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
Asset	Liability
+ Deposit at the Bank of Canada	+ Issued bonds

Bank of Canada
Asset	Liability
+ 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):

Fed
Asset	Liability
+ 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):

Fed
Asset	Liability
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).