Money Creation, Policy Innovation and Fiscal-Monetary Coordination
——An exclusive interview with Paul Sheard, the former Vice Chairman of S&P Global and a former Senior Fellow and Research Fellow at Harvard Kennedy School
Author: GAO Zhanjun Paul Sheard
Inan exclusive interview with China Forex, Dr. Paul Sheard shared his insights with Dr. Gao Zhanjun, Executive Editor-in-Chief of China Forex, on money creation, fiscal-monetary coordination, and the disruptive power of cryptocurrencies and AI, among other critical topics.
Paul Sheard, an Australian-American economist, is the former Vice Chairman of S&P Global and a former Senior Fellow and Research Fellow at Harvard Kennedy School. He spent eight years at Lehman Brothers, initially as Chief Economist, Asia, and later as Global Chief Economist and Head of Economic Research. He then worked four years at Nomura Securities as Global Chief Economist and Global Head of Economic Research. He served six years at S&P Global, most recently as Vice Chairman. Prior to this role, he held the positions of Executive Vice President and Chief Economist, and earlier served as Chief Economist and Head of Global Economics and Research at Standard & Poor's Ratings Services. He held Lecturer and Associate Professor positions, respectively, at the Australian National University and Osaka University, and was Visiting Scholar and Visiting Assistant Professor in the Department of Economics at Stanford University. Sheard has served on several expert councils of the World Economic Forum (WEF).He is a member of the Board of Advisors of the Levy Economics Institute of Bard College, and sits on the board of the Foreign Policy Association. Additionally, he is a member ofthe Bretton Woods Committee, the Council on Foreign Relations, the Economic Club of New York, and the National Committee on US-China Relations. He has authored or edited five books, including The Crisis of Main Bank Capitalism (published in Japanese by Toyo Keizai Shinposha, 1997), which won the Suntory-Gakugei Prize in the Economics–Politics Division, and The Power of Money (Matt Holt imprint of BenBella Books, 2023), a Wall Street Journal Business Bestseller. In 2006, Sheard was named by Advance as one of 100 Leading Global Australians.
Sheard holds a PhD and a Master of Economics from the Australian National University (ANU). In 2019, his alma mater, Monash University, awarded him an honorary Doctor of Laws.
The following conversation, presented in an edited format, highlights key issues related to money creation, the way in which the monetary system operates, the nexus of fiscal and monetary policy, and the disruptive power of cryptocurrencies and AI, along with core fundamental and institutional matters that feature prominently in the frontiers of discussion.
Discussion 1
Center of the storm: witnessing the 2008 US and Global Financial Crisis
Dr. Gao: It's a great honor to have you today for this conversation. You have built an illustrious career spanning academic and professional practice. Your latest work, The Power of Money, a Wall Street Journal bestseller, is both provocative and insightful, and has drawn widespread attention. Today we will cover a range of topics, but let's begin with the 2008 US and Global Financial Crisis, because as Lehman Brothers' Global Chief Economist back then, you were right at the center of the storm. Lehman Brothers filed for bankruptcy on September 15, 2008, marking the climax of the subprime mortgage crisis. Its collapse sparked the world's worst financial turmoil since the 1930s, which quickly went global.
Dr. Sheard: Yes, I was the Global Chief Economist of Lehman at the time. We produced the Global Weekly Economic Monitor, a very popular piece about 80 pages long, covering the whole global economy, which was published on Friday, right at lunchtime EST. Lehman went bankrupt in the early hours of Monday morning on September 15, 2008. We came into work and then there were bankruptcies in the UK and all sorts of things, but we basically just went on and continued to do our job. And we ended up publishing the weekly economic monitor on Friday under the Lehman banner even after it declared bankruptcy. Our clients really seemed to appreciate that.
Dr. Gao: Did you anticipate Lehman Brothers' bankruptcy in the preceding week? I was working at CITIC Securities back then, and we closely monitored developments in the US throughout that turbulent period.
Dr. Sheard: Right. The week prior, the stock price was falling and rumors were swirling. Heading into that weekend, most people believed a rescue deal would emerge, similar to the one announced in March of that year for Bear Stearns. Bear Stearns was eventually sold to JPMorgan Chase for US$10 per share, and the Fed took on US$30 billion of its toxic assets. Lehman was four times bigger than Bear Stearns, and the TARP (Troubled Asset Relief Program) did not exist yet. Obviously, Lehman's management pursued various fundraising efforts and sought capital from such places as South Korea. I don't know if they went to China, but they were trying to get money from the likes of Warren Buffett, and maybe the Middle East, all sorts of places. And there were these spin-off ideas, maybe spin off some of the subprime mortgage book into a separate company and try to recapitalize, all sorts of ideas. But it looked really bad.
