My Visit to the US Treasury, Part 1

Posted on 3 November 2009 by David Merkel

This will have to be brief, because I am tired.? I have had to deal with family and work issues today, and only now have time to blog.

You might have seen my fanciful post, Fallowhaven, Part 1.? I wrote that because I thought I could reveal almost nothing of my visit to the US Treasury today.? As it is, I can talk about it, but not quote any officials there, nor say who was there from the Treasury.

My surprise was that only bloggers were there.? I expected reporters from major papers, but that was not the target audience.? The closest to mainstream media would have been Megan McArdle, who presumably said she would be there (there was a placard for her), but did not show.? The rest of us were independents:

As I write now, only John Jansen has commented on the meeting, and only briefly.? I have a lot to say about the meeting, but I can’t get it into one post.? I will spread it out over several posts, and try to explain the? views of the Treasury, are where they make sense, or not.

I appreciated being able to meet my fellow bloggers.? Putting faces to the names is special.? Would that I could bring all of the major investment/finance/economics bloggers together for a gathering.? There would be many disagreements, but it would sharpen us all.

More tomorrow –? I want to talk about the successes and failures of the current rescue, and how the Treasury views them.

I’d like to know if anyone at the Treasury shows any signs of adequately understanding basic monetary operations. I recently attended a joint AARP/OECD briefing on pensions worldwide. I pointed out that a of their fundamental assumptions had completely changed since Nixon closed the gold window in 1973. The OECD guy acknowledged the significance of that change, admitted that all pension planning was still slowly, not rapidly, adjusting to the (new?) reality, but defended the OECD approach since “everyone else is doing it”.
The AARP lady refused to even talk to me! Afterwards two people heatedly accused me of being a LaRouche member. (Luckily I laughed so hard they believed I wasn’t.) They then said the only people they’d ever heard mention the gold std were LaRouche wackos. Sad commentary.
So, as a test, I’d like to know what all bloggers present here think about the operational details of reserve bank accounting – and whether that will change your approaches sooner rather than later. Here’s one link to start with.
***********
From: Joseph Lando, Managing Director, Goldman Sachs
Sent: Wednesday, November 04, 2009

*Not house view.

Since March I have been arguing that the world was a better place than people thought. I am now shifting my core view, which still might take several months to develop in the marketplace.

Skipping to the Conclusions
1. Deflation will be the surprise theme of 2010, when Congress will go into a pre-election deadlock; elections have only underscored this is the public direction
2. Excess Reserves will neither generate new lending nor generate inflation; actually, the quantity of reserves (M0) basically has no real economic effect
3. ZIRP and QE actually CONTRIBUTE to the deflation mostly by depriving the spending public of much-needed coupon income
4. When Federal Tax Rates increase in 2011 this problem will become even more severe
5. The overall level of public indebtedness (vs GDP) will not put upward pressure on yields in this backdrop and there will be a reckoning in the high-rates/?deficit hawk? community
6. Strong possibility that QE will actually be upsized next year rather than ended when the Fed observes these effects (and this might actually make things WORSE)

The Explanation (a Journey)
It seemed fairly intuitive and obvious for thousands of years that the Earth was at rest and the Sun moving around it. Likewise, it has ‘seemed’ that the Fed controls the money supply, balances the economy by setting interest rates and fixing reserves which power bank lending, that more ‘Fed’ money means less buying power per dollar (inflation), that the federal government needs to borrow this same money from The People in order to be able to spend, and that it needs to grow its way out of its debt burden or risks fiscal insolvency. I have, in just a fortnight, been COMPLETELY disabused of all these well-entrenched notions. Starting from the beginning, here is how I now think it works:

