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Painstaking, dot-point summary – bond issuance doesn’t lower inflation risk

I will finish this week with a painstaking, dot-point summary of some key elements of Modern Monetary Theory (MMT) to show clearly why bond-issuance which might accompany a budget deficit doesn’t lower the inflation risk of the deficit spending – not now, not tomorrow, nor at some mythical “long-run” point in time. All the inflation risk is on the spending (aggregate demand) side. The monetary arrangements that might or might not accompany the spending decisions of government do not add or subtract from the inflation risk. Mainstream theory thinks they do. That theory is demonstrably false. I will also cover several related myths that seem to have cropped up over the last week – both in the international media and among the comments made on this blog. It seems that we need some baby steps. So with my fire-suit (always) on I hope you all enjoy it. Some of the critics might like to read this news item before they start.

1. Governments need to fund spending myth

A sovereign government that issues its own currency can never be revenue constrained in that currency as an intrinsic fact. It makes no sense to say that government spending is being “financed” by the users of that currency (the non-government sector). The users ultimately depend on the government spending to acquire the currency.

Governments can introduce all sorts of institutional machinery to curtail their fiscal freedom – such as special accounts which bond-issue revenue is placed and from which they spend – and make it look as if they are being funded by proceeds from taxation and debt-issuance. But they are just ideological layers that carried over from the fixed exchange rate/convertible currency system and have no intrinsic meaning in a fiat monetary system.

2. The household and sovereign government analogy myth

Thus the mainstream economics starting point – the analogy between the household and the sovereign government – which claims that any excess in government spending over taxation receipts has to be “financed” in two ways: (a) by borrowing from the public; and/or (b) by “printing money” misses the point that the household uses the currency and the government issues it. The government budget is not a big household budget. Household have to finance all spending prior to spending. The household cannot spend first. The government has to spend first and does not to finance such expenditure – in the normal use of term as applied to a household.

3. The government budget constraint myth

Mainstream economists erroneously build on the household analogy and claim that just like a household the government is bound by the so-called government budget constraint (GBC). The GBC says that the budget deficit in year t is equal to the change in government debt over year t plus the change in high powered money over year t. So in mathematical terms it is written as:


This says that the Budget deficit = Government spending + Government interest payments – Tax receipts must equal (be “financed” by) a change in Bonds (B) and/or a change in high powered money (H). The triangle sign (delta) is just shorthand for the change in a variable.

The mainstream economist considers this to be an ex ante (before the fact) financial constraint that the government is bound by. They also erroneously claim that “money creation” results from the government asking the central bank to buy treasury bonds in return for printing “money” which the government then spends.

In normal times, this “debt monetisation” is not a viable option for a central bank. I explain that in these blogs – Deficit spending 101 – Part 1Deficit spending 101 – Part 2Deficit spending 101 – Part 3.

The mainstream claims that if governments increase the money growth rate the extra spending will cause accelerating inflation because there will be “too much money chasing too few goods”! So they claim that governments should only issue debt to “fund” deficits because that reduces the inflation risk.

Lurking behind this view is the Quantity Theory of Money which is an accounting statement linking the outstanding stock of money to the nominal level of GDP. This accounting identity is usually written as MV = PY where M is the stock of “money”, V is the velocity of circulation (or the times that M turns over per period), P is the price level and Y is real GDP. The relationship just says that total spending (MV) has to be equal to nominal GDP (real GDP times the price level) as a matter of national accounting.

If you assume full capacity utilisation is always maintained and V is constant then any change in M must directly impact on P. So if M accelerates – under these assumptions – so will P (that is, inflation).

Once you assume away all the interesting things about the economy (that is, the business cycle – by assuming full employment always) then it is trivial that if M rises so will P. But if Y is below full employment then extra spending can clearly stimulate the real side of the economy without increasing prices. The vast array of evidence over many years supports the notion that increases in aggregate spending when the economy is below full employment stimulate real output and only if aggregate demand is pushed beyond the real capacity of the economy do price pressures build (excluding supply-induced inflationary episodes).