Heading into the weekend, most people expected either Bank of America or Barclays to acquire Lehman, or a bank consortium to step in under pressure from New York Fed President Timothy Geithner and Secretary of Treasury Hank Paulson, with the Fed likely to launch a Bear Stearns-style toxic asset purchase program. As I mentioned in my book, based on various accounts and autobiographies, a classic Catch-22, chicken-and-egg situation unfolded. Treasury Secretary Paulson said we couldn't put government money into this, we couldn't get the Fed or Treasury involved, because there were no rescue White Knights, because Bank of America and Barclays were not coming in. Other banks declined to form a consortium, as they waited for the government or Fed support. It was a typical standoff: a Nash equilibrium. If the Treasury and Fed had come in, the consortium would have come in; and if the consortium had come in, the Fed and the Treasury would have come in. But neither of them wanted to move first, so it didn't happen. That was an extremely hectic weekend, especially Sunday. The situation was far too complex for a deal to be struck in time. But I think a deal could have been done, and, if so, it would have been beneficial.
Dr. Gao: Many argue that failing to bail out Lehman Brothers was a mistake. Do you share this view?
Dr. Sheard: Well, I think history cannot be rewritten, so judgment is never easy. What would the alternative have entailed? In my book, I argue that the authorities should have launched some form of rescue operation for Lehman. The challenge lay in an intricate political landscape and prevailing public opinion at the time. In the US, the US$700 billion bank recapitalization framework under TARP would never have come into being without this financial crisis. It was not just Lehman Brothers facing trouble. American International Group (AIG), Bank of America, Citibank, Goldman Sachs, Morgan Stanley and others were also in distress. It was Lehman's collapse and the ensuing financial turmoil that pushed Washington to roll out the bank recapitalization plan. Without such a severe systemic shock, Congress would have lacked the political resolve to approve the TARP and speed up the overhaul of the banking sector. On the other hand, the recession, the global financial crisis and the resulting disruptions inflicted massive losses. Overall, from a policy standpoint, it would have been preferable to deliver a rescue package for Lehman while rolling out TARP, mandating full disclosure by banks and pushing through recapitalization. This approach would have benefited the US economy, the financial system and the global economy at large. European and Japanese counterparts felt aggrieved, as they saw the crisis originating on Wall Street yet ending up dragging the whole world into recession and financial turmoil. I still believe that alternative path would have been better, though policy decisions are never flawless.
Dr. Gao: Policymakers chose not to bail out Lehman Brothers. Was it because the Federal Reserve and the US Treasury lacked the capacity to do so, or simply the political will?
Dr. Sheard: They claimed they didn't have the capacity. The Treasury claimed, rightly, that the TARP had not yet been established, so no funds for bank recapitalization had been authorized to inject into the financial system.The Fed claimed that it didn't have authority. I discuss this at length in one chapter of my book. According to the Fed's explanation, it could not invoke its power under Section 13(3) provisions, which were later revised under the Dodd-Frank Act. This section stipulated that in "unusual and exigent circumstances" the Fed could extend loans to any individual, partnership, or corporation. What constitutes such unusual and exigent circumstances? They apply when an entity "is unable to secure adequate accommodations from other banking institutions." When would a bank be unable to obtain funding elsewhere? Typically, when market participants fear it is insolvent. Additionally, Section 13(3) required all Fed loans to be "secured to the satisfaction of the Federal reserve bank." The rule does not explicitly reference financial crises, yet it clearly envisages such a scenario. The Fed was permitted to provide unlimited funding under these conditions without seeking approval from the Treasury or Congress, provided the collateral met the Board's requirements.
About a month later, Bernanke stated in public speeches that the Fed could assist AIG but not Lehman, bercause Lehman lacked sufficient collateral to fully secure the loan. I contend in my book that this reasoning is flawed. When the Board of Governors of the Federal Reserve System invoke Section 13(3) to authorize their constituent Federal reserve banks to make such loans "secured to [their] satisfaction," the seven governors must deem the collateral adequate under the "unusual and exigent circumstances." It didn't mean that the collateral had to be entirely risk-free. Central banks routinely apply conservative haircuts to collateral. Logically speaking, if Lehman could have offered perfectly sound, over-secured collateral, it would have easily have been able to obtain loans from private markets.
