...against fictions and other tall tales

Thursday, 19 January 2012

Guest post by Joseph Laliberté: “Prudential liquidity” for a country with its own floating currency: frivolous and meaningless

The following is a translated version of a post originally published in French on Joseph Laliberté's blog, Défricher l'économie, dated November 19, 2011. In the post, Joseph examines a recent announcement by the Bank of Canada using insight from Modern Monetary Theory.

The Bank of Canada recently announced its intention to increase to 20% the share of the debt issued by the federal government that it buys directly at government debt auction (note: it should be noted that the auction itself is managed by the Bank of Canada). This initiative is set in motion in the context where the federal government wants to increase its 'prudential liquidity' by $35 billion.

A logical question from this would be where will the Bank of Canada find the $7 billion (that is to say, 20% multiplied by 35 billion)? The answer is nowhere. This money will appear on the balance sheet of the Bank of Canada as if by magic. Here's what will happen to the balance sheet of the Government of Canada and the balance sheet of the Bank of Canada when the operation is realized:

Government of Canada
+ Deposit at the Bank of Canada
+ Issued bonds

Bank of Canada
+ Government of Canada bonds
+ Deposit from the Government of Canada

All the Bank of Canada needs to create such accounting entries is...a computer with a spreadsheet program (for instance, a 286 computer equipped with the 1993 version of Lotus would do). It should further be noted that this transaction is internal to the federal government given that the Bank of Canada is a Crown corporation that is ultimately owned by the people of Canada.

I can already hear the good "old school" post-Keynesians saying that the example above holds only for the 20% share of new debt issuance that the Bank of Canada buys directly at auctions.

Moreover, these critics may also point out that in countries having their own currency, but where the central bank is not allowed to buy bonds directly from the government (i.e. its treasury or finance department), the above example would also not hold. In my view, it would still hold, but one small step would need to be introduced. Using the United States as an example, the Fed would need to first buy Treasuries (à la QE2) on the secondary market from private banks, and credit these banks’ checking account at the Fed (called excess reserves):

+ U.S. Treasuries
+ Excess reserves

Then the U.S. Government would issue new treasuries on the market, which would simply result in excess reserves being transferred from private banks’ checking account at the Fed to the U.S. government deposit account also at the Fed (that is, bonds issuance by the U.S. government would “mop up” or drain excess reserves):

No change
- Excess reserves
+ Deposit from the U.S. Government

Therefore, in technical term, it is the capacity of a country with its own floating currency to create reserves at will that renders the issue of whether such a country has enough "prudential liquidity" frivolous and irrelevant. Although Warren Mosler’s saying that a country with its own currency never has or does not have its own currency has been the subject of some friendly criticism lately, I still find it relevant: in both examples, Canada and the United States are not richer, poorer, safer or riskier because they suddenly have more prudential liquidity in their account at the central bank.

In a nutshell, the concept of prudential liquidity is relevant for countries that do not have their own floating currency (e.g. Greece, Ireland, Portugal, France, etc), just like it is relevant for households and businesses, but it is meaningless for a country with their own floating currency (e.g. U.S., Canada, Sweden, Japan, United Kingdom, etc).


  1. nods Joseph Laliberte & Circuit! excellent initiative. the most pragmatic deterrent to ineffective liquidity management is prudential liquidity. BoC's and Fed have learned much from Asia in this regard.

  2. Hi, what is the process that disallows a country with a pegged currency from creating reserves? I'd like to understand that better. Tks.

  3. Anonymous:
    The country with a pegged currency (just like a regular households or businesses) has to borrow the amount first within the private banking sector. Therefore the reserve drain operation (which is the bond or loan issuance) happens concomitantly with deposits being created in the private banking system.

    Let say Country A is on a pegged currency. Country A issues a bond that is purchased by private Bank X. Then private bank X balance sheet will become:
    bonds from Country A
    deposit from Country A

    So any loans generated within the private banking system corresponds to what is depicted above. No excess reserve is created. Please note that a country with its own currency could also follow what is depicted above, but in its case, excess reserve creation remains an option. Moreover, it is its central bank that dictates short term rates on government debt (the central bank could also dictate long term rate if it wishes).

  4. tks Jos ... is there a difference between a situation where Country A is in, say, the Eurozone (where it doesn't own the currency it uses), or if it actually does have its own currency, but pegs it against another (like the USD, for example)?

  5. Anonymous,
    Excellent question... certainely part of the difference lies in the fact that a country in a "pure peg" (e.g. Argentina in the 1990s) has no authority whatsoever vis-à-vis the central bank of the currency-issuing country (e.g. Argentina had no authority vis-à-vis the Fed). Similarly, Greece has obviously very little authority vis-à-vis the ECB, but at least it is a member of the ECB and could try to influence (not that this would make any difference on ECB policy). Greece could therefore be considered on a "quasi" pure peg.

