Saturday, February 26, 2011

A big pension fund manager goes to school, Mike Norman style

I had a conversation with a large pension fund manager recently on the subject of "Quantitative Easing" and deficits. This guy runs a portion of a $100 billion public worker retirement fund. (I leave him and the state, nameless.)

In the portion of money that he runs, he's heavily invested in gold because he basically thinks that the Fed is printing "too much money" and there's gonna be hyperinflation. "heavily invested," I mean that the guy has about 0.2% in gold out of that $100 bil. (I guess his bosses don't share his concerns.)

I tried to explain to this guy that there's nothing really different between a Treasury security and a reserve deposit (except for duration) and when the Fed conducts QE, all it's doing is stripping the public of one asset (a Treasury) and replacing it with another (a reserve deposit). No new money has been created and therefore, it shouldn't be inflationary let alone hyperinflationary. All that happened was that the composition of the public's financial assets changed, with a shift in duration from positive duration more toward zero duration.

He couldn't get it. Didn't wanna get it.

We didn't even go into the discussion about how there is so much slack capacity: in labor, industry, housing, etc. Where's the inflation going to come from unless it's a case of the market being manipulated (which I think it might be, but that's a whole, other story).

On the subject of gov't spending he said, "What if the Fed didn't buy Treasuries?"

The question was posed in a way that seemed to suggest that he thought the Fed was some kind of "enabler." That the Fed "funded" the government by buying Treasuries. By the way, a lot of people have this impression. I heard Schiff (gag) talk about this on Freedom Watch recently.

First let me say this: the Fed is PRECLUDED BY STATUTE from buying from the Treasury. The Fed buys bonds in the secondary market. Moreover, primary dealers, who do business directly with the Fed are OBLIGATED to participate in auctions, but granted, that does not mean they necessarily have to buy what the Treasury is selling.

But let's examine his question..what happens if the Fed went on strike and didn't buy Treasuries?

Well, as far as the government is concerned, nothing at all. The Treasury would keep right on selling bonds just the way it always does and that would drain reserves in the banking system causing the Fed funds rate to rise.

Hey, wait a minute! Cause the Fed funds rate to rise??? Well guess what? That's the same thing as the Fed having made a monetary policy move to raise interest rates, right? By not buying bonds the Fed has, de-facto, raised its target rate.

The only problem is, the Fed doesn't raiise or lower rates unless it wants to. That's why everyone waits around until 2:15pm ET on FOMC meeting see what the Fed's GONNA DO!

The FOMC decides on the rate it wants in accordance with its dual mandate of low inflation and high employment (the latter mandate may soon be taken away by Congress, at least that's how it seems from Republicans like Paul Ryan).

Why, then, would the Fed not buy bonds? That would essentially cede monetary policy directly to the Treasury and create a wonderful reason for the Fed not to exist. And unless the Fed is intent on committing institutional suicide, I don't think that happens. The Fed likes being the Fed.

Okay, what if nobody bought the bonds? I mean NOBODY! (This was actually the next question this money manager asked me.)

Then rates would probably rise to a level where risk free returns were available for below the cost of what someone could borrow money for. In other words you could go to the the bank, take out a loan for, let's say, 5% interest and invest in risk free Treasuries at, let's say, 6%? The world would be doing that all day long and soon enough that interest premium would be wiped out.

No doomsday. No end of the world, no hyperinflation.

That's how it works, Mr. Billion Dollar Money Manager. That's how it works.



Red Rock said...

But won't banks always price money above the T-bill rate?

Calgacus said...

Red Rock & Mike: Mosler relates in his book how he & his investors made a pile of dough when incredibly, Italian banks were lending at 12% or so & Italian government bonds were at 14%. An indicator of how much stupidity mainstream "economics" created over the past few decades.

Tom Hickey said...

Who lets people like this have a say in managing 100B of OPM? Might as well give a monkey some darts.

Red Rock said...


Warren Buffet has warned about our federal debt and has no apparent understanding of MMT yet I assume you'd trust your money to him? I'm willing to wager his track record is way better than Mike's....

mike norman said...

Red Rock,

You don't have to be Tiger Woods to play a decent game of golf. Equating Buffet to the average pension fund manager is ridiculous. Furthermore, Buffet doesn't go around saying we're bankrupt. Come on, seriously. I've been trading for 30 years and have done quite well for myself. I personally, do not manage money by choice. And Buffet's recent track record is not that stellar.

Tom Hickey said...

Red Rock, the point is not so much that the guy that Mike was talking to was clueless as that he was uninterested in listening to what Mike had to say because he had a made up mind. Being ignorant is one thing; not being curious is another, and being closed is yet another. Combined in a money manager, this is a serious problem.

Red Rock said...

Buffet was just an example. There are thousands of traders and investors out there with audited track records who have no concept of MMT whatsoever and have stellar returns. Tom seemed to be implying that you have to understand MMT to successfully manage money. I believe that's demonstrably wrong.

And Mike, please, Buffett's recent track record is not that good?! You try managing several hundred billion dollars and let's see how well you do. If Buffet were still managing fifty million, I'm sure he'd be on fire.

gilcelia said...

Buffet happened to make his fortune during the longest bull run in history which happened to coincide with the end of the gold standard era.

Tom Hickey said...

Red Rock: Tom seemed to be implying that you have to understand MMT to successfully manage money.

Of course, people have made lots of money without an inkling of MMT, and understanding MMT is not going to guarantee anyone doing well in financial markets.

But that's not the point. Did you read what I wrote at 2:10 in clarification. The problem here is severe cognitive bias to the point of being debilitating.

Seething said...

"The FOMC decides on the rate it wants in accordance with its dual mandate of low inflation and high employment (the latter mandate may soon be taken away by Congress, at least that's how it seems from Republicans like Paul Ryan)."


They only give lip service to that latter mandate, anyway.

Been that way for a long time.

William said...

When the Fed conducts QE, it is doing more than replacing one asset (a Treasury) with another (a reserve deposit). It also creates new bank deposits for the sellers of the assets bought by the Fed. The new reserves have no direct effect on the economy, but the new bank deposits certainly do. They represent added liquidity (immediate spending power) for the sellers. I think one reason we haven't seen dramatic effects from the added liquidity is because the sellers of the securities were mainly large financial institutions and the wealthy, whose propensity to save rather than consume is high. However if that liquidity were broadly distributed across the three middle income quintiles, we would have seen a significant increase in consumer spending.

Jack Farrales said...

Are you saying that if the Fed stopped buying treasuries, nothing would happen? How about the price and the yield.?

googleheim said...

Remember when under Bush II in 2001/2002, everyone of the republican kind were out there telling everyone to go shopping in the name of patriotism ?

Now it is the opposite because Obama a black person is "in power"

It's not patriotic to shop and stimulate the economy now ?

what hypocrisy against the USA !

and the dept of education is unconstitutional to Ron and Rand Paul and the Rick Perry plus other Republikkkans.

ORIMONEY said...

That fund manager is smarter than you Mike. Gold is up over 300% since 2000! What else do you need to know! I don't know about you but I would rather trust my money to Ron Paul than Ben Bernanke. The only thing he knows is money printing. Money is a medium of exchange, the fuel that facilitates exchanges. Real wealth is produced when the society is more productive, not when it is flooded with money.

Red Rock said...

Gilcelia, Wrong! Buffet's best returns were well before Nixon took us off the gold standard. What nonsense gets spouted here in defense of MMT. Buffet is worth 50 billion or so and Gilcelia says it was due to the bull market and Mike says his track record isn't that great. Wow! Talk about deniers!

Tom Hickey said...

