Are the Bank of Canada's bond purchases illegal?

Pierre Poilievre, Conservative MP for Carleton, alleges that the Bank of Canada's bond buying program contravenes the Bank's powers enunciated in the Bank of Canada Act.

The unprecedented money printing the government is doing to fund its spending is not only causing an inflation tax, it is illegal under the Bank of Canada Act. pic.twitter.com/KDfJd3niPJ

— pierrepoilievre (@PierrePoilievre) July 20, 2021

Allegations that the Bank of Canada has broken the law should be taken very serious. They should not be made lightly, either. We give our public servants at the Bank of Canada a wide range of powers to enact monetary policy, but only within the bounds that we permit them.

Poilievre has been actively criticizing the Bank of Canada's pandemic response ever since Covid-19 hit in 2020. I can't say I've ever seen as much Bank of Canada-targeted criticism emanating from a single Canadian politician since Poilievre began his campaign. It breaks with a long Canadian political tradition of staying (mostly) silent on the Bank of Canada's operations.

I have mixed feelings about Poilievre's approach. Yes, it's great to have more public discussion about arcane topics like the Bank of Canada Act. On the other hand, up till now Canada has avoided most of the hyperbole and conspiracies that bedevil U.S. central banking. It would be nice if things stayed that way.

Poilievre's allegations were first aired in Parliament in June. A month later he posted them on Twitter, where I became aware of them. (They garnered over 900 retweets, which is a lot for a tweet about an arcane issue like the Bank of Canada Act!) Poilievre's claims are based on his reading of Section 18(j) of the Bank of Canada Act. Section 18(j) allows the Bank to make loans to the Federal government, but those loans should not "exceed one-third of the estimated revenue of the Government of Canada for its fiscal year."

Poilievre calculates that given 2021 government revenue estimates, this would cap Bank of Canada loans to the Federal government at $118 billion. Poilievre then points to the Bank of Canada's purchases of Government securities, which have pushed the Bank's holdings of Federal government debt above the $400 billion level. Poilievre suggests that this contravenes 18(j).

The allegations caught the attention of columnist Andrew Coyne, who takes a dig at Poilievre:

Alternatively, there’s your theory that the Bank has illegally purchased $300 billion in government bonds and no one noticed it but you.

— Andrew Coyne (@acoyne) July 20, 2021

In fairness to Poilievre, it's not unimaginable that the Bank of Canada has done something illegal and no one has noticed but him. 

Back in August 2007, after all, the Bank of Canada announced its intention to extend its purchases of certain kinds of securities. It was responding to the first signs of a nascent crisis in credit market. Unfortunately it lacked jurisdiction to purchase these instruments. Its actions were unwound by September 2007 in order to bring the Bank back in compliance with the Bank of Canada Act.

I only know this because I phoned the Bank of Canada up that August wondering what legal justification it had for its actions. Several awkward conversations later, it was apparent that a mistake had been made by bank officials.

My observations made their way into a report that December for the CD Howe Institute. From there a process to update the Bank of Act began. After discussions in Parliament (including a contribution from then-governor Mark Carney here) the eventual result was an update to the Act in the spring of 2008. Tucked into Bill C-50, changes included striking out Section 18(k) and rewriting Section 18(g).

These modifications to the Bank of Act made it permissible for the Bank of Canada to conduct the purchases it had originally set out to do in August 2007, and prepped it for the much bigger fallout to come: the September 2008 credit crisis.   

So maybe Poilievre has caught a breach of law. It's happened before. That being said, echoing Coyne (who cites economist Mike Moffatt), I'm not convinced by the meat of Poilievre's argument.

In response to Poilievre's allegations about 18(j) being broken, Bank of Canada officials would probably respond that their large-scale asset purchases are authorized under Section 18(g).

The Bank of Canada's ability to make securities purchases for monetary policy purposes is set out in Section 18(g), which replaced the much narrower 18(k) in 2008. The scope of Section 18(g) is very broad. First, it is open-ended about what instruments it allows the Bank to purchase. These securities can include bonds, stocks, commercial paper, mortgage-backed securities, and more.* Second, 18(g) doesn't say anything about the Bank's purchases needing to happen in the open market. If necessary, the Bank of Canada can buy straight from the issuer.

The bit of legalese that Poilievre points to, 18(j), only applies Bank of Canada loans to the Government, say a line of credit or some other type of credit facility. Because the Bank has limited its interaction with the government to buying securities, 18(j) hasn't been triggered. And so Poilievre's allegations are just that, allegations.

Section 18(j) was devised to prevent the Bank of Canada from financing the government and preserving the Bank's independence, as Poilievre rightly points out here. And I think that's a laudable goal.

In that spirit, it's worth considering that most (but not all) of the Bank of Canada's purchases of government bonds have occurred in the open market. That is, most of the securities in the Bank's government bond portfolio were bought only after the public had initially purchased them from the Government. So in a sense, the Bank has prudently removed itself from the initial price discovery process.  

More specifically, the Bank has purchased $362 billion in Government bonds since March 2020. Of that amount, $303 billion, or 84%, was bought in the open market. The remaining $59 billion was bought directly from the Government.

Since the pandemic broke out in March 2020, the @bankofcanada has bought $362 billion worth of Federal government bonds. Most of these have been bought in the open market, but 16% ($56 billion) were bought directly from the government at periodic bond auctions.

Running tally: pic.twitter.com/DbNoS1819r

— John Paul Koning (@jp_koning) July 26, 2021

Even when the Bank does participate in bond auctions, it does so on a non-competitive basis. That is, the Bank pays the average of all competitive bids submitted to the auction. The competitive bids are provide by banks and other primary dealers. This practice further prevents the Bank of Canada from playing an active role in setting the government's cost of capital.

So to sum up, I think the Bank of Canada is on firm legal ground. Furthermore, I also think the spirit of 18(j), a prohibition on financing the government, remains intact.

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* The one security that Section 18(g)(i) deems to be off limits are instruments that "evidence an ownership interest or right in or to an entity." If I recall correctly refers to certain types of asset-backed commercial paper (ABCP).

How the Bank of Canada's balance sheet went from $118 billion to $440 billion in eight weeks

Ever since the coronavirus hit, the Bank of Canada's balance sheet has been exploding. In late February its assets measured just $118 billion. Eight weeks later the Bank of Canada has $440 billion in assets. That's a $320 billion jump!

To put this in context, I've charted out the Bank of Canada's assets going back to when it was founded in 1935. (Note: to make the distant past comparable to the present, the axis uses logarithmic scaling.)

The rate of increase in Bank of Canada assets far exceeds the 2008 credit crisis, the 1970s inflation, or World War II. Some Canadians may be wondering what is going on here. This blog post will offer a quick explanation. I will resist editorializing (you can poke me in the comments section for more colour) and limit myself to the facts.

We can break the $320 billion jump in assets into three components:

1) repos, or repurchase agreements
2) open market purchases of Federal government bonds
3) purchases of Treasury bills at government auctions.

Let's start with repos, or repurchase operations. Luckily, I don't have to go into much detail on this. A few weeks back Brian Romanchuk had a nice summary of the Bank of Canada's repos, which have been responsible for $185 billion of the $320 billion jump.

With a repo, the Bank of Canada temporarily purchases securities from primary dealers, and the dealers get dollars. This repo counts as one of the Bank of Canada's assets. Some time passes and the transaction is unwound. The Bank gets its dollars back while the dealers get their securities returned. The asset disappears from the Bank of Canada's balance sheet.

The idea behind repos is to provide temporary liquidity to banks and other financial institutions while protecting the Bank of Canada's financial health by taking in a suitable amount of collateral. If the repo counterparty fails, at least the Bank of Canada can seize the collateral that was left on deposit. This is the same principle that pawn shops use. The reasons for providing liquidity to banks and other financial institutions is complex, but it goes back to the lender of last resort function of centralized banking. This is a role that central banks and clearinghouses inherited back in the 1800s.

How temporary are repos? And what sort of collateral does the Bank of Canada accept? In normal times, repos are often  unwound the very next day. The Bank also offers "term repos". These typically have a duration of 1 or 3-months. The list of repo collateral during normal times is fairly limited. The Bank of Canada will only accept Federal or provincial debt. That's the safest of the safe.

But in emergencies, the Bank of Canada is allowed to extend the time span of its repos to as long as it wants. It can also expand its list of accepted collateral to include riskier stuff. Which is what it did in March 2020 as it gradually widened the types of securities it would accept to include all of the following:

Source: Bank of Canada

That's a lot of security types! (The list is much larger if you click through the above link to securities eligible for the standing liquidity facility, see here. Nope, equities are not accepted as collateral.)

As for the temporary nature of these repos, many now extend as far as two years into the future. See screenshot below:

Source: Bank of Canada

(Note that the Bank of Canada has a very specific procedure for moving from "regular" purchases to "emergency" purchases. Part of this was implemented due to its initial reaction in 2007 to the emerging credit crisis. It accidentally began to accept some types of repo collateral that were specifically prohibited by the Bank of Canada Act. The legislative changes implemented in 2008 remedied some of the problems highlighted by this episode and codified the process for going to emergency status. Yours truly was involved in this, click through the above link.)

