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Tuesday, October 22, 2013

What Is A Government Bond?

This primer answers the question “What is a government bond?” is in terms of defining what a bond does. The answer is that a government bond is an instrument that drains reserves from the banking system. This is not the standard way of looking at government bonds, but I believe it is the key ingredient explaining why the rate expectations theory provides the best description for bond market pricing. (Note: this analysis does not apply to sub-sovereign governments, like Provinces, States or Municipalities.) One can equivalently say that bonds are "forward money".

Note that I am not discussing the legal/financial structure of bonds, I will eventually write a primer on that topic.

This article is an introduction to some core concepts of Modern Monetary Theory (MMT). Although I associate this explanation with MMT, it is clear that it was foreshadowed by earlier economists, such as Abba Lerner. I am currently not in a position to say who was the first to do this mode of analysis.

Bonds As "Forward Money"


The simplest version of what I am describing here is that bonds are "forward money". The only problem with this description is that the term "money" has a lot of emotional baggage attached to it. As a result, not every reader thinks of the same thing when they see the term "money".

But let us assume that we agree what money is, and we are in a country that uses dollars to denominate money. Instead of holding money, a person could hold a 3-month Treasury Bill, which will be redeemed for $100 in "money" at maturity in three months. The advantage is that you can buy the Treasury Bill now, typically less for $100. (Unfortunately, central banks have recently driven interest rates negative in some currencies, which means that people have actually paid more than $100 to get $100 in the future.)

Since bonds by other issuers can default, we cannot assume that they correspond to forward money.

The weakness with this formulation is that it does not answer the question: why does the government create "forward money"? The rest of the article answers that question.

MMT Analysis Of Government Spending


I normally do not approve of attempting to analyse a government like it was a corporation, but in this case I am going to apply a corporate accounting principle to the government. In this analysis, I consolidate the accounting of the central bank with the central government. This consolidation means that debts between the Treasury and the Central Bank are netted out. Although the distinction between the Treasury and the Central Bank matters for legal purposes, they have no economic impact on outside entities. This simplification eliminates a lot of technical and institutional details that I view as being mainly distractions (although I may cover them in later articles).

Let us examine how a government spends, as seen from the point of view of MMT. (For simplicity, I’ll assume that the government pegs the overnight interest rate, and that the banking system was holding its desired level of reserves before the operations begin. The current environment in the U.S. is slightly different.)

  1. The government issues a cheque for $1 million to some entity in the economy. In this case, a government contractor.
  2. The cheque is cashed, and as a result of the clearing operation, the contractor gets an increase of $1 million in her deposit account at the bank, and the bank gets an increase of $1 million at its account at the central bank. (The central bank is a bank for banks.) The deposit at the central bank is known as a “reserve” in the terminology used in the U.S. (The term is not applicable for a country like Canada that has abolished reserve requirements, but the U.S. usage is probably best known, so I will use it here.)
    All else equal, the commercial bank now has an excess of reserves. The bank will want to trade these excess reserves away in the interbank market, putting downward pressure on the interbank rate.
  3. Since the central government targets a specific target for the overnight rate, this downward pressure has to be resisted to keep the overnight rate on target. It could use an “open market” operation (a repo) to temporarily remove these excess reserves. However, the government can permanently remove those excess reserves by issuing a bond. For example, it could issue a $1 million in bonds. To pay for the bond, buyer’s bank will transfer $1 million to the government. The buyer’s account at her bank will be reduced by $1 million, and the bank’s account at the central bank (reserves) will also be reduced by $1 million. (This reverses the cash flows between the public and the aggregated private sector in step 1.)
To summarise:
  1. Government issues cheque. (No impact on interest rates.)
  2. Cheque cashed. (Excess reserves reduces interest rates.)
  3. Bond issued to return reserves to desired level. (Interest rates rise back to target level.)

From this viewpoint, there is no risk that the government will have a problem“financing" its government deficits. The money that is used to pay for government programs is first created, and then excess money is drained away to keep interest rates at levels desired by the government to regulate economic activity. And since the objective of interest rate policy is to control things like inflation, it makes no sense for the government to object to the level of bond yields.

The Classical “Loanable Funds” Version


I believe that the above analysis is not how most people have been taught to think about government finance. I think the more standard way of looking at the transaction could be summarised as:

  1. Government wants to pay a contractor, and so issues $1 million in bonds. This raises interest rates, as you have to convince an investor to reduce cash levels to buy the bond. Reserves drop to a “too low” level, pushing up financing costs.
  2. The cash is transferred to the account of the contractor, and reserves rise back to an acceptable level.

This analysis is just a rearrangement of the order of operations in the previous case, but it apparently leads to a very different outlook on the impact of deficits on bond yields. The government must “borrow before spending”, and more borrowing implies higher bond yields courtesy of supply and demand.

Reconciling The Two Views


I think it is easy to see why supply has limited impact on bond yields if we think in terms of these sequences of operations. The distinction between the two views is artificial, based on an attempt to isolate one transaction “at the margin”. In practice, government finance is a repetitive process. The steps (1)-(3) in the MMT sequence are repeated indefinitely, with all the individual operations being small (at least if you consider a $10 billion bond auction to be small). It is impossible to define a “first operation”. Therefore, you cannot base an argument on the government needing to borrow before spending; it borrows before, during, and after spending.

If there are any supply and demand effects, they are very short term in nature (for example, yields may drift up going into an auction, etc.). There is a lot of speculative capital searching for opportunities in the fixed income market, so there is a spectacular amount of capital available to bridge any short-term supply and demand mismatches that could occur. This lets bond market participants focus almost solely upon the expected path of short rates in order to price bonds.

In conclusion, a government bond is an instrument to remove reserves from the banking system. The continuous circular flow of the creation and destruction of reserves causes supply and demand impulses to effectively net out to zero over time, and therefore has no major impact on the level of yields.
 
See Also:



(Note: Updated in November 2014.)

(c) Brian Romanchuk 2013

6 comments:

  1. Assuming that the two banks mentioned in the three-step example are not identical, how does the fact that the reserves of the second bank (introduced in step 3) have been reduced affect the reserves held by the first bank? How have the reserves of the first bank magically disappeared and with it the first bank's (introduced in step 1) desire to "sell off" its excess reserves and thereby putting downward pressure on the target rate?

    3. Since the central government targets a specific target for the overnight rate, this downward pressure has to be resisted to keep the overnight rate on target. It could use an “open market” operation (a repo) to temporarily remove these excess reserves. However, the government can permanently remove those excess reserves by issuing a bond. For example, it could issue a $1 million in bonds. To pay for the bond, buyer’s bank will transfer $1 million to the government. [Why would there be a buyer?] The buyer’s account at her bank will be reduced by $1 million, and the bank’s account at the central bank (reserves) will also be reduced by $1 million. (This reverses the cash flows between the public and the aggregated private sector in step 1. [How does this relate to the first bank's desire to reduce excess reserves? How have the first bank's excess reserves been drained? How does it affect its trading behaviour, and how does this help maintain the desired target rate?]

    I am highly appreciative of your fine blog. Please do bear with me when my questions may be distorted in awkward ways owing to my being entirely new to the topic.

    Thanks for help and best regards, Georg Thomas

    ReplyDelete
    Replies
    1. Hi,

      In the 3 step example, the cheque (written by the government) is drawn on the government's bank, which is the central bank. The only effect of the cheque cashing on that leg of the transaction is that the Treasury's balance at the central bank is lowered; the central bank does not have reserves (which are deposits with itself).

      The reduction of the balance of the Treasury at the central bank does not impact the ravage sector, as it is a purely intra-government accounting entry. (Remember that the Treasury owns the central bank, and so lending operations between the treasury and the central bank are effectively loans to itself.) Eventually, the Treasury balance has to be recharged, which is done via bond issuance.

      As for your second question, I think it is largely covered by the above explanation. As to why a buyer would want to buy a bond or a Treasury bill, they almost always offer a yield pickup over deposits. In the U.S. system before 2008, banks were not paid interest on excess reserves, so it was always better to buy a Treasury bill.

      If the Treasury held cash at commercial banks (which is done sometimes under differ banking system regimes; for example, the U.S. Treasury did this before the creation of the Fed Reserve system), a government cheque would just be a transfer within the private sector. In such a case, the government has to have the private sector money before it spends, like other private sector entities.

      I hope this covers your questions. I should point out that I cover this in greater detail in my ebook "Understanding Government Finance" (end of commercial plug :-> ).

      Delete
  2. Thanks for prompt and pertinent help. I have just bought your e-book "Understanding Government Finance," which I shall work through tomorrow, before I dare bother you again. Best regards from Germany, Georg Thomas.

    ReplyDelete
    Replies
    1. Thanks! I hope you enjoy it; feel free to ask any question (about bond market economics at least...).

      Delete

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