Jack, the Fed is already paying a support rate on reserves, effectively setting the FFR that way. Moreover, the Fed is targeting quantity rather than price in POMO, so it is not setting price and therefore yield. The Fed is just providing greater liquidity by taking tsys off the market, presumably in expectation of driving savings into higher risk assets, e.g., equities, to run up equities "higher than they would be otherswise," artificially pumping the wealth effect to push domestic consumption.

Matt Franko said...


We may have to wait until June when QE ends to finally see what happens when the Fed leaves the market.

But, as far as the next two weeks, if the pattern of what they have been doing continues, we should see weakness in the bond prices. The pattern has been weakness in the first two weeks of the month (perhaps leading up to when payroll taxes/income tax withholding are due (15th-ish)), then the prices solidify for the second two weeks of the month.

I'm going to be watching for a continuation of this pattern.

Mario said...

I completely understand all of that Mike and thank you for putting it all here in this way. :D

My one question is this:

When the government spends the Fed gives the Treasury dollars but what does the Treasury give the Fed in return for those dollars? Especially if they are precluded from buying bonds from the Treasury as you state.

If someone can please tell me this that would be GREAT for me, b/c everything else makes sense to me!!!

thank you!!!

Tom Hickey said...

Mario, the Fed supplies the Treasury with reservers to clear its checks. The Treasury gives the Fed bonds, which the Fed cannot accept in direct exchange, so it auctions them off and receives reserves in return. The reserves that are put in the Treasury account and get transferred to banks' account through settlement are then recouped by the Fed though bond sales. In this way the excess reserves from deficit spending are drained from the interbank system by the Fed's selling tsys in offset.

It's a bit more complicated that that in practice. Here is the accounting.

Mario said...

Tom you're awesome. Thank you that makes perfect sense now. You rock.

One more question then:

If the deficit expenditures are "drained" as you say by the interbank system buying bonds from the Fed...then where does the potential "inflation" come from that is the only real concern or issue with deficit spending? Isn't that inflation "absorbed" by the bonds sales?

Again thank you again. I love ths stuff. :D

Mario said...

William, wouldn't the Fed buying bonds in QE2 take away assets as the seller no longer gets the interest on the bond? The Fed gets that interest now instead...therefore QE2 is slightly deflationary if anything. The fed just gives that interest earned right back to the Treasury so really the whole thing was a wash...except that the Fed potentially came in at a particular price to support the bond curve they want to see.

In regards to QE I think the real point is that those assets the Fed bought were "toxic" to the sellers so the cash they received just helped them to stay afloat and therefore was not exactly "inflationary."

I could be wrong here so Tom or whomever feel free to chime in here.

Tom Hickey said...

There was just a discussion of this over at Warren's place and it has come up in many other places, too. The answer is that substituting on form of government liability, e.g., zero term, with another, longer term, makes no difference wrt demand-side inflation because inflation is demand-driven and term does not affect demand. Supply-side inflation has to do with supply of resources and goods, and it is not affected by term, either.

Inflation comes down to changes in propensity to consume/save relative to real resources available. Proportion of reserves and tsys doesn't affect this relationship.

QE is like wagging the dog's tail wrt propensity to consume/save. It doesn't increase the propensity to consume, and the liquidity provided flows from lower risk savings (tsys) into higher risk saving vehicles like equities, or maybe commodities, driving up prices. This enhances the wealth effect, which the Fed assumes will increase the propensity to consume, because people feel richer even if they have not realized the gain.

For example, the Fed doen't force anyone to sell tsys. It offers a good enough good deal to affect savings preferences, which results in a portfolio shift, not greater consumption. The structure of the deal incentivizes greater risk assumption, because the Fed is paying more for the tsys than they would otherwise be priced. When an indifference level is reached wrt risk, then funds shift into what is anticipated as a better opportunity. So funds flow into equities and prices rise higher than they would be otherwise.

Mario said...

very interesting Tom.

So really then the mechanics of government spending is really just a wash b/c we are only really talking about term structures of portfolios.