1. The first dollar is created when Treasury gives it to someone in exchange for something – ammo, a bridge, labor. It is a coupon. In exchange for your bridge, here is something you – or anyone you trade it with – can give me back to cover your taxes. In the mean time, it goes from person A to person B, gets deposited in a bank, which then deposits it at the Fed, which then records the whole thing in a giant spreadsheet. Liability: One overnight reserve/demand deposit/tax coupon. Asset: IOU from Treasury general account. Tax day comes, Person A pulls his deposit, ?cashes in? the coupon, the Treasury scraps it, and POOF, everything is back to even.
2. For various reasons (either a gold-standard relic or a conscious power restraint, depending who you ask), we ?make? the Treasury cover its ?shortfall? at the Fed and SWAP one type of tax-coupon (a deposit or reserve) for another by selling a Treasury note. Either the Fed (in the absence of enough reserves ? we?ll get to this) or a Bank (to earn risk-free interest) or Person A (who sets a price for his need to save) is ?forced? out his demand deposit dollar and into a treasury note at the auction clearing price. What about the fact that treasuries aren?t fungible like currency? On an overnight basis, that doesn?t really constrain anyone?s behavior. A reserve or a deposit means you get your money back the next day. Same thing with a treasury. Functionally it?s cash and won?t influence your decision to buy a car. Likewise for the bank. In the overnight duration example, it does NOT affect their term lending decisions if they have more reserves and few overnight bills, or more bills and fewer reserves. It?s even possible to imagine a world (W.J.Bryan?s dream) where the Fed, with its scorekeeping spreadsheet, combines the line-items we call treasuries and reserves.
3. Total ?public sector dissavings is equal to private sector savings (plus overseas holdings)? as a matter of accounting identity. This really means that the only money available to buy treasuries came from government itself (here I am being a bit loose combining Tres+Fed), from its own tax coupons. If there aren?t enough ready coupons at settlement time for those Treasuries, the Fed MUST ?supply? them by doing a repo (trading deposits/coupons for a treasury by purchasing one themselves at least temporarily). They don?t really have a choice in the matter, however, because if the reserves in the banking system didn?t cover it, overnight rates would go to the moon. So in setting interest rates they MUST do a recording on their spreadsheet and the Fedwire and shift around some reserve-coupons (usable as cash) for treasury-coupons (usable for savings but functionally identical).
4. Thus ?monetizing the deficit? is actually just the Fed?s daily recordkeeping combined with its interest rate targetting, just ?keeping the score in balance.? However, duration is real, as only overnight bills are usable as currency, and because people (and pensions!) need savings, they need to be able to pay taxes or trade tax-coupons for goods when they retire, and so there is a price for long-term money known as interest rates. The Fed CAN affect this by settings rates and by shifting between overnight reserves, longer-term treasuries, and cash in circulation. When the Fed does a term repo or a coupon sale, they shift around the banking and private sector?s duration, trading overnight coupons for longer-term ones as needed to keep the balance in order.
5. But all this activity doesn?t influence the real economy or even the amount of money out there. The amount of money out there dictates the recordkeeping that the Fed must do.
6. This is where QE comes in to play. In QE, aside from its usual recordkeeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it ?needed? to do all along. Again, they force people out of treasuries and into cash and reserves.
7. The private sector is net saving, by definition. It has saved everything the Treasury ever spent, in cash and in treasuries and in deposits. In fact, Treasuries outstanding plus cash in circulation plus reserves are just the tangible record of the cumulative deficit spending, also by IDENTITY.
8. So when QE is going on, there is some combination of savers getting fewer coupons ? which constrains their aggregate demand just like a lower social security check would, and banks being forced out of duration instruments and into cash reserves. I do not think this makes them ?lend more? ? their lending decision was not a function of their ?cashflow? but rather a function of their capital and the opportunities out there (even when you judge a bank?s asset/equity capital ratio, there is no duration in accounting, so a reserve asset and a treasury asset both ?cost? the same). If they had the capital and the opportunities, they would keep lending and ?force? the Fed to give them the cash (via coupon passes and repos, which we then wouldn?t call QE but rather ?preventing overnight rates from going to infinity?). As far as I can tell, excess reserves is a meaningless operational overhang that has no impact on the economy or prices. The Fed is actually powering rates (cost of money) not supply (amount of money) which is coming from everyone else in the economy (Tres spending and private loan demand).
9. I?ll grant there is a psychological component to inflation phenomenon, as well as a preponderance of ignorance about what reserves are, and that might result in some type of inflationary event in another universe, but not in the one we are in where interest rates are low and taxes are going up and the demand for savings is therefore rising rather than falling.
10. One can now retell history through this better lens. Big surpluses in ’97-’01, then a big tax cut in ’03. Big surpluses in ’27-’30, then a huge deficit in ’40-’41. Was an aging Japanese public ‘shocked’ into its savings rate or is that savings just the record of the recessionary deficit spending that came after ’97? It will be interesting to watch what happens there as the demographic story forces households to live moreso off JGB income – will this force the BOJ to push rates higher or will they never ‘get it’ and force the deflation deeper?
11. There are, as always mitigating factors. Unlike in the Japan example, a huge chunk of US fixed income is held abroad, so lower rates are depriving less exported coupon income which is actually a benefit. There is of course some benefit from lower private sector borrowing rates as well – MEW, lower startup costs for new capital investment, etc. Also, even if one denies that higher debt/gdp ratios are what weakened it (rather than China’s decisions – again something unavailable to Japan), the dollar IS weaker now which is inflationary. But this is all more than offset, I think, by ppl’s expectation that higher taxes are coming, and that’s hugely deflationary and curbs aggregate demand via multiple channels.
12. Additionally, there seems to be a finite amount of political capital that can be spent via the deficit, and that amount seems to be rapidly running out. See https://portal.gs.com/gs/portal/home/fdh/?st=1&d=8055164 . The period of deficit stimulus is mostly behind us. Instead, people are depending upon ZIRP and the Fed to stimulate the economy, and in fact there is marginal, and possible negative, stimulation coming from that channel. The Fed is taking away the social security checks knowns as ?coupon interest.?
13. Finally, there is a huge caveat that I can?t get around, which is whether we are measuring inflation correctly. It happens that I don?t think we are ? strange effects like declining inventory will provide upward pressure and lagged-accounting for rents providing downward pressure in the CPI. This is an unfortunate, untradeable fact about the universe that I think will be offset by other indicators (Core PCE) sending a better signal. But this is part of the reason this whole story will take time to develop in the marketplace. As a massive importer of goods and exporter of debts we are not quite Japan, but the path of misunderstanding is remarkably similar.