Anyways, we've dealt with the $185 billion in repos. Now let's get into the second component of the big $320 billion jump: open market purchases of long-term government bonds, or what the Bank of Canada refers to as the Government of Canada Bond Purchase Program (GBPP). This accounts for another $50 billion or so in new assets.

Whereas a repo is temporary, an outright purchase is permanent. Some commentators have described the purchases that the GBPP is doing as "quantitative easing". But the Bank of Canada has been reticent to call it that. When it first announced the GBPP, it said that the goal was to "help address strains in the Government of Canada debt market and enhance the effectiveness of all other actions taken so far."

This is a non-standard reason. Large scale asset purchases are normally described by central bankers as an alternative tool for stimulating aggregate demand. Usually central banks use interest rate cuts to get spending going. But when interest rates are near 0% they may switch to large scale asset purchases. (The most famous of these episodes were the Federal Reserve's QE1, QE2, and QE3). But the Bank of Canada seems to be saying that its large scale purchases are meant to fix "strains" in the market for buying and selling government bonds, not to stoke the broader economy. 

Together, the GBPP and repos account for $235 billion of the $320 billion jump.

Let's deal with the last component. Another $65 or so billion in new Bank of Canada assets is comprised of purchases of government Treasury bills (T-bills). A T-bill is a short term government debt instrument, usually no more than one year. This is interesting, because here the Bank of Canada can do something a lot of central banks can't.

Most central banks can only buy up government debt in the secondary market. That is, they can only purchase government bonds or T-bills that other investors have already purchased at government auctions. The Bank of Canada doesn't face this limit. It can buy as much government bonds and T-bills as it wants in the primary market (i.e. at government securities auctions).

Since the coronavirus crisis began, the Federal government under Justin Trudeau has revved up the amount of Treasury bills that it is issuing. As the chart below illustrates, in the last two Treasury bill auctions (which now occur weekly instead of every two weeks) it has raised $35 billion each.

For its part, the Bank of Canada bought up a massive $14 billion at each of these auctions. That's 40% of the total auction. In times past, the Bank of Canada typically only bought up around 15-20% of each auction. This 15-20% allotment was typically enough to replace the T-bills that the Bank already owned and were maturing.

By moving up to a 40% allotment at each Treasury bill auction, the Bank of Canada's rate of purchases far exceeds the rate at which its existing portfolio of T-bills matures. And that's why we're seeing a huge jump in the Bank of Canada's T-bill holdings.

(So who cares whether the Bank of Canada buys government bonds/T-bills directly at government securities auctions instead of in the secondary market, as it is doing with the GBPP?  It's complicated, but part of this controversy has to do with potential threats to the independence of the central bank. But as I said at the outset, I'm resisting editorializing.)

These three components get us to $300 billion. The last $25 billion is due to other programs. I will list them below and perhaps another blogger can take these up, or I will do so in the comments section or in another blog post:

+$5 billion in Canada Mortgage Bonds
+$5 billion in purchases via the Provincial Money Market Purchase Program (PMMP)
+$1 billion in Provincial bonds
+$8 billion in bankers' acceptances via the Bankers' Acceptance Purchase Facility (BAPF)
+$2 billion in commercial paper
+$1 billion in advances

And that, folks, is how the Bank of Canada's assets grew to $440 billion in just two months.

Fiatsplainin'

I am a big fan of coinsplainers like Andreas Antonopoulos. Listening to Andreas explain how bitcoin works is a great learning opportunity for folks like myself who know far less about the topic. I am less impressed when bitcoiners engage in fiatsplainin', since they generally have an iffy understanding of the actual financial system and central banking in particular.

So for the benefit of not only bitcoiners, but anyone interested in the topic of money, I'm going to fiatsplain' a bit. (I really like this term, I got it from an Elaine Ou blog post)

Paul Krugman recently had this to say about the difference between bitcoin and fiat money:

"So are Bitcoins a superior alternative to $100 bills, allowing you to make secret transactions without lugging around suitcases full of cash? Not really, because they lack one crucial feature: a tether to reality.

Although the modern dollar is a “fiat” currency, not backed by any other asset, like gold, its value is ultimately backed by the fact that the U.S. government will accept it, in fact demands it, in payment for taxes. Its purchasing power is also stabilized by the Federal Reserve, which will reduce the outstanding supply of dollars if inflation runs too high, increase that supply to prevent deflation.

Bitcoin, by contrast, has no intrinsic value at all. Combine that lack of a tether to reality with the very limited extent to which Bitcoin is used for anything, and you have an asset whose price is almost purely speculative, and hence incredibly volatile."

Now if you've been reading my blog for a while, you'll know that I agree with Krugman's point that bitcoin lacks a tether to reality while a banknote doesn't. He mentions two forces that anchor a $100 banknote, or provide it with intrinsic value: tax acceptability and a central bank's guarantee to regulate its quantity. Let's explore each of these anchors separately, starting with tax acceptability.

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The idea that taxes can determine the value of a fiat currency is easier to grasp by looking at currencies issued during the American colonial era. Coins tended to be scarce in the 1700s and there were few private banks, so the legislatures of the colonies issued paper money to meet the public's demand for a circulating medium. They had a neat trick for ensuring that this paper money wasn't deemed worthless by citizens. A fixed quantity of paper money was issued concurrently with tax legislation that scheduled a series of future levies large enough to withdraw each of the notes that the legislature had issued. This combination of a fixed quantity of notes and future taxes of the same size was sufficient to give paper money value, since the public would need every bit of paper to satisfy their tax obligations.

Examples of colonial currency (it's worth enlarging this image to see the detail) From: Early Paper Money of America

Crucially, once a colonial government had received a note in payment of taxes, it removed said note from circulation and destroyed it. If the government re-spent notes that had already been used to discharge taxes, this would be problematic. The tax obligation would be more-than-used-up, leaving no reason for the public to demand outstanding banknotes. Krugman's "tether to reality" would have been removed.

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The modern day version of Krugman's tax acceptability argument is a bit more complicated. For starters, no one actually pays their taxes with banknotes. Rather, the tax acceptability argument applies to a second instrument issued by central banks otherwise known as reserves (in the U.S.) or settlement balances (in Canada). All commercial banks keep accounts at the central bank, these accounts allowing them to make instant electronic payments to other banks during the course of the business day, or to the government, which typically will also have an account at the central bank.

When Joe or Jane Public are ready to settle their taxes, they initiate a set of financial transactions that ultimately results in their bank depositing funds on their behalf into the government's account at the central bank. To satisfy the public's demand to make tax payment, commercial banks will want to have some central bank settlement balances on hand. So the existence of taxes "drives" banks to hold a certain quantity of central bank settlement balances, thus generating a positive price for these instruments. And since a banknote is in turn tethered to a central bank deposit via the central bank's promise to convert between the two at par, by transitivity the banknote is also tethered.

Unlike the colonial era, however, the tax authority—the government—can't destroy money. The government can either accumulate central bank deposits, or spend them, but it can't cancel them. What generally happens with the government's account at the central bank is that as soon as it is topped up with some tax receipts, they get quickly spent on government programs, salaries, and other expenses. So these funds simply boomerang right back into the accounts that commercial banks keep at the central bank, undoing the tethering that is achieved by tax acceptability.

Put differently, for every bank that demands settlement balances to pay taxes, and thus help gives those balances value, there is a government official who spends them away, and negates this value. So government taxes by themselves don't anchor modern central bank money.

To really anchor the value of central bank money, the government needs to withhold from spending the money it has received from taxes. The more it resists spending incoming tax flows, the more balances accumulate in its account at the central bank. If the government keeps doing this, at some point almost every single deposit that the central bank has ever issued will have been sucked up into the government's account. With almost no deposits remaining for paying taxes—and thus no way for the public to avoid arrest for failure to meet their tax obligations—the value that banks collectively place on deposits will reach incredible heights.

And that explains how tax acceptability (combined with a strategy of not spending taxes received) can provide modern fiat money with backing sufficient to generate a positive price.

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Let's turn now to Krugman's second reason for central bank money having intrinsic value, the central bank itself. As I said earlier, a government can freeze deposits by accumulating them, but it can't destroy them. The only entity that can destroy money is the central bank. It achieves this is by conducting open market sales of bonds and other assets. When it sells a bond to a bank, the central bank gets one of its own deposits in return, which it proceeds to destroy.

Imagine that banks collectively decide they have too many central bank deposits and start to sell them (a scenario I discussed here). This sudden urge to rid themselves of money will cause inflation. In a worst case scenario, they will get so desperate that the purchasing power of money falls to zero. The central bank can counter this by selling assets and destroying deposits. In the extreme, it can sell each and every one of the assets it owns, shrinking the deposit base to zero. Its actions will drive the value of deposits into the stratosphere, since banks need a token amount to make interbank payments.

And that, in short, explains how central banks can provide dollars with backing sufficient to generate a positive price.