So nominal values of government spending are basically irrelevant while real values are relevant to the actual economy...aka the goods and services provided by government spending that enter in the market and effect the market. That's why billy blog always says the government can provide hip replacements forever so long as there's titanium to do it. Makes perfect sense now.

Based on the way the Fed actually functions...which is valuable and good in and of is clear that the Fed simply CANNOT get us out of this recession except through a very meager "trickle-down effect" through higher/lower risk asset allocations in portfolios.

Therefore the REAL PLACE to kick-start this economy lies with fiscal policy both in terms of spending as well as in terms of proper regulation and de-regulation of business. And in those regards I am not feeling like we are on the right path...yet NFP was pretty darn good and unemployment is going down...yet still why does it all feel "off" for some strange reason? Could those trends be results of 2009 and 2010 and that the decisions we're making now not even going to be felt until 6-10 months down the road? It just takes time I guess to really spread throughout the land.

Thank you Tom. :D

Tom Hickey said...

Correct, Mario.

The reason it is feeling strange is that this economic recession resulted from a financial crisis involving the long financial cycle that ends in Ponzi finance. The Ponzi is still being worked out and has some time to go.

While the economy is doing reasonably well and it looks like things are picking up again, there are still many financial problems in the US and around the world. We are not out of the woods by a long shot. There is still a lot of fiscal drag, which the cb's cannot address effectively and governments apparently won't even though they can if they are monetarily sovereign. The EZ is another story.

A shock anywhere could upset the whole apple cart due to the high level of systemic risk. Systemic risk has actually increased since the inception of the crisis rather than decreased, because the big banks have become bigger through consolidation and preferential treatment. Now the Too Big To Fails are Too Big To Save. The next round will be devastating when it hits.

Mario said...

Tom you may be interested in these panel university discussions from back in 2009. James Galbraith, whom I think Warren works with, speaks in it as well and makes some very interesting points as does Keith Hart if you know of him.

Also, what would happen if the Fed couldn't sell the bonds they got from the Treasury b/c the banks didn't want to buy them? Is that possible? Would that mess things up somehow?

Tom Hickey said...

Mario, in QE1 the Fed bought a lot of MBS to lighten up the balance sheets of the big banks. This was done under the Fed's emergency powers. Ordinarily, the Fed is only permitted to deal in tsys.

There was no inflationary pressure at the time. The threat was deflation and global depression if the interconnected financial system failed.

In the end, governments will have to eat most of the toxic waste on way or another. There are better and worse ways. The better way is without accountability. The worse way is without accountability. So far, worse is winning hands down.

Tom Hickey said...

"The better way is with accountability. The worse way is without accountability."

But you figured that out.

Mario said...

yup that's exactly how I see it too and yeah I caught that with/without part. :)

also essentially the Fed chooses the amount of bank lending that will take place by setting the Fed Funds Rate. Bank reserves can always "be there" (that's not the issue) it's just a matter of if the Fed wants them to be there or not based on economic conditions they see.

In this post, Mike says that if the Fed didn't buy anymore bonds and banks kept on buying bonds from the Treasury then the Fed Funds Rate essentially rises b/c reserves are shrinking. However if the ACTUAL Fed Funds Rate is still low (like it is now) and reserves are shrinking...couldn't the banks just "regain" those higher reserve levels through lending again? The Fed Funds Rate only rises when the Fed actually raise the

Tom Hickey said...

Mario, the Fed auctions tsys to its primary dealers. The prerequisite of being a PD is participating in the auctions. PD have the option of dropping their dealership but not of not participating.

Moreover, there will never be an illiquid market in tsys short of doomsday. The question is terms. All the talk of inflation means is that yields on tsys will become extremely high relative to other similar assets. With the US economy still the largest by far, the US the world's only superpower with no credible challenger, etc., all this talk is just hot air. Where is the money going to go?

For example, the latest buzz is about the renminbi replacing the USD as the world's reserve currency. The renminbi is pegged to the dollar! How ridiculous can you get.

Most of the scuttlebutt (Navy term maning "chatter") out there is just bilge. And I am talking about the "professionals."

Mario said...

That makes perfect sense on the PD side and doomsday...I completely agree with all of that and the scuttlebutt nonsense too. US $ is here to stay most agreed. Remember Fear and Greed make for more money you got to keep the people on their toes!! (who's talking about muni bonds and city defaults anymore eh!?!?). It's so rigged it's not even funny.

I just wanted to make sure on those fronts, b/c a "finance guy" I know personally who apparently trades Irish and Greek bonds was plugging away at me and I wanted to get my facts straight to back to him. What you said about PD's and doomsday is exactly what I thought but I just wanted to make sure.

Thank you!!

I answered my own question regarding Mike's statement about the FFR, b/c I realize now that if the Fed didn't buy bonds then yes there would be no increased bank reserves b/c that is how they are capitalized after loans are made. My bad!!! Essentially, as Mike said in this post, that would never happen b/c the Fed would basically be taking away its own job. I love the Fed.

Thank you again Tom!!! You're a great help...hey maybe YOU are the man to put MMT together into a book or something...what do you think man? I got your back homey!! :D

Mario said...

Does anyone know if the normal population is able to participate in those Fed auctions with the PD's?

Or is it no different than just buying bonds from the Treasury normally?

Tom Hickey said...

Only PDs can participate in a Fed tsy auction. That's what a PD is.

The Fed doesn't deal with the public, either in its auctions or in the interbank system (FRS). Banks have to either belong to the FRS directly or go through a bank that is a member.

Mario said...

bummer but makes sense. I am actually just staring an econ course at school right now (getting my second BA now) and can't wait to find out what they say about monetary policy and the Fed. haha!!

Thanks again Tom. :D

Mario said...

tom do you have the link to the discussions over at warren's blog regarding inflation you mentioned?

Tom Hickey said...

Mario said...

awesome...great post indeed!

Cheers mate!

Mario said...

Tom isn't it true then that whenever the government spends, banks' assets are increased by the amount of interest they earn on the bonds they buy from the Fed (which the Fed got from the Treasury when it spent)?

Government spending then actually creates a regular savings plan for the banking industry no?

Tom Hickey said...

Yes. The interest is a subsidy for participating in a monetary operation that is unnecessary under the current system. The same thing could be accomplished by going to bonds and the Fed paying a support rate on excess reserves equal to the targeted overnight rate.

Mario said...


What do you mean by "going to bonds"?

Mario said...

when you say "paying a support rate equal to the overnight rate" do you mean that any excess reserves would earn interest at the Fed Funds Rate?

I don't understand why this would be necessary (I'm not against it just understanding why). Probably when I understand what you mean by "going to bonds" it will make more sense.

Tom Hickey said...

What do you mean by "going to bonds"? should be no bonds. Sorry.

If bonds, which drain excess reserves, were not issued in offset of deficits, then excess reserves would drive the overnight rate to zero. If the Fed did not wish to set the overnight rate to zero, then it could pay a support rate on the excess reserves equal to it target.

Mario said...

ha!! you're right!! In effect then the Treasury would not be giving the Fed anything in return for the money that the Fed gave the Treasury so the Fed would always be running a deficit with the Treasury, but I mean that's okay with me b/c it's all a wash anyway (one government agency to another government agency = zero anyway).

So really the only reason we sell those bonds to the PD's is to drain the excess reserves and bonds are a great medium for that process since they are just dollars with a different term structure (aka the banks' subsidy for participating).

That's actually pretty funny when you think about how else they could do it. I am sure the banks wouldn't like that idea since who doesn't like a government subsidy!!!

That would greatly disrupt the bond market, bond curve, etc. too eh?

such cool stuff.

Thanks man.

I still swear you should be the guy to write the MMT book and/or launch a wiki, website, wikipedia, etc. Why don't you go for it Tom? ;)