* Credit due Warren Mosler and moslereconomics.com for guiding my logic.

8 thoughts on “My Visit to the US Treasury, Part 1”

jck says:

3 November 2009 at 6:56 am

missed that one, was in turkey. maybe next time, would be nice to meet fellow bloggers.
matt says:

3 November 2009 at 10:20 am

This summit is amusing (and suspicious) after the O administration has recently lamented the rising importance of blogs in the media space.
David Merkel says:

3 November 2009 at 10:49 am

jck — it would have been fun to have had you there. If you are ever on the DC/Baltimore area, let me know. I’ll buy lunch or dinner.

Matt — yeah, there is that. I thought about that before going, but had no idea it would only be bloggers. I expected to see the WP, WSJ, NYT, etc., and I would be a smaller presence in a larger gathering.
AllanF says:

3 November 2009 at 7:05 pm

Unless I mis-read, (just double-checked, I didn’t) AI claims the G-man himself was there.

Did anyone ask when we can expect the fraudulent conveyance trials to be ram-rodded through to claw-back bonuses? Or are kangaroo courts strictly limited to bankruptcy proceedings?

I would have preferred Karl Denninger or Mish to be invited, though perhaps they baulked at the original terms.
ndk says:

3 November 2009 at 7:30 pm

I love watching them attempt to re-establish control over the message, rather than trying to change their policies to something defensible. You go, Geithner. You go.
Gary says:

3 November 2009 at 9:07 pm

No good can come from secret meetings in a supposed democracy
David Chessik says:

5 November 2009 at 11:12 am

Wow!,

I have a Christmas gift for you if you will send me your address. It is two superballs in a velvet pouch. Next time they invite you, if you bring a pair of balls with you, maybe you’ll be able to tell them to shove it when they start to tell you what you can say and what you cannot say. Those who are timid when threatened must be slaves. By the way, did you notice the elephant in the room?
Roger Erickson says:

7 November 2009 at 10:14 am

I’d like to know if anyone at the Treasury shows any signs of adequately understanding basic monetary operations. I recently attended a joint AARP/OECD briefing on pensions worldwide. I pointed out that a of their fundamental assumptions had completely changed since Nixon closed the gold window in 1973. The OECD guy acknowledged the significance of that change, admitted that all pension planning was still slowly, not rapidly, adjusting to the (new?) reality, but defended the OECD approach since “everyone else is doing it”.
The AARP lady refused to even talk to me! Afterwards two people heatedly accused me of being a LaRouche member. (Luckily I laughed so hard they believed I wasn’t.) They then said the only people they’d ever heard mention the gold std were LaRouche wackos. Sad commentary.
So, as a test, I’d like to know what all bloggers present here think about the operational details of reserve bank accounting – and whether that will change your approaches sooner rather than later. Here’s one link to start with.
***********
From: Joseph Lando, Managing Director, Goldman Sachs
Sent: Wednesday, November 04, 2009

*Not house view.

