(Note: this article is an excerpt from the book Understanding Government Finance - Appendix A.2) The working assumption within this report is that the central bank only owns Treasury bills and bonds. This corresponds to standard practice in the “Anglo” economies (Canada, United States, United Kingdom, and Australia). However, not all central banks operate in this fashion, nor did “Anglo” central banks historically. An alternative framework is for private banks to borrow directly from the central bank, possibly in the form of overdrafts (a negative deposit balance), or by discounting their assets (loans or bonds).
A pure “overdraft” economy operates solely without the use of bonds; all credit is in the form of bank loans. This is somewhat approximated by the Continental European economies, where banks are the major source of funding for businesses. North American economies are somewhat mixed; small and medium businesses tended to use bank finance, while larger businesses relied on the bond and equity markets. More recently, specialised financial companies and securitisations have made inroads into areas that were traditionally served by banks. For those who are interested, this type of economy is discussed in greater length Section 4.3.8 in Professor Marc Lavoie’s textbook Post-Keynesian Economics: New Foundations.
Since my focus here is on government finance, I will only look at the effects on the central bank. If the central bank no longer is purchasing government bonds, the operations I laid out in Chapter 4 no longer apply. Instead, the “position-making instrument” will be central bank lending against private sector assets. This could be done either as discounting or repo operations.
In order to picture the effect, to shift to such a system, the central bank would have to replace all of the government bonds on its balance sheet with private sector financial assets.
Since the central bank does not directly purchase bonds, it appears that it could lose control of government bond and bill yields. However, this appearance is probably misleading, so long as it is possible for the banks to rediscount government bonds and bills at the discount rate. If Treasury bill yields were much higher than the central bank’s administered discount rate, banks would arbitrage the bill market by buying them and funding the positions at the discount rate. Therefore, in such an environment, Treasury yields may no longer trade with lower yields than other high quality bond yields, but they should not have much higher yields. Although it appears that private sector would have a greater chance of forming a cartel and refuse to roll government debt, this should be more than balanced by the very effective club that the central bank has poised over the banking system, as described below.
In such a system, the central bank is no longer a refuge for economic theorists, since it operates like a bank. Central bank staffing budgets would have to make room for new teams of credit analysts. The central bank would be a major source of funding for the financial system, and taxpayers would not tolerate credit losses. Therefore, the central bank would have to understand the financial firms it is lending to, as well as the assets it is lending against. This is in complete contrast to the position of the central banks during the Financial Crisis, where they had little idea what was happening in the financial system until it was too late. The Fed was even forced to bring in private sector managers to manage the insanely complicated assets it purchased during bailout programmes.
Moving to such a system in the United States was a reform advocated by Hyman Minsky in Chapter 13 of Stabilizing an Unstable Economy. His concern was that the financial system has an innate tendency to drift from safe (“hedge”) financing schemes towards “speculative” or “Ponzi” financing. If the U.S. Federal Reserve was deeply involved in determining which assets it was willing to lend against, it could act as a countervailing force against this tendency for excessive risk. If it thought a type of lending was unsafe, it could make it ineligible for rediscounting at the central bank. Some specialist lenders may take their chances with such lending, but they would be outside the safety net of the lender-of-last-resort operations. Minsky argued: “Central banks have to steer the evolution of the financial structure.”*
The fact that the central bank is a major source of funding for the banks in such a system means that “rollover” risk can easily be contained by central bank arm-twisting. It is very difficult for banks to collude against the interests of a major source of their short-term funding (as well as the source of their banking license). This means that switching to such a system does not truly create constraints on government finance, but it does require that the central bank bureaucracy be staffed with people who seek to defend the national interest, even at the cost of overriding “market forces.”
I agree with Minsky that such a reform would be one of the few mechanisms that would bring some stability to financing arrangements. The catch is that I doubt that such muscular interventions into the banking system fit current political trends. Progressives would be horrified to see the government actively involved in providing financing for bankers, while free market advocates would be horrified by the scope of the government interventions. It might require the financial system to blow itself up in an even more impressive fashion to force deep reforms of this nature.
* Page 359 of Stabilizing an Unstable Economy, by Hyman Minsky. Published by McGraw Hill, 2008.