4. The money multiplier myth

The mainstream then link the monetary base (bank reserves and currency on issue) to the stock of money via the money multiplier – another major flaw in their reasoning. Please read my blog – Money multiplier and other myths “> – for more discussion on this point.

The money multiplier model says that: M = m x MB. So if a $1 is newly deposited in a bank, the money supply will rise (be multiplied) by $10 (if the RRR = 0.10). The alleged linkages are (assuming banks are required to hold 10 per cent of all deposits as reserves):

  • A person deposits say $100 in a bank.
  • To make money, the bank then loans the remaining $90 to a customer.
  • They spend the money and the recipient of the funds deposits it with their bank.
  • That bank then lends 0.9 times $90 = $81 (keeping 0.10 in reserve as required).
  • And so on until the loans become so small that they dissolve to zero …

The problem is that this stylised mainstream text-book model isn’t even close to how things actually operate in the banking sector. The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share.

These loans are made independent of their reserve positions. Depending on the way the central bank accounts for commercial bank reserves, the latter will then seek funds to ensure they have the required reserves in the relevant accounting period. They can borrow from each other in the interbank market but if the system overall is short of reserves these “horizontal” transactions will not add the required reserves. In these cases, the bank will sell bonds back to the central bank or borrow outright through the device called the “discount window”. There is typically a penalty for using this source of funds.

Reserve balances are not initially required to “finance” bank balance sheet expansion. A bank’s ability to expand its balance sheet via lending is not constrained by the quantity of reserves it holds or any fractional reserve requirements. Loans create deposits which are then backed by reserves after the fact. The process of extending loans (credit) which creates new bank liabilities is unrelated to the reserve position of the bank.

6. What about open market operations? These are allegedly how the central bank increases or decreases the money supply. The mainstream argue that if the central bank wants to increase the money supply it would purchase bonds in the markets.

But this would just add reserves to the banking system. In the real world, the banks will try to lend those reserves out because they don’t want to be stuck with under performing deposits and competition in the overnight markets will drive the interest rate down. Clearly, if the central bank wants to maintain control over a positive overnight interest rate it has to then drain the excess reserves which would require it offer the banks an interest-bearing asset commensurate with the overnight rate. That is, it would have to sell bonds in an open market operation. The reverse is true if it tried to reduce the money supply by selling bonds. This drains reserves from the cash system and would probably leave some banks short of required reserves. Given the only remedy for an overall shortage of reserves is intervention from the central bank the attempt to decrease the money supply fails.

It is clear that the central bank then is unable to control the volume of money in the system although it can control the price through its monetary policy settings. The monetary base does not drive the money supply. In fact, the reverse is true. Bank reserves at any point in time will be determined by the loans that the banks make independent of their reserve positions.

5. The “free lunch – pay for it later” inflation myth

We know that the Quantity Theory of Money is inapplicable to economies which are constrained by deficient demand (defined as demand below the full employment level). When nominal demand increases in such an economy firms respond by increasing real output (and employment) rather than prices. There is an extensive literature supporting that statement. So when governments expand deficits to offset a collapse in private spending, there is plenty of spare capacity available to ensure output rather than inflation increases.

Some mainstream economists call this the “free lunch” period which eventually has to be paid for courtesy of the so-called “long-run budget constraint”. They claim that when aggregate demand reaches real output capacity the “free lunch” for budget deficits run out and they are forced to (finally) obey the long-run budget constraint because at that point taxes have to be increased to curtail aggregate demand to prevent inflation. This amounts to raising “taxes to pay for past, present or future government spending”.

This is of-course an absurd construction of events. The only constraints on nominal government spending are real. The government can purchase whatever is for sale in the currency it issues whenever it chooses. Its past fiscal position is irrelevant to that capacity. Please note: that doesn’t mean it can spend infinite amounts without any problems. The statement is that it can – that is, the intrinsic capacity of a fiat-issuing government.

So, please recite the next sentence several times – noting it is not a general jargon-ridden statement but a clear, concise, definitive fact – there is a real constraint on all spending (public and private).

The government could keep driving nominal demand with ever increasing deficits beyond the full capacity point if it wanted to. Hyperinflation would eventually result. If government aims to promote public purpose via full employment and high real income growth then you would question the sanity of a government that pushed deficit growth beyond the full employment point.

