Market participants need public debt

I read a 2006 research paper from the New York Federal Reserve today entitled – Why Is the U.S. Treasury Contemplating Becoming a Lender of Last Resort for Treasury Securities?. The article bears on the discussions recently here about the motive for issuing bonds and the likely consequences of not issuing them. It also brings back the memory of how the Australian government was duped by financial markets into continuing to issue debt even when they were running surpluses. That single act demonstrated beyond doubt that that public debt-issuance isn’t about funding net public spending. Rather, the continued issuance of public debt is a form of corporate welfare which makes the task of making profits through trading financial assets in private captial markets that much easier. Typically, it is the top-end-of-town who complain about welfare payments making the poor lazy. Well, the on-going issuance of public debt makes the private users of the same lazy because they do not have to create low risk products themselves. It is a total con job!

The NYFR paper examines a proposal from 2005 where the US Treasury “would make available to private market participants additional supplies of Treasury securities, over and above the amounts originally issued, on a temporary basis during periods of unusual market stress”. The paper said:

The idea of a backstop lending facility reflects a significant evolution in the role of Treasury securities in the American financial system. Until recently, it was a virtually universal understanding that the Treasury issued securities to finance the federal deficit and to refinance maturing debt. The securities might be short-term bills attractive to corporate treasurers or longterm bonds attractive to pension funds, but they were always a consequence of the government’s need for cash. A backstop lending facility turns this understanding on its head: the Treasury would be issuing securities not because it needs cash, but because market participants need securities.

First, the “universal understanding” became erroneous in 1971 when the Bretton Woods system collapsed and fiat currencies were introduced, freeing the national government spending of the previously binding revenue constraints. After that time, all the institutional apparatus that national governments (which issue their own currency) maintain as artefacts of the old convertible currency system are voluntary and unnecessary.

I use the term unnecessary to mean raising cash from private markets to fund government spending above taxation revenue. Even the taxation revenue is unnecessary in a fiat monetary system.

Second, it is clear that the NYFR paper is presenting the mainstream macroeconomics textbook version of public finance. That bond sales are used to raise cash for governments to spend. The institutional machinery that the US government employs – for debt-issuance and Treasury banking – certainly give the impression that the government drags in cash from the private sector via the debt sales and then spends it. But the veils they have in place do not negate a basic principle in Monetary Monetary Theory (MMT) that in a real world fiat monetary system there are no financial constraints on government net spending.

Third, it is clear from the opening paragraph that various financial market players (corporate treasurers and pension funds) find the public debt very advantageous. And once you understand their needs you start to see beyond the simplistic and erroneous “debt funds spending” claims and you gain a much more nuanced appreciation of the value the debt has for private financial markets.

So the final sentence is in actual fact a statement about the current system not what would be the case should the US Treasury initiate this 2005 proposal. In other words, in a sovereign nation “the Treasury would be issuing securities not because it needs cash, but because market participants need securities”.

That is a very powerful statement and allows the reader to ask the right questions by way of gaining a better understanding of what is what. Under the mainstream lie that debt is issued to fund net spending, the right questions are more veiled. So the obvious question is why would market participants need securities?

Once you answer that question you gain an appreciation of what it is all about? Then you are in a better position to understand that governments issue public debt to drain reserves not to finance net public spending.

The NYFR paper said the motivation for suggesting the provision of a “backstop lending facility” stems from the increasing “chronic settlement fails in Treasury securities”. What is a settlement fail?

A settlement fail is a securities transaction that does not settle as initially scheduled, i.e., the securities are not delivered by the seller (and, consequently, are not paid for by the buyer) on the date originally specified by the two parties. As explained below, chronic (or widespread and persistent) fails limit the ability of putative sellers to solicit bids from competing buyers and burden market participants with greater exposures to credit risk. Put
simply, they increase the cost of trading Treasury securities.

What does that mean?

The paper provides an historical insight into the way C19th banking where the central bank became the “lender of last resort of money” to ensure that in times of money shortages the tendency to suspend the “convertibility of bank deposits” would be prevented. The problem of convertibility led to the creation of the Federal Reserve system in 1913.

The Federal Reserve Banks became lenders of last resort and provided “the country with a more elastic currency” (that is, a currency more sensitive to demands).

So the proposal for the US Treasury to become a lender of last resort of public bonds was designed to overcome situations where the private markets were unable to match the supply of and the demand for public bonds at some points in time. This “market failure” would then impose unnecessary costs on the party who was victim of the failure to deliver on a contract.

What sorts of contracts are we talking about?

The paper notes that:

The keys to appreciating why the Treasury might want to become a lender of last resort of Treasury securities are (1) understanding the central role of Treasury securities in managing interest rate risk and (2) understanding how the use of Treasury securities in risk management has fostered the development of, and is dependent on, a market for borrowing and lending those securities.

Note the use of the “dependent on”. That is, the public debt instruments are like a drug to the junkie modern capital markets. They have built their risk management systems and profit-seeking behaviour around the expectation that there will be a constant supply of public debt.