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Which of Krugman's two forces—tax acceptability or a central bank's guarantee to regulate the quantity of money—is more important for imbuing little electronic bits with value?

We know that a government can anchor a fiat money purely through tax acceptability. Colonial money proves it. (Here is another example from the Greenback era) But can a fiat currency be anchored solely through the actions of the central bank, without the help of tax acceptability? Let's set the scene. Imagine that the government has unplugged itself from the central bank by closing its account and instead opening accounts at each of the nation's commercial banks. Since all incoming tax receipts and outgoing government payments are now made using private bank deposits, the government no longer generates a demand for central bank settlement balances.

This "unplugging" needn't drive the value of central bank money to zero. The central bank has assets in its vault, after all, so any decline in the value of central bank money can be easily offset by an appropriate set of central bank open market sales and concomitant reductions in the quantity of deposits. So the answer to my question in the previous paragraph is that money doesn't require tax acceptability to have intrinsic value. Tax acceptability is sufficient, but not necessary.

That being said, on a day-to-day basis the value of modern central bank money is regulated by a messy combination of both factors. Money is constantly flowing in and out of the government's account at the central bank, and this can have an effect on the purchasing power of money. Likewise, central bank open market operations are frequently conducted on a daily basis in order to ensure the system has neither a deficiency nor an excess of balances. It's complicated.

And that ends this episode of fiatsplainin.' Fiat money is indeed backed and has intrinsic value, as Krugman says, and it does so for several reasons.

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PS. If you are interested in colonial currency, you should read some of Farley Grubb's papers.

Addendum:

On Twitter, someone had this to say about my post:

Ummm one may pay taxes in Arizona in Bitcoin.

Argument fails on factual grounds.

Bitcoin is tethered to reality. @paulkrugman https://t.co/Z8ojvzw8FX

— ฿ryce Weiner (@BryceWeiner) March 22, 2018

฿ryce gives me the perfect opportunity to keep fiatsplainin'. Contrary to ฿ryce's claim, the fact that Arizona plans to accept tax payments in the form of bitcoin does not provide bitcoin with a tether to reality. For every bitcoin that Arizona accepts, it will just as quickly spend it away. The first is undone by the other. You'll notice that this is the same reason I gave for modern central bank money not necessarily being anchored by tax acceptability; whereas taxes vacuum up central bank money, government officials typically reverse this vacuum by quickly spending it, so the net effect is a wash.

To tether central bank money to reality, governments need to not only make it tax acceptable but also  be ready to let those balances pool up in its account, thus setting a limit on the overall supply of balances. Likewise with bitcoin. If the Arizona government were to accumulate incoming bitcoins as part of an overall policy of never spending them, then it would be removing bitcoins from circulation, in essence "destroying" them. And this would provide bitcoin with a true anchor. Of course the Arizona government isn't going to do this. It will want to rid themselves of bitcoins the moment it gets them.

From corporate bonds to a fiat CPI standard

Michigan Central Railroad 3.5% Bearer Bond with attached coupons, 1902

David Glasner is frustrated that there is no satisfactory theory of the value of fiat money, noting that "it's just a mess, a bloody mess, and I do not like it, not one little bit."

According to David, the core problem is the backward induction argument. Say that a valued fiat object provides no non-monetary services so that its price depends entirely on the expectation of future resale. This is a highly precarious situation since it it inevitable that someday no one will want to exchange for that fiat object. But if it is certain that no one will accept it at some point in the future, then why accept it in the first place? The explanation for the object's value rests on an "unlimited supply of suckers", as David puts it, hardly good fodder for a long term theory of asset prices.

David proposes tax acceptability as his way out of the problem, although he doesn't seem to be entirely convinced by this explanation. (I've never liked the tax-acceptability theory, as I wrote here. )

But there may be another solution to the backwards induction problem. I'm going to show that the market establishes the value of modern fiat money under a CPI standard in the exact same way that it establishes the value of a very familiar instrument; the standard corporate bond. Since corporate bonds are not subject to the backwards induction critique, then by analogy neither should fiat paper. What follows is a gradual progression from the one to the other with the aim of showing that if you can value a bond you can value a Federal Reserve note.

1. Start with a company, say Apple, that in addition to issuing corporate stock issues bonds. These are regular bonds. Each of them has a recurring quarterly claim on a nominal quantity of Apple income as well has the right to a final return of principal upon maturity. Should Apple be liquidated, bond holders get a first claim on whatever remains of the business. The market takes these terms and conditions into account and establishes a market price for the bonds. Pretty standard stuff.

2. A few years later Apple converts some of its bonds into bearer form, ie. they are printed on paper and transferable by hand, while leaving the rest unaltered. It issues these bearer bonds in both small denominations like 1/10, 1/4, 1, 5, and 10 units, as well as large 100 and 500 denominations. Attached to each bearer bond is a series of coupons. To receive interest, the bond owner detaches the coupon and brings it to Apple each quarter in return for a dollar payment.

Despite these changes, the market continues to value bearer bonds in the same way as the firm's regular bonds. Still pretty standard.

3. Next Apple ceases to periodically redeem its bearer bonds when they mature, converting them into perpetual bearer bonds. A perpetual is not as valuable as an equivalent series of redeemable Apple bonds, but the market can still establish a positive price for a perpetual debt instrument as easily as it can a fixed term bond.

4. Say that Apple begins to accept these perpetual bearer bonds as payment at Apple stores. Other merchants copy Apple. Bearer bonds become a highly liquid exchange medium. A liquidity premium develops, with Apple bearer bonds often trading at a higher price than Apple's regular bonds, despite the former being perpetual instruments. (Apart from the unusually large liquidity premium on bearer bonds, this is still pretty standard stuff.)

5. As the liquidity services thrown off by Apple's perpetual bearer bonds grows, Apple realizes that it can reduce the coupon rate it offers without losing too many investors. Apple eventually ceases paying any interest at all—owners of bearer bonds are sufficiently happy with the liquidity return provided by the bearer bonds that they do not require a pecuniary return. The bonds have effectively become "cash", or 0% yielding paper notes.

The market values these no-interest bonds in the same way they do the normal bonds. Both have first dibs come final liquidation of Apple. The difference is that whereas the regular bonds are fixed term, bearer bonds are perpetual; regular bonds pay interest while bearer bonds don't; and the bearer bonds carry a large liquidity premium whereas the regular bonds are illiquid.

6. The economy begins to spontaneously de-dollarize and Apple-ize. Merchants first set prices in terms of both "Apples" and dollars, and eventually just Apples. Debt contracts are redenominated into Apples. The market will continue to value both bearer and normal bonds in the same way as before.

7. Initially the Apple price level moves around according to the whims of the market. Later, Apple decides to stabilize prices by targeting a 0% rate of growth in the price of a basket of consumer goods, a CPI basket. One way it can do so is by varying the quantity of Apple bearer bonds in the economy via open market operations. If Apple increases the amount of bearer bonds via open market sales, then the liquidity premium on bearer bonds is reduced and the price level rises. If it engages in open market sales, the amount of bearer bonds is decreased, their liquidity becomes more valuable on the margin and the price level falls.

Alternatively, Apple can vary the 0% coupon rate on bearer bonds. If the purchasing power of Apple bearer bonds is rising, i.e. the economy is characterized by deflation, Apple can counteract this by reducing the coupon rate (to the point of even introducing a negative Gesell tax), thereby making bearer bonds less attractive and forcing the price level back up. By increasing the fixed coupon payment, it can do the opposite and prevent inflation.

8. Now Apple decides to let bearer bonds fall at 2% a year, or allow them to purchase 2% less of the consumer basket each year. As in step 7, it varies the coupon rate or conducts open market operations to counteract any forces that would prevent it from hitting its target.

We have now arrived at a modern fiat CPI standard. What was once a standard bond has been converted into a highly liquid perpetual bearer instrument with a 0% coupon (flexible upwards or downwards) that falls in value by 2% a year, and also happens to be the economy's medium of account.  This modified bond is the equivalent of the so called "fiat money" issued by the likes of the Fed and the Bank of Canada, or what is otherwise known as cash. Since the market can easily value Apple's regular bonds without falling prey to the David's backwards induction problem, then surely it can value Apple's modified bond after taking into account all the extra bells and whistles that have been added in steps 1 to 8.

(With apologies to Nick Rowe)

Rates or quantitites or both

Roaming around the econ blogosphere, I often come across what seems to be a sharp divide between those who think monetary policy is all about the manipulation of interest rates and those who think it comes down to varying the quantity of base money. Either side get touchy when the other accuses its favored monetary policy tool, either rates or quantities, of being irrelevant. From my perch, I'll take the middle road between the two camps and say that both are more-or-less right. Either rates, or quantities, or both at the same time, are sufficient instruments of monetary policy. Actual central banks will typically use some combination of rates and quantities to hit their targets, although this hasn't always been the case.