Since March I have been arguing that the world was a better place than people thought. I am now shifting my core view, which still might take several months to develop in the marketplace.

Skipping to the Conclusions
1. Deflation will be the surprise theme of 2010, when Congress will go into a pre-election deadlock; elections have only underscored this is the public direction
2. Excess Reserves will neither generate new lending nor generate inflation; actually, the quantity of reserves (M0) basically has no real economic effect
3. ZIRP and QE actually CONTRIBUTE to the deflation mostly by depriving the spending public of much-needed coupon income
4. When Federal Tax Rates increase in 2011 this problem will become even more severe
5. The overall level of public indebtedness (vs GDP) will not put upward pressure on yields in this backdrop and there will be a reckoning in the high-rates/?deficit hawk? community
6. Strong possibility that QE will actually be upsized next year rather than ended when the Fed observes these effects (and this might actually make things WORSE)

The Explanation (a Journey)
It seemed fairly intuitive and obvious for thousands of years that the Earth was at rest and the Sun moving around it. Likewise, it has ‘seemed’ that the Fed controls the money supply, balances the economy by setting interest rates and fixing reserves which power bank lending, that more ‘Fed’ money means less buying power per dollar (inflation), that the federal government needs to borrow this same money from The People in order to be able to spend, and that it needs to grow its way out of its debt burden or risks fiscal insolvency. I have, in just a fortnight, been COMPLETELY disabused of all these well-entrenched notions. Starting from the beginning, here is how I now think it works:

1. The first dollar is created when Treasury gives it to someone in exchange for something – ammo, a bridge, labor. It is a coupon. In exchange for your bridge, here is something you – or anyone you trade it with – can give me back to cover your taxes. In the mean time, it goes from person A to person B, gets deposited in a bank, which then deposits it at the Fed, which then records the whole thing in a giant spreadsheet. Liability: One overnight reserve/demand deposit/tax coupon. Asset: IOU from Treasury general account. Tax day comes, Person A pulls his deposit, ?cashes in? the coupon, the Treasury scraps it, and POOF, everything is back to even.
2. For various reasons (either a gold-standard relic or a conscious power restraint, depending who you ask), we ?make? the Treasury cover its ?shortfall? at the Fed and SWAP one type of tax-coupon (a deposit or reserve) for another by selling a Treasury note. Either the Fed (in the absence of enough reserves ? we?ll get to this) or a Bank (to earn risk-free interest) or Person A (who sets a price for his need to save) is ?forced? out his demand deposit dollar and into a treasury note at the auction clearing price. What about the fact that treasuries aren?t fungible like currency? On an overnight basis, that doesn?t really constrain anyone?s behavior. A reserve or a deposit means you get your money back the next day. Same thing with a treasury. Functionally it?s cash and won?t influence your decision to buy a car. Likewise for the bank. In the overnight duration example, it does NOT affect their term lending decisions if they have more reserves and few overnight bills, or more bills and fewer reserves. It?s even possible to imagine a world (W.J.Bryan?s dream) where the Fed, with its scorekeeping spreadsheet, combines the line-items we call treasuries and reserves.
3. Total ?public sector dissavings is equal to private sector savings (plus overseas holdings)? as a matter of accounting identity. This really means that the only money available to buy treasuries came from government itself (here I am being a bit loose combining Tres+Fed), from its own tax coupons. If there aren?t enough ready coupons at settlement time for those Treasuries, the Fed MUST ?supply? them by doing a repo (trading deposits/coupons for a treasury by purchasing one themselves at least temporarily). They don?t really have a choice in the matter, however, because if the reserves in the banking system didn?t cover it, overnight rates would go to the moon. So in setting interest rates they MUST do a recording on their spreadsheet and the Fedwire and shift around some reserve-coupons (usable as cash) for treasury-coupons (usable for savings but functionally identical).
4. Thus ?monetizing the deficit? is actually just the Fed?s daily recordkeeping combined with its interest rate targetting, just ?keeping the score in balance.? However, duration is real, as only overnight bills are usable as currency, and because people (and pensions!) need savings, they need to be able to pay taxes or trade tax-coupons for goods when they retire, and so there is a price for long-term money known as interest rates. The Fed CAN affect this by settings rates and by shifting between overnight reserves, longer-term treasuries, and cash in circulation. When the Fed does a term repo or a coupon sale, they shift around the banking and private sector?s duration, trading overnight coupons for longer-term ones as needed to keep the balance in order.
5. But all this activity doesn?t influence the real economy or even the amount of money out there. The amount of money out there dictates the recordkeeping that the Fed must do.
6. This is where QE comes in to play. In QE, aside from its usual recordkeeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it ?needed? to do all along. Again, they force people out of treasuries and into cash and reserves.
7. The private sector is net saving, by definition. It has saved everything the Treasury ever spent, in cash and in treasuries and in deposits. In fact, Treasuries outstanding plus cash in circulation plus reserves are just the tangible record of the cumulative deficit spending, also by IDENTITY.
8. So when QE is going on, there is some combination of savers getting fewer coupons ? which constrains their aggregate demand just like a lower social security check would, and banks being forced out of duration instruments and into cash reserves. I do not think this makes them ?lend more? ? their lending decision was not a function of their ?cashflow? but rather a function of their capital and the opportunities out there (even when you judge a bank?s asset/equity capital ratio, there is no duration in accounting, so a reserve asset and a treasury asset both ?cost? the same). If they had the capital and the opportunities, they would keep lending and ?force? the Fed to give them the cash (via coupon passes and repos, which we then wouldn?t call QE but rather ?preventing overnight rates from going to infinity?). As far as I can tell, excess reserves is a meaningless operational overhang that has no impact on the economy or prices. The Fed is actually powering rates (cost of money) not supply (amount of money) which is coming from everyone else in the economy (Tres spending and private loan demand).
9. I?ll grant there is a psychological component to inflation phenomenon, as well as a preponderance of ignorance about what reserves are, and that might result in some type of inflationary event in another universe, but not in the one we are in where interest rates are low and taxes are going up and the demand for savings is therefore rising rather than falling.
10. One can now retell history through this better lens. Big surpluses in ’97-’01, then a big tax cut in ’03. Big surpluses in ’27-’30, then a huge deficit in ’40-’41. Was an aging Japanese public ‘shocked’ into its savings rate or is that savings just the record of the recessionary deficit spending that came after ’97? It will be interesting to watch what happens there as the demographic story forces households to live moreso off JGB income – will this force the BOJ to push rates higher or will they never ‘get it’ and force the deflation deeper?
11. There are, as always mitigating factors. Unlike in the Japan example, a huge chunk of US fixed income is held abroad, so lower rates are depriving less exported coupon income which is actually a benefit. There is of course some benefit from lower private sector borrowing rates as well – MEW, lower startup costs for new capital investment, etc. Also, even if one denies that higher debt/gdp ratios are what weakened it (rather than China’s decisions – again something unavailable to Japan), the dollar IS weaker now which is inflationary. But this is all more than offset, I think, by ppl’s expectation that higher taxes are coming, and that’s hugely deflationary and curbs aggregate demand via multiple channels.
12. Additionally, there seems to be a finite amount of political capital that can be spent via the deficit, and that amount seems to be rapidly running out. See https://portal.gs.com/gs/portal/home/fdh/?st=1&d=8055164 . The period of deficit stimulus is mostly behind us. Instead, people are depending upon ZIRP and the Fed to stimulate the economy, and in fact there is marginal, and possible negative, stimulation coming from that channel. The Fed is taking away the social security checks knowns as ?coupon interest.?
13. Finally, there is a huge caveat that I can?t get around, which is whether we are measuring inflation correctly. It happens that I don?t think we are ? strange effects like declining inventory will provide upward pressure and lagged-accounting for rents providing downward pressure in the CPI. This is an unfortunate, untradeable fact about the universe that I think will be offset by other indicators (Core PCE) sending a better signal. But this is part of the reason this whole story will take time to develop in the marketplace. As a massive importer of goods and exporter of debts we are not quite Japan, but the path of misunderstanding is remarkably similar.

* Credit due Warren Mosler and moslereconomics.com for guiding my logic.

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