This should also prompt you to ask: What is all the scaremongering about that constantly is warning us that the bond markets are about to stop fund sovereign governments? Answer: the junkies will continue to want their daily hit!

Public debt instruments are traded in private capital markets by agents who “actively manage their exposure to fluctuations in interest rates by hedging, selling liquid instruments short against relatively static (and less liquid) long positions when they want to reduce risk’.

A short position is one where you currently do not own the asset and agree to sell it at some specified future date for some specified price (say Px). You then hope to buy it on the spot market at that future date for a lowere price, say (Py) whereupon you can then deliver on the contract at the previously agreed higher price. So this part of the portfolio is very liquid and allows for better cash management among other things.

In the context of using treasury securities for short selling the seller typically will borrow the bonds to “make the delivery to the buyer”. The borrowers pay a fee to the lender – this is organised in a variety of ways. The lender accepts an IOU that the bonds will be returned. Shifts in the borrowing fees equilibrate the market so that “a higher fee makes financing a short position more costly, reducing demand to borrow the security. It also makes lending the security more rewarding, bringing out additional supply.”

Hedgers utilise a range of “intermediate and long-term fixed income securities with on-the-run Treasury securities, Treasury futures contracts, and interest rate swaps”.

The paper notes that liquid “Treasury securities are important to managing interest rate risk for four reasons”:

• “Treasury securities are used directly for hedging less liquid securities”.
• “Treasury securities serve as the ultimate reference point for pricing Treasury futures contracts”.
• “Treasury securities are used by swap dealers as short-term swap hedges, and thus contribute to the efficiency of the swaps markets.
• “Market participants undertake spread trades against Treasury securities when they think a particular sector is mispriced; buying a security in a relatively cheap sector against selling a Treasury security short, or vice versa. Spread trades are important to keeping relative prices and yield spreads more stable than they might otherwise be, thereby reducing basis risk and facilitating hedging.”

So the “ability to borrow Treasury securities is thus vital for both hedgers and spread traders and plays a central role in modern interest rate risk management”.

This is a huge market and at times in recent years (prior to the crisis) lenders of bonds would face non-delivery at the end of the contract because of a shortage of treasuries relative to the intended use of them for short selling.

You might ask: why doesn’t the borrowing fee change to ration demand to render it consistent with supply? The reality is that the borrowing fees have a limited range in which they can move – they cannot “exceed the interest rate on general collateral repurchase agreements”. If the borrower doesn’t deliver then the lender will be short of cash and will have to borrow the short-fall or lend less. There is a financial formula which then ties the borrowin fees to the repurchase rate.

The paper was written in the context of “chronic fails in 2001 and 2003)” which had “two important consequences”.

The simplest version of a lending facility would have the Treasury lend securities on demand at a borrowing fee equal to the GC rate. This would give sellers an opportunity to cure their settlement fails by borrowing securities from the Treasury at a fee equal to the implicit cost of their fails. Requests to borrow from the Treasury for reasons other than to resolve chronic fails would be unlikely, because private market borrowing fees are less than the GC rate when
fails are not chronic, i.e., a borrowing fee equal to the GC rate would price the Treasury out of the market except when fails were chronic. The Treasury would require collateral to limit its exposure to credit risk, so the facility would replace the unsecured credit exposures presented associated with chronic fails with secured borrowings.

So under the proposal, the issue of public bonds would become unlinked to what was happening with net spending.

If you then think about this, independently of the specific proposal that the paper is considering, public debt serves a core function for private profit-seeking. The mainstream macroeconomics textbooks and commentators never emphasise this aspect of public debt.

They are always relating it back to profligate government spending and the sovereign default. The reality is that public debt plays no fundamental role in funding government spending. But it plays a very crucial role in underpinning the risk management in the private sector.

In other words, public debt is really corporate welfare.

Australia … gave the game way in 2002

I wrote several papers some years back (2002) about the pressure the big financial market institutions (particularly the Sydney Futures Exchange) were placing on the then federal government to continue issuing public debt despite the government running increasing surpluses. Nowhere did we read the contradiction of this position.

Which is: according to all the logic that the government and these institutions continually pumped out that the government was financially constrained and had to issue debt to “finance” itself. But the Australian government was running increasing surpluses at this time and the logic would suggest that they should not be issuing debt at all!

Of-course, the logic is nonsense in the first place but the debate at the time never question that aspect. The Treasury which does understand that a sovereign government is not revenue constrained because it is the monopoly issuer of the currency would never admit that publicly.

In December 2002, the Australian Treasury conducted a review to consider “the issues raised by the significant reduction in Commonwealth general government net debt for the viability of the Commonwealth Government Securities (CGS) market”.
You can download our Submission (written by my friend and sometime co-author Warren Mosler and me) and you can download the Treasury (2002) Review Of The Commonwealth Government Securities Market, Discussion Paper, Commonwealth of Australia, October.