Just to refresh, central banks carry out monetary policy by manipulating the total return that they offer on deposit balances. This return can be broken down into a pecuniary component and a non-pecuniary component. By varying either the pecuniary return, the non-pecuniary return, or both, a central bank is able to create a disequilibrium, as Steve Waldman calls it, which can only be re-equilibrated by a rise or fall in the price level. If the net return on balances is sweetened, banks will flee assets for balances, causing a deflationary fall in prices. If the return is diminished, banks will flock to assets from balances, pushing prices higher and causing inflation.

The pecuniary return on central bank balances is usually provided in the form of a promise to pay interest, or interest on reserves.

The non-pecuniary return, or convenience yield, is a bit more complicated. I've talked about it before. In short, it's sorta like a consumption return. Because central bank balances are useful in settling large payments, and they are rare, banks find it convenient to hold a small quantity of them as a precaution against uncertain events. This unique convenience provided by scarce balances is consumed over time, much like a fire extinguisher's property as a fire-hedge is consumed though never actually mobilized. By increasing or decreasing the quantity of rare balances, a central banker can decrease or increase the value that banks ascribe to this non-pecuniary return.

Now some examples.

The best example of a central bank resorting solely to the quantity tool in order to execute monetary policy is the pre-2008 Federal Reserve. Before 2008, the Fed was not permitted to pay interest on reserves (IOR). This meant that the only return that Fed balances could offer to banks was a non-pecuniary convenience yield, a point that I described here. By adding to or subtracting from the quantity of balances outstanding the Fed could alter their marginal convenience, either rendering them less convenient so as to drive prices up, or more convenient so as to push prices down.

The Bank of Canada is a good example of a central bank that uses both a quantity tool AND an interest rate tool, though not always both at the same time. Since 1991, according to Mark Sadowski, the BoC has paid interest to anyone who holds overnight balances. This is IOR, although in Canada we refer to it as the deposit rate. In addition to paying this pecuniary return, BoC balances also yield a non-pecuniary return. Banks who hold balances enjoy a stream of consumptive returns, or a convenience yield, that stems from both the rarity of BoC balances and their exceptional liquidity.

The best way to "see" how these two returns might be decomposed is by looking at the short term rental market for Bank of Canada balances, or the overnight market. In Canada, this rate is called CORRA, or the Canadian overnight repo rate. A bank will only part with BoC balances overnight if a prospective borrower promises to sufficiently compensate the lending bank for foregone returns. Assuming that the Bank of Canada's deposit rate is 2%, a potential lender will need to be compensated with a pecuniary return of at least 2% in order to dissuade them from socking away balances at the BoC's deposit facility.

The lender will also need to be compensated for doing without the non-pecuniary return on balances. If the overnight lending rate, CORRA, is 2.25%, then we can back out the rate that a lender expects to earn for renting out the non-pecuniary services provided by balances. Since the lender of balances receives the overnight rate of 2.25% from the borrowing bank, and 2% of this can be considered as compensation for foregoing the 2% pecuniary return on balances, that leaves the remaining 0.25% as compensation to the lender for the loss of the non-pecuniary return.

So in our example, the pecuniary and non-pecuniary returns on BoC balances are 2% and 0.25% respectively, for a total return of 2.25%.

The Bank of Canada meets each six weeks, as Nick Rowe points out, upon which it promises to provide banks with a given return on settlement balances, say 2.25%, for the ensuing six week period. When it next meets, the Bank will  introduce whatever changes to this return that are considered necessary for it to hit its monetary policy targets. The BoC can modify the return by changing either the pecuniary component of the total return, the non-pecuniary component, or some combination of both.

Say it modifies only the non-pecuniary component while leaving their pecuniary return untouched. For instance, with the overnight rate trading at 2.25%, the BoC might announce that it will conduct some open market purchases in order to increase the quantity of balances outstanding, while keeping the deposit rate fixed at 2%. By rendering balances less rare, purchases effectively reduce the non-pecuniary return on balances. As a reflection of this shrinking return, the overnight rate may fall a few basis point, or it may fall all the way to 2%. Whatever the case, the rate at which banks now expect to be compensated for foregoing the non-pecuniary return on balances has been diminished. Banks will collectively try to flee out of overpriced clearing balances into assets, pushing up the economy's price level until balances once again provide a competitive return. This sort of pure quantity effect is the story that the quantities camp likes to emphasize.

The story told by the quantities camp is exactly how the BoC loosened policy between April 2009 and May 2010. At the time, the BoC injected $3 billion in balances *without* a corresponding decrease in the deposit rate. The overnight rate fell from 0.5% until it rubbed up against the 0.25% deposit rate. The lack of a gap between the overnight rate and the deposit rate indicated that the injection had reduced the overnight non-pecuniary return on balances to 0%. After all, if lenders still expected to be compensated for forgoing the non-pecuniary return on balances, they would have required that the overnight rate be above the deposit rate.

The BoC's decision to reduce the overnight non-pecuniary return on balances to 0% would have generated a hot potato effect as banks sold off lower-yielding BoC balances for higher-yielding assets, thus pushing prices higher. A change in quantities, not rates, was responsible for the April 2009 to May 2010 loosening.

Likewise, in June 2010, the BoC tightened by using quantities, not rates. Open market sales sucked the $3 billion in excess balances back in, thereby increasing the marginal convenience yield on central bank balances. The deposit rate remained moored at 0.25%, but the overnight rate jumped back to 0.5%, indicating that the overnight non-pecuniary return on balances had increased from 0% to 0.25%. This sweetening in the return on balances would have inspired a portfolio adjustment away from low-yielding assets into high-yielding central bank balances, a process that would have continued until asset prices had fallen far enough to render investors indifferent once again along the margin between BoC deposits and assets. Once again quantities, not rates, did all the hard work.

While the BoC chose to tighten in June 2010 by changing quantities, it could just as easily have tightened by changing rates. For instance, if it had increased the deposit rate to 0.5% while keeping quantities constant, then the net return on balances would have risen to 0.5%, the same return that was generated in the last paragraph's quantities-only scenario. This sweetening in the return on balances would have caused the exact same chain of portfolio adjustments and falling asset prices that the quantities-only scenario caused.

Alternatively, the BoC could have tightened through some combination of quantities AND rates. It might have increased the deposit rate from 0.25% to 0.4%, and then conducted just enough open market sales to increase the non-pecuniary return on balances from 0% to 0.1%, for a total combined return of 0.5%. The ensuing adjustments would have been no different than if tightening had been accomplished by quantities-only or rates-only.

Putting aside the period between April 2009 and June 2010, does the Bank of Canada normally execute monetary policy via rates or quantities? A bit of both, I'd say. At the end of a six week period, say that the Bank wishes to tighten. It typically tightens by announcing a 0.25% rise in its target for the overnight rate combined with a simultaneous 0.25% rise in the deposit rate. The overnight rate, or the rental rate on clearing balances, will typically rise immediately by 0.25%, reflecting the sweetened return on balances.

Did rates or quantities do the heavy lifting in pushing up the return on balances? Put differently, was it the threat that open market sales might increase the convenience yield on balances that tightened policy, or was it the improvement in the deposit rate? I'd argue that the immediate punch would have been delivered by the change in the deposit rate. CORRA, the rental rate on balances, jumped because overnight borrowers of BoC balances were suddenly required to compensate lenders for the higher pecuniary rate being offered by the BoC on its deposit facility. Quantities don't enter into the picture at all, at least not at first. The rates-only camps seems to be the winner.

However, as the ensuing six-week period plays out, market forces will push the rental rate on BoC balances (CORRA) above or below the Bank's target, indicating an improvement or diminution of the total return on balances. The BoC has typically avoided any incremental variation of the deposit rate to ensure that the rental rate, or return on balances, stays true to target over the six week period. Rather, it has always used quantity changes (or the threat thereof) to modify the non-pecuniary return on balances during that period, thereby steering the rental rate back towards target. First rates, and then quantities, conspire together to create Canadian monetary policy.

To sum up, the Bank of Canada's monetary policy is achieved, it would seem, through a complex combination of rate and quantity adjustments. The rates vs. quantities dichotomy that sometimes pops up on the blogosphere simplifies what is really a more nuanced story. Monetary policy can certainly be carried out by focusing on quantity adjustments to the exclusion of rate adjustments (as was the case with the pre-2008 Fed) or vice versa . However, modern central banks like the Bank of Canada use rates, quantities, and some combination of both, to achieve their targets.

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Note: The elephant in the room is the zero-lower bound. But the zero lower bound needn't prevent rates or quantities from exerting an influence on prices. On the rates side of the equation, the adoption of a cash-penalizing mechanism along the lines of what Miles Kimball advocates would allow a central bank to safely push rates below zero. As for the quantity side of the equation,  the threat of Sumnerian permanent increases in the monetary base may not be able to reduce the overnight non-pecuniary return on balances once that rate has hit zero, as Steve Waldman points out... but they can certainly reduce the future non-pecuniary returns provided by balances. Reductions in future non-pecuniary returns should be capable of igniting a hot potato effect, albeit a diminishing one, out of balances and into assets.

Toying with the monetary transmission mechanism

Does it matter what the Fed buys? ...from whom? ...or how? I don't think so.

