{"id":8225,"date":"2010-02-24T17:52:21","date_gmt":"2010-02-24T06:52:21","guid":{"rendered":"https:\/\/billmitchell.org\/blog\/?p=8225"},"modified":"2010-02-24T17:52:21","modified_gmt":"2010-02-24T06:52:21","slug":"bond-markets-require-larger-budget-deficits","status":"publish","type":"post","link":"https:\/\/billmitchell.org\/blog\/?p=8225","title":{"rendered":"Bond markets require larger budget deficits"},"content":{"rendered":"

\t\t\t\tToday I have been reading all the documentation surrounding the proposals issued by the Bank of International Settlements<\/a> to reform the regulatory system for international banking. These considerations then took me to an interesting paper from Deutsche Bank where they refute (albeit unintentionally) much of the media hysteria about exploding government bond yields and bond markets “closing governments down” because their deficits are “ballooning out of control”. In fact, the DB Report shows categorically that within the new regulatory framework that the BIS (and hence the Australian Prudential Regulation Authority<\/a> will introduce), there is scope for larger budget deficits. In terms of the state of the Australian labour market and the very slow growth that the world economy will experience in the coming years, a further stimulus package is necessary. The DB Report implies that the bond markets would welcome it. Curious?
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\nTypically the financial market commentators all run a similar line. But there are times when the game becomes clearer – when self-interest actually discloses things that the popular media do not care to report. When these disclosures are made you get a picture into the true nature of the monetary system and the way the government operates within it and impacts on the non-government sector.<\/p>\n

Special Pleading Classic One<\/u><\/p>\n

One classic instance of this type of event occurred in Australia in 2002. At that time, the thinning of the federal bond market was a topic of discussion during the Review of the Commonwealth Government Securities Market<\/a>.<\/p>\n

At that time, the federal government had been running budget surpluses since 1996 and economic growth was only maintained by the massive buildup in household debt which kept consumption expenditure afloat. It was an unsustainable growth strategy because the private sector cannot increasingly accumulate debt.<\/p>\n

The stock adjustments arising from the surpluses saw the outstanding stock of federal government debt fall dramatically as the government systematically undermined private wealth holdings. As this was occurring, the key financial market players who had been vehemently demanding the conservative government retrench the welfare state, public fiscal exit plans and introduce widespread deregulation (the cries never really change to they) started to realise that the thinning bond markets were not in the best interests.<\/p>\n

The Review was announced after the industry had lobbied the federal government relentlessly to salvage their own corner of corporate welfare.<\/p>\n

You can read the Treasury Discussion Paper<\/a> along with all the public submissions, including that produced by The Centre of Full Employment and Equity<\/a> (written by myself and Warren Mosler) if you are interested.<\/p>\n

In our Submission, we addressed several claims made in the Treasury Discussion Paper, which was released to accompany the review. We also addressed the claims made by the Sydney Futures Exchange<\/a> that by eliminating the CGS market the government would “deny superannuants an A$ denominated (default) risk free investment for their retirement planning at a time of an ageing population and in a mandatory superannuation environment.”<\/p>\n

We noted that what is not often understood is that Commonwealth Government Securities (CGS) are in fact government annuities. That is, guaranteed income streams.<\/p>\n

We also wondered whether the “free market” lobby that were making these points (about superannuation losing out) really wanted the private sector to have access to government annuities rather than be directing real investment via privately-issued corporate debt, as an example<\/p>\n

The point is also applicable to claims that CGS facilitate portfolio diversification. Why would Australians want to provide government annuities to private profit-seeking investors? This clearly interferes with the investment function of private markets.<\/p>\n

We argued that direct government payments be limited to the support of private sector agents when failures in private markets jeopardise real sector output (employment) and price stability. Later in the Report we detailed that this support should be largely confined to providing employment guarantees and that government endeavour be focused on the provision of first-class education, health, aged care and other activities which unambiguously advance public purpose.<\/p>\n

In this context, we also demanded a comparison of this method of retirement subsidy against more direct methods involving more generous public health and welfare provision and pension support. No such comparison was ever forthcoming from the government or its private sector puppeteers who were both rushing to increase the surpluses and had actively promoted the reduction of welfare benefits that were being received by the disadvantaged Australians and wide scale deregulation and privatisation.<\/p>\n

The financial markets had been leading voices at the time (and still) demanding the government cut its deficit and get the “public debt-monkey” off the back of the economy. The neo-liberal government fell into line and started to run massive surpluses (even though unemployment and underemployment was very high) and regularly announced how it was retiring the public debt.<\/p>\n

It was truly ironical while the government was acting according to the wishes of the financial sector – once it became obvious that the “corporate welfare” part of the deal was threatened – the very same financial players sought reassurances from government that a minimum volume of public debt would be issued each year even though (in their own words) it was not required to fund any deficits – there were surpluses after all at the time.<\/p>\n

It was incredible really that these characters who kept the line that debt is used to fund deficits – suddenly (but subtly) shifted their line demanding more debt even though there was in their own logic no need for it. The public never really were party to the debate – it was rather technical – and so they never really were exposed to the double-standards operating.<\/p>\n

The whole Review and the subsequent decisions<\/a> highlighted the hypocrisy of the “debt-monkey lobby”. It became clear to those in the know that the actual agenda operating was that the financial organisations (banks etc) wanted to get rid of all government support (welfare) unless it impinged on their own ability to live the high-life. Then it was fine.<\/p>\n

In our Submission, we argued that the roles identified by IMF, Australian Treasury and the Sydney Futures Exchange among others for the government bond market are not justifiable on public good grounds. They were classic examples of special pleading by an industry sector for public assistance in the form of risk-free government bonds for investors as well as opportunities for trading profits, commissions, management fees, and consulting service and research fees.<\/p>\n

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, more welfare cutbacks, and the deregulation of markets in general, including various utilities and labour markets.<\/p>\n

Specifically, government price level intervention into private markets is typically challenged by economists on efficiency grounds. What is not widely understood is that government bonds issuance is a form of government price level intervention in interest rate markets. The burden of proof falls on those arguing in favour of government bonds issuance to show that the market in question is incapable of viable operation without government intervention and will, unassisted, produce outcomes detrimental to the macro priorities of full employment and price stability. No such arguments have ever been convincingly presented.<\/p>\n

We also noted a larger irony in the entire discussion – as all parties to the debate, including the Treasury omitted discussion of the primary role of government bonds in the context of a flexible exchange rate system – that is, to support the term structure of interest rates rather than to fund government expenditure. This omission subsequently undermined much of the validity of the arguments advanced.<\/p>\n

Today … another classic case<\/u><\/p>\n

I thought about this again today when I read a report published last Monday (February 22, 2010) from Deutsche Bank – Bond Supply – implications for Bank Liquid Asset Portfolios<\/a> – thanks to The Age economics writer Peter Martin for the link.<\/p>\n

The DB document (from its Sydney branch) notes that:<\/p>\n

\nWe think it very likely that the 2010 Budget will project a much lower peak in gross Commonwealth debt than was the case in the mid-year economic and fiscal outlook. While good news for the Government, a lower peak and the likely intent by the Government to start repaying this debt as soon as it can has implications for the proposed reforms to bank liquidity arrangements.\n<\/p><\/blockquote>\n

First, they are noting that our misanthropic federal government (at least when it comes to the unemployed) is talking big about getting the deficit back into surplus as soon as possible and reducing the debt burden we are allegedly leaving to our grandchildren. They have devised some ridiculous formulas (fiscal rules) that they will implement to achieve these aims.<\/p>\n

The Government will never learn it seems. 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. <\/p>\n

The Government rehearses the conservative logic that by running budget surpluses they are “saving” and these “resources” are then able to be used by the private sector. The government sees a virtue in retiring net government debt. But a government surplus is an equal reduction in non-government net income and net financial assets.<\/p>\n

This net income and resulting net financial assets serve as the “equity” that supports the private sector’s credit structure. By removing this net income and net financial assets, government budget surpluses undermine the credit structure, which ultimately readjusts to its reduced equity base as Hyman Minsky showed in his writings in the 1980s.<\/p>\n

The economy will only sustain high levels of output after the government realises deficits sufficiently large to restore necessary income and equity to support an expanding private sector credit structure.<\/p>\n

Further, the Government does not require budget surpluses to retire debt. The government can retire debt at any time it wants by using the RBA’s support rate rather than public debt for interest rate support when it net spends. <\/p>\n

Additionally, the RBA always has the open option to purchase and thereby retire remaining public debt outstanding. Again, this simply exchanges one private sector asset, public debt, for another, RBA member bank balances.<\/p>\n

While net taxation revenue will also retire debt, we repeat that this will ultimately not reduce cumulative government deficit spending and therefore in the long term not retire debt. <\/p>\n

It is fare better to let market forces determine the level of government deficit spending. A fixed-wage Job Guarantee policy can attenuate any tendency towards financial instability and provide the “switch” between private and public sector employment over the business cycle, as well as provide an anchor effect to the price level.<\/p>\n

I have always found it ironic that during a time of heightened appreciation of market forces, the option to let market forces determine the size of the fiscal deficit has not been open to discussion. But in saying that I do not find it surprising, as the presumed fixed exchange rate assumptions and restrictions take precedence.<\/p>\n

Second, what about these “proposed reforms to bank liquidity arrangements”? Before I look at them we need some background.<\/p>\n

Basel I and II<\/strong><\/p>\n

The Bank of International Settlements (BIS) convened the so-called Basel Committee on Banking Regulations and Supervisory Practices (known initially as the Cooke Committee) in 1974 in reaction to the growing international financial instability. The initial concern was to provide a level playing field in international banking. But declining capital levels would also come to the fore.<\/p>\n

They sought to develop a common minimum standard of capital adequacy that all international banks should maintain. They wanted to ensure stability of the international financial system but allow the banks freedom to determine their own portfolio choices and allow competition.<\/p>\n

Basel I<\/u><\/p>\n

As the potential for major international bank failure grew as risk levels were rising, the Basel Committee on Banking Supervision which at that time comprised central banks and supervisory authorities of 10 countries met in 1987. The work culminated in the Basel Capital Agreement published in July 1988 (which was called Basel I).<\/p>\n

The methodology defined a “minimum” amount of capital that banks should retain – the minimum risk-based capital adequacy. You can read up on the details HERE<\/a><\/p>\n

Several amendments have been made to the original accord.<\/p>\n

The new approach to regulation no longer prescribed the asset composition of the banks’ balance sheets. Earlier approaches forced banks to hold certain types of assets (government bonds) in strict proportions. This system of regulation was ineffective because the banks were continually innovating and taking business “off the balance sheet”. For example, banks started to own finance companies which were not subject to regulation.<\/p>\n

The Basel I approach, however, still gave banks a wide freedom to lend. But banks with high risk lending strategies were “forced” to hold a relatively high proportion of shareholder equity.<\/p>\n

Sticking points were how to define capital (which was essential if they were going to impose capital adequacy.<\/p>\n

Capital plays a very different role in the bank than it does in the corporation.<\/p>\n

In the latter case, capital facilitates the transfer of ownership of assets, profits, etc to shareholders. Capital is also a means of raising funds through share issues. So that rising debt\/equity ratios will usually push the cost of debt up and force the firm to resort to equity for further expansion.<\/p>\n

But banks can have virtually unlimited leverage and the amount of debt a bank can raise depends more on its perceived safety than its debt\/equity ratio. For a bank, the liability side does not exist purely to fund the activities of the bank. It is a part of the activities of the bank. They can (in theory) borrow whatever they need as part of their normal activities of intermediation.<\/p>\n

An essential role of bank capital is to act as a buffer against losses. It is the last line of defence against losses.<\/p>\n

Basel I defined a two-tiered capital classification:<\/p>\n