This is Part 2 of the two-part series which focuses on the question: If governments are not financially constrained in their spending why do they issue debt? Part 1 focused on the historical transition of the monetary system from gold standards to the modern fiat currency systems and we learned that the necessity to issue public debt disappeared as fixed exchange rates and convertibility was abandoned in the early 1970s. However, there are many justifications for continuing to issue debt that circulate. In this Part, I consider those justifications and conclude that the on-going practice of government’s issuing debt to the non-government sector is primarily an exercise in corporate welfare and should not be part of a progressive policy set.
There are many other justifications offered for debt-issuance, which do not directly challenging the mainstream economist’s claim that debt-issuance is essential to ‘fund’ a government deficit, but operate somewhat tangential to it.
We learned a lot about these sort of arguments during a particularly enlightening episode in Australian financial history at the turn of the last century.
This is what happened.
We find a hint, in the Australian government’s Budget Paper No 1 for 2012-13, under Statement 7 entitled Future of the Commonwealth Government Securities Market.
The Treasury wrote:
In 2002-03, the Review of the Commonwealth Government Securities Market was undertaken in response to concerns about the future viability of the declining CGS market. Since this review, successive governments have committed to retaining a liquid and efficient CGS market to support the three- and ten-year Treasury Bond futures market, even in the absence of a budget financing requirement.
The term ‘budget financing requirement’ is, of course, not a financial requirement that is intrinsic to the monetary system. It is a voluntarily imposed rule that the sees the Australian government issue debt to match its deficit spending.
The convention could be abandoned at any time without any change in the government’s capacity to spend resulting.
So what was the 2002 Review about.
In 1996, the conservatives won federal office in Australia and built on the neoliberalism of the previous Labor Party by pursuing fiscal surpluses.
The Commonwealth government allowed outstanding debt to mature (and be paid out) and systematically reduced its net debt position as it ran surpluses.
By the end of the Century, the government bond market was becoming ‘thin’, which just means there were much less bonds available for trading in the secondary bond market.
The Government came under pressure from the big financial market institutions (investment banks and other players, particularly the Sydney Futures Exchange) to continue issuing public debt despite the increasing fiscal surpluses.
At the time, the contradiction involved in this position was a talking point although I did a lot of radio interviews trying to get the ridiculous nature of the discussion into the public arena.
The federal government was continually claiming that it was financially constrained and had to issue debt to ‘finance’ itself. But, given they were generating surpluses, then it was clear that according to this logic, further debt-issuance was redundant.
What transpired demonstrated categorically what purpose the debt was serving.
The Government bowed to the pressure from the large financial institutions, and, in December 2002, set up a formal – Debt Review to consider “the issues raised by the significant reduction in Commonwealth general government net debt for the viability of the Commonwealth Government Securities (CGS) market”.
I made a Submission (written with Warren Mosler) to that Review.
And the Enquiry was flooded with special pleading like had not been aired in public before.
The Treasury’s (2002) own – Review Of The Commonwealth Government Securities Market, Discussion Paper claimed that purported CGS benefits include:
… assisting the pricing and referencing of financial products; facilitating management of financial risk; providing a long-term investment vehicle; assisting the implementation of monetary policy; providing a safe haven in times of financial instability; attracting foreign capital inflow; and promoting Australia as a global financial centre.
We heard some of that during the GFC – that the liquid and risk-free government bond market allowed many speculators to find a safe haven.
In other language – that the public bonds play a welfare role to the rich speculators.
The Sydney Futures Exchange Submission to the 2002 Enquiry considered these functions to be equivalent to public goods.
It was very interesting watching the nuances of the federal government at the time. On the one hand, it was caught up in its ideological obsession with “getting the debt monkey off our backs” – which was tantamount to destroying private wealth and the associated income streams and forcing the non-government sector to become increasingly indebted to maintain spending growth.
But it was also under pressure to maintain the corporate welfare. There was no public goods element to the offering of public debt. The argument from the financial institutions amounted to special pleading for sectional interests.
To understand all this we have to first establish what the legitimate responsibility of a currency-issuing government is in relation to the financial system.
Financial stability is a public good
The government is intrinsically responsible for maintaining financial stability.
The financial system is linked to the real economy via its credit provision role. Both households and business firms benefit from stable access to credit.
To achieve financial stability:
(a) the key financial institutions must be stable and engender confidence that they can meet their contractual obligations without interruption or external assistance.
(b) the key markets are stable and support transactions at prices that reflect fundamental forces.
There should be no major short-term fluctuations when there have been no change in fundamentals.
Financial stability requires levels of price movement volatility that do not cause widespread economic damage.
Prices can and should move to reflect changes in economic fundamentals.
Financial instability arises when asset prices significantly depart from levels dictated by economic fundamentals and damage the real sector.
Collapses brought on by injudicious speculation that do not affect the real sector or that can be insulated from the real sector by appropriate liquidity provisions are not problematic.
In general though, we want to build an institutional and regulative structure that insulates the real economy from financial collapses.
The essential requirements of a stable financial system are:
1. Clearly defined property rights;
2. Central bank oversight of the payments system;
3. Capital adequacy standards for financial institutions;
4. Bank depositor protection;
5. An institutional lender-of-last resort when private institutions refuse to lend to solvent borrowers in times of liquidity crisis;
6. An institution to ameliorate coordination failure among private investors/creditors;
7. The provision of exit strategies to insolvent institutions.
While some of these requirements can be provided by private institutions, all fall in the domain of government and its designated agents.
However, what is important for this two-part series, is that none of these requirements rely on the existence of a viable government bonds market.
Private goods are traded in markets where buyers and sellers exchange at prices that reflect the margin of their respective interests.
At the agreed price, ownership of the good or service transfers from the seller to the buyer.
A private good is ‘excludable’ (others cannot enjoy the consumption of it without being party to the transaction) and ‘rival’ (consuming the good or service specific to the transaction, denies other potential consumers its use).
Alternatively, a public good is non-excludable and non-rival in consumption. Private markets fail to provide socially optimal quantities of public goods because there is no private incentive to produce or to purchase them (the free rider problem).
To ensure socially optimal provision, public goods must be produced or arranged by collective action or by government.
Thus, financial system stability meets the definition of a public good and is the legitimate responsibility of government.
So then what are the alleged benefits of public debt issuance?
Most of the arguments made in favour of sustaining public debt issuance can be reduced to 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.
It is ironic that these arguments are inconsistent with rhetoric forthcoming from the same financial sector interests, in general, about the urgency for less government intervention, more privatisation, more general welfare cutbacks, and the deregulation of markets in general, including various utilities and labour markets.
Specifically, government price level intervention into private markets is typically challenged by economists on efficiency grounds.
Public debt issuance is a form of government price level intervention in interest rate markets.
The burden of proof falls on those arguing in favour of such 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 we discussed earlier – full employment etc.
Pricing other products
One argument mounted to support public debt issuance is that it supports the yield curve and is used by financial markets as the benchmark risk free asset, which provides a benchmark for pricing any other risky debt securities.
However, there are clearly alternatives:
1. The market could price securities against other securities with similar characteristics.
2. Market participants could price securities with respect to the interest rate swap curve.
Interest rate swaps have become a central part of the so-called ‘fixed income market’.
Pimco writes (Source):
An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter.
A common arrangement has been to cast the ‘swap’ agreements relative to the London Inter-Bank Offered Rate or LIBOR, which is the interest rate that banks charge each other for short-term loans.
It is too complicated to go into detail here, but one party, which might be a corporation, swaps the uncertainty of a floating LIBOR for a fixed interest rate, hoping that rates do not rise. The counterparty hopes rates will rise which means the floating stream will be higher than anticipated when the contract was entered into.
The ‘swap curve’ shows the swap rates for all the maturities in which these arrangements are made and follows the government debt yield curve very closely, which is why I argue the ‘market’ already has a vehicle to use in pricing securities.
Market participants already use the interest rate swap curve to price securities. Regardless, the term interest rate structure remains a meeting of supply and demand. Buyers and sellers of bonds desire to attract each other and meet at a price.
Are the proponents of retaining public debt issuance really claiming that without government intervention in the credit markets via debt issuance borrowers and investors cannot sufficiently come together at a price?
Are they saying that the interest rate market does not have sufficient levels of participation, information and competition to adequately determine price without government intervention?
It is doubtful that either position can be substantiated, and certainly not to the degree needed to support the issuance of public debt with their high real macro costs which I will outline below.
Managing financial risk
Another argument is that on-going public debt issuance supports a number of derivative markets that help private traders manage financial risk, particularly in relation to interest rate risk.
What are their real interest rate risks of these businesses? What are the real economic costs of these feared changes?
Without going into detail, it is important to ask which businesses ‘need’ to use public debt to manage risk. The reality is that on-going public debt issuance supports and encourages speculation, rather than real investment behaviour.
Some financial market speculation (which is tied to helping real output producing firms off-load exchange rate risk, for example) is sound. But that is a tiny proportion of the financial market transactions that occur each day.
So can the support of particular businesses in this manner which add nothing to the well-being of the population be an appropriate use of public policy?
It is in this context that I use the term corporate welfare in association with the issuance of public debt.
It should also be understood that MMT advocates the simplification of financial markets and the phased elimination of speculative behaviour that provides no real benefits to the population.
Providing a long term investment vehicle
The crude argument is that workers have a right to expect their savings will be held in risk-free assets and that public debt issuance provides those assets.
It is a simplistic argument and while I am supportive of workers being able to save (risk manage their futures) in a safe way, that doesn’t justify the massive corporate welfare that accompanies the issuance of public debt.
More specifically, it is argued if superannuation and life companies were unable to purchase government debt then they would struggle to match their long-dated liabilities with appropriate returning assets.
Further, the claim is that eliminating the government bonds market would deny workers of a risk free asset to invest their savings in. Retirement planning would become highly uncertain and risky.
What is not often understood is that government bonds are in fact government annuities.
Do the proponents of on-going government bonds really want the private sector to have access to government annuities rather than be directing real investment via privately-issued corporate debt, as an example?
This point is also applicable to claims that government bonds facilitate portfolio diversification. Why would we want to provide government annuities to private profit-seeking investors?
This interferes with the investment function of markets. Direct government payments should be limited to the support of private sector agents when failures in private markets jeopardise real sector output (employment) and price stability.
We would also require a comparison of this method of retirement subsidy against more direct methods involving more generous public health and welfare provision and pension support.
But there is a much more effective way to provide a risk-free savings vehicle for workers. The government could create a National Savings Fund, fully guaranteed by the currency-issuing capacity of the government, which could provide competitive returns on savings lodged with the fund.
There would be no public debt issuance (and the associated corporate welfare and government debt management machinery) required.
The government could meet any nominal liabilities at any time.
Providing a safe haven
Government securities are alleged to provide a ‘safe haven’ for investors when there is financial instability.
The ‘flight to quality’ argument suggests that it is beneficial to the macro economy for investors to have a risk free domestic asset available to avoid capital losses on other assets.
However, in addition to the previous point regarding subsidy through government annuities, government bonds compete directly with these other assets, thereby driving down their prices and exacerbating matters during ‘flights to quality’.
In a monetary economy, investors can always hold money balances by increasing actual cash holdings or banking system deposits.
Widespread use of deposit insurance would mean that bank deposits would be equivalent to holding government bonds anyway for all practical purposes.
That also passes the ‘risk’ to private banks when they select their assets and selection of assets is regulated by the central bank.
There is no compelling real macroeconomic reason why risk and return decisions by private maximising agents should be ‘further protected’ by retreat to a market distorting government annuity.
Further, during a ‘flight to quality’ only the relative prices of various fixed income securities can change, not the quantity, as investors compete for the existing stock of outstanding government debt.
At the macro level, this process does not reduce risk.
Implementing monetary policy
So we are back to the starting point, where a lot of people think MMT justifies the issuance of public debt through appeal to the central bank’s desire to maintain an interest rate policy target through open market operations (selling debt to drain reserves).
However, as we have all learned since the GFC (but in Australia we already knew it before that), the central bank can maintain any interest rate target it chooses without any open market operations simply by providing a competitive support rate on excess reserves.
It requires no public debt in this regard.
So all the arguments that the central bank might need stocks of government bonds to sell or loan to commercial banks to stabilise interest rates, maintain liquidity, hit price stability targets are all spurious.
Some argue that the Basel requirements for capital adequacy require governments to provide the banks with risk-free bonds.
But again, the central bank can create risk-free, high-quality assets to sell to the commercial banks if it wants to increase the quality of the banks’ asset portfolio.
No government bond market is necessary to accomplish that.
So the reason governments issue debt is not to allow the central bank to maintain an interest-rate target.
There are many other arguments that are put forward to justify the ongoing issuance of public debt. All of them can be reduced to special pleading by speculators for risk free assets.
What are the real economic costs involved in issuing government debt?
The real economic costs involved in issuing government debt
The real costs of any resource-using activity are measured by the opportunity costs of not using these resources in alternative activities.
The operation of public debt markets absorb a diversity of real resources deployable elsewhere.
While this is difficult to assess in the context of an economy without public debt markets, some points can be made to structure our thinking.
The opportunity costs in terms of the labour employed directly and indirectly in the public debt ‘industry’ are both real and large.
The ‘cottage industry firms’ that characterise the public debt industry use resources for public debt issuance, trading, financial engineering, sales, management, systems technology, accounting, legal, and other related support functions.
These activities engage some of the brightest graduates from our educational system and the high salaries on offer lure them away from other areas such as scientific and social research, medicine, and engineering.
It could be argued that the national benefit would be better served if this labour was involved in these alternative activities.
Government support of what are essentially distributional (wealth shuffling) activities allows the public debt market to offer attractive salaries and distorts the allocation system.
While this labour may move within the finance sector if public debt issuance terminated, the Government could, for example, generate attractive opportunities by restoring its commitment to adequate funding levels for research in our educational institutions.
On balance, public debt markets appear to serve minor functions at best.
The public debt markets add less value to national prosperity than their opportunity costs. A proper cost-benefit analysis would conclude that the market should be terminated.
And finally, the motivation
In Part 1, we contrasted the requirements of government in terms of the Bretton Woods system and the modern, fiat currency systems.
The collapse of the Bretton Woods system in 1971 freed currency-issuing governments of any financial constraints, which meant that the previous rationale for issuing debt into the non-government sector to avoid compromising the central bank’s responsibility for defending an agreed currency parity no longer applied.
But the practice of debt-issuance continued.
Governments continue to impose voluntary constraints on themselves to satisfy the dominant ideological demands of the elites.
A little case study demonstrates how this played out in the post-fixed exchange rate world.
The Australian Office of Financial Management (AOFM) was set up as a special part of the Federal Treasury to management federal debt in the 1980s. The Australian experience is common around the world in almost all countries.
While there was a lot of hoopla about it being an “independent agency”, the reality is that this is all largely cosmetic – the AOFM is still part of the consolidated government.
Prior to the establishment of the AOFM, government bond issues were made using the ‘tap system’. The government would announce some face value and coupon rate at which it would issue debt and ‘turn the tap on hard enough’ to meet the demand at that yield.
Occasionally, given other rates of return in the financial markets the issue would not be fully subscribed – meaning some of the net spending would be covered. in an accounting sense. by central bank buying treasury bills (government lending to itself!).
In other words, the government could sell bonds directly to the central bank at whatever rate it deemed useful (including zero) and the private bond markets could do little about it.
This was common practice around the world.
This system was highly criticised by private bond markets and the neo-liberal cheer squads in economics departments.
In 2000, the Deputy Chief Executive Officer of AOFM (seemingly content on perpetuating neo-liberal myths) claimed the practice was:
… breaching what is today regarded as a central tenet of government financing – that the government fully fund itself in the market. It then became the central bank’s task to operate in the market to offset the obvious inflationary consequences of this form of financing, muddying the waters between monetary policy and debt management operations.
The so-called “central tenet” – is pure ideology and has no foundation in any economic theory. It is a political statement.
In the face of massive pressure from the neo-liberal lobbies, the Australian government at the time it established the AOFM also changed the way the Australian government bond market operated.
They replaced the tap system with an auction model to eliminate the alleged possibility of a ‘funding shortfall’.
Accordingly, the system now ensures that that all net government spending is matched $-for-$ by borrowing from the private market. So net spending appeared to be ‘fully funded’ (in the erroneous neo-liberal terminology) by the market.
The central bank wasn’t prohibited by law from purchasing government debt (directly) for ‘liquidity management’ purposes but the change meant that the price (yield) would vary to accommodate even the most risk-averse private bond dealer and so the volumes would always be sold.
But in fact, all that was happening was that the Government was coincidently draining the same amount from reserves as it was adding to the banks each day via the fiscal deficit and swapping cash in reserves for government paper.
The auction model merely supplied the required volume of government paper at whatever price was bid in the market. So there was never any shortfall of bids because obviously the auction would drive the price (returns) up so that the desired holdings of bonds by the private sector increased accordingly.
As an aside, at that point the secondary bond market started to boom because institutions now saw they could create derivatives from these assets etc. The slippery slope was beginning to be built.
But you see the ideology behind the decision by examining the documentation of the day.
Around the time these changes were introduced, the Deputy Chief Executive Officer of AOFM gave a speech.
He spoke of so-called captive arrangements, where financial institutions were required under prudential regulations to hold certain proportions of their reserves in the form of government bonds as a liquidity haven.
… the arrangements also ensured a continued demand from growing financial institutions for government securities and doubtless assisted the authorities to issue government bonds at lower interest rates than would otherwise have been the case … Because such arrangements provide governments with the scope to raise funds comparatively cheaply, an important fiscal discipline is removed and governments may be encouraged to be less careful in their spending decisions.
So you see the ideological slant.
They wanted to change the system to voluntary limit what the Federal government could do in terms of fiscal policy. This was the period in which full employment was abandoned and the national government started to divest itself of its responsibilities to regulate and stimulate economic activity.
And in case you aren’t convinced, here is more from AOFM:
The reduced fiscal discipline associated with a government having a capacity to raise cheap funds from the central bank, the likely inflationary consequences of this form of ‘official sector’ funding … It is with good reason that it is now widely accepted that sound financial management requires that the two activities are kept separate.
Reduced fiscal discipline … that was the driving force.
They knew that the public didn’t have a clue about any of this but had been conditioned to associated rising public debt with all manner of bad things – overspending, mismanagement, intergenerational harm (burdening the grandkids), risk of going broke, and all the rest of it.
They knew that if they forced governments to issue debt to match deficits, through these institutional arrangements, which they knew were unnecessary for the reasons that the public were led to believe (funding governments), then the public could be politically manipulated to reject progressive policies.
They were aiming to wind back the government and so they wanted to impose as many voluntary constraints on its operations as they could think off.
All basically unnecessary (because there is no financing requirement), many largely cosmetic (the creation of the AOFM) and all easily able to be sold to us suckers by neo-liberal spin doctors as reflecting … read it again … “sound financial management”.
What this allowed was the relentless campaign by conservatives, still being fought, against the legitimate and responsible use of fiscal deficits.
Part of this post was drawn from an edited version of a submission that I made with Warren Mosler in 2001 to the Commonwealth Debt Inquiry, which sought to justify why the government should continue to issue debt when it was in fact running increasing surpluses.
Yes, Warren and I and others have been at this for a very long time!
1. There is no need to issue public debt (September 3, 2015).
2. Direct central bank purchases of government debt (October 2, 2014).
3. Market participants need public debt (June 23, 2010).
That is enough for today!
(c) Copyright 2020 William Mitchell. All Rights Reserved.