‘Creeping Into The Unconventional’ And Why Everything You Thought You Knew Is Wrong

Earlier this week, a reader wondered what Harley Bassman, inventor of Wall Street’s most-cited benchmark for rates volatility, thinks of Modern Monetary Theory (MMT).

The question came in response to a reprint of a piece Bassman penned in 2016 on the (remote) possibility that the Fed could eventually embark on a gold purchase program.

In fact, Bassman has weighed in on MMT on a number of occasions over the past two years. For example, last year he wrote that while he doesn’t “believe MMT is viable over the long-term, it is unlikely my personal horizon will overlap its eventual denouement”.

That line gave MMT patron saint (and now New York Times bestselling author) Stephanie Kelton a chuckle. Bassman’s point, obviously, was that while he’s still in the camp which believes the theory is too good to be true (that’s an oversimplification of his position, but in the interest of brevity, I’ll use it here to describe MMT critics as a group), it could be quite a while before the proverbial chickens come home to roost once overt deficit monetization is undertaken.

Bassman was writing well before anyone knew about something called “COVID-19”. The pandemic will likely have a lasting economic legacy, and part of that legacy will be that, at least temporarily, it prompted policymakers to cast aside concerns about debt, deficits, and the monetization of debt and deficits by central banks.

This is a subject that deserves every bit of the press it’s received — and then some.

In a good note out earlier this week, TD’s head of global macro strategy, James Rossiter, takes up the discussion.

The point here isn’t to beat any dead horses (so to speak), but rather to highlight some additional color in order to help connect the dots for readers, who have shown quite a bit of interest in this ongoing debate.

“What has been remarkable about the stimulus measures announced to date is the relatively similar sizes of deficit expansions and central bank QE programs”, Rossiter notes.

“For Canada and the UK, our expectations are that QE will almost perfectly match deficits in 2020 [while] in the euro area, QE is likely to outstrip government deficits”, he adds, before noting that “while in the US, the deficit looks set to out-strip QE significantly, the Fed has been more creative in its crisis response than many of its G10 peers, so QE perhaps does not proxy as well the central bank’s crisis response”.

Obviously, this is not a coincidence. Monetary policy as it manifests in asset purchases is being calibrated based on the size of the debt governments issue to finance virus relief spending.

The buying of government bonds by a nation’s central bank is by definition debt monetization. To say otherwise is to traffic in nonsense. The fact that there’s an intermediary (primary dealers) doesn’t change this. That setup is simply a Wizard of Oz-ish “pay no attention to the man behind the curtain” dynamic.

In their note (dated Wednesday), TD inadvertently underscores how maddeningly self-referential this has all become. Consider this passage, for instance:

As debt levels pile up and QE becomes increasingly pervasive, questions are being asked about the independence of monetary and fiscal policy. As the chart above shows, it looks like the two are acting in a coordinated fashion, with QE closely matching new debt. The re-activation of the UK government’s “ways and means” account at the Bank of England has led to accusations of debt monetization there (we disagree: it is an accounting operation until the government issues more debt later this fiscal year; it has yet to be used in 2020). Pure monetary transfers to households from the governments in Japan and elsewhere have been dubbed “helicopter money” (we disagree: the government is borrowing to finance them). As central banks are swift to say, they are merely pushing back on the same negative shock as the government, so it only appears that fiscal and monetary policies are being explicitly coordinated.

Note the second “we disagree” point. I don’t want to come across as derisive towards TD (because their note is actually quite good) but, I’d be remiss if I didn’t ask readers to consider whether it makes sense to say that monetary transfers to households are not “helicopter money” because “the government is borrowing to finance them”, when it is the central bank that is buying the newly-issued debt. That is question-begging at its best (or worst, depending on how you want to look at it).

TD goes to ask what might well be described as one of the most important questions of our time, economically speaking. To wit:

What’s so wrong about central banks permanently raising the monetary base as the government borrows, especially if it’s debt monetization rather than helicopter money? 

