Saturday, March 21, 2015

Are Open Market Operations Distortionary?

Many of my fellow free bankers agree that when banks accommodate changes in the demand to hold their monetary liabilities, the result is equilibrating and nondistortionary.   However, they believe that when a central bank adjusts the quantity of base money to accommodate changes in the demand for it, there is something problematic with the process.   The injection of base money is somehow distortionary.

Now, I don't want to claim that this could never be a problem.   The Fed's policy since 2008 has most certainly become very distortionary--intentionally   Perhaps there should be no surprise that the Fed has attempted to funnel money into housing.    Using government interventions of one sort or another to promote home ownership has been the norm for  nearly a century now.

Still, let us suppose that the government has a national debt because of past wars but that it now balances its budget.    The central bank always adjusts the quantity of money by buying and selling existing government bonds.  

If some household chooses to save by spending less on consumer goods and instead purchasing government bonds, then the result is a higher price of bonds and a lower yield.   The increase in price and decrease in yield has to be sufficient to persuade someone to reduce their holdings of the government bonds.   The most likely result is that those least attached to holding government bonds purchase some other sort of financial asset.   That results in higher prices and lower yields on those assets.   The final result is a decrease in the amount saved and increase in the amount invested.   This is an expansion in spending on consumer goods that only partly offsets the initial decrease and an expansion in spending on capital goods.  

An increase in supply creates a surplus at the initial price, but as the price decreases, quantity supplied decreases and quantity demanded increases returning to an equilibrium where quantity supplied and demanded are equal.   The price is lower and the quantity is higher.   Apply econ 101 to saving supply and investment demand.

While the existence of this national debt requires that interest be paid and so taxes collected, I find it difficult to see how the individual saver who purchases these bonds has created some kind of distortion.   While the result is unlikely to be exactly the same as it would have been if that household had saved by purchasing some private security--stock or bond--we can hardly expect that such purchases would have directly funneled resources into the firms that issued those particular securities.   The process of coordinating saving and investment occurs through adjustments in financial asset portfolios and interest rate signals that result in an appropriate decrease in the quantity of saving supplied and increase in quantity of investment demanded.

Now, suppose that instead of purchasing government bonds, the household that initially saved accumulated central bank issued hand-to-hand currency.   Income was earned and not spent on anything.   Paper notes are stuffed into a safe-deposit box.     Further suppose the central bank makes a standard open market purchase.   It creates new money out of thin air and purchases government bonds--just accommodating the increase in the demand to hold money.

The result after that point is exactly the same as what would have happened if the household had directly purchased the government bonds.   As explained above, this results in appropriate adjustments in the price and yield on those government bonds and on other financial assets such that the amount saved and invested adjust to coordinate the increase in saving.    Further, there is no significant difference as far as the adjustment to this additional saving than would have occurred if the household had purchased privately-issued stocks or bonds.

Given the dominant Keynesian (old or new) framing, a central bank that accommodates an increase in the demand to hold base money by expanding the nominal quantity issued through open market purchases of government bonds would be described as lowering the interest rate to stimulate consumption and investment spending.   The market coordination process to an increase in the supply of saving leading to lower interest rates and so a readjustment in the quantity of saving supplied and increase in the quantity of investment demanded is twisted into some kind of intervention by the Fed -- pushing interest rates too low in order to unnaturally stimulate spending.   That is an inappropriate framing.

Now, I will surely grant that the potential for a central bank to create an excess supply of money is much greater than that of private banks issuing any sort of money, and especially money redeemable in some other form of money currently being used.   My point is simply that to the degree a central bank limits its issue of new money to the amount demanded, there is nothing especially distorting about the process.   It is coordinating.   The proper comparison is not what would happen if the nominal quantity of money remained fixed and there was a deflation of prices and wages.  Nor is the proper comparison to what would have happened if there had never been an increase in the supply of saving.  The proper comparison is what would happen if there was a increase in the supply of saving by purchasing government bonds.

With an ordinary fractional reserve banking system, an increase in the demand to hold bank deposits is directly an increase in desired lending to a bank but indirectly funding for whatever projects the bank finds profitable.   That is the nature of the contract between bank and depositor and the logic of financial intermediation.    Similarly, an increase in the demand for base money under a monetary regime where the central bank makes ordinary open market purchases is directly a loan to the central bank, but indirectly a loan to the government.   If the government is balancing its budget, then the effect is simply a coordinating expansion in other sorts of private spending.    At least, as long as the central bank limits its issue of money to amounts that people choose to hold.


  1. One difference between your 2 scenarios is that when the CB purchases govt bonds it gets interest from the govt that it later pays back as CB profits. This allows the govt to tax less or spend more . This will almost certainly have some secondary distortionary effects unless the govt simply gives everyone back an equal share of the saved tax money (which is perhaps what you are assuming here).

  2. I am not worrying at all about those second order effects on the government's budget. I think it is helpful in that scenario to drop the veil of an independent central bank and instead consider the government borrowing at a zero interest rate by issuing currency. Interest cost is lower and so the needed taxes are lower. Even so, I favor privatization of currency issue so that any benefit from borrowing at zero interest by the issue of currency is competed away to the benefit of bank customers.

  3. Before one can answer the question as to whether QE is distortionary, one has to answer the question as to whether GOVERNMENT BORROWING ITSELF is distortionary. To illustrate, assuming, as claimed by Milton Friedman, that governments should borrow NOTHING, then QE has a “distortion reducing” effect in that it disposes of government debt.

    An alternative and popular assumption is that government should borrow JUST TO FUND public investments. On that assumption QE is not an option because the total amount of government borrowing is pretty much fixed in the short term by the later “just to fund public investments” assumption.

    In the latter scenario government would have to implement Bill’s “supply the economy with whatever amount of money it wants” idea by having the state create and spend new money into the economy. And indeed, I favour the later policy as does Positive Money and most MMTers, far as I can see.

    I did a post on the above topic on my own blog recently:

    1. If the quantity of base money solely changes through purchases and sales of government bonds, then the maximum increase in the quantity of money is the outstanding government debt, not new borrowing.

      If money is necessarily matched by debt (not necessarily government debt,) then the quantity of money is limited by total outstanding debt, now new lending.

      While I am open to the notion that the government debt should be zero, I would count base money as part of that debt. Such a view points to full privatization of money--which I favor anyway.

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