The Fed says unless you can prove that you have this fully secure collateral, we're not going to lend it to you. But if you can prove that, I'm sure lots of other banks would be prepared to provide some finance. So, my argument is, I'm not a lawyer, but to be "satisfied" just means that they have to be satisfied within the overall context of Section 13(3) and all agree that the emergency action is warranted. I think that at the very least the Fed could have provided an enormous amount of liquidity that could have saved Lehman and could have taken a lot of collateral. It would have been taking some risk. But the difference with the Fed is that the Fed's own actions endogenously influence the state of financial markets and the state of the economy.
Dr. Gao: Right, that's endogenous.
Dr. Sheard: They're not some exogenous actor, what they do will influence the future course of the economy, and the value of the collateral is endogenous to their own actions. So, when they forced Lehman into bankruptcy by saying they're not going to use Section 13(3), that led to the financial system collapsing, the economy going into a deep recession, and of course the value of Lehman Brothers' assets and collateral dropped sharply. You sometimes hear, Zhanjun, people say the Fed was right, but they are making that judgment after the fact. If the Fed had acted differently, the whole course of the US and world economy would have been different!
Banks act as intermediaries: they hold highly illiquid, economically productive and profitable assets, while liquefying claims for individual depositors, so they can easily monetize their assets into liquid consumption. It's a great human innovation. But if confidence in the banking system erodes and holders of liquid claim no longer want to keep their funds in banks and choose to move them elsewhere, banks will face a liquidity shortfall.
Dr. Gao: That's a mismatch.
Dr. Sheard: Yes, it's a mismatch. And the only entity in the economy that can solve that problem is the central bank, so that's why the central bank's role as lender-of-last-resort is so important. The government through the central bank can step in as the liquidity provider and instantly liquefy assets, and it doesn't have to force the banks to have a fire sale of their illiquid assets. So, in a financial crisis, the role of the central bank as lender of last resort is really important. In a sense, the Fed failed to fulfill that responsibility in September 2008, with quite major consequences.
But this also gets back to monetary and fiscal policy, which we will no doubt talk about. Monetary policy is technocratic and fiscal policy is political. The lender-of-last-resort function is technocratic at one level, but it's obviously also very political. Decisions over who gets bailed out, when they get bailed out, how much they get bailed out, what strings are attached to the bailing-out. Central banks themselves, even though they know they're the ones that have the leeway, that have the trigger on the tool, they're very reluctant to use that, because by its very nature they're stepping into political territory. So that's where in the framework you need some political involvement in the process as well. But the politicians often don't want to make the decision either.
Discussion 2
Highly prominent in the policy debate: Japan's bubble burst and lost decades
Dr. Gao: Let's talk about the intriguing policy debate about the bursting of Japan's asset price bubble at the end of 1989 and early 1990, and also its "lost decades" afterwards. You started your research on Japan, and you entered financial markets in Japan, and you have experienced so many things in terms of rapid Japanese economic growth, soaring equity and real estate markets, the bursting of the bubble and then the "lost decades." You were highly prominent in the policy debate related to all the issues above in real time. So, I guess you might be the best person to talk with about what has been going on in Japan since the 1980s until very recently.
Dr. Sheard: Fantastic question. Japan is a great place for economists to study what's going on in terms of speedy economic growth and also the bursting of a bubble, financial crises, banking crises, mounting government debt, numerous innovative monetary policies and related fiscal issues.
So, going way back, first you had the post-war recovery, followed by what's known as the "high-growth era" generally spanning 1955 to around 1971. The 1970s brought two oil shocks, and Japan lost competitiveness in a lot of basic material industries that had been helping to drive the postwar high growth. By the late 1970s and the early 1980s, Japan was home to these structurally depressed industries. Legislation was enacted, and the government launched a large-scale program to assist the structural adjustment of these depressed industries, which proved quite successful.
But then we get into the 1980s and Japan again went into the next phase, which was adapting to a slower growth economy and also facing pressure from the US to open its capital markets and economy more generally. And the basic business model was changing in Japan, because successful companies like Toyota, which had been dependent on banks for their funding no longer needed them, they had enough internal cash flow. So, banks started to look around for other sources of loan demand, and more money started to go into the real estate sector.
