Stephanie Kelton’s book The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy finally clarifies something I always wondered about.
In studying Modern Money Theory over the years, I have always felt that selling Treasury Bonds to “offset” federal budget deficits was somewhat counter-productive. On the one hand, deficit spending injects money into the private sector of the economy. On the other hand, selling Treasury Bonds drains money out of the private sector. Every time I have heard Stephanie Kelton talk, she says that Treasury Bonds are just another form of money. I kept saying to myself, but although Treasury Bonds can be bought and sold (traded) in the bond market, they are not like ordinary money. You cannot go to the grocery store and buy a loaf of bread with a Treasury Bond.
It took until page 98 in her book for Stephanie Kelton to finally say the words I have been longing to hear for years.
When the Fed wanted to raise interest rates, it sold some of its Treasuries. Buyers paid for those bonds using a portion of their bank reserves. By removing enough reserves, the Fed could move the interest rate up. To cut rates, the Fed would do the opposite, buying Treasuries and paying for them with newly created reserves.
When I first started reading this excerpt, my mind played its usual trick of thinking you don’t raise interest rates by selling bonds. Selling a large quantity of something lowers its price. Then my other brain kicked in to remind myself that the bond price changes inversely to the bond interest rate. A cheaper bond has a higher interest rate. When interest rates go down, existing bonds that pay the old, higher rate get more expensive to buy.