Consider this example. Assume the economy is currently at full employment and private spending (including net exports) is 90 per cent of GDP and public net spending (deficit) is 10 per cent of GDP. Now if potential output (that is, the real output constraint) is growing at say 4 per cent per annum, both private spending and public spending can growing at 4 per cent per annum without pushing the economy beyond the inflation barrier (although at near full capacity there might be some individual sector bottlenecks).

If non-government saving is equal to 10 per cent of GDP then the budget deficit would have to remain at 10 per cent of GDP continuously to support aggregate demand growing at 4 per cent per annum and full employment being sustained.

If, say private sector spending grew at say 5 per cent per annum (with all other parameters unchanged) then the economy would quickly hit the inflation barrier. In that situation, to prevent inflation the government would have to cut its own spending and/or increase taxes to cut the spending of the private sector to bring total nominal aggregate demand growth back to 4 per cent per annum.

The increased taxes are not “paying back” previous deficits nor are they funding anything. They are just maintaining aggregate demand growth in line with real output potential.

The point is that deficits are flows and exhaust each year as does the national income that is created. Every “new” year, the spending flows add to demand which drives income and output (and employment). No government has to pay back last year’s deficit.

The other point is that the inflation risk of government deficits (and all spending) is in terms of the impact on aggregate demand. Inflation is the result of excessive nominal demand (relative to real output capacity – the supply capacity of the economy). Whether the government sells bonds or not is totally irrelevant in this regard. Which leads us to the …

6. Governments choose between printing money and debt issuance to fund deficits myth

Within the government budget constraint literature – once the QTM is used to dissuade governments from “printing money” – the attention turns to taxation and debt issuance.

The mainstream claim that governments have to “finance” all spending either through taxation; debt-issuance; or money creation. As we will see government spending is performed in the same way irrespective of the accompanying monetary operations.

But the mainstream rank the three so-called funding options in terms of their expansionary impact and their inflation risk. Countless chapters on fiscal policy in mainstream macroeconomic text books go through this analysis and mislead their students as a consequence.

So printing money is most expansionary (because it is alleged it not only increases spending but also reduces interest rates – so thwarting their crowding out analysis). Bond sales are less expansionary because they forces up interest rates which crowd out some private spending. The extreme mainstream view is that the interest rate effect totally swamps the government spending stimulus and there is no gain in output.

But all these claims are without foundation in a fiat monetary system and if you gain an understanding of the banking operations that occur when governments spend and issue debt you will see why.

I know some people claim that MMT cuts debate short by saying it is just a matter of understanding banking operations or something like that. Given we have written millions of words over the last few decades minutely describing these operations I fail to comprehend the attack. It just resonates that the critics cannot come to terms with the detail. You will find very little in mainstream macroeconomics textbooks or related literature describing in detail what happens when a government spends, for example.

The mainstream economists construe that governments have a choice when they run deficits – either sell bonds or “print money”. That choice doesn’t transcend the textbook world I am afraid. In the real monetary system – the one we all live in – governments do not spend in that sort of choice-constrained framework.

Government spending is just a process of electronic entries into bank accounts. Millions of transactions every day. Once all these transactions are accounted for (and non-government people and firms have deposited their receipts etc) the manifestation in the banking system is an increase in reserves.

So government spending results in the Treasury credited the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made. Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet). Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. But at this stage, M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. In other words, budget deficits increase net financial assets in the non-government sector.

If that spending pushes the economy beyond the inflation barrier then the government has to curb public spending growth or private spending growth (by increased taxation). There are other tools (price controls) but we won’t consider them here.

7. The bonds are less inflationary myth

So what would happen if a sovereign, currency-issuing government (with a flexible exchange rate) ran a budget deficit without issuing debt?

Reflect back on Item 6 and realise that when there are excess reserves in the cash system as a result of deficits there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities).

Accordingly, the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target. Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation.

There is no sense that these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance. So M1 (deposits in the non-government sector) rise as a result of the deficit without a corresponding increase in liabilities. It is this result that leads to the conclusion that that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, reduces the money supply.