The Federal Government was running huge surpluses by this time and clearly did not need in terms of “neo-liberal” logic to issue debt to “fund” anything. The Treasury Discussion Paper (Page 2) gave the game away by claiming that purported CGS benefits include:

assisting the pricing and referencing of financial products; facilitating management of financial risk; providing a long-term investment vehicle; assisting the implementation of monetary policy; providing a safe haven in times of financial instability; attracting foreign capital inflow; and promoting Australia as a global financial centre.

So using the same sorts of arguments that New York Federal Reserach paper was advancing.

The Sydney Futures Exchange Submission to the enquiry considered these functions to be equivalent to public goods.

The reality of the day was that the SFE went ballistic as the bond market starting thinning due to the Australian government retiring its debt. The Australian government was caught up in its ideological obsession with “getting the debt monkey off our backs” – which was tantamount to destroying private wealth and income streams and forcing the non-government sector to become increasingly indebted to maintain spending growth).

The public good argument has to be distinguished from argument tantamount to special pleading for sectional interests. Private markets under-produce public goods. When economic activity provides benefits beyond the space defined by the immediate ‘private’ transaction, there is a prima facie case for collective provision. If CGS markets could be shown to produce public goods that enhance national interest, which cannot be produced in any other (more efficient) way, then this would be a strong, pro-CGS argument.

But we argued in our submission that: (a) the benefits identified by Treasury which are used to justify the retention of the CGS market can be enjoyed without CGS issuance; and (b) more importantly, these benefits cannot be conceived as public goods, and rather, at best, appear to accrue to narrow special interests.

While the maintenance of financial system stability meets the definition of a public good and is the legitimate responsibility of government, the roles identified by IMF (in the paper – IMF (2002) The Changing Structure of the Major Government Securities Markets: Implications for Private Financial Markets and Key Policy Issues, Chapter 4), the Treasury and SFE Discussion Papers among others for the CGS market are not justifiable on public good grounds.

We also argued that:

They appear to be special pleading by an industry sector for public assistance in the form of risk-free CGS for investors as well as opportunities for trading profits, commissions, management fees, and consulting service and research fees.

Furthermore, and ironically, their arguments are inconsistent with rhetoric forthcoming from the same financial sector interests in general about the urgency for less government intervention, more privatisation (for example, Telstra), more welfare cutbacks, and the deregulation of markets in general, including various utilities and labour markets.

We justified this conclusion by closely examining futures markets, the superannuation markets and related issues. It should be understood that CGS are in fact government annuities.

We asked the question:

Do the proponents of CGS really want the private sector to have access to government annuities rather than be directing real investment via privately-issued corporate debt, as an example? This point is also applicable to claims that CGS facilitate portfolio diversification. Why would Australians want to provide government annuities to private profit-seeking investors? … We would also require a comparison of this method of retirement subsidy against more direct methods involving more generous public health and welfare provision and pension support.

So the continued issuance of debt despite the Government running surpluses was really a form of “corporate welfare” – to provide safe investment vehicles to private investment banks.

We argued that all the logic used by the Government in the Treasury Discussion Paper applies only to a fixed exchange rate regime. With flexible exchange rate, where monetary policy is freed from supporting the exchange rate, there is no reason for CGS issuance.

We argued that in this context the real policy issue was how well the Government was performing relative to the essential goal of full employment. We concluded the macroeconomic strategy had failed badly. So you will see that 9 years ago we were predicting today’s mess (in actual fact I have writing going back to 1996 predicting the crisis). This is how we put it:

Despite the government rhetoric that the “strategy has contributed to Australia’s sound macroeconomic framework and continuing strong economic performance”, the recent economic growth has been in spite of the contractionary fiscal policy. Growth since 1996 has largely reflected increased private sector leveraging as private deficits have risen. Further, the recent ability of the Australian economy to partially withstand the world slowdown is due to the election-motivated reversal of the Government’s fiscal strategy, which generated the first deficit in 2001-02 since 1996-97.

A return to the pursuit of surpluses will ultimately be self-defeating. For all practical purposes any fiscal strategy ultimately results in a fiscal deficit as unsustainable private deficits unwind. But these deficits will be associated with a much weaker economy than would have been the case if appropriate levels of net government spending had have been maintained.

So the bottom line in this debate (which led to a Treasury Inquiry) was that the demand for continued public debt-issuance even though the federal government was running increasing surpluses appeared to be special pleading by an industry sector to lazy to develop its own low risk profit and too bloated on the guaranteed annuities forthcoming from the public debt.

In other words, that is, in blog language, they were just self-serving greedy hypocrites.

Please read my blogs – Doublethinkand The problem of being a macro economist – for more discussion on this point.

And the issue also resonates with an earlier blog – Bond markets require larger budget deficits – where I noted that under new Basel guidelines, the private banks will demand even more public debt to satisfy their needs for quality assets.

Conclusion

It is sometimes good to find these sorts of papers. While they wouldn’t admit to agreeing with me they do give the game away.

It is a pity that the public is not more informed of these matters.

That is enough for today!