Regular readers will know that I have spent quite a lot of time reading the…
Will we really pay higher interest rates?
In this blog, we consider the debt question (again) with streamlined language to ensure it is accessible to all who choose to read it. Yesterday I asked whether future taxes will be higher, which is now being claimed by conservatives who are running a relentless political campaign against the demise of neo-liberalism. Today, the partner claim: will we be paying higher interest rates because of the borrowing? Answer: no! Whether interest rates are higher or lower in the future will have little to do with the movements in today’s budget balance. It is possible that voluntary arrangements set in place by the Australian government in the past will drive interest rates up. But if that occurs it will because the Government wants higher interest rates rather than having anything to do with the net spending that is being engaged in to stop employment growth falling off the cliff. So time to discuss bond markets a bit.
First, to repeat … but you can never say it enough … the notion of a “government budget constraint” only applies ex post, as a statement of an accounting identity that has no significance as an economic constraint. In an accounting sense, it is certainly true that any increase of government spending will be matched by an increase of taxes, an increase of high powered money (reserves and cash) and/or an increase of sovereign debt held. But this does not mean that taxes or bonds actually “finance” the government spending. They do not!
Government might well enact provisions that dictate relations between changes to spending and changes to tax revenues (a balanced budget, for example); it might require that bonds are issued before deficit spending actually takes place; it might require that the treasury have “money in the bank” (deposits at the central bank) before it can issue a cheque; and so on. These provisions might constrain government’s ability to spend at the desired level. However, economic analysis shows that they are self-imposed and are not economically necessary – although they may well be politically necessary.
As I have mentioned in previous blogs (and extensively in my published academic work) … while a sovereign government is not financially constrained it still issues debt to control its liquidity impacts on the private sector. Government spending and purchases of government bonds by the central bank add liquidity, while taxation and sales of government securities drain private liquidity. These transactions influence the cash position of the macroeconomic system on a daily basis and on any one day they can result in a system surplus (deficit) due to the outflow of funds from the official sector being above (below) the funds inflow to the official sector. The system cash position has crucial implications for the central bank, which targets the level of short-term interest rates as its monetary policy position. Budget deficits result in system-wide surpluses (excess bank reserves).
An important point to be made regarding treasury operations by a sovereign government is that the interest rate paid on treasury securities is not subject to normal “market forces” unless the government voluntary chooses to do so (as in Australia with its auction system – more about which later).
The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward whatever rate the central bank offers to pay commercial banks for excess overnight reserves. If the RBA decided not to pay any support rate (it currently pays commercial banks just below the official rate) then the Treasury could always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero).
This accentuates the point that a sovereign government with a floating currency can issue securities at any rate it desires – normally a few basis points above the overnight interest rate target that the central bank has set. There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero). But it is simply false reasoning that leads to the belief that the size of a sovereign government deficit affects the interest rate paid on securities.
While all these statements are conceptual and reflect the essential elements of a modern monetary system, several readers have asked me to explain how the bond market actually operates on a day to day basis. So here is a quick commentary which I will follow up on in later blogs.
In the past (prior to 1982), a tap system operated where the government would set the interest rate and then supply bonds to investors up to demand. Sometimes investors did not take up as much as the Government desired. The extra funds came from contra entries in the RBA-Treasury accounts (the government borrowing from itself!).
This system was atacked in the early 1980s by the conservative government and the financial community as they all developed their neo-liberal credentials. What transpired was the development of the The Australian Office of Financial Management (AOFM) which in its own words “is a specialised agency within the Treasury portfolio responsible for management of Australian Government debt. The AOFM’s activities include the issue of Treasury Bonds, Treasury Notes, management of the Australian Government’s cash balance, and management of a portfolio of debt and investments.” The creation of the AOFM was largely cosmetic – it is still part of the consolidated government.
The tap system was severely criticised by neo-liberals. To get an idea of the historical debate you might want read this speech, which was the text of a presentation made by Peter McCray, Deputy Chief Executive Officer, AOFM in 2000. In terms of the fact that the tap system sometimes led to the government lending to itself, McCray says that this would be
breaching what is today regarded as a central tenet of government financing – that the government fully fund itself in the market. It then became the central bank’s task to operate in the market to offset the obvious inflationary consequences of this form of financing, muddying the waters between monetary policy and debt management operations.
First, this so-called central tenet is just one of the bits of ideological baggage that have constrained governments from creating full employment. There is no foundation in economic theory for it. It is a political statement.
Second, the statement “obvious inflationary consequences” is also not based on sound modern monetary theory nor is it evidence-based. Once again it is a political statement reflective the free market ideology. It is not obvious when you have persistently high unemployment that net government spending not accompanied by reserve drains (bond issues) will be inflationary. It is highly likely that it will not be! But at any rate it is an empirical questions. Statements like this from the senior AOFM official just show how captive this part of the public service became under the neo-liberal fist!