However, the reality is that:

  • Building bank reserves does not increase the ability of the banks to lend.
  • Banks do not lend bank reserves
  • The money multiplier process does not describe the way in which banks make loans.
  • Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

Think about it like this:

(a) if there were no bonds issued the bank reserves would rise in level. This doesn’t alter the capacity of the private sector to spend nor the bank’s ability to lend.

(b) if instead bonds are issued the level of bank reserves fall and the level of public debt rises. This just amounts to the central bank doing some accounting entries to swap the private “saving” from “reserve accounts” to “outstanding loan accounts”. This has no impact on the government spending or the inflation impact of the government spending.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

Other related blogs include – Why history matters and The complacent students sit and listen to some of that.

8. What if the private sector spend more myth

This myth goes like this. The private sector will distrust a government that doesn’t issue debt and so will seek to hold their accumulated wealth in real assets to hedge against inflation. As a result they will desert the currency.

First, how do these people pay taxes? They have to have the issued currency to pay taxes. They cannot present a gold bar or a piece or real estate or any other asset to the government to relinquish their tax obligations. Yes some might go off-shore but not everyone can do that.

Second, the reserves that governments drain when they issue debt reflect prior public spending. The government just borrows back their own spending to ensure the central bank can manage its liquidity aims.

Third, bonds are highly liquid and holding them doesn’t constrain private spending capacity.

Fourth, if the non-government entities (firms and people) so decide to spend all the “money” that results from government spending – that is, not leave any in accumulated financial assets – then nominal spending growth will increase and the government has two choices. It can decide that more private spending relative to public net spending is good (in the mix of final goods and services) and cut back its own discretionary net spending. The actual budget deficit will shrink anyway because of the automatic stabilisers.

Alternatively, it might consider the current (non-inflationary) public command over real resources is desirable and so it will seek to curb the private spending via taxation.

There is no inevitable descent into hyperinflation.

Musical relief

After a week of reading nonsensical mainstream economics literature and realising (via some of the commentators here) that people still want to defend it – my Friday musical interlude is the great Bo Diddley from 1955 – soothing us with his vibrato. Beautiful.


Here is an assignment for all those who still want to defend mainstream macroeconomics.

Please present a detailed analysis – including a thorough explication of the monetary operations of the Bank of Japan over the last 20 years or so – to explain why Japan has not experienced sky-rocketing interest rates and hyperinflation.

As a secondary assignment please explain why interest rates and inflation are not rising rapidly in the US at present with particular attention to the spiralling of bank reserves and the almost zero demand for private credit.

When you have done that please send it to me and I will highlight it in a blog post. But it will need to be at least 6 thousand words so we avoid statements like “bond issuance reduces inflation risk” and “printing money is hyperinflationary” and “it is just a matter of time” and “Japan is culturally different”. We have heard all those statements before.

Saturday Quiz

The Saturday Quiz will be back sometime tomorrow – even harder than last week!

That is enough for today!

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    This Post Has 206 Comments
    1. WHQ
      I think you are being a bit unfair making these demands that i be a clarevoyant. However currently agricultural land has risen 17% since last year and according to the government there is inflation as they measure it. If wages were to rise i am sure they would be delighted – which would presumably add to inflation. If we know that in future inflation will fall because things are so bad, or we know that permanent higher inflation is not something that is bad, then we can enable more stimulus and not worry about inflation.

    2. Mainstreamers are really saying that they are more interested in maintaining relative wealth than promoting absolute wealth.

      It is much more important, in their world view, to have the fanciest mud hut on the Savannah.

    3. Hi there,

      In the end of the blog Bill says:
      “Fourth, if the non-government entities (firms and people) so decide to spend all the “money” that results from government spending – that is, not leave any in accumulated financial assets – then nominal spending growth will increase and the government has two choices. It can decide that more private spending relative to public net spending is good (in the mix of final goods and services) and cut back its own discretionary net spending. The actual budget deficit will shrink anyway because of the automatic stabilisers.”

      What are these automatic stabilisers? Would the government deficit shrink automaticaly even if the government did not decide for it? Why?

      Thanks for any light!