The Fed currently buys and sells government-issued and guaranteed securities from designated primary dealers. It does so publicly and transparently. In the case of QE, it announces ahead of time the quantities it will purchase. Prior to 2008, it announced that it would conduct enough purchases to drive the fed funds rate up or down by x%.*

But let's modify the monetary policy transmission mechanism a bit. Say that a few years from now the Fed decides to buy and sell bitcoin, bitcoin claims, and other cryptocoins instead of government securities. Rather than executing these trades through a select posse of firms, it'll transact broadly with Joe Public. And rather than announcing purchasing intentions, it will carry them out surreptitiously. Big as these changes may seem, altering the route won't impede the transmission of monetary policy. Whether it quietly buys bitcoin from the public or pre-announces government bond purchases with primary dealers, the Fed will still continue to keep a firm grip on the economy's price level.

There are a few ways for a hypothetical bitcoin transmission mechanism to work. Here's one way. Say the Fed wants to loosen policy and push prices up by, oh, 5%. Fed officials fan out across the US, looking for local bitcoin over-the-counter exchanges. Bitcoin OTC markets exist on street corners, in coffee shops, houses, cafés, public libraries, city parks, and bars. These informal OTC exchanges are where Joe Public congregates to truck and barter bitcoin. Once located, the Fed officials begins to write out cheques to OTC traders in exchange for bitcoin at the going market price. The Fed now has bitcoin on the asset side of its balance sheet. OTC traders have Fed cheques which they proceed to deposit at their local bank.**

So far the Fed's purchases haven't had an effect on the price level — neither the price of bitcoin nor the price of goods have budged. Note that even if Fed officials accidentally nudge bitcoin OTC prices up a bit through their buying, arbitrageurs will quickly counterbalance this by routing sales away from centralized bitcoin exchanges like Mt-Gox (assuming it still exists in a few years) to OTC markets, driving OTC prices back to their fundamental value.

The OTC traders' Fed cheques having been deposited in the banking system, banks proceed to load them into Brinks trucks for delivery to the local district Fed for clearing and settlement. During the clearing process, a large settlement imbalance in favor of private banks emerges, an imbalance that has arisen thanks to the Fed's cheque-writing campaign. The Fed settles its debts by crediting the reserve accounts of creditor banks with newly created deposits.

Only now is our bitcoin transmission mechanism poised to push prices higher. Banks collectively find themselves with an excess stock of reserves. But there is no place for this excess to go. Within the next few hours, banks will madly compete to get rid of their reserves. They'll do so by buying up financial assets like bonds, stocks, MBS, and bitcoin from other banks.*** As a result of their combined efforts, the prices of all these assets will quickly rise. Put differently, the purchasing power of reserves will fall. This decline will only stop when the purchasing power of reserves has fallen to a low enough level that they are once again willingly held by bankers. While this will happen very fast with financial asset prices, stickier prices like goods and labour will take longer to adjust upwards.

In a nutshell, that's how the Fed's bitcoin purchasing policy succeeds in increasing the price level. And if the Fed falls short of hitting its 5% growth target, it need only send out more officials to write more checks for more bitcoin until it hits its mark.

Let's make a few changes to our transmission mechanism. To streamline the process, the Fed decides to funnel purchases to a select number of bitcoin dealers rather than spraying them broadly. Should the Fed require it of them, these chosen dealers are required to quote the quantity of bitcoin they are willing to sell and at what price.

Does the decision to funnel purchases rather than spray them change anything? Not at all. Fed cheques are still deposited by bitcoin sellers at their banks and these checks are settled with reserves. Whether funneling or spraying, banks still end up with an excess reserve position which they will try to rectify by simultaneously buying up assets. The only resolution to this will be a quick rise in prices. A primary bitcoin dealer system, it would seem, is no different a transmission mechanism than our earlier broad Joe Public approach.

The Fed may even require that bitcoin dealers hold inventories of government bonds and submit bond quotes from time to time in addition to bitcoin quotes. Even if the Fed decides to purchase bonds rather than bitcoin, nothing about the transmission mechanism changes—Fed cheques still result in excess reserve positions at banks, and these can only be equalized by a rise in prices. But now we're back at our current system in which primary dealers sell bonds to the Fed.

The Fed may even start to publicly announce its intentions to make bitcoin purchases rather than surreptitiously writing checks. Anticipating that they will soon be inundated with excess reserves upon hearing the announcement, banks won't wait for the reserves to arrive before trying to offload them. Rather, they'll sell immediately. This will quickly push asset prices higher. Smart speculators and investors, anticipating that forward-looking bankers will quickly spend their reserves after the Fed announces its intention to buy bitcoin, will try to beat the bankers to the punch by purchasing assets the moment an announcement is made.

So when the Fed's purchasing intentions are announced, market prices adjust even before the Fed carries out the actual purchases. Without an announcement, however, the cheques must physically enter the economy and cause a reserve imbalance before prices begin to adjust, a process that will only start a day or two after and will proceed in a jagged manner.

The upshot of all this is that it doesn't matter what the Fed buys, nor from whom. Monetary policy works irrespective of the route. As for the "how",  the Fed's decision to publicize their intention to make bitcoin purchases rather than quietly writing out cheques has the effect of dramatically speeding up what would otherwise be a circuitous transmission process.

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* For simplicity, I'll be assuming a world in which the Fed doesn't pay interest on reserves.
** Even if OTC traders don't accept cheques, they'll accept bank notes, and the same analysis applies.
*** In addition to purchasing financial assets, banks will try to lend them away to other banks in the interbank market, receiving the overnight interest rate in return. This will cause the interbank lending rate to fall. 

Give Bernanke a long enough lever and a fulcrum on which to place it, and he'll move NGDP

I'm running into a lot of central bank doubt lately. Mike Sax and Unlearning Economics, for instance, both question the ability of the Federal Reserve to create inflation and therefore set NGDP. The title of my post borrows from Archimedes. Give any central banker full reign and they'll be able to increase NGDP by whatever amount they desire. But if rules prevent a central banker from building a sufficiently long lever, or choosing the right spot to place the fulcrum, then their ability to go about the task of pushing up NGDP will be difficult. It is laws, not nature, that impinge on a central bankers ability to hit higher NGDP targets.

Sax and Unlearning give market monetarists like Scott Sumner, king of NGDP targeting, a hard time for not explaining the "hot potato" transmission mechanism by which an increase in the money supply causes higher NGDP. I'm sympathetic to their criticisms. I've never entirely understood the precise market monetarist process for getting from A to B to C. Nick Rowe would probably call me out as one of the people of the concrete steppes, and no doubt I'd be guilty as charged. But I've always enjoyed looking under the hood of central banking in an effort to figure out how all the gears interact.

Nevertheless, I agree completely with the market monetarists that, at the end of the day, a central bank can always advance NGDP to whatever level it desires, as long as the central banker is unrestrained and willing. As Scott Sumner says, "I don't care if currency is only 1% of all financial assets. Give me control of the stock of currency, and I can drive the nominal economy and also impact the business cycle."*

Given the opacity of the market monetarist mechanism, here's my own explanation for how central banks can jack up the price level to whatever height they desire.

The central bank's Archimedean lever is their ability to degrade, or lower the return, on the dollar liabilities it issues. Any degradation in central bank liabilities must ignite a "musical chairs" effect as the banks holding these now inferior liabilities madly seek to sell them. Their value will fall to a lower level (ie the price level will rise) until the market is once again satisfied with the expected return from holding them… at least until the central bank starts to degrade their return again. Because an uninhibited central bank can perpetually hurt the quality of its issued liabilities, it can perpetually create higher inflation and NGDP. It only hits a limit when it has degraded the quality of its liabilities to the point of worthlessness. When that happens the price level ceases to exist.

Let's get more specific on how a central bank degrades the return on its liabilities.

Any central bank that pays interest on deposits can degrade their return by pushing interest rates down. From an original position in which all asset returns are equal, a decline in rates suddenly makes central bank deposits worse off than all other competing assets. Profit-seeking banks will simultaneously try to offload their deposits in order to restore the expected return on their portfolios. But not every bank can sell at the same time, so the price of deposits must drop. Put differently, inflation occurs. Once deposits have fallen low enough, or alternatively, once the price level has inflated high enough, the expected return on deposits will once again be competitive with the return on other assets. Voilà, NGDP is at a new and higher plateau.

Many central banks don't pay interest on deposits. Rather, they keep the supply of deposits artificially tight and force banks to use these deposits as interbank settlement media. The difficulty of obtaining these scarce deposits, combined with their usefulness in settlement, means that deposits yield a large non-pecuniary return. A non-pecuniary return is any benefit that doesn't consist of flows of money (ie dividends or interest). A banker enjoys the steams of relief and comfort thrown off by a central bank deposit, just as a consumer enjoys the shelter of a house or the beauty of gold jewelery.**

Just as a central bank can degrade the pecuniary interest return on deposits, it can degrade their non-pecuniary return. It does so by injecting ever more deposits into the system. With each injection , the marginal deposit provides a steadily deteriorating non-pecuniary benefit to its holder. The bigger the glut of deposits, the worse their return relative to all other assets in the economy. Banks, anxious to earn a competitive return, will race to sell their deposit holdings. The price of deposits will drop to a sufficiently low enough level to coax the market to once again hold them. This is inflation.

