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.)
- The government issues a cheque for $1 million to some entity in the economy. In this case, a government contractor.
- 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.
- 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.)
- Government issues cheque. (No impact on interest rates.)
- Cheque cashed. (Excess reserves reduces interest rates.)
- 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:
- 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.
- 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.
(Note: Updated in November 2014.)
(c) Brian Romanchuk 2013