{"id":10404,"date":"2010-06-23T16:27:16","date_gmt":"2010-06-23T06:27:16","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=10404"},"modified":"2010-06-23T16:27:16","modified_gmt":"2010-06-23T06:27:16","slug":"market-participants-need-public-debt","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=10404","title":{"rendered":"Market participants need public debt"},"content":{"rendered":"

\t\t\t\tI 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?<\/a>. 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!
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\nThe 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:<\/p>\n

\nThe 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.\n<\/p><\/blockquote>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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.<\/p>\n

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”.<\/p>\n

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?<\/p>\n

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.<\/p>\n

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?<\/p>\n

\nA 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
\nsimply, they increase the cost of trading Treasury securities.\n<\/p><\/blockquote>\n

What does that mean?<\/p>\n

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.<\/p>\n

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).<\/p>\n

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.<\/p>\n

What sorts of contracts are we talking about?<\/p>\n

The paper notes that:<\/p>\n

\nThe 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.\n<\/p><\/blockquote>\n

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.<\/p>\n

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!<\/p>\n

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’.<\/p>\n

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.<\/p>\n

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.”<\/p>\n

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”.<\/p>\n

The paper notes that liquid “Treasury securities are important to managing interest rate risk for four reasons”:<\/p>\n