But what if a central bank needs to degrade its assets even more than this in order to get NGDP to rise? Can it inject more deposits? This will achieve little because once deposits are plentiful, their non-pecuniary benefit hits zero. When there is no non-pecuniary return left for a central bank to reduce, successive injections will be irrelevant with regards to the price level. More on this later.

Can it reduce interest rates below zero? We know this will pose a problem because if the central bank embarks into negative territory, it risks having all of its negative yielding deposits being converted into 0% yielding cash. And when this happens the central banks loses its interest rate lever altogether. This is the so-called zero-lower bound.

But all is not lost. In order to forestall a mass conversion of negative-interest central bank deposits into 0% yielding cash, Miles Kimball has proposed that a central bank need only cease par conversion between deposits and dollar notes. The introduction of a floating rate would allow a central bank to set a penalty on cash conversion such that when rates fall below zero, cash yields the same negative return as deposits. This removes the incentive for people to “simply hold cash”. With this mechanism is in place, interest rates can easily be moved into negative territory, thereby pushing up prices and NGDP.***

But let's say Miles's option is off the table. A second approach is the New Keynesian one. Even if a central bank can't make their depositors worse off today -- they already pay the minimum 0%, after all, and can't go lower -- a central banker can promise to make depositors worse off tomorrow by maintaining rates at 0% for longer than they otherwise should. To avoid being hurt tomorrow, depositors will simultaneously try to offload the central bank's liabilities today until their price reaches a level low enough to compensate the market. Thus a promise to degrade in the future creates present inflation and higher NGDP.

QE is another oft-mentioned approach for increasing NGPD, but it won't be very effective. If deposits on the margin have already ceased providing non-pecuniary returns, introducing more of them makes little difference. As I noted in these two posts, large purchase will only have an effect if they were carried out at the wrong prices. Here, the Fed would be effectively "printing" new liabilities and purchasing an insufficient amount of earnings-generating assets to support those liabilities. As long as the market doesn't expect the government to bail out the irresponsible central bank by immediately topping it up with new assets, central bank liabilities will be forthwith flagged as being more risky. This means that relative to other assets, the return on deposits is now insufficiently low. Only a fall in their price, or inflation and higher NGDP, will coax investors to hold deposits again.

The above is a very Sproulian way of hitting higher NGDP targets.

Because modern-day QE has been carried out at market rates in big, liquid markets, and not at the wrong prices, central banks doing QE have amassed a sufficient amount of earnings-generating assets to support their liabilities, and therefore fail to compromise their underlying quality. QE is a poor lever for increasing inflation and hitting higher NGDP.

Here is the last Archimedean lever for degrading central bank liabilities and pushing up NGDP. As I've already pointed out, the New Keynesians want to reduce the present interest return on deposits by attacking future returns. We can appropriate this forward-looking strategy and use it to attack the future non-pecuniary returns provided by deposits.

Say that a central bank promises to put off making deposits scarce again in the future. Put differently, it says that it won't mop up excess deposits with open market sales till well-after the expected date. This means that the future reversion of deposits to their special status as 'rare settlement asset' will have been pushed down the road. As long as this commitment is credible, then the market's assessment of the future marginal non-pecuniary return thrown off by a deposit -- a function of their rarity -- will be reduced. Today's deposit holders, conscious of not just present but future returns, will now be holding a worse asset than they were before the announcement. They will simultaneously try to sell deposits until their price has fallen to a low enough level to bribe the market into once again owning deposits . Once again, we've created inflation and higher NGDP.

This last lever seems to me to be a decent market monetarist transmission mechanism. You'll notice that it is similar to the New Keynesian lever in that it endeavors to reduce the present return on deposits by promising to attack their future return. Maybe that's why I've had so many difficulties dehomogenizing Krugman and Sumner -- they both want to attack future returns. Where the argument between them gets heated concerns the specific return each group wants to attack: New Keynesians want to push down future interest rates, whereas Market Monetarists absolutely despise talking in terms of interest rates.

From a concrete steppes person to any market monetarists who may be reading this: what do you have to say about the above transmission mechanism? In emphasizing the importance of the quantity of money and expectations, aren't market monetarists really just proposing to attack the future non-pecuniary return on deposits? Aren't they guaranteeing to put off sucking out excess deposits till well after they responsibly should?

Recapping, here are the various sure-fire Archimedean levers for pushing NGDP up, even when interest rate are at 0% and deposits plentiful:

1. Miles Kimball's floating conversion rate and negative returns
2. Sproulian purchases at wrong prices****
3. Krugman's New Keynesian credible commitment to keep future interest rates too low
4. Market monetarist's credible commitment to keep future non pecuniary returns too low

Now some of these techniques are legal and some aren't. The most direct ones are not, namely Miles's negative interest rates and open market operations at silly prices. I call these the most direct strategies because their success doesn't depend on long range commitments to attack future returns. The problem with commitments to reduce future returns, i.e. numbers 3 and 4, or the "Krugmnerian" position, is that they require future central bankers (and their political masters) to uphold their end of the bargain. If the market has little confidence in the wherewithal of future central bankers to carry through on their predecessor's promises, then a central bank will not be able to reduce present returns by attacking future returns. Positions 1 and 2, on the other hand, directly reduce today's returns on deposits and therefore are less dependent on the future actions of others.

So to sum up, to doubt that a central bank can drive up NGDP is to doubt that the central bank can manipulate their omnipotent Archimidean lever, namely their ability to degrade its own liabilities. Certain laws might prevent degradation. So do frictions put up by the politically-linked nature of central bank policy. But as long as these impediments are removed, then nothing can prevent a central bank from pushing up NGDP.

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Notes:
You can accept all of these points and still believe in so-called "endogenous money". It doesn't change anything.  

* For now I'm agnostic about the last bit of Scott's phrase, namely "impact the business cycle". In this post I've worked purely with the price side of things. The careful reader may notice that Scott's quote is a working-over of an old Rothschild quote: "Give me control of a nations money supply, and I care not who makes it’s laws." 
** Another word for non-pecuniary return is convenience yield. When writing in a purely monetary context, I've referred to the specific non-pecuniary return provided by exchange media is their monetary optionality, or their moneyness.
*** One other lever for degrading is a policy of randomly freezing deposits. I've written about this here. Say that deposits are plentiful such that the marginal deposit no longer yields a non-pecuniary return. It's still possible to decrease this return even further. Say banks face the possibility that the central bank might randomly block their access to deposits for a period of time. Central bank liabilities, once excellent settlement media, are no longer as effective due to potential embargoes preventing them from serving that purpose. Their non-pecuniary return now less than before, banks will hastily try to sell deposit holdings in order to maintain the expected return of their portfolios. Prices rise, as does NGDP. Like negative interest rates, at some onerous rate of embargoing deposits, depositors will flee into non-embargoed 0% cash. So some scheme like Miles Kimball's floating exchange rate between cash and deposits is necessary to prevent mass conversion into paper.
****I'm not saying Mike Sproul necessarily advocates this policy, but if he did need to jack up inflation, I think it might be one of his go-to options since it is entirely consistent with his "backing" theory.

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Changes
21.08.2103 -  I'd be guilty [as charged]

Market monetarists and "buying up everything"

Market monetarists have a reductio ad absurdum that they like to throw in the face of anyone who doubts the ability of central banks to create inflation. It goes like this; "So, buddy, you deny that central bank purchases can have an affect on the price level? What if a central bank were to buy up every asset in the world? Wouldn't that create inflation?" Since it would be absurd to disagree with their point, the buying up everything gambit usually carries the day.

In this post I'll bite. I'm going to show how a money issuer can buy up all of an economy's assets without having much of an effect on the price level.

Let's return to my Google parable from last week. You don't have to read it, but you should. If you don't have the time, here's a brief summary. In an alternate world, Google stock has become the world's most popular exchange media and all prices are expressed in terms of Google shares. Google conducts monetary policy by changing the return it offers shareholders, thereby ensuring the price level is stable. The reason I'm using a Google monetary world rather than our own is that it cuts through all the accumulated baggage associated with our central bank-dominated monetary discussion. A new set of lenses may let us see a bit more clearly.

Say that financial assets trade at or near fundamental value, where fundamental value is the present value of returns to which assets are a claim. Deviations from fundamental value are fleeting since investors will either buy undervalued assets or short overvalued ones.

Google announces that it wants to double the price level, or, alternatively, to cut the value of Google shares in half. It will go about this by purchasing financial assets until this target has been met. [One niggling detail here is that Google's charter prevents it from consciously overpaying for assets. More on this later]

Google starts printing huge amounts of new shares and injecting them into the economy by buying stocks, bonds, commercial paper, derivatives, and whatnot. Their wallets flush with new Google cash, individuals start to spend away unneeded cash balances, putting downward pressure on Google's share price, and upward pressure on prices. Google's mandated doubling of the price level seems well on its way to being fulfilled.

But something halts the decline. The moment that anxious sellers push Google shares below fundamental value, investors step in and buy all shares offered. No matter how long Google's buying rampage continues, and how large the supply of Google cash in the economy, these investors mop up all unwanted shares. This has the effect of putting a floor under the price of the stock, and vice versa places a ceiling on the amount of inflation that can be created. Thanks to the investment demand for its shares, Google can buy up all the world's assets while hardly causing an increase in the price level.

The reason that investors willingly set a floor beneath Google's stock price is that Google is buying up assets at market prices, as stipulated by its charter. In buying at these prices, Google's fundamental value will never change, no matter how many shares it prints. Say that equity in our Google universe tends to trade at a risk-adjusted multiple of 10x earnings (i.e. a share is worth ten times current per-share earnings). Since Google is prohibited from paying more than 10x risk-adjusted earnings for the assets it acquires, and is itself valued at the same 10x earnings multiple, its fundamental value after each acquisition remains the same. In other words, Google has the same per-share earnings throughout its purchasing campaign. When anxious transactors try to rid their wallets of the excess exchange media created by Google "printing", -- say they drive Google shares towards 9x earnings -- savvy investors will immediately jump in and buy the undervalued stock, enjoying a free lunch until they've pushed Google's price back up to its fundamental value of 10x earnings.

So contra the market monetarist claim, the economy's reigning monetary superpower can print and buy up all the world's financial assets -- yet not cause inflation.

There are a few simplifications I've made here. Acquirers incur transaction costs. Commissions must be paid to investment bankers, for one. Secondly, there really is no such thing as "one market price". Financial assets trade in a range called the bid-ask spread. If Google always buys at the higher ask price rather than patiently waiting to be filled at the lower bid price, then it will consistently lose small amounts on each transaction. This means that after each acquisition, Google's fundamental value will have declined by a few beeps, and investors will bid Google shares down a bit. But this transaction effect is small, nor is it equivalent to the effect that market monetarists are talking about when they refer to central bank power over the price level.

Now back to the real world. Whatever general rules of finance that apply to Google's highly liquid financial media apply just as ably to the Fed's highly liquid financial media. See my previous post on this. So take out every mention of Google share in the above text and substitute it with Fed deposit and the same conclusions can be drawn.

Lastly, just like Google's charter prevents it from overpaying, the Federal Reserve Act specifies that the Fed must buy all assets in the open and liquid market, effectively preventing the Fed from overpaying for assets. So our analogy is more appropriate than one might initially assume.

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PS. I'm not saying that central banks can never push up the price level via mass purchases. I'm saying that given a certain set of constraints, a central banker can buy up every single asset in the economy without having much of an effect on the price level. It is interesting that this constraint, embodied in our hypothetical Google's charter, approximates to the rules that actually govern the Fed and other central banks -- namely that assets must be bought at market prices. Remove this constraint and it would be very easy for either Google or a central bank to push up the price level, as my previous post showed.

Google as monetary superpower — a parable

In trying to understand how modern monetary policy works, I find it useful to create parables, or alternate monetary worlds, and put them through the wringer. Hopefully I can learn a bit about our own world via these bizarro universes.

Let's say that in an alternate universe, people have decided to use Google stock (in bearer and digital form) as way to conduct most transactions. To top it off, all prices are set in fractions of a Google share. Shares get issued into the economy when Google pays employees with stock, makes corporate acquisitions, or purchases things from suppliers. Shares are removed when Google does buybacks.

Here are some questions we can ask of our Google priced world. What can Google do to cause the price level to rise? to fall? What do open market operations do, and what happens when Google "prints"?  Does Google QE have a large effect on the price level, or is it irrelevant? Once we've answered some of these questions, we can take what we've discovered over to our own universe in which Federal Reserves notes and deposits are monetary dominant and ask the same questions: what did QE1, QE2, and QE3 accomplish? What happens when the Fed "prints"? How does the Fed determine the price level? Let's explore our Google universe a bit and see what it has to teach us. [1]

In our alternate universe, people hold Google shares in bearer format in their wallets, or they own shares as electronic entries in a centralized database. Should you walk into a store to buy cigarettes, the sticker price might be 0.3 Googles. You can either hand over 3 Google bearer shares, each equal to 1/10th of a full share, or you might electronically debit your Google share account for the full amount.

Like any other share, a Google share is also a claim on the cash flows of the underlying business. Say that a week has passed and Google's shares have exploded in value due to higher margins announced at their quarterly earnings call. Now when you go to the store to buy cigarettes, they cost only 0.1 Googles. Alternatively, Google's prospects take a turn for the worse when it is sued for massive copyright infringement. Now when you go to buy cigarettes, a pack costs you 0.8 Googles. You get the point. A Google price level would be highly volatile, with all the thorny macroeconomic implications that such instability brings with it.

Google has come to recognize the public service that Google shares provide as both a medium of exchange and a unit in which other people post prices. It decides to take steps to ensure that Google shares neither rise too fast nor fall too much, or, put differently, that the general price level should be stable.

The manipulation of Google's returns shapes the price level 

One way Google can go about managing the price level is by varying the returns that shareholders enjoy. If the general price level is falling too fast, or, put differently, if Google shares are in a bull trend, CEO Larry Page may choose to suddenly announce that going forward, less earnings will flow to shareholders. By increasing the interest coupon on all Google-issued bonds, a larger share of profits will be diverted from the equity class to bondholders. In reaction to this announcement, Google's share price fall and, conversely, the price level begins to rise. This only makes sense. After all, in one fell swoop the present value of future Google shareholder income, often called fundamental value, has been reduced.

On the other hand, if inflation is the problem (i.e.if Google shares are collapsing), Larry Page might announce that henceforth bond coupons are to be cut, thus diverting more of the firm's profits back to shareholders. The share price will pull out of its bear trend -- after all, shareholders can expect a greater discounted flow of income than before -- and conversely, the price level will cease bounding upwards.

Larry Page has thus emerged as the economy's price-level setter. By either diverting profits away from or sluicing profits towards shareholders, Page holds the general price-level steady.

What do Google open market purchases do?

You'll note that I haven't mentioned money supply changes (ie. Google share supply changes) as the driver of the price level. Changes in the quality of Google shares -- their fundamental value -- and not the quantity of shares have been driving the price level up till now.

In fact, the classical example of an increase in the quantity of money -- broad open market purchases of assets -- needn't make much of a difference to our Google-determined price level. As long as Google consistently buys liquid and quality earning assets with newly printed shares and/or invests in decent projects that are neither over- nor underpriced, then all shareholders will retain the same claim on earnings that they did prior to the open market operations being conducted. Fundamental value remaining constant upon the completion of open market purchases, Google's share price will remain unchanged, as will the economy-wide price level.

This isn't to say that open market purchases are always neutral. One way for Google to use open market operations to affect the price level would be to issue new shares in such a way that upon completion, Google's per share earnings will have declined. We can call these sorts of transactions dilutive acquisitions. The best way to make a dilutive acquisition is to overpay for assets or buy worthless assets. Put in a bid for a collection of awful paintings, offer to pay a 50% premium to take out a company that already trades at fair value, or purchase a rail car full of carrots set to go bad the next day. Each of these transactions will permanently impair Google's per-share earnings base and destroy fundamental value. Google's share price will plummet to a new and lower floor as a result, the mirror image of which is a jump in the economy's price level.

On the flip side, Google can fight inflation by making a series of stock-financed accretive acquisitions. Buy up companies trading at undervalued prices and/or invest in projects with superior risk-adjusted yields. As a result of an accretive open market purchase, Google shareholders will enjoy an increase in per-share earnings. Should Google shares be in the midst of a bear trend (ie. inflation), a series of these accretive acquisitions will halt the bear and stabilize the price level.

This is an odd observation. We are accustomed to thinking of open market purchases, or money printing, as increasing the "money supply" and therefore causing inflation. This mental short cut is a result of a naive version of the quantity theory of money, a theory which posits a positive relationship between the money supply and the price level. But in the previous paragraph I've demonstrated how Google open market purchases increase the "money" supply yet cause deflation, not inflation. [2]

There is a lack of symmetry between overpaying to stop a deflation in the Google price level and underpaying to stop an inflation. One is easier to do than the other. To overpay for something, just go to any store and offer twice the sticker price for an item. No store owner will try to dissuade you. Google could offer to buy a few million shares of Microsoft at 20% above market value. They'd have no shortage of investors willing to take them up on that offer. On the other hand, try walking into the same store and offering to pay half the indicated sticker price, or watch Google try to wade into the market for Microsoft shares only to bid 20% under the current price. You're not going to be able to buy anything at the store, nor will Google get any offers for Microsoft.

The upshot of this asymmetry is that it's far easier for Google to stop a deflation with open market purchases  than to stop an inflation with open market purchases.

Google QE is irrelevant...