The neo-liberal era demanded that tried and tested social democratic practices give way to privatisation, outsourcing and a primacy of the capitalist market place in allocating resources. It demanded a diminuition in the role of government. We are now living through the costly aftermath of following that route. But at the time it changed the way the Government behaved in terms of debt markets.
First, I had no problem with them floating the exchange rate. Unlike what many so-called progressive economists think, this was in fact a beneficial development because it restored the full potential of fiscal policy with a sovereign currency. Under the fixed exchange rate system, monetary policy (buying and selling AUD in the foreign exchange markets) was used to maintain the exchange rate at the agreed parity. So given we typically run current account deficits (which mean the supply of AUD > demand for AUD in the forex market) there was often downward pressure on our exchange rate. The RBA then had to buy up the excess demand of AUD (take liquidity out of the economy) and this caused interest rates to rise and domestic spending to fall. So our domestic economy was always adjusting to the needs of the fixed exchange rate and fiscal policy was captive. Any time it tried to improve economic growth (which increased imports), monetary policy would have to contract to defend the exchange rate. So with flexible rates, the adjustment to supply and demand imbalances in the forex market on any particular day is done by the AUD and the domestic economy can then, potentially, move to and sustain full employment with appropriate fiscal policy settings (typically via budget deficits).
Second, the Federal government of the day, in concert with many national governments all increasingly coming under the neo-liberal sway, considered it necessary to make further voluntary or self-imposed changes. Foreign banks were allowed in and banks were deregulated which made them more risky because what had traditionally been a reliable retail banking service morphed, virtually overnight, into a globalised wholesale banking service with little staff development to support this shift. So in the early days several failed – State Bank of South Australia, for example and many customers were burned by borrowing in foreign currencies after being encouraged by ill-trained bank staff. Remember all the Swiss Franc loan failures and farm repossessions in the 1980s. It was clear this deregulation was going to eventually come unstuck in a broader way – as it has now – but the dominant voices in the media, business, government, the academy – were all neo-liberal. Mostly because they were reflecting vested interests who stood the most to take short-term profits and run.
McCray’s (senior AOFM offical) take on this was:
… there is no question, from a perspective that now encompasses nearly twenty years of evolution and reform in the Australian financial system, that the exercise – which remains ongoing – has paid handsome dividends, significantly enhancing financial sector competition, consumer choice and operational efficiency.
That position cannot be maintained now the whole house of cards has crumbled.
Anyway, the Federal government also invoked stupid reforms to the way government bond markets operated. While the detail is interesting, you should understand that these policy choices and changes to the “operations” of the bond markets were all voluntary choices by the Government based on ideology. There is nothing essential about the changes. Further, they are largely cosmetic.
The major shift was to ensure that all net spending was matched $-for-$ by borrowing from the private market. So net spending appeared to be “fully funded” (in the erroneous neo-liberal terminology) by the market. No: all that was happening was that the Government was coincidently draining the same amount from reserves as it was adding to them each day and swapping cash in reserves for government paper. The bond drain meant that competition in the interbank market to get rid of the excess reserves would not drive the interest rate down.
Budget deficits put downward pressure on the short-term interest rate. The bond sales maintained the specific interest rate. However, the specific arrangements that were chosen allowed the market to price the debt accordingly.
So many myths were paraded at the time. For example, McCray from the AOFM claims
Fundamentally, government debt management is about managing risk. In issuing debt, governments take on large exposures to market prices, creditworthiness and operational failure. The government debt manager’s approach to managing these risks can send signals to the market about acceptable standards of behaviour.
There is no risk in government debt issued by a sovereign government in its own currency. They can always pay it back by simply crediting a bank account the amount due. To suggest otherwise is deceptive or a reflection of ignorance.
Anyway, the tap system was replaced in 1982 with an “auction model” mainly because of the alleged possibility of a funding shortfall. A totally spurious concept of-course. We should be absolutely clear about this. To construct the shortfall as a problem was a purely neo-liberal contrivance. They claimed it introduced uncertainty to the funding process. It did not in actual fact to anything like that.
What it meant was that investors had converted a desired amount of their reserves into government paper and were happy with their portfolios at the rate of return on the paper that the government was offering. That is all it meant.
The auction model merely supplied the required volume of government paper at whatever price was bid in the market. So there was never any shortfall of bids because obviously the auction would drive the price (returns) up so that the desired holdings of bonds by the private sector increased accordingly. However, McCray from the AOFM admits that “The move to bond auctions enabled “the authorities to sell large quantities of stock with minimal disruption to interest rates.” That is, interest rates did not get pushed up significantly. The reason: it was a reserve maintenance operation as previously discussed!
At that point the secondary bond market started to boom because institutions now saw they could create derivatives from these assets etc. The slippery slope was beginning to be built.
The other major reason for introducing the auction method is well expressed in the following tract from McCray’s speech. He is talking about the so-called captive arrangements, where financial institutions were required under prudential regulations to hold certain proportions of their reserves in the form of government bonds as a liquidity haven.