Then you had the Plaza Accord in 1985, aimed at strengthening major currencies, including the yen, against the dollar, followed by the Louvre Accord in 1987.So, all of these set the stage for a massive asset price bubble to develop in the second half of the 1980s. There's still debate about what exactly caused it. It was a classic kind of bubble in the sense of irrational exuberance. Bank lending poured into real estate, often indirectly through real estate companies, development companies, and non-bank financial corporations. One of the features of corporate organization in Japan wasinterlocking shareholdings and these helped to fuel the bubble as well as the rise in equity prices fed further rises through the extensive equity holdings Japanese companies had in each other. Monetary policy had been kept very loose because the yen was appreciating. The Nikkei stock market index peaked on the last trading day of the 1980s at close to 40,000, and real estate prices continued to go up until the third quarter of 1990. But basically, at the end of the 1980s and the beginning of the 1990s, the bubble burst. When a bubble bursts, the bigger the bubble, the bigger the burst.
The collapse in equity and real estate prices left the banking system and much of the corporate sector essentially insolvent, with negative equity if you had marked assets to market. But companies and banks didn't have to mark their assets to market. Banks did not have to disclose their nonperforming loans to any great extent. Also, accounting at the time was done on a parent company basis. Big companies in Japan had hundreds of subsidiaries and affiliates, so it was very easy for companies to park their bad assets in subsidiary balance sheets, not on that of the parent company. This explains why the banking crisis in Japan in the first half of the 1990s was on a slow burn.
Now Japan had set up a deposit insurance corporation (JDIC) in 1971, but the JDIC didn't make a payout until 1992. Essentially, when you came into that period of the bursting of the bubble, no bank depositor had ever lost any money in the banking system in the postwar period, so to Japanese households and corporations the banking system was perceived as totally safe. Everybody thought the government would stand behind the system, which they did. What happened from 1992 to 1995 was that a number of smaller institutions started to go belly up. There were bank runs, but the regulators put the lid on things by leaning on bigger banks to engage in rescue mergers with the failing banks. The JDIC started to pay out some money to sweeten the deals. It would protect depositors indirectly because the bigger bank took over the deposits and then got some money from the JDIC to compensate them for the risks they were taking.
And that's what happened until the beginning of 1995. It was 1995 when the financial crisis really erupted. What happened in 1995? You had the Mexico debt crisis in December 1994, and then you had a disastrous earthquake in Japan in January 1994, the Great Hanshin Earthquake. I happened to be living in the area at the time with my family and we experienced the devastation first hand. The earthquake triggered insurance companies to pull back funds from overseas because they needed to make payouts. This caused the yen to strengthen, dealing a shock to the system. The stock market fell even further. The pressures on the system just became too big and the government had to move. There was a whole lot of stuff going on. The Bank of Japan (BOJ) cut the official discount rate (ODR) down to 50 basis points, and that was the beginning of super low interest rates in Japan. But the whole system was deleveraging, and when the banking system, corporate and household sectors are deleveraging, monetary policy has virtually no stimulative effect.
A key decision was made in June 1995 when the minister of finance came out and announced that all bank deposits would be guaranteed. Because by that time, people had been looking at the banking system and asking if my deposits were really safe, a little bit like what happened in the US in 2008. And people started to notice actually no, you're only guaranteed up to the equivalent of about US$115,000 at the time, that wasn't very much for a system that was collapsing. So, the government stepped in and said, don't worry, everything is guaranteed. The announcement by the government was enough to quell the incipient financial crisis and prevent a run on deposits in the banking system. Most people don't even know about this. That blanket guarantee looks a bit like what happened with the Silicon Valley Bank here in the US just three years ago.
Dr. Gao: Exactly.
Dr. Sheard: It's very similar. But here's what's different: It solved one important problem, and there wasn't a run on the banking system, you got financial stability. But it didn't address the underlying situation that many companies were insolvent and many of the major banks were heavily underwater, but that was not disclosed officially. And so, what the government did was to put in place what was called a 5-year financial stabilization program. Under this plan, for 5 years, all bank deposits would be guaranteed. But what they did not do, which is more important than what they had done, was to force the banks to disclose the true state of their balance sheets and put in place a massive bank recapitalization program. I was in Tokyo at the time, I was very vocal and prominent in the policy debate, and I was arguing that guaranteeing bank deposits is only the first step in solving the problem. You have to do two more things. One is to disclose the true state of the balance sheets. But if you do that, it's obvious that the banks are insolvent. So simultaneously you have to have a massive injection of capital into the banking system, which initially can only come from the government. You address the problem head on. You clean the problem up and then you move on.
