Why UK investment bonds for housing & infrastructure are a bad idea

The UK newspapers have been full over the past few days of the latest wheeze to boost investment whilst maintaining austerity and not increasing on balance sheet public borrowing.

Apparently Clegg and Cameron have ordered a reluctant Treasury to implement a scheme on the following lines:

-bonds are issued off balance sheet by the private sector for public infrastructure and social housing

-these are taken up by pension funds and private savers

-the government guarantees these bonds.  As this is considered to be a ‘contingent liability’ this is considered not to add to public spending (though debt rating agencies will of course consider it)

-there could be a tax break to encourage such ‘saving’

The first issue is that unlike debt finance it will not add to aggregate demand just shift it.  There will be a transfer from private bank accounts to public ones.  This will only cause growth if the multiplier of the investment is greater than the multiplier of the opportunity cost of what it would have been spent on.  This is likely to be positive (greater than 1) because of the likelihood that much money was held in idle balances and because of the high multiplier in construction etc.  However the netting will reduce the impact and is likely to be less than from debt (or other State) finance.  This is because debt finance causes over the first half of the period an expansion in aggregate demand which can cause growth.  That growth then can offset the deflationary impact of the loan being paid back over the second half of the loan period.  The ‘ricardian equivalence’ argument is sometimes put in terms of additional taxation to pay for the lending, but this is secondary, loans are expansionary in terms of AD when taken out and contractionary when paid back.  If a government has a budget constraint and sticks to it over the loan period then it will spend an increased fixed amount of its budget on loan repayments but if the investment causes growth then other government expenditure need not decrease in proportion – i.e. there need not be any tax increases at all.  In addition tax breaks and the presentation of very attractive investments could lead to decreases in consumption and increases in savings rates – both negative to aggregate demand.

The second issue will be how withdrