Yesterday I reported on a document I received from one of the largest international investment banks in the world. That document is part of that organisation’s advice it gives to bond investors. I used some of the document to illustrate that the understandings of how a modern monetary system operates that I write about here are also now out there in the real world – in the financial markets where bonds are bought and sold. I didn’t identify the document because it is a subscribers-only publication sent to me by the author and I respect his privacy. Today’s blog provides some more insights that will help you better understand the public debate and allow you to cut through the nonsense being peddled by all and sundry.
The purpose of my blog is always to take us back to the basics – the essential way the system functions. Once that is understood you can then impose whatever politics you like on top and advocate whatever you please. But it is reprehensible to try to blur your politics by using macroeconomic theory which has no validity and is designed to appear to be authorative and generates the ideological conclusions you desire.
The document provides some further information to reinforce this point:
Over the last five years the 10yr JGB yield has averaged 1.56% whilst the debt/GDP ratio has been at 162%. Throughout the ten year period after 1990, when the real estate and equity market bubble burst, the 10yr yield continued to fall as the debt/GDP% increased … There is no historical evidence of positive correlation between budget deficits and bonds yields in Japan, if anything the relationship is negative … the debt ratio has no relevance to the path of bond yields. Bond yields started a downward
trajectory in the post bubble years.
What we learn from Japan is that the huge deficits added reserves to the banking system and financed rising savings in the private sector. From the early 1990s onwards, private confidence in the future was low and so banks found it hard to find credit-worthy customers. In fact, borrowers in net terms were paying down their debts as a safety-first measure in uncertain times. So we had a combination of a dearth of credit-worthy borrowers and rising private saving. Ordinarily this flight into private saving and deleveraging would cause a dramatic decline in GDP growth and very sharp increases in unemployment as employment growth fell apart. What rescued the Japanese economy was the rising fiscal deficits.
In this sense, the fiscal deficits stopped the inevitable income adjustments (decline) from occuring because they “funded” the rising saving desires by maintaining sufficient spending to support output and income generation at non-recession levels. The economy certainly suffered but it kept growing (at very low rates) because Japanese Government’s resolve to ignore the neo-liberal advice to the contrary (not to run deficits) and the downgrading of their sovereign debt ratings by the discredited ratings agencies.
The other salient point is that the Japanese Government held firm to this strategy and avoided falling prey to the growing claims that the rising deficits (as a proportion of GDP) would drive up interest rates and cause inflation. This is a fundamental lesson for all Governments who are currently being bombarded by the deficit-debt hysterics and being urged to get the budget back into the black as quickly as possible.
In this regard, the document concludes that:
The biggest risk to the global economy right now would be for governments to attempt to reduce fiscal deficits too quickly.
But I go a bit further than this and argue that deficits are the typical or normal situation rather than being a cyclical phenomena. So while the automatic stablisers will reduce the deficit as the economy returns to stronger growth but the discretionary component of the budget will normally have to keep adding reserves on a daily basis because private sector entities will normally desire to net save a positive proportion of GDP. That is, the net government spending will have to provide the spending left by this net withdrawal for output to remain at high levels.
Anyone who says that the government should balance the budget on average over the course of the business cycle – or worse still to achieve a budget surplus on average over the business cycle – are clearly denying that the non-government sector on average desires to net save a positive fraction of GDP over the same cycle. The recent period of negative private saving and massive leveraging of the private sector is atypical (in the extreme).
It is clearly difficult for people to understand the national accounting relationships between government and non-government – so that a government deficit is $-for-$ equal to the non-government surplus. But understanding this accounting relationship is crucial to getting a complete grasp on the fiat monetary system.
The document says that:
The link between the budget deficit and savings is a powerful one but not immediately intuitive from a householder’s perspective. Deficits can actually be good for bond markets (yes you have read this correctly). This is difficult to accept from the perspective of personal accounting, as how completely illogical it would be for personal savings to increase whilst borrowings go up!
In short … governments are different. Governments have to spend before savings can take place. Deficit spending will add to nominal saving of financial assets, something that can be shown through the national accounting identity … Deficits raise the private sector savings and holdings of financial assets because the private sector keeps the bond or reserve. In accounting terms it shows up as an asset on the private sector’s balance sheet and as a liability for the government.
This makes the point very clear.
Now what about interest rates and the deficits?
Whatever else is said about Japan, here is the chart that tells you what happened to budget deficits (as a percentage of GDP) and interest rates (both overnight – the call rate and 10-year bond yields). The chart also gives you information about the yield curve itself by allowing you to see the variations in the spread between the short-term rates that are set by government (in this case, the Bank of Japan) and the longer yields. The other maturities along the yield curve (different assets) are well represented by the 10-year government bond rates.
The point is simple yet powerful. Rising budget deficits do not push up interest rates.
The document says that governments (the consolidated central bank and treasury) “can set whatever rate they choose”. Accordingly, we need to understand that:
(m)ost importantly, bond sales are for interest rate support, they are not actually used to ‘finance’ deficit spending. The purpose of selling bonds, along with paying interest on excess reserves, is to control the Fed funds target rate. For the US government and Fed respectively, both selling bonds and the existence of excess reserves can be regarded as a way to drain the system of money, representing an effective tax on banks because of the opportunity foregone to earn a higher rate of interest.
While the example is in the context of the US system, the same appliesto all sovereign countries. But there are some deeper insights here that will also help us understand the way in which government spending impacts on the monetary system. The government deficits adds reserves to the banking system. The impact on the “cash system” provides net financial assets to the non-government sector which allow the latter to pay taxes in the currency of issue but also allow the non-government sector to swap the non-interest earning reserves for interest-earning bonds (government debt).
This is why I say often that the funds used to buy the debt (which is the government is constructed as “borrowing”) come from the government itself! This is an essential difference between the government and a household. Try telling the bank that your spending provides the funds to pay for the debt you have with the bank! You will not get very far.
The crucial point is that any analysis of government budgets based on so-called household budgets should be dismissed immediately as being non-applicable. There are no insights about public spending that can be gained from understanding the dynamics of household budgets.
What about deficits and debt?
The document concludes the following:
… the level of deficit has no bearing on the amount of bonds that end up being held by the private sector, this is a function of the interest rate targeting method. Recall that the BoJ’s ZIRP (zero interest rate policy) was accompanied by the BoJ paying 0% on reserves. Of course rational banks responded by not holding reserves at the BoJ, they bought a lot of government bonds instead. The US Fed pays 25bp on excess reserves but it could pay nothing at all, thereby encouraging banks to buy interest-bearing government bonds instead.
The same conclusions apply to Australia, as a sovereign government. You will have read constantly that the deficits are all on the “government’s credit card”. Again, the analogy with the household sector is invoked – it is deeply flawed as I noted above. The government doesn’t have a credit card because it doesn’t need one. My credit card allows me to purchase things in advance of having the income and then I have to pay it back. The sovereign government is not revenue-constrained so the analogy of spending on credit is totally inapplicable. So any time you see this sort of rhetoric – dump it in the rubbish bin. It is designed to mislead you and to steer your thinking towards neo-liberal conclusions.
Take the recent nonsense coming from the Australian shadow treasurer who bouyed up by the deficit nazis is constantly hammering our ears with nonsense about the debt buildup and crippling interest rates. At a recent press interview, he gave five answers in a row to five different questions. Here are his answers (edited) – the questions are largely irrelevant:
The increase in interest rates by the Commonwealth Bank today is directly linked to Kevin Rudd’s debt. If Kevin Rudd is going to borrow up to $3 billion a week, it is inevitably going to put upward pressure on interest rates and the decision by the Commonwealth Bank today is just the beginning … If the Government is borrowing so much money in competition with the banks, then the cost of funds to the banks will inevitably rise. You cannot continue with low interest rates whilst the Australian Government is borrowing billions of dollars every week to hand out cheques for $900.
His solution to the crisis is that:
Well the Government should reduce its borrowings. The Government should spend less money. If the Government is borrowing money in direct competition with the banks then it inevitably pushes up the cost of money to the banks and it inevitably has an impact on the price of a mortgage for everyday homeowners.
And the record gets stuck!
We have always been warning that when the Government borrows so much money in competition with the banks who themselves borrow money, then inevitably the cost of money is going to rise and the ultimate price of that is going to have to be paid by homeowners because of Kevin Rudd’s debt.
And continues to be stuck:
But the Government does have an influence on the cost of borrowings for the banks. When the Government is out there borrowing $3 billion dollars a week to fund their $900 cash splashes, to fund waste and mismanagement, building classrooms in schools that are about to be demolished – this is the price Australians are paying for Kevin Rudd’s debt. There’s no argument about it.
Please push that stylus forward:
… This is the price Australians are going to pay for the Federal Government borrowing tens of billions of dollars and the Federal Government being out there in competition with the banks in borrowing markets … There’s only so much money in the world and if the Federal Government for the first time is borrowing money on such a large scale in competition with the banks then the cost of funds to the banks is inevitably going to rise and they’’re going to pass straight through to home borrowers.
None of this should be taken serious. I don’t make political statements in a party-preference sense but just on pure economic theory terms if this idiot was to ever be in charge of fiscal policy then the Australian population would decline by at least one as I migrate to somewhere else (I suspect the population would decline by at least 2!).
The debt issuance has nothing to do with financing the deficits but has everything to do with offering the non-government sector alternative financial assets to holding reserves. There are no interest rate implications as discussed above.
The document has this to say:
Not everyone can relate to this idea of unconstrained spending or that the causality runs from the Government spending money because from the perspective of personal finances, average income and expenditure must balance over-time. People save to purchase something or borrow the money and pay it back later. But it is not the same for governments who can spend freely, unconstrained by targets unless they choose them. The key difference between governments and households, is that the government always creates reserves and deposits when it spends, whilst it destroys reserves and deposits when it sells a bond or taxes the population. When selling a bond the government is actually exchanging it for a deposit, just a simple accounting entry.
But there is an interesting question about which end of the yield curve the government might like to work within – that is should it issue long maturing debt or debt of shorter-maturities?
The document has this to say on this question:
Governments do not need to issue longer-term securities if they don’t want to. If the yield on longterm bonds is too high relative to short maturities, then the simplest thing to do is to issue more short ones; which is exactly the position the US and UK governments find themselves in today. The current steepness of the US yield curve … is almost entirely explained by increased inflation expectations since the start of the year. Curve steepening has occurred for all major yield curves as these inflation expectations normalised; in the US example 10yr BEs have gone from zero to 200bp since the start of the year. So the move in the curve should not be confused with Sovereign solvency fears, just a return to more normal inflation expectations after a period of being excessively low.
So as the investors are becoming more optimistic they are expecting the price level to nudge back to the the normal capacity levels. The adjustments in the long yields are miniscule. Also note that this readustment in prices does not amount to inflation. All hotels in the US at the moment (at least the ones I stay in – that is, not the “Ritz”!) are offering excellent discounted Deals. As occupancy rates increase they will restore their price levels to ensure their long-term target rates of returns are achieved. That is not inflation!
But the important point is that a sovereign government has all the cards. The Hockey nonsense above suggests that the government becomes captive of its own profligate ways and has to borrow its way out of this excess. Just like a household … no? No!
This is not even remotely correct. The government borrowing is doing us a favour. The government can choose to issue debt $-for-$ to match net spending; it can choose the yield that it issues the debt at – although many governments leave this to an auction process – but that decision is voluntary; it can choose whatever maturity it issues the debt at – short or long or in-between!; and clearly, it can choose not to borrow at all and just leave the impacts of the net spending as excess reserves. End of story. The government holds all the cards.
So that is the blog for today.
At present (for the next two days) I am the guest of the United Nations Development Program at the Levy Economics Institute workshop on Employment Guarantee Policies. I am giving a talk today and appearing on a panel tomorrow. The location is upstate New York (on the Hudson River) and while it is a long way from the surf it is still very lovely. I might write tomorrow’s blog reporting on my activities here. There is a growing swell of support for Job Guarantee policies as an intrinsic part of a development strategy and particularly as a means of dealing with the impact of the current economic crisis.
Then again I might write it about something else!