Now the Japanese adopted the opposite approach, which was the approach of forbearance. Forbearance means you don't disclose and deal with everything at once. You disclose the true state of balance sheets gradually over time bit by bit, you use the flow of profits that banks are making to absorb the losses. The hope is that if you do that for long enough eventually you get through the problem. But first of all, in Japan's case the problem is too big, and it took more like 10 years than 5 years to work through it. And secondly, confidence was lost in the system. If you lose credibility, you lose policy effectiveness. That's what happened in Japan. Then the third issue was that around 1994 the economy slipped into deflation and a long period of debt deleveraging. The flipside of a deleveraging private sector was a blowout in the budget deficit as the government sector was forced to absorb the private sector's excess savings. The Japanese used forbearance, trying to play for time, but that didn't work, it just pushed the economy into "lost decade" territory.
The BOJ did ease monetary policy, cutting interest rates to 50 basis points, and then later on did zero interest rate policy, and eventually QE (quantitative easing), but monetary policy is not very effective in a deleveraging environment. As for fiscal policy, because the budget deficit was getting bigger and a mountain of government debt was piling up, there was a reluctance to do sustained fiscal expansion on the scale necessary, it was always stop-start.
So, the policy mix of banking policy, monetary policy and fiscal policy was the worst combination. Why did the policy makers not implement the right policy mix? The scale of the problems was huge and the system was not capable of reacting in the way needed. Nobody in the system – government officials, bankers or corporate management – wanted to take responsibility or exercise strong leadership. They went the de facto easy route, which is to cover things up, pull the levers that you can and play for time.
Dr. Gao: Those might be the reasons why some economists in the US back then, including Ben Bernanke and Paul Krugman, all criticized Japan's policy responses to these issues, though Krugman apologized in 2014. As a critic of the BOJ's monetary policy communication and actions, you have been a strong supporter of the Bank's April 2013 policy shift under Governor Haruhiko Kuroda, describing it as the monetary policy equivalent of a Copernican Revolution.
Dr. Sheard: When Governor Kuroda came in, Zhanjun, he didn't just change the operation of monetary policy by launching a very large-scale expansion of the BOJ's balance sheet, implementing a program of so-called Quantitative and Qualitative Easing (QQE), he also changed the BOJ's communication in a very significant way. What I mean is the following. Governor Masaaki Shirakawa, the previous governor, had propounded a theory of the case to the public. In fact, I happened to meet Governor Shirakawa two days ago in New York, just by coincidence, a charming, really nice man and very intelligent, an economics professor now. His argument was that the BOJ by itself couldn't get the economy out of deflation and achieve its price stability goal, it needed the help of the government and the private sector. Why is that? His diagnosis was that the underlying reason for deflation was the declining potential growth rate and the depressing effect which was having on the psychology of the private sector. Meanwhile, you have an aging society and people are saving for their retirement because they're worried about the future. So, what is the solution to that? The solution in his theory was structural reform by the government to raise the potential growth rate. His argument was thatmonetary policy could help, but the government, working with the corporate sector, needed to address the fundamental problem: the declining real growth rate. The corporate sector had to respond by investing and innovating, thus generating higher productivity and a higher potential growth rate.
Now, if you believe that story, it's hopeless. First of all, the signal from the BOJ to the public was, we can't do this, whereas that's the opposite of inflation targeting theory suggests the central bank needs to do. Inflation targeting theory holds that the central bank is able to manage the inflation expectations of the public. That rests on the public believing that the central bank has the tools to achieve its inflation target and is determined to use them. Then the public rationally should say, why should I bet against that? People will adjust their inflation expectations and those expectations will becomeself-fulfilling. But if the central bank says, no, we can't do it, then the public has no reason to change their inflation expectations. That's the first problem, Governor Shirakawa's communication was counterproductive to the whole idea that the BOJ could end deflation.
