Modern Monetary Theory

By Steven J. Grisafi, PhD.

As best I can understand the arguments of its proponents, the purpose of Modern Monetary Theory is to explain the curvature of the interest rate yield curve. Whereas central banks can assert the short term interest rate by their rate of payment on overnight reserves maintained on their accounts, this fixation has unknown consequences for the interest rates demanded at longer terms. An important aspect of Modern Monetary Theory is the independence of a central bank from the authority of the treasury of the government they both serve. As a consequence, whenever discussing Modern Monetary Theory one must always distinguish between currency issuing authorities that do and do not maintain central bank independence. We have a peculiar situation when considering the European Union and its central bank because, unlike the situation in the United States of America, it is the European Central Bank that issues the currency and not the treasury. This is because there is no treasury for the European Union.

Proponents of Modern Monetary Theory contend that the sale of government bonds is part of a government’s effort to establish monetary policy. The sale of bonds by the treasury is not part of its fiscal responsibilities because the treasury has the authority to issue currency at will. The treasury does not need to sell treasury bonds to fund the operations of the government due to its ability to create money by granting credit. But this process of granting credit occurs in tandem with the central bank which maintains the government’s ledger, as well as the assets and liabilities of all banking authorities that maintain an account with the central bank. Hence, when one speaks of central bank independence one actually refers only to its ability to decide the overnight interest rate. Everything else is beyond its control and this is where Modern Monetary Theory enters the world of finance.

The Treasury of the United States of America may choose to sell its bonds or notes. Modern Monetary Theory says that the sole purpose of doing so is to influence the interest rate at the time frame for those securities. The Treasury need not sell these securities merely to fund the operations of the federal government of the United States. But because the Federal Reserve Bank of the United States has sole discretion of its choice for the overnight interest rate its pays on reserves held in its accounts, any sale of Treasury Notes or Treasury Bonds can only affect longer term interest rates thereby influencing the curvature of the yield curve. Now one must question: Does the United States Treasury have sole authority for the granting of credit that occurs during deficit spending? No, it does not. This is where Quantitative Easing enters the world of finance.

The independence of the Federal Reserve Bank of the United States from the United States Treasury is greater than the mere ability to set overnight interest rates. It is the central bank that has the ability to credit or debit banks maintaining reserve accounts with the central bank. It may do so at the discretion of the treasury, but it may also do so independently as in the process of Quantitative Easing. As such one can recognize that Quantitative Easing is a form of deficit spending. Its only distinction is that because it is a central bank that grants the credit the process is described as monetary policy. But herein one ought recognize the redundancy. Do we really need a central bank solely for its independent ability to set overnight interest rates? One might argue that while the treasury can influence longer term interest rates the independent ability of the central bank precludes profligacy of politicians. But does it really, when we do not know of any mechanism by which the sale government bonds serves to manipulate longer term interest rates?

Central bank independence is an illusion. Similar economists who are appointed to positions in the central bank are also appointed to positions in the treasury. For a fiat currency issuing entity, central bank independence is non sequitur. The functions of a central bank ought to be those of the treasury. When the Federal Reserve Bank of the United States was created the United States Dollar was based upon a gold standard. This is no more, and so ought to be the central bank, if indeed we were truly confident of Modern Monetary Theory. Now, this begs the question: How does the sale of government bonds affect the curvature of the yield curve? The difficulty resides in our ignorance of how price changes in the sale of bonds affect their interest rate. We know of the familiar rule of thumb that bond prices vary inversely proportional to their interest rates. But what does this average effect obscure? When the United States Treasury chooses to sell bonds what are the indications upon which the major players place their bids for these bonds? It cannot be solely the prevailing interest rates when the sale itself is meant solely to influence interest rates. That is, of course, if we are to believe this particular assertion of Modern Monetary Theory. One might expect that any sale of new government bonds would raise interest rates at the maturity term for the sale because the supply of bonds is increased by the sale and investors would demand an interest rate premium. But obviously this is not always the case. So other factors exist beyond control of both the treasury and its central bank. Then why have both a treasury and a central bank? Profligate politicians cannot dictate terms to the bond market. So separating the functions of a central bank from its treasury serves no purpose. It is just another farce perpetrated upon the people.

Now one might return to the peculiar situation within the European Union. Let no one confuse the distinction of having the functions of a central bank usurped by the treasury and the functions of a treasury usurped by a central bank. The distinction is disasterous as we have seen for the member nations of the Eurozone. The distinction occurs as a result of a lack of political unity. That the member nations of the Eurozone do not comprise a single political entity is the cause of their suffering. The European Central Bank has usurped the functions that a Treasury of the European Union (Eurozone in this case) ought to possess. However unless, and until, the member nations of the European Union choose to become a single nation no such Treasury of the European Union can exist.

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