Only one of the following statements can be true when you observe rising government bond yields for new issues
Answer: Bond prices are falling in response to demand.
The answer is Option (b) that bond prices are falling in response to demand.
The first option provided "that government spending is becoming more expensive" assumes that there is some revenue constraint on government spending.
The interest servicing payments come from the same source as all government spending - its infinite (minus $1!) capacity to issue fiat currency.
There is no "cost" - in real terms to the government doing this.
The concept of more or less expensive is therefore inapplicable to government spending.
The third option "that government spending is increasing the cost of borrowing for private investors" is also based on the flawed mainstream concept of crowding out.
The normal presentation of the crowding out hypothesis, which is a central plank in the mainstream economics attack on government fiscal intervention, is more accurately called "financial crowding out".
In this blog post - Studying macroeconomics - an exercise in deception - I provide detailed analysis of this hypothesis.
By way of summary, the underpinning of the crowding out hypothesis is the old Classical theory of loanable funds, which is an aggregate construction of the way financial markets are meant to work in mainstream macroeconomic thinking.
The original conception was designed to explain how aggregate demand could never fall short of aggregate supply because interest rate adjustments would always bring investment and saving into equality.
Mainstream textbook writer Mankiw assumes that it is reasonable to represent the financial system to his students as the "market for loanable funds" where "all savers go to this market to deposit their savings, and all borrowers go to this market to get their loans.
In this market, there is one interest rate, which is both the return to saving and the cost of borrowing."
This doctrine was a central part of the so-called classical model where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times.
If consumption fell, then saving would rise and this would not lead to an oversupply of goods because investment (capital goods production) would rise in proportion with saving.
So while the composition of output might change (workers would be shifted between the consumption goods sector to the capital goods sector), a full employment equilibrium was always maintained as long as price flexibility was not impeded.
The interest rate became the vehicle to mediate saving and investment to ensure that there was never any gluts.
The supply of funds comes from those people who have some extra income they want to save and lend out.
The demand for funds comes from households and firms who wish to borrow to invest (houses, factories, equipment etc). The interest rate is the price of the loan and the return on savings and thus the supply and demand curves (lines) take the shape they do.
This framework is then used to analyse fiscal policy impacts and the alleged negative consequences of fiscal deficits - the so-called financial crowding out - is derived.
Mankiw (in his First Principles) says:
One of the most pressing policy issues ... has been the government fiscal deficit ... In recent years, the U.S. federal government has run large budget deficits, resulting in a rapidly growing government debt. As a result, much public debate has centred on the effect of these deficits both on the allocation of the economy's scarce resources and on long-term economic growth.
So what would happen if there is a fiscal deficit?
The erroneous mainstream logic is that investment falls because when the government borrows to finance its fiscal deficit, it increases competition for scarce private savings pushes up interest rates.
The higher cost of funds crowds thus crowds out private borrowers who are trying to finance investment.
This leads to the conclusion that given investment is important for long-run economic growth, government fiscal deficits reduce the economy's growth rate.
The analysis relies on layers of myths which have permeated the public space to become almost "self-evident truths". Obviously, national governments are not revenue-constrained so their borrowing is for other reasons - we have discussed this at length.
I discussed that issue in the introductory suite of blog posts:
1. Deficit spending 101 - Part 1 (February 21, 2009).
2. Deficit spending 101 - Part 2 (February 23, 2009)
3. Deficit spending 101 - Part 3 (March 2, 2009).
But governments do borrow - for stupid ideological reasons and to facilitate central bank operations - so doesn't this increase the claim on saving and reduce the "loanable funds" available for investors?
Does the competition for saving push up the interest rates?
The answer to both questions is no!
Modern Monetary Theory (MMT) does not claim that central bank interest rate hikes are not possible.
There is also the possibility that rising interest rates reduce aggregate demand via the balance between expectations of future returns on investments and the cost of implementing the projects being changed by the rising interest rates.
But the Classical claims about crowding out are not based on these mechanisms.
In fact, they assume that savings are finite and the government spending is financially constrained which means it has to seek "funding" in order to progress their fiscal plans.
The result competition for the "finite" saving pool drives interest rates up and damages private spending.
A related theory which is taught under the banner of IS-LM theory (in macroeconomic textbooks) assumes that the central bank can exogenously set the money supply.
Then the rising income from the deficit spending pushes up money demand and this squeezes interest rates up to clear the money market.
This is the Bastard Keynesian approach to financial crowding out.
Neither theory is remotely correct and is not related to the fact that central banks push up interest rates up because they believe they should be fighting inflation and interest rate rises stifle aggregate demand.
Further, from a macroeconomic flow of funds perspective, the funds (net financial assets in the form of reserves) that are the source of the capacity to purchase the public debt in the first place come from net government spending.
Its what astute financial market players call "a wash".
The funds used to buy the government bonds come from the government!
There is also no finite pool of saving that is competed for. Loans create deposits so any credit-worthy customer can typically get funds.
Reserves to support these loans are added later - that is, loans are never constrained in an aggregate sense by a "lack of reserves".
The funds to buy government bonds come from government spending! There is just an exchange of bank reserves for bonds - no net change in financial assets involved. Saving grows with income.
But importantly, deficit spending generates income growth which generates higher saving. It is this way that MMT shows that deficit spending supports or "finances" private saving not the other way around.
Acknowledging the point that increased aggregate demand, in general, generates income and saving, Luigi Passinetti the famous Italian economist had a wonderful sentence I remember from my graduate school days - "investment brings forth its own savings" - which was the basic insight of Keynes and Kalecki - and the insight that knocked out classical loanable funds theory upon which the neo-liberal crowding out theory was originally conceived.
So that leaves the option "that bond prices are falling in response to demand".
In macroeconomics, we summarise the plethora of public debt instruments with the concept of a bond.
The standard bond has a face value - say $A1000 and a coupon rate - say 5 per cent and a maturity - say 10 years.
This means that the bond holder will will get $50 dollar per annum (interest) for 10 years and when the maturity is reached they would get $1000 back.
Bonds are issued by government into the primary market, which is simply the institutional machinery via which the government sells debt to "raise funds".
qIn a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the the institutional machinery is voluntary and reflects the prevailing neo-liberal ideology - which emphasises a fear of fiscal excesses rather than any intrinsic need.
Once bonds are issued they are traded in the secondary market between interested parties.
Clearly secondary market trading has no impact at all on the volume of financial assets in the system - it just shuffles the wealth between wealth-holders.
In the context of public debt issuance - the transactions in the primary market are vertical (net financial assets are created or destroyed) and the secondary market transactions are all horizontal (no new financial assets are created).
Please read my blog post - Deficit spending 101 - Part 3 - for more discussion on this point.
Further, most primary market issuance is now done via auction. Accordingly, the government would determine the maturity of the bond (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) being specified.
The issue would then be put out for tender and the market then would determine the final price of the bonds issued.
Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.
Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (inflation or something else).
So for them the bond is unattractive and they would avoid it under the tap system.
But under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.
The mathematical formulae to compute the desired (lower) price is quite tricky and you can look it up in a finance book.
The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.
When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).
When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.
Further, rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this).
But they may also indicated a recovering economy where people are more confidence investing in commercial paper (for higher returns) and so they demand less of the "risk free" government paper.
So you see how an event (yield rises) that signifies growing confidence in the real economy is reinterpreted (and trumpeted) by the conservatives to signal something bad (crowding out).
In this case, the reason long-term yields would be rising is because investors were diversifying their portfolios and moving back into private financial assets.
The yield reflects the last auction bid in the bond issue.
So if diversification is occurring reflecting confidence and the demand for public debt weakens and yields rise this has nothing at all to do with a declining pool of funds being soaked up by the binging government!
The following blog posts may be of further interest to you:
That is enough for today!
(c) Copyright 2021 William Mitchell. All Rights Reserved.