation. That needs to be taken one step further, with the transaction system incorporated into a similar body.

There are lots of ways of designing a mutual transaction system. But at its core is one concept - that transactions operate on the balance sheet of the central bank, not the individual banks. So you would have a Transaction Department at the Bank of England (alongside the Issue and Banking Departments) and current and savings account ultimately represent liabilities on that balance sheet.

The functional aspects are less important - existing bank accounts could be held in trust by the current banks, run as separate subsidiaries companies and a myriad of different other options. But the key point is that the operational entity is acting as agent and the legal ownership and responsibility is always at the central bank. That makes anything recorded in the transaction system exactly the same as holding cash. You have a receipt for liabilities at the central bank.

However that makes the individual banks short of deposits and balancing liabilites. The replacement on the individual bank's balance sheets is of course an overdraft from the central bank - as mentioned in the section on lending. Existing banks would then have to get the match funding to free themselves from the central bank lending restrictions, conform to requirements or just enter run-off.

The transaction system is like the road or rail infrastructure and is a common good required by all. Inevitably the state will have to fund its existence - because there is no money in running it. I see the state providing a 'white box' system that anybody authorised can put a marketing veneer on. Done correctly it would mean that you can literally operate your bank accounts through any of the competing front ends. Account numbers would stay the same whoever you are notionally with.

Shadow banks would just have an account on the transaction system like everybody else and would lend by advance - paying money from their account into somebody else's. Overdrafts would be authorised by the underwriters for state funds. All that does is lower the limit at which transactions are refused to somewhere below zero. You could have a combined savings/transaction account by allowing the customer to increase the limit at which transactions are refused above zero.

This design maintains the mutual elements of the UK banking system - our common cash machine system and payments infrastructure as well as the 'free banking' transaction system, it frees the lenders from a crippling cost obligation and it ensures that everybody can rely on 'cash in the bank' being there - regardless of the turmoil in the lending institutions.

The one casualty is interest on deposits. To have interest on deposits in a private system there has to be income from somewhere else to pay that interest. Therefore in this system it becomes a line item of government spending - likely via interest bearing accounts for individuals at National Savings. Paying interest on deposits in this way is then really just the same as paying coupons on Gilts. Gilts, of course, would cease to be issued under any rational government.

Summary

Much of this is an amalgam of ideas from all over the place. There's nothing new as such - perhaps just a slightly different arrangement.

There are some key points though:

• People who put money in the banks believe they are storing an asset safely. It's important that the reality reflects that belief. The bank illusion must be maintained at all times - whether individual institutions fail or not.
• We can keep the free banking and mutual nature of our cash machines and payments system. It's a good thing to have a freely available rapid transaction system just like it is a good thing to have freely available banknotes and coins.
• Lenders have to be allowed to go bust. Constant forbearance is a bad thing in a capitalist system. Failures must fail and the costs borne by those funding those operations. The state's job is to mitigate the effects of failures in the private capitalist system.
• Lending of state money is a valuable way of dynamically increasing and shrinking the money supply. It's automatic and distributed. It helps the capital development of the economy and helps to dilute the ownership of equity. But the nature of that lending has to be tightly controlled.
• Getting the state to lend directly via agents in the field would lower the barrier to entry in lending.

UK: Vacancy Ratio and People Wanting Work - Mar 2013

People wanting work. There's a definitely drop from the peak, but overal the number of people in the pool isn't going down that much.

The ratio of people out of work wanting work to vacancies. This continues to fall, and the vacancies seem to be with larger companies.

The UK participation rate.

This is the ratio of those 'in the labour force' (ie unemployed and employed) to the household population. It differs from the ONS's 'employment rate' in that it doesn't exclude those over 65 (although over 65s who want a job are still classed as 'retired').
This is still historically in very high territory.

Source: Office of National Statistics, tables MGSC (ILO Unemployment Level Ages 16-64 - Quarterly seasonally adjusted), LFM2 (Inactive - wants a job - Quarterly seasonally adjusted), YCCX (Part time workers - reason for working part time, could not find full time job - Quarterly seasonally adjusted), AP2Y (All vacancies - Quarterly seasonally adjusted), MGSL (LFS Household Population - all aged 16 and over - Quarterly seasonally adjusted) and MGRZ (Employment Level - all aged 16 and over - Quarterly seasonally adjusted).

The misuse of the fiscal multiplier

The misuse of the fiscal multiplier effect is beginning to annoy me and it's about time that the record is set straight on the issue.

You are seeing classic lines like this :

Tax cuts are only one third as effective as government investment in new capital spending projects

and the propaganda is then backed up by some magic number calculation that shows the multiplier is 1.5 for capital spending and 'only' 0.5 for tax cuts. Obviously the bigger number is better because, well, it always is isn't it.