Secondly, if you really believe that theory, the idea that the government could implement structural reform that could raise future potential growth so much that it would raise inflation expectations by maybe two and a half percentage points, that's just like fantasy land. The only way realistically that potential growth could have been raised so dramatically if the government implemented a massive immigration program. But Governor Shirakawa never proposed that policy, which was obviously too politically sensitive. What Governor Kuroda did when he came in was to reverse the BOJ's message and say, no, we can do it, we have the tools, and we will use them, and do whatever it takes. That solved the monetary policy part of the equation. The problem was that the government used the cover of QQE to double the consumption tax rate, from five to ten percent, draining consumer purchasing power. Monetary and fiscal policy were working at cross purposes yet again.
Discussion 3
The Power of Money: money creation and its policy implications
Dr. Gao: Now let's talk about your book, The Power of Money (Sheard, Paul. The Power of Money: How Governments and Banks Create Money and Help Us All Prosper. Matt Holt Books, an imprint of BenBella Books, Inc, 2023.), a Wall Street Journal bestseller. Congratulations!
Dr. Sheard: Thank you very much.
Dr. Gao: This is a provocative and fascinating book, and the topics are very timely. I still remember back in 2019, there was a testimony at the Committee on the Budget of the House of Representatives in the US. The Committee titled the hearing "Reexamining the Economic Costs of Debt". Expert witnesses included Olivier Blanchard, L. Randall Wray, Jared Bernstein, and John Taylor. This should have been a completely ordinary hearing. However, it attracted considerable attention due to the participation of Wray, a representative of the controversial unorthodox theory known as "Modern Money Theory" (MMT), which is very much related to the topic of your book.
Dr. Sheard: Right. This book is about money. I spent more than twenty years in financial markets, much of it as a chief economist at various institutions explaining monetary and fiscal policy issues to clients in this era of "unconventional monetary policy" and rising government debt levels. What I realized is that, although people in financial markets are very intelligent, they often lack a solid understanding of these issues. I wanted to write a book that explains these concepts in terms ordinary people can understand. I didn't want to write an academic treatise meant only to gather dust on a shelf. Economists, financial practitioners, central bankers and governments often discuss monetary and fiscal policy using frameworks and jargon that I find highly misleading. A great deal of confusion surrounds how the system actually operates. My main goal for this book was to clear up that confusion and lay out the reality. I hope that after reading it readers could gain a clearer grasp of how the system functions and draw their own conclusions about contentious policy issues.
Now what is the book about? First, I seek to answer two core questions, The first is: where does money come from? How does it enter the system? When you ask economists to define money, they typically list its classic functions: a unit of account, a medium of exchange, and a store of value. This framework dates back to William Stanley Jevons, a famous economist in the 1800s, who first formalized these concepts. It describes the necessary functions of money, yet it fails to explain what money truly is and where it originates.
From there, economists usually jump to categorizing various measures of the money supply, called monetary aggregates, notably M0, M1, M2, and M3, which essentially add less liquid forms of money as the number go up. Money features centrally of course in various macroeconomic models such as IS/LM and aggregate demand and aggregate supply models, and in different schools of thought, including Keynesian, monetarist, rational expectations, and real business cycle theories. But we rarely give serious thought to how money comes into existence and enters the economy in the first place.
On the other hand, many books explore the history of money, tracing its evolution from commodity money to fiat money, and now to crypto currencies. I chose not to write another history of money. The first few chapters focus on how money enters a growing economy. I use the bathtub analogy: imagine the economy as an expanding bathtub, growing 2% or 3% each year. The water inside represents money. Too much water leads to overflow, that's inflation; too little water leaves the tub cold, that's deflation. As the bathtub expands, the volume of water must rise steadily as well. How exactly does this happen? Most economists will say the central bank controls the money supply by shifting out a vertical money supply curve. If you probe, they will cite the money multiplier: the central bank creates base money by adding reserves, which then multiply through the banking system. This is the standard narrative, and it is one thing I wanted to debunk.
I break down the creation of money, taking M2 as a benchmark, into three primary channels. The most important is bank lending. When banks issue loans, they create money. Lending and money creation go hand in hand. We commonly call banks deposit-taking institutions, but they are in essence deposit-creating institutions.
The second channel is government budget deficits. This newly created money is usually converted into government bills and bonds. For reasons I find puzzling, economists do not classify government bonds as money. Classic macroeconomic models, including the Keynesian framework, treat bonds and money as two distinct assets. Whereas if you think about how money comes into existence and all the mechanics, it's much more natural to me to think of money and government bonds as two different forms of consolidated government liability or money. Now, you might say, hold on a minute, government bonds use the unit of account and they are a store of value, but they're not a medium of exchange. True, we don't actually use government bonds directly as a medium of exchange, but that's really just a technical or regulatory issue. Money market funds typically hold government bills and are considered part of M2. So are money market deposit accounts and you can write checks on these. So, it is better to think of government bonds as being a form of money or purchasing power but a bit further out on the liquidity curve than, say, bank demand deposits.