    4. My question concerns US Treasury securities held by investors (state and local governments, private and foreign investors). I have said in a discussion with Joe Firestone:
      I think that the investors’ securities tie up a lot of dollars in time-deposit accounts and out of circulation where they might be harmful, if our government wishes to engage in deficit spending on some other objectives while avoiding inflation.

      Joe replied:

      You haven’t gotten to the part of [my] book yet on inflation. You’ll see when you get there that using Treasury debt securities, rather than just having reserves in accounts at the Fed is unlikely to make any material difference when it comes to circulation of money that may be harmful to the economy. That’s true because those holding securities are able to borrow against them, and leverage their bond collateral multiple times at banks when they need liquidity. So, securities don’t remove money from circulation to any greater degree than would be the case without them.

      There is an awful lot of money tied up in investors’ Treasury securities. In 2015 the Gross Federal debt is $18.6 T.
      The debt held by the public (excluding govt series securities and securities at the Fed) is $11.1T. The debt held by the banks is $407B, so about $10.7T is, I believe, held by investors. China and Japan hold huge amounts of that debt, but the point is that they are investors, and their dollars likely came from their selling their exports to us (our imports). So, my question is

      How much of those securities are leveraging loans from banks, with bank lending contributing new money to the money supply and potentially causing inflation.

      I don’t see any serious inflation right now. But if the inflationary effect of leveraging all those investor securities were real, shouldn’t we see much inflation now? The $407B at the banks I think are for deficit spending and borrowed interest. I think the $2.54T in securities at the Fed represent purchases of deficit-spending securities from the banks. The current level of $407B is likely for deficit spending in the past fiscal year.

      So what is the connection between investor US Treasuries and bank lending? Bank lending would reflect investors leveraging loans with their Treasury securities, using the money corresponding to the securities held in time-deposit accounts at the Fed.

      And suppose there is a huge effect of investors generally using savings to leverage loans from the banks; what can the Fed or the government do to put dampers on that when such lending becomes inflationary? Raise interest rates to high levels after attaining full production and employment and stable prices and wages? On the other hand, there may still be a large saving effect in investors buying those securities.

      Now as for banks having to buy the Fed’s Treasury securities during inflations, my next question is, to what extent do banks leverage their lending or borrowing or hedging positions based on those securities? Can they do so legally?

    5. Dear Bill,
      Still working my way slowly through parts of your incredibly impressive blog history. These two statements have me a little confused:

      “Reflect back on Item 6 and realise that when there are excess reserves in the cash system as a result of deficits there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities).”


      “Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.”

      These two statements appear contradictory if you assume that lower interest rates increase inflation pressure. So if you increase the reserve position of the banks it drives down interest rates and increases demand, thus putting upward pressure on prices.

      Does the validity of the second statement rely on the use of other interest rate control mechanisms, like paying interest on reserves? Or have I misunderstood something?


    6. A comment about households not spending first.

      I always spend first and then worry about paying afterwards. I follow the S(TaB) approach except I cannot tax! Lol But seriously I have arranged large credit lines that allow me to spend and if my revenue falls short I delve into my credit lines ie increase my liabilities thereby increasing assets for the companies holding the lines. To avoid depression — ie personal bankruptcy — I curtail my spending and transfer more revenue or disposable income to my LOCs (reducing both my liabilities and the companies assets). Which paradoxically should contribute to lower inflation and recession/depression in the economy.

      To some extent I follow the government funding approach. But it occurs to me that what I do could be seen as inflationary since I may not concern myself with the price of something I want including the low interest rate on my LOCs. This may be the factor that the central banks address when they try to reduce inflation by raising interest rates. If there are a lot of people like me, that is a problem and a factor in bidding up the price of assets such as housing where I can use my equity in my properties to fund spending. Taxing me has the same effect to some extent because that also curtails my spending ie curtails adding to my liabilities and to companies’ assets.

      When I was married, my budget officer — wife — would serve to evaluate some of our/my spending. Now I have to use self-restraint occasionally. But since this is not a marital or personal advice column I will stop there.

      Suffice it to say, I see more parallels between my household budget and the government spending than is sometimes acknowledged!

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