On the other side you have this belief that if the multiplier is less then 1 for any activity then you shouldn't undertake it.

Let's expose the assumptions those statements are based upon:

1. There is a fixed amount of money available
2. If the government spends from this fixed pot of money, it automagically crowds out an alternative activity with a multiplier of one.
3. That you can ignore the effect on the distribution of savings.

All of those beliefs are rubbish.

Let's look at what the multiplier is first so you can understand what is underneath the numbers. 

The multiplier is fairly straightforward. If the government gives money to somebody then they will spend some of it and save some of it. What they spend likely causes a real transaction to occur - and an amount of taxation. What they save will either go to reducing debt or building up financial savings. And in either case the banking system retains what isn't taxed away as bank reserves.

What is spent becomes somebody else's income. Rinse and repeat. 

The calculation of the multiplier however only adds up the GDP impact of the transactions over a time period. It is silent on the impact of extra savings caused by the process. And that is where the problem starts.

Firstly it biases the multiplier against tax cuts. The mathematics of the multiplier demonstrates that clearly. It's standard knowledge in simple Keynesian Models that the tax multiplier = 1 - spending multiplier.

So obviously the fiscal multiplier for a tax cut is going to be less than equivalent government spending. That's because you are, as a matter of policy, allowing extra savings first before any consumption happens. Duh!

Secondly the debate is always based upon an amount of government expenditure. Function finance thinking shows this is putting the cart before the horse. Rather than saying how much output can we get for £10bn of government action, we should be saying given we have a GDP output gap of £80bn how much do we need to deploy on the various policies to get that - given the multipliers and savings/income distribution of those policies.

Thirdly there is this idea that government actions inevitably prevents private sector action. This is crowding out again. Endogenous money theory demonstrates that the money supply is elastic. It goes up and down as required by the demands in the economy. You won't run out of money. So if there is stuff stood idle, it can always be brought into use without affecting anything else.

So suggesting that government action with multipliers less than one shouldn't happen is nonsense. It ignores the value of net-savings. It ignores the obvious point that a do-nothing alternative means that nothing additional happens.

Relieving the burden of debt on individuals is a valuable action. It makes them feel more secure and therefore more likely to spend in the future. It reduces the size of bank's balance sheet in the economy and allows you to narrow them more easily - diluting their economic power so that they are no longer too big to fail.

I think that's something we should be looking at doing. Yet you'll still get people pointing out that it has a low fiscal multiplier and we'd be better off building bridges to nowhere instead.

There's more to this game than GDP I feel. The distribution of net-financial assets matters.

Why Citizens Income/Universal Pension/Income Guarantee can't work

Sometimes I find the quality of debate depressing. In this paper, supposedly on idleness, there isn't a single mention of generating a permanent direct job programme that ensures that people have something to do. It's all indirect and hairy fairy. Irritating. Stick tax rates up on rich people and give it to the poor; that'll cure it. Nirvana will be with us by Tuesday lunch. Honestly, the ideas haven't really evolved since Robin Hood's days.

If the market equilibrium processes worked we wouldn't need to intervene.

Stuff for people to do doesn't turn up magically - it has to be created and organised. You can't just give people money and expect it all to sort itself out. The economic system has systematically failed to create adequate work for people to do. Why on earth would anybody think that if you just shuffle the cash around it would magically create an adequate standard of living? It's a pipe-dream.

If there is one thing to be taken from MMT it is that there is no direct connection between money and stuff. The monetary circuit and the real production circuit have no direct link. Instead the process operates more like electrical induction. Sometimes the flow of money induces lots of efficient real production, sometimes the same flow of money induces nothing of real benefit at all.

Assuming a one-to-one correlation between money and stuff is a dangerous simplification that will lead you into error.

I'm very grateful that Pavlina Tcherneva has taken the time to write up the argument for why we need a proper Job Guarantee - an alternative job offer available to all at the living wage working to further the public good - that helps anchor the monetary and real circuits together. And I can do no more than offer a quote from that paper - which I would encourage you all to read in full.

For a genuine transformation within the marketplace or the household, an active agent of change is needed. Income support programs are passive agents of change – they make their recipients invisible and hide them from the sphere of most socio-economic life. Even if income afforded greater degree of freedom to individuals, transformative changes occur when individual action is harnessed by institutions that can propel the collective interests forward. The JG is just such an institution—it puts human needs first and redefines what is “efficient” from what is “profitable” to what is “socially useful”. It engages its members directly in the goal of advancing the public purpose and is therefore a program that promotes inclusion.