Friday, 13 April 2012

The fixed exchange rate system at the heart of MMT

Out of the debate over at Steve Keen's blog a key point arose that I figured would be worth breaking out:

Have you ever wondered why banks denominate their accounts in the liabilities of another bank? That can only be because they are in a fixed exchange arrangement with that other bank – which they are required to maintain.

MMT primarily describes the policy benefits of a particular system – one where the private banks are locked in a fixed exchange rate system for their own liabilities with the liabilities of one or more central banks under a legally enforced arrangement, but where that central bank floats their own liabilities on the currency markets.

It also describes the follies that ensue when the central banks fix the exchange rate of their liabilities with each other or with a supranational central bank.

To pay your taxes you need to present the government’s own bank’s liabilities to settle that debt. If you don’t then you haven’t settled them.

Therefore for the taxes to be credited to the National Loan Fund Account or Consolidated Fund Account (using the UK as an example), the banks making the payment have to have access to central bank liabilities.

It is the function of the intermediary Government Banking Service to translate whatever liabilities the punter provides into central bank liabilities which can be transferred to the Tax accounts at the central bank.

And that is the key driver in the system. The operation of the tax account at the central bank is the way that central bank liabilities are given to and taken from the private banks rather than lent to them.

And that matters – due to the fixed exchange rate between the central bank and the private banks.

I’ll use Treasury rather than Government. Government owns or controls both the central bank and the Treasury in modern states. MMT generally consolidates the balance sheets of Treasury and Central Bank to avoid the confusion of the internal transactions.

The Treasury can’t create central bank money. If it credits an account, one has to be debited as well. The tri-party transaction involves the Treasury, the central bank and the private bank.

What the Treasury is doing functionally is purchasing new private bank liabilities with central bank liabilities via the internal fixed exchange rate mechanism.

So an amount of central bank liabilities are transferred to the private bank. That causes the private bank to increase its own assets and liabilities via the fixed exchange rate structure. Those private bank liabilities are then transferred to the target of Treasury’s beneficence.

You’ll note that mechanism is functionally the same as the private bank issuing a loan. Assets and liabilities are increased and the private bank receives an income from the assets (interest on reserves). It is forced private bank money creation.

Similarly in reverse. The overburdened tax payer presents some private bank liabilities to the Government Banking Service at a private bank. The private bank transfers some central bank liabilities to the Treasury central bank account and the private bank extinguishes an amount of its own assets and liabilities under the fixed exchange rate mechanism to maintain parity with the central bank.

Again functionally the same as paying off a private loan. Assets and Liabilities go down and the private bank loses the income from the assets. In other words forced private money destruction.

The relationship of Government to central bank is generally one of beneficial owner (and often legal owner). Therefore it can direct the bank and Treasury receives the bank dividend. Pretending otherwise is a fantasy.

So not only can it drain its account balance to spend, it can ultimately ‘borrow’ from the central bank and cause the central bank to enter into money creation – unless the Government as a whole has signed up to some supranational pact preventing that by treaty (and the Government wishes to abide by the treaty).

And that’s the key to Treasury Bonds and Cash. Both are the same thing really. Cash is a bearer bond directly representing Central Bank liabilities. Treasury bonds are Treasury liabilities operating as a proxy for Central Bank liabilities.

To purchase both you have to have central bank liabilities. So issuing either of them to third parties is destructive to private bank money via the fixed exchange mechanism. In the same way as tax or paying off a loan they both reduce the assets and liabilities of the private banks – and therefore their income.

Treasury Bonds then wander off value-wise on their own merry way. But Treasury Bonds denominated in the liabilities of the Central Bank will always be worth the same as Cash the day before the Bond redemption date – unless the government in question is prevented by treaty from directing the central bank to create money (or the Government has gone mad and voluntarily decided to default).

That understanding that the central bank is ultimately the creature of Government is what controls the price of government bonds. The markets know that the central bank can (and importantly will) switch them for private bank liabilities in a flash – and they are not going to get such a good deal on the private bank liabilities.

And if you have a hog-tied central bank or a government that is known to be reticent at deploying its central bank for whatever ideological reason then you end up with issues. Hence the problem with the Eurozone.

For me the key to this whole system is the central bank – the one highest in the hierarchy of liabilities that floats its own liabilities – and the mechanism by which its liabilities are given to other entities, lent to other entities or taken away from them.

The operational differences between lending those liabilities and giving and taking them away in this fixed exchange rate structure with private liabilities is the bit that is fascinating systemically.

Who decides whether to lend or give is a political question.