… the arrangements also ensured a continued demand from growing financial institutions for government securities and doubtless assisted the authorities to issue government bonds at lower interest rates than would otherwise have been the case … Because such arrangements provide governments with the scope to raise funds comparatively cheaply, an important fiscal discipline is removed and governments may be encouraged to be less careful in their spending decisions.
So you see the ideological slant. They wanted to change the system to voluntary limit what the Federal government could do in terms of fiscal policy. This was the period in which full employment was abandoned and the national government started to divest itself of its responsibilities to regulate and stimulate economic activity. The legacy is the mess we are in now.
The investment community were also pressuring government at the time to deregulate and allow them to operate more freely in the secondary markets. They won the battle and so began the derivatives spiral which has revealed itself in today’s calamities.
Prior to the establishment of the AOFM, the central bank handled all the debt management and issuance for the Commonwealth government. It was argued at the time that this blurred things – the monetary policy roles including liquidity management and the debt management. It was clear then that the tap rate offered by the RBA was consistent with its monetary policy objective (some short-term interest rate).
The real reason for the shift to the auction model administered by the AOFM (which is really just an arm of Treasury) is provided by McCray in his speech to the ADB:
The reduced fiscal discipline associated with a government having a capacity to raise cheap funds from the central bank, the likely inflationary consequences of this form of ‘official sector’ funding … It is with good reason that it is now widely accepted that sound financial management requires that the two activities are kept separate.
Read it over: reduced fiscal discipline … that was the driving force. They were aiming to wind back the government and so they wanted to impose as many voluntary constraints on its operations as they could think off. All basically unnecessary (because there is no financing requirement), many largely cosmetic (the creation of the AOFM) and all easily able to be sold to us suckers by neo-liberal spin doctors as reflecting … read it again … “sound financial management”.
What this allowed was the relentless campaign by conservatives, still being fought, against the legitimate and responsible use of budget deficits. What this led to was the abandonment of full employment. And as they reduced the legitimate role of government before our very eyes and imposed huge costs on the most disadvantaged workers in our communities we applauded them and voted for more. And it got worse in the 1990s and beyond. But if these changes had not been as consequential in that regard as they have been … then anyone in their right mind who understood what was going on would not be able to stop laughing – the transparency of their motivation was so obvious!
I will talk more about whether we have to pay higher interest rates in a further blog.
Digression: Consumer sentiment
Today’s data shows that consumer sentiment has risen 8.3 per cent in the last month. This is a substantial rise. But the level of consumer sentiment index is still in the pessimistic range. But it suggests to me that the expansionary measures taken by the Federal government may be providing some sort of confidence floor for the economy.
Tomorrow, the April labour force data comes out and then we will see what the labour market is doing. If the sharp decline from last month is maintained then it will signal significant rises in unemployment are likely throughout 2009 unless further stimulation and a ramped up Jobs Plan is forthcoming.
Digression: Guaranteed bank misbehaving
All members our big government-guaranteed banking cartel are refusing to pass on the latest RBA interest rate cut. Given that their costs of funding (and hence their profits) are being reduced because they are trading on the Federal government guarantee then I would compel them to pass on the cuts. If not, I would withdraw the guarantee … and then watch the customer base move to the other institutions that did agree.
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Great post, Bill!
I finally found that post which could help me clear some of my concerns. Great and here we go.
My understanding now is that regardless of the Moon phase, government will ALWAYS be able to issue overnight debt in the amount of budget deficit for each given day at yield just 1bp above central bank support rate. However I am confused about debt with longer maturities. As there is no real reason to issue long-term debt and it is done solely to satisfy private sector needs, does it mean that government yield curve is 1bp above the expected future support rate?
Government bonds are as good as cash for the purpose of banking system. Does it mean that actually we make matters too complex here? Are bonds issued only to give the non-banking sector access to the support rate?
I looked at bloomberg data for US and while in general effective federal funds rate was super close to the target rate, there were still periods of rather significant divergences (up and down). Does it mean a failure of central bank in managing cash liquidity in the system?
Prior to the establishment of the AOFM debt management was carried out by the Treasury. The RBA executed the bond auctions on behalf of the Treasury as an agent, purely because of its ownership of the RITS dealing and settlement system. This practice continued well after the establishment of the AOFM, although auctions are now conducted by the AOFM via the Yieldbroker system.
A separation was thus maintained between the monetary policy setting aspects of the RBA’s activities and debt management prior to the establishment of the AOFM.
Reasonable people can debate the inflationary impact, but does it not follow that if a government has the ability to monetize its debt then it is only paying lip service to central bank independence in regards to the setting of monetary policy?
I am writing in regard to the Canadian experience. It seems to me that during 1938 – 1974 Canada used the BofC to fund it’s budget deficits thereby funding development and social programs. I’m not sure exactly how this policy was implemented. I’m just wondering if you are familiar with what happened in Canada. Did they use a system similar to the Australian tap system? What was the interest rate policy? I think this was during a time of fixed exchange rate (I could easily be wrong). I guess I want to know how the system operated.
If my questions are inappropriate to the discussion at hand, I apologize, but the Australian situation reminded me somewhat of Canada.