How to ‘fund’ hurricane Sandy (Part II)

As predicted, it only took a few days before the usual gnashing of teeth arose as to how we “fund’ the reconstruction efforts necessitated by Hurricane Sandy’s devastation.  A Reuters piece yesterday by Cate Long (, “Can the Port Authority and MTA afford the repairs after Hurricane Sandy?”) suggests a rather innovative solution:

“The most obvious source of funding for these projects would be for the Federal Reserve to purchase public infrastructure bonds instead of the $40 billion a month of mortgage-backed securities it has been buying. The housing market is important, and keeping mortgage rates low is useful, but investing in public infrastructure is much more important for the nation now. This approach would require a small legislative change to Section 14(b) of the Federal Reserve Act, which currently only allows the Fed to purchase of municipal bonds that mature in six months or less. These infrastructure bonds must be issued with maturities extending from 30 to 50 years, because the assets they fund will last at least that long. In two months, the Fed could buy $80 billion in infrastructure bonds. That would build some very important public infrastructure.”

It’s clear that as USERS, rather than ISSUERS of dollars, the Port Authority and Metro Transit Authority are limited by the dollars they collect in revenues or the money they raise via the capital markets. The Federal Reserve Act could be amended in the manner suggested by Long, but the reality is that spending on real assets is a Treasury function and the only reason to involve the Fed has to do with longstanding deficit phobias about national debt.  In our view, the Treasury can comfortably help the Port Authority and MTA fund the reconstruction of the northeast, much as it pays for the reconstruction of a country in the aftermath of a war.

In spite of what the fear-mongers in Congress or the Peterson Institute are saying today, the truth is that if a government issues a currency that is not backed by any metal or pegged to another currency, then there is no reason why it should be constrained in its ability to “finance” its spending by issuing currency. If true, then a sovereign government doesn’t need tax and bond revenues to spend, as it can spend by issuing currency. Modern sovereign governments actually spend by crediting bank accounts. Taxes result in debits of bank accounts; so budget deficits lead to net credits and budget surpluses lead to net debits. At the macroeconomic level, government spending increases private disposable income and taxes reduce it. A deficit then is the situation when the government is adding more to private disposable income than it’s taking away from it; it’s a net addition to private income. A government surplus has to equal the non-government sector’s deficit; government’s deficit equals the non-government surplus.

Government normally sells treasuries more or less equal in volume to its budget deficits—that is in part a function of trying to maintain a reserve rate and also a legal requirement that the government has to issue Treasuries 1 to 1 in proportion to what it spends.  The legal requirement is a legacy of the gold standard era where dollars had to be backed by a fixed quantity of gold specie.  That’s no longer the case today as we have indicated above.

And from an accounting perspective, budget deficits generate non-government surpluses, or saving. This is because government spending in excess of its taxing creates non-government income that is saved. When the US Treasury sells bonds, some of that created income is devoted to saving in the form of government debt. Otherwise, this saving can be held in the form of non-interest-earning cash or bank deposits. To summarize, when the value of checks Treasury writes to the private sector is greater than the value of private sector checks written to pay taxes, the private sector receives net income and accumulates wealth.

When the treasury spends by sending a check to somebody in the private sector, the check is deposited in a bank. (Increasingly, the deposits are made directly through wire.) The Fed then credits the bank’s reserve account at the Fed and debits that of the Treasury. The opposite happens when the public pays its taxes: Treasury’s account at the Fed is credited, and the bank’s reserve account is debited.

In case the public decides it doesn’t want bank deposits and would rather have cash, households and firms withdraw currency from their bank accounts, and bank reserves decrease by an equal amount. The same happens when the public prefers to keep its wealth in the form of government bonds. The sale of treasuries to the public results in a debit in their banks’ reserve account as bond buyers write checks against their bank account and the Fed then debits the reserve accounts of banks and credits the Treasury’s account at the Fed.

Every time the treasury spends, bank reserves are credited—so long as the non-bank sector does not withdraw cash from accounts. If banks already had the quantity of reserves they desired (which would be the normal case), Treasury spending creates excess reserves in the system. Banks offer excess reserves in the overnight, fed funds, market. Of course all this can do is to shift the excess reserves from one bank to another because reserves will not leave the banking system except through cash withdrawals. Finding no takers for the reserves, this will bid down the fed funds rate, effectively to zero if the Fed doesn’t intervene. To provide a substitute for the excess reserves and to hit its fed funds rate target, the Fed then sells treasuries to the private sector, transforming the wealth held in the form of bank deposits and reserves into treasury securities. Bank reserves are debited by the amount of the treasuries sold (whether banks or their customers buy them). Effectively this is just a substitution of low earning excess reserves for higher earning treasuries. And it is done to accommodate the demand for treasuries as indicated by a falling overnight fed funds rate (banks do not want to hold the existing quantity of reserves, so they are bidding it down). In other words, sales of treasuries should be thought of as a monetary policy operation that accommodates portfolio preferences of banks and their customers.

To recap, a government deficit generates a net injection of disposable income into the private sector, generating an increase in its saving and wealth which can be held either in the form of government liabilities (cash or treasuries) or non-interest earning bank liabilities (bank deposits). If the non-bank public prefers bank deposits, then banks will hold an equivalent quantity of reserves, cash, and treasuries with the distribution among these government IOUs depending on bank preferences.

A government budget surplus has exactly the opposite effect on private sector incomes and wealth: it’s a net leakage of disposable income from the non-government sector that reduces net saving and wealth by the same amount. As the government takes more from the public in taxes than it gives in its spending, this results in a net debit of bank reserves and reduction in outstanding cash balances. If banks had previously held the amount of reserves and cash desired (which would be the normal case), the budget surplus will cause them to fall short of the desired holding of reserves and vault cash. They can go to the fed funds market to obtain reserves, but this is a system shortage that cannot be met by interbank lending, so the resulting shortage of cash and reserve balances forces the private sector to sell treasuries to the Fed to obtain the reserves desired. The Fed then adds reserves to bank deposits at the Fed. The Fed can simultaneously reduce the Treasury’s deposit at the Fed and return the treasuries to the Treasury. This is a retirement of government debt, which is what must take place as a result of government surpluses.

To reiterate: there is no financial constraint on the ability of a sovereign nation to deficit spend. Note that this doesn’t mean that there are no real resource constraints on government spending; this should be the real concern, not financial constraints. If government spending pushes the economy beyond full capacity, inflation will result. Inflation can result even before full employment if there are bottlenecks or if firms have monopoly pricing power.  That’s clearly not the case we have prevailing today. Government spending can also increase current account deficits, especially if the marginal propensity to import is high. This could affect exchange rates. The alternative would be to use fiscal austerity to try to keep the economy sufficiently depressed that pressures on prices or exchange rates are eliminated.  That has created the social catastrophe that is Europe today. The Eurozone crisis has illustrated that the losses due to operating below full employment are almost certainly much higher than economic losses due to inflation or currency depreciation—it is an entirely separate matter from financial constraints or insolvency.

Once we begin to understand these elementary points, we can have a rational discussion as to the best means forward of repairing the damage wrought by this horrendous “perfect storm”.

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