Posted by: Dirk | November 15, 2013

Some Unpleasant Monetary Arithmetic

Sargent and Wallace in their seminal 1981 paper Some Unpleasant Monetarist Arithmetic describe a monetary system which is very different from what we see today. On page 1 the authors write:

The public demand for interest-rate bearing government debt constraints the government of a monetarist economy in at least two ways […] upper limit on the real stock of government bonds […]

The problem with this is that the Federal Reserve Bank holds US treasury securities outright, as data from the FED shows:

FEDERAL RESERVE statistical release

H.4.1

Factors Affecting Reserve Balances of Depository Institutions and     
Condition Statement of Federal Reserve Banks                                                November 14, 2013

1. Factors Affecting Reserve Balances of Depository Institutions
Millions of dollars
Reserve Bank credit, related items, and                          Averages of daily figures         Wednesday  
reserve balances of depository institutions at             Week ended    Change from week ended  Nov 13, 2013 
Federal Reserve Banks                                     Nov 13, 2013  Nov 6, 2013 Nov 14, 2012              

Reserve Bank credit                                         3,822,130   +   19,225   +1,029,811    3,863,922  
  Securities held outright (1)                              3,590,340   +   17,049   +1,000,240    3,630,670  
    U.S. Treasury securities                                2,131,729   +   11,211   +  480,874    2,137,037  
      Bills (2)                                                     0            0            0            0  
      Notes and bonds, nominal (2)                          2,029,515   +   11,181   +  461,558    2,034,815  
      Notes and bonds, inflation-indexed (2)                   88,589            0   +   16,245       88,589  
      Inflation compensation (3)                               13,624   +       29   +    3,069       13,633  
    Federal agency debt securities (2)                         59,080            0   -   22,822       59,080

So, the public demand for interest-bearing government debt does not constrain the government by setting an upper limit on the real stock of government bonds. Why? Because the central bank demands interest-bearing government debt. This is called quantitative easing (QE) and has happened during the financial crisis. Here is how that developed exactly:

WSECOUT

Which means that whatever is happening in reality now, looking at it through a Sargent/Wallace lens will not show you what is going on.


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