If Google announced its own version of QE or QE2, say $500 billion in upcoming treasury bond purchases, neither the announcement nor the actual purchases would be likely to affect the price level much. This is because the markets in which Google is buying assets are very deep and the announced purchases are being conducted at market prices. Google's risk-adjusted per share earnings, or fundamental value, will be the same both before and after QE.

In order to get the price level to rise or, equivalently, the value of Google shares to fall, rather than announcing QE of $x billion, Google should announce purchases of $x billion at a y% premium to the last market price. The losses incurred upon acquiring these assets at non-market prices would immediately drive the value of Google shares down, and the price level up. So the way to give QE bite is to be irresponsible and conduct purchases at silly prices.

...well, not entirely irrelevant: manipulating Google's liquidity premium 

Having just said that Google open market purchases are irrelevant if they target assets trading at market values, I'm going to backtrack a bit. This isn't entirely correct, because we need to include the idea of a Google liquidity premium.

Before Google shares ever became popular as exchange media, they were valued as mere equity claims. Rational traders would have ensured that the price of shares did not fluctuate far from their fundamental value, or the risk-adjusted net present value of cash flows thrown off by Google's underlying business. In this respect, Google stock was like any other stock, whether it be Apple, Cisco, or Exxon.

As Google shares became more widely used as exchange media, their price would have risen above fundamental value by a thin sliver called a liquidity premium. In essence, where before a Google share threw off a single pecuniary stream of cash flows, that same share now throws off not only the pecuniary stream but also a stream of non-pecuniary services related to its liquidity. All things staying the same, the addition of this extra non-pecuniary stream of services would have put a Google shareholder at an advantage relative to shareholders in other companies. After all, the quality of being moneylike, or having what I like to call "moneyness", is a desirable property in an asset. These excess returns would not have lasted long. The market would quickly bid up the price of Google stock until it offered a return commensurate with all other assets. The amount by which Google's price would have been bid up is what we call the liquidity premium.

The general price level thus contains within it two components. The first and original component is explained by Google's fundamental value. The rest of the price level is related to Google's liquidity, or a liquidity premium.

As already noted, QE, or open market operations at market prices, can't affect the first component. Both before and after QE, Google's per-share cashflow stay the same. But QE can affect the latter component, the liquidity premium. The increase in the supply of shares brought about by QE means that the marginal owner of Google exchange media finds their demand for liquidity satiated. What follows is the hot potato effect that market monetarists so dearly cherish. Those with an excess supply of Google exchange media will sell whatever shares (ie. cash) they no longer need, putting downward pressure on the price of shares and upward pressure on the price level. This is the classical quantity theory of money, in which an increase in the supply of media of exchange pushes the price level higher.

But the hot potato effect will not cause shares to fall by more than the value of their liquidity premium. If they fall by more, then share's will effectively be worth less than their fundamental value, a situation that won't last long as rational investors bid share prices back up. There is a floor below which more QE simply has no effect.

The depths to which Google's price falls because of QE depends on the size of the liquidity premium relative to fundamental value. The larger the liquidity premium, the more there is for QE to shrink, and the greater the price-level effect. I doubt that Google's liquidity premia will be very large, especially in open and competitive markets, so I don't think QE will push the shares down much or bring prices up too high. To get a massive rise in the price level, better for Google to announce QE at non-market prices. The effect would be a double whammy: not only would Google's liquidity premium shrink via the classical hot potato effect, but its fundamental value would deteriorate too.

Having explored our Google monetary universe, let's transfer what we've learnt to our own universe in which central banks such as the Federal Reserve are monetary dominant.

Making the analogy to the Fed: manipulating deposit rates to shape the price level  

Just as Google varies the price level by fiddling with the return on Google stock, the Fed can vary the price level by toying with the return that investors expect to enjoy on Fed-issued financial instruments. One obvious difference is that Google issues stock whereas the Fed issues deposits. But this is a difference of degree, not of kind. Both a deposit and a stock are instruments that provide a claim on their issuer. A deposit provides a safer fixed claim whereas a stock provides a riskier floating claim, but at the end of the day both instruments derive their value from their ability to act as titles to underlying businesses. The better the underlying business, the more valuable each respective claim will be.

If inflation is moving up too fast, the Fed can divert extra income towards depositors by increasing the interest rate it offers on deposits. This notching up of the interest rate enhances the life-time value of cash flows thrown off to owners of central bank deposits relative to other assets. This excess return will be quickly arbitraged away as investors compete to buy deposits, pushing their price up until they offer the same return as all other assets. This brings the general price level down, nipping inflation in the bud.

Vice versa, if the price level is deflating too fast (ie. if deposits are rising in value), the Fed can reduce the interest rate on deposits. This lowers the return on deposits relative to all other assets in the economy. Investors sell deposits until their price has fallen to a low enough level that they once again offer a competitive return. Thus the Fed terminates an incipient deflation.

Open market purchases by the Fed

Large open market purchases at market prices bring in a sufficient amount of earning assets to ensure that depositors will always receive the same risk-adjusted return that they enjoyed prior to the open market operations. There is thus no reason for the market to bid the price of deposits down when the Fed announces open market operations. Deposits are just as fundamentally sound as they were before.

On the other hand, if the Fed creates new deposits to purchase a collection of awful paintings, or offers to pay a 50% premium to take out a company already trading at fair value, or buys a rail car full of almost rotten carrots, the value of deposits will fall and the price level rise. This is because the Fed now owns less income-generating assets than before, thereby rendering it more difficult to make future interest payments to depositors. The risk-adjusted return on deposits -- their fundamental value -- has deteriorated. Investors will quickly bid down the price of Fed deposits until they once again offer a sufficient return to compete with other assets. A series of these dilutive purchases, much like Google's dilutive purchases, will put a halt to any deflation.

Manipulating the liquidity premium on Fed deposits

As in Google's case, open market purchases at market prices can't hurt the underlying fundamental value of Fed-issued deposits. But purchases will still have a bite on the price level by reducing the liquidity premium on Fed deposits.

I'll hazard a guess that the liquidity premium on Fed deposits is normally much higher than what Google would enjoy in our Google monetary universe. This is because unlike Google, the Fed can force banks to use deposits as an interbank settlement medium. By limiting the amount of deposits it issues and inhibiting the ability of competitors to provide alternatives, the Fed ensures that its deposits command a higher liquidity premium than they would in a free market. Thus, open market purchases and sales, even at market rates, will typically have significant effects on prices since a proportionally larger part of the price level is explained by deposit liquidity premia. In other words, the monetarist hot potato effect is large.

This has all changed since 2008. The Federal Reserve operates with a massive amount of excess deposits, or reserves. The supply of deposits is no longer special, artificially limited, or difficult to acquire. This means that the liquidity premium on deposits is probably much lower than before. So while open market purchases at market rates may have some effect on reducing prices, they can only narrow what was already a very thin liquidity premium. In other words, today's hot potato effect set off by QE is a feeble version of what it was before 2008.

To sum up...

The Google price level is determined by two elements: the underlying earnings power of Google's business as well as a liquidity premium arising from the superior ease of transacting with Google shares. Google monetary operations can change the price level by working on either of these two elements. I've hypothesized that the same rules apply to the Fed.

If we can take one lesson from our Google monetary universe, it's that mass open market purchasing schemes like QE probably have little bite because they don't change the fundamental value of Google or the Fed. QE has been conducted at close-to-market prices, and therefore brings an appropriate amount of assets onto the Fed's balance sheet to support the deposits created.

Nor do mass open market operations affect the liquidity premium much, since the current glut of Fed-issued deposits means that their liquidity premium is probably very small. In order for QE to significantly push down the return provided by deposits, and drive up prices, the Fed needs to do more than announce large asset purchases -- it also needs to announce that it will buy at wrong prices.

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[1] This blog post is pretty much a mashup of everything I've read over the last few years  from Nick Rowe, champion of the hot-potato effect, Mike Sproul, defender of the fundamental/backing theory of money,  Stephen Williamson, who likes to talk about liquidity premia, and Miles Kimball, who introduced the blogosphere to Wallace Neutrality.

[2] Everything I've said about Google open market purchases is just as applicable to open market sales. The classical quantity theory of money story is that open market sales reduce the supply of money, therefore causing deflation, or a fall in the price level. But if asset sales are conducted at the going market rate, then in Google's case, expected per-share earnings stays exactly the same as before and there is no reason to expect Google's share price to improve.

Google can use open market sales to affect the price level only if it sells assets at non-market prices. For instance, Google might conduct share buy backs when it perceives that its shares are underpriced. If Google execs have evaluated the situation correctly, then each open market sale will improve Google's financial situation and cause the share price to jump. On the other hand, Google can purposefully sell assets held in its portfolio at below-market prices in order to hurt fundamental value and cause inflation. 

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Updates:
03.08.2013 - added the reference to Miles Kimball in note 1
03.08.2013 - Changed "advantage relative to other shareholders" to "would have put a Google shareholder at an advantage relative to shareholders in other companies"
03.08.2013 - Added "moneyness" link.
21.08.2013 - exploded [added "in value"]
21.08.2013  - "open market purchases at market prices can't hurt the underlying financial viability" ... financial viability changed to fundamental value.