    Where it is more complicated is when we talk about political heavy weights within the Euro zone like Germany and France. I am not willing to say that Germany is on "quasi" pure peg just like Greece is simply because Germany could have massive influence on ECB policy if it wants to. If Germany one morning thinks it is a good idea for the ECB to buy national goverments debt, it is very likely that this will happen fairly quicky, and even more so if France is on side (can we imagine the ECB President standing up to both France and Germany? Maybe, but he will have to resign soon afterward!).

    So all to say that there are very good reasons why the market has been treating Germany as a "quasi" currency-issuing country so far in this crisis: political weight matters. This is why MMTers talk about the "hierarchy of money". For a currency issuing government like Canada, the government itself sits on top of this hierarchy.

  6. Joseph Laliberté great stuff in your blog. I have a few queries:
    You refer to some of the Euro-Area countries as quasi currency issuing sovereigns. The underlying premise being that they have the political clout to unilaterally dismiss the constitutional mandate of the ECB regardless of the impact it may have on other EA sovereigns that don't enjoy the size or force, who can't persuade the ECB in their favor. Is constitutional dismissal actually possible?

    My second question refers to a comment made by another interlocutor JHCraw where he concludes that taxation does not fund deficits and is actually a fiscal mechanism (Govt alternative to CB intervention) to alleviate liquidity from the system...Do you agree with this position, and is this position only tenable for 'true' currency issuing sovereigns? Is it tenable for EA sovereigns under existing conditions as you outline above or do we have a two-tier purpose for taxation?

    1. I concur with GC. One modest note: under the circumstances, the EA members should be thankful that Mr. Draghi dropped rates, and incited secondary market operations. Aside from the overall bearish outlook on the euro, lower rates further depressed the currency, and will probably spur some foreign trade (which is needed by most EA members inc. Germany), although global demand is very slack.

  7. Keynespendulum:
    I am no expert on constitutionnal affairs, or for that matter on ECB governance, but as far as I can tell, the modus operandi of the Euro zone is to have Germany and France agree together on something behind close doors and then presenting to others: "here's what we all going to do". In my view, pushing political power to its logical extreme, military force matters a great deal. I have always thought that before Greece decides to go back to the drachma, and before Greece tells the Bundesbank that all the Euros it owes it are being converted to drachma, Greece should sign a comprehensive military cooperation agreement with the United States. (bullying of nations that default is inversely related to its military strenght... Creditors tried to bully Argentina, but nobody has tried to bully Russia when it defaulted).

    Regarding your second question, this is something on which I am working right now, and I intend to post on it soon. Raising the overnight rate (i.e. using monetary policy) instead of increasing tax (i.e. using fiscal policy) is in my view a highly imperfect tool in trying to tame inflation (taxation directly destroys deposits, while raising interest rate aims at trying to slow down their creation, the outcome in the latter case being highly uncertain.

  8. Thank you for your comment on my second question. I look forward to your article, as always.
    On the other hand, I apologize for maybe having misled you in qualifying certain EA sovereigns as ones "that don't enjoy the size or force, who can't persuade the ECB in their favor." I referred to their economic profiles, not military capabilities.

    1. KP, just to clarify: JL did not say some EMU countries are quasi currency-issuing sovereigns. This is what JL wrote:

      "I am not willing to say that Germany is on "quasi" pure peg just like Greece is simply because Germany could have massive influence on ECB policy if it wants to. If Germany one morning thinks it is a good idea for the ECB to buy national goverments debt, it is very likely that this will happen fairly quicky, and even more so if France is on side"

      All he is saying is that (1) Greece could be seen as being on a quasi pure peg and (2) Germany has much more influence over the ECB than periphery nations.

      In my view, the former is a good way of putting it. The latter is an incisive read of the internal euro politics.

  9. @KP Your caution is valid! The ECB has no constitutional ground to prescribe or impose measures and actions beyond its mandate, nor does any member or limited group of members have the constitutional privilege to constrain the ECB to direct action it does not intend.

    Frankfurt cannot legitimate the political and constitutional umbrella required by the ECB in order for the latter to assume the role of lender of last resort without Treaty changes.

    What the ECB is being asked for is an open-ended commitment to support member debts by accepting to underwrite potential default. This is equivalent to a transfer of fiscal sovereignty that will de facto make all euro-zone countries responsible for each other's debts. Even if the ECB had the legal power to assume this responsibility under the European treaties, (and it says it doesn't), it cannot enforce reforms nor guarantee results thence, nor can it ensure that it will minimize potential losses for taxpayers.

    @JL nods!! nice article. You have a gritty style, esp in your blog, notwithstanding my limited french. Your content is great.