That passage generally hews to the accepted notion that we aren’t splitting hairs when we distinguish between debt monetization and helicopter money.

I would argue that it is splitting hairs — especially at this juncture, when governments and central banks are so clearly coordinating.

Here is TD laying out the supposed difference:

Creeping into the Unconventional: “Simple” debt monetization is when a central bank buys new government debt in the primary market and holds it permanently. If the central bank precisely buys all new debt issued, then debt held by the private sector would not change, despite higher government deficits and debt. This would limit the response of yields on government debt to the new supply of debt, and could boost economic activity by eliminating Ricardian equivalence. There are also more subtle ways to conduct debt monetization, as some G10 economies have done in the 20th century.

Uncharted Territory: Despite the term being thrown around loosely, helicopter money is something that’s been off-limits for most central banks since inflation targeting regimes became the norm. There have been more subtle, indirect ways of central banks financing government debt, but on the whole, the concept of a central bank buying government debt and writing it off (or simply printing money for the government) has seen little practice in developed economies in the last few decades.

The Ricardian equivalence point is notable, but before I touch on that, I’d kindly ask readers to consider whether there really is a distinction between the two purportedly different concepts described in those simple paragraphs.

While it’s true that the market would take note (and that’s putting it mildly) of a decree by a government to cancel all of its own debt held by the central bank, one wonders if that would really have much of an effect on consumer inflation expectations in developed economies.

Sure, such a move would push up market-based measures of inflation expectations dramatically (indeed, for the first day or two after a hypothetical cancelation of central bank-held government securities, there would be all manner of volatility), but does the public in the US or Japan or France or the UK really know enough about QE to react in a way that would trigger a self-feeding hyper-inflationary spiral? The average American doesn’t even know what the Fed is, let alone what the Fed does, let alone what QE is. And we’re supposed to believe that if the Treasurys on the Fed’s balance sheet were simply canceled, that Americans would suddenly behave in a way that would drive up prices for things like bread? The vast majority of Americans aren’t even financially literate.

But let’s leave that extreme example aside, because it’s controversial and, in the event the public did figure it out, it’s possible things could go decisively wrong.

TD assumes simple debt monetization, where the charade is maintained, and then elaborates on why this may be desirable under the current circumstances. To wit, from the same note:

There are some fundamental economic arguments in favor of debt monetization, especially in the current circumstances. First, expanding the monetary base permanently should in theory be somewhat inflationary, and in a world where debt levels are surging, even if to still-sustainable levels, a little extra inflation could be a welcome development to deflate debt. Second, to the extent that fiscal spending is financed by the central bank, then Ricardian equivalence is less likely to hold, as individuals and firms won’t expect to have to pay higher taxes in the future so that the government can pay off its debt. They are therefore more likely to spend now, when the economy most needs it. While it’s not been used recently, there are a number of examples of developed economies successfully pursuing forms of debt monetization outside of wartime during the 20th century. In many (if not most) cases, the policies were complex, opaque, and importantly, not inflationary. Japan, under guidance of Finance Minister Takahashi conducted monetary financing in the 1930s to try to boost economic activity, and Canada did so in various forms from the 1930s until the mid-1970s, in part via the Bank of Canada’s Industrial Development Bank.

Those are all crucial points. As Bassman wrote in 2016 (and as plenty of other commentators have reminded the world at a time when debt continues to pile up), “there are only two avenues out of a debt crisis — default or inflate, and inflation is simply a slow-motion default”.

That kind of “slow-motion default” wouldn’t necessarily be the worst thing in the world for lower- and middle-income earners. If they can secure enough in the way of wage growth to keep pace with inflation, the people who will be disproportionately impacted by a “slow-motion” default would be creditors of all sorts.

On the Ricardian equivalence bit, note that I’ve discussed that at length in these pages, most recently in “‘It’s The Private Sector, Stupid’ – Trump May Have A Ricardian Equivalence Problem“. If the central bank holds the debt, then it may change the psychological calculus that, if you buy the theory, says the private sector will preemptively tighten its belt during periods of belt-loosening by the public sector.

But perhaps the most crucial point of all comes when TD notes that we crossed the Rubicon on this years ago, once it became clear that the total unwinding of central bank balance sheets was unlikely at best, and probably impossible. Of course, if you don’t ever allow the assets to runoff, then it’s debt monetization. Here’s one last excerpt from the note:

Central banks that have been conducting QE for over a decade and fully reinvesting maturing assets, like the BoE and ECB, are to some extent already conducting stealth debt monetization, and it will certainly ex-post look like debt monetization if balance sheets are not run down any time soon. But inflation over this period has remained tame, and in most cases below central banks’ targets (and certainly never far above them). The distinction that needs to be made here is that true debt monetization involves an explicit, ex-ante commitment by the central bank to permanently reinvest maturing debt forever, whereas the BoE and ECB currently see their reinvestments as temporary aspects of their policy regime, and still intend to one day let debt assets mature (even if that may be a long, long way in the future). The Fed avoided this label to some degree between 2017 to 2019, when it allowed its balance sheet to slowly run off.

The Fed may have “avoided” that label temporarily, but it was always explicit that the post-financial crisis balance sheet would be larger than pre-crisis, and that was before COVID came calling.

Now, the situation for the G4 looks like this:

Do not kid yourself: That is never (ever, ever) going to be unwound — not completely. This will never be “normalized”. In fact, it makes no sense to use that term anymore, because we’re a dozen years in — what you see in the chart is normal.

And that, folks, is the point.

“How long until a central bank decides that it needs to maintain the current size of its balance sheet to successfully implement monetary policy, and announces that it intends to fully reinvest its government debt indefinitely?”, TD asks.

We do not have to wait until central banks say that explicitly. The fact that the Fed was forced to start buying bills last autumn after the consequences of balance sheet rundown became clear in funding markets is evidence that even tentative steps down the road to unwinding balance sheets will cause technical tremors in the market’s plumbing. Giant strides down that road would lead to tantrums and worse.

But the funniest thing about all of the above is that the entire discussion rests on an observably false narrative about the sequencing of government spending.

In other words: Everything said above only makes sense if you assume something that isn’t even true in the first place.

On Saturday, in a tweet, Stephanie Kelton wrote that “MMT shows that it makes no sense to ask, ‘How should the government finance its spending?'”. She added the following, which I’ll present without further comment.

There is only one way to pay. All spending is already “money-financed.” So many people fail to understand this and end up saying that MMT advocates monetary-financing. That is wrong. 

I explain this in the book, using what I call the S(TAB) model. Taxes And Borrowing are secondary to Spending. They do not finance the spending.

By the time the government sells bonds, the spending has already been financed.


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20 thoughts on “‘Creeping Into The Unconventional’ And Why Everything You Thought You Knew Is Wrong

    1. It’s not clear you understand the context for this debate, let alone the debate itself. I can only do so much, folks.

      1. I didn’t mean to come across as irritable with this reply — I had quite a few technical snags while writing this lengthy post. Anybody here use a Mac? If so, you know what the “spinning rainbow wheel of doom”/”beachball of doom” is. I was plagued with that while finishing this piece. It’s enough to leave one temporarily insane.

  1. With apologies for not knowing all the vernacular of the banking and financing transactional systems, I wonder if anyone can estimate the cost of these gargantuan transactions that have been processed through various financial intermediaries when the government could have made these direct transactions. I’m guessing the intermediaries are loving the fed’s purchase of trillions.

  2. I’ve lost count already on how many commentators, including many respected ones, who sum the fiscal deficit and the FED balance sheet increase and term that the amount of overall “stimulus”, without realizing most of it is double counted.

  3. It seems to me that no discussion about the limits of MMT is the greatest challenge with MMT. It seems no way to measure how much MMT is the correct amount and what if anything to do but to perpetuate it to infinity. No one it seems in these pages defends the thought that at one point it will fail but be dammed if anyone can point to a reasonable explanation why it will fail, when it will fail and how it will fail. Maybe I am missing the point and am still trying to excise the demon of hyperinflation caused by deficit spending as we knew it to occur in history. I am trying to read with an open mind.

    1. It’s certainly fair to question the limits of MMT, but I think the main point that H is consistently trying to make is that we already have MMT in practice and that the notion of the government running a deficit is an artifice that doesn’t really tell us anything meaningful. We need to have the discussion about what the limits to MMT might be, but we can’t have an honest discussion if most people can’t recognize the reality of where we are today. Otherwise, we are just talking past each other.

      Now if we accept that MMT is already being practiced, I would argue that our obsession with deficits has already caused the current version of MMT to fail. By hamstringing our government for the sake of “fiscal responsibility,” we have left the dirty work to the Fed but they are limited in how they can respond which has led to massive inequality and limited real economic growth.

      As far as the historical examples, I think it’s important to understand the differences between say, the US today and examples like the Weimar Republic or Zimbabwe. We have a fiat currency and serve as the world’s reserve currency. Could that go away? Eventually perhaps (see Dalio’s analysis about previous superpowers), but there aren’t a lot of good candidates coming along anytime soon. That doesn’t mean we run the printing press at full bore, but we do have options should inflation start to heat up.

      In the meantime, we could do a lot of good investing in things that improve lives. I’d start with infrastructure and education (early childhood and college) programs, but that’s a separate topic.

      1. I guess I am sold on the concept that we are at MMT. These pages have enlightened me to that fact. If that is true for most if not all readers then the task should be to build on that. However there are likely some or even most as you say readers here that have not understood this point.

    2. I should also add that, as H has stated repeatedly, the other alternative to our current form of MMT would be the Austrian economics solution of letting companies go bankrupt which would almost certainly lead to a severe depression. I would also argue that scenario would be a massive failure in both human and economic terms.

      To be fair, I haven’t personally experienced the type of inflation we had in the early 80s, but we made it through that without too much damage. I also recognize the short-term incentives politicians have to provide free stuff so to speak, but right now, we are already doing that and most of that stuff right now is going to the already wealthy.

      Side note: I do appreciate that people can have serious discussions here. These are important questions and it’s nice to know that the readers here can generally understand the nuance in these discussions.

      1. I have also been enlightened to the fact that these calamities are avoiding massive disruption at the cost of enriching the already rich who have controlled the narrative by widespread propaganda about how it is immoral to help the poor. To me that is the real battle, the moral imperative that is neither moral nor an imperative. I appreciate learning that simply cutting out the middlemen does much to reduce this inequality inflating machine.

        Personally I think we have rationalized starvation as a moral imperative versus giving money to the already rich in the form of Tax cuts. However the poor spend what you give them and the government gets back 50-80% of what they layout in subsequent taxation as the money rolls through the economy. Give it as a tax cut to a rich man and you may not see it back in the taxation system for a generation or two. To have built these beliefs through systemic propaganda as a means to destroy the Federal Government due to hate for the Union win over the Confederacy as some people believe is something more should be aware of. My point is: there are lots of forces at work here and not all of it is ignorance.

  4. Really nice exposition of a complicated and complex debate; I plan to read it a couple, four times over the next few days to make sure I totally understand all the competing positions.

    On the inflation point, however, this graph seems key: “That kind of ‘slow-motion default’ wouldn’t necessarily be the worst thing in the world for lower- and middle-income earners. If they can secure enough in the way of wage growth to keep pace with inflation, the people who will be disproportionately impacted by a ‘slow-motion’ default would be creditors of all sorts.”

    If inflation is based on expectations of future inflation driven by pressure on wages, how can we be talking about MMT-driven inflation when the job security expectations of low- and middle-income earners — let alone their expectations for higher wagers anytime soon — are low and sinking.

    (Full disclosure: I have argued both sides of the inflation-coming debate.)

  5. “By the time the government sells the bonds, the spending has already been financed.” No kidding, and the source of the financing is the buyer of the bonds. The financing doesn’t occur until the bond is bought. Is she is saying that the spending is financed “before” the bond is bought? If so, how? The word “financing” means “to provide funds for”. What funds are provided if the bonds are not purchased? It seems like what she is talking about is a proposition rather than a description of what is actually happening now. The only way to pay for spending without taxpayer or bondholder dollars is for the central bank to issue a credit directly from its balance sheet, and have that suffice as “payment”, “funding”, or “financing” of said spending. That would undeniably be “monetary-financing”.

    1. Chris, I think you have just discovered reality my friend. We spend money first, and take it in later. You do realize that Kelton worked on Capitol Hill, right? This, from you: “The financing doesn’t occur until the bond is bought”, is literally not true, my friend. Welcome to reality! In all seriousness, I suggest you order Dr. Kelton’s book. You’ll be in for a real shocker.

      1. The key point here, Chris, is that we create the money out of thin air. We do not have to wait on China to “lend” us dollars, nor do we have to wait on taxpayers to send us a check. That just isn’t true. We just keystroke dollars into existence. I realize that is an uncomfortable reality for a lot of folks, but there it is.

        Here is a bit more:


    2. Words matter. Federal “debt” in a misnomer. The currency creator does not need to “borrow” currency, anymore than an apple farmer needs to borrow apples. The Federal “debt” is the stock of Treasury securities which, in turn, are simply savings accounts that pay interest and provide a safe place to store dollars which helps maintain demand for the currency.

      “Debt” must be paid back, while created currency (by spending it into the economy) can be taxed back (destroyed), but does not have to be.

      Treasuries securities are purchased with dollars that are already in existence (either sovereign-created, or bank -credit). The government chooses to match deficit-creation (spending) with Treasury sales, but it is not functionally required; it is a vestigial action from the gold standard days.

      Also, inflation is the only non-self-imposed limit on deficit spending…and since inflation is a result of shortages (not too much money), if the spending is productive then there will be no shortages and, therefore, no inflation.

      1. There is always a shortage of Real Estate. Now we can talk of allowed purposes, but the bottom line is that not all things can be ‘produced’. So inflation can and does result from increased money. Not all economic problems can be solved by limiting factory wages combined with the liberal application of the rod.

  6. We all laughed at Japan back at the turn of the century and after 2009. “Why don’t they follow our example and let capitalism clear away the losers? They should just rip off the band-aid like we did!”

    Fast-forward 10 years. The BOJ had led the way in MMT and were are, once again, following.

  7. Maybe this is nothing to worry about. Who knows. Unless “no free lunch” is a flawed theory, one suspects that the risks are being minimized at present due to conviction that inflation does not appear to be “always and everywhere a monetary phenomenon.” We will only know how useful or innovative or how dangerous MMT is until after the fact.

    1. One thing clear to me from these pages is that MMT is not a flawed theory. It is as I love to see in the physical world, one of the valid competing theories that explain our reality.

      The usefulness of MMT has been recently demonstrated.

      However your point about danger seen only in retrospect is sadly one of the human conditions we are faced with on many fronts. Examples: climate change, unfettered pollution, explosions, OSHA, FAA safety procedures and many many other examples.

  8. We may be in the unconventional “weeds” these days as the problem is different from any in my 75 years experience, the basic underlying tools/levers we are fiddling with have been around. What does appear to be happening is that we are collectively more sensitive to the labels applied to people and their actions these days so it seems that much of the conversation about policy is about labels rather than actual actions. “Helicopter money,” MMT or whatever. The discussion should stay, as it does in most of H’s work, on reporting actions. Seems to be a lot of sophistry going on in pundit town. If anyone actually knows what the heck the world will look like after two or three years of COVID remediation I sure haven’t found them yet. For now the market feels a lot like it should carry the poet’s warning, “Abandon hope all ye who enter here.”

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