And then the third and least important one is central banks. Central banks create money, but in a very limited way, namely by supplying cash (banknotes) to the public and reserves to the banking system. These comprise the monetary base and show up on the balance sheet of a central bank as its liabilities.Reserves are deposit accounts that banks maintain at the central bank. Banks can lend their reserves to one another, but they can't lend them to regular borrowers. These reserves in a sense are trapped on the central bank's balance sheet.
Central banks create reserves and therefore base money when they do QE, but this is a more nuanced story and, as I just said, the reserves created just sit there. When a central bank does QE, it buys government bills or bonds and creates reserves in the banking system. If it buys the bills or bonds from banks, it just creates reserves, but if it buys them from entities not having reserve accounts at the central bank it creates deposits in the banking system too, increasing M2. When the central bank does QE, what it's doing is taking bonds and turning them into central bank reserves and possibly bank deposits, it's just changing the form of money. Where did the bonds come from to begin with? Well, they were issued to absorb, neutralize, or sterilize the reserves that were created in the first place when the government ran a budget deficit. Running a budget deficit creates reserves and issuing bonds expunges them. When they do QE, central banks are just reversing the operation; they are not injecting new purchasing power into the economy.
The second thing I want to explain in my book is how monetary policy works and how fiscal policy works, and to explain the relationship between them.
What is the right was to think about government debt? Because so much of the policy debate is hijacked by the idea that mounting government debt means we are mortgaging the future of our grandchildren and we are headed for a huge day of reckoning and a future debt crisis. I talk about that quite a bit, trying to explain that government debt is not really debt. I often use a USD 20 bill like this one here with Andrew Jackson on it to explain. This is a Federal Reserve note, a liability of the Fed. Notwithstanding its historically-conditioned peculiar organizational structure, the Fed is part of the federal government. The USD 20 bill is money issued by the federal government through the Fed. In fact, the two signatures on the bill, that aim to bolsters its legitimacy, are those of the Secretary of the Treasury and the Treasurer of the United States, who is a different Treasury official. If you took this money, a liability on the balance sheet of the Federal Reserve, to the Fed (or a bank acting on its behalf) and said, I want my money
back, they would just hand the USD 20 bill back to you or maybe give you twenty one dollar bills. This is what it means to be in a fiat money system, a system in which money has the value it does because the government deems it so and society as a whole goes along with that. Banknotes are a form of money issued by the government that never has to be repaid.
Central bank reserves are just a digital form of banknotes – the reserves never have to be repaid either – and government bonds are just one step removed from reserves.That step is QE or the central bank buying up the bonds. The central bank determines the aggregate amount of reserve in the system. The reserves just sit there forever, until something else happens: the central bank does quantitative tightening (QT), or the money moves into banknotes, or the government issues debt securities that will expunge those reserves. The central bank always gets to determine at any point in time the level of aggregate reserves and they never have to be repaid. Now, think of the stock of government debt. The central bank, which is part of the government, in theory conceptually could buy up all of the outstanding government bills and bonds, turning them into reserves. So, government bonds are one step removed froma form that never has to be repaid and that step is controlled by the government itself. So, it is misleading to think of government bonds as debt because it is debt that never really has to be repaid.
I also have a chapter on financial crises and one on inequality, because you can't really talk about money without talking about what could go wrong with it. I have a chapter on the euro whose prospects I'm quite negative on. What about the international aspects of money? I have a chapter on that, and I have a chapter on crypto currencies.
Dr. Gao: Some of the ideas you just gave are actually against many people's thinking. From your book, I can see that you have tried very hard to convince them. In trying to understand fiscal policy debates, you distinguish between two levels of analysis, one is the fundamental level, the other is the institutional level. By "fundamental level" you mean how things work in principle or in the abstract; by "institutional level" you mean how things work in practice, in the real world, given the institutional rules in place. At the fundamental level, you say governments create money when they run a budget deficit. At the institutional level, it appears that they have to borrow money in order to run a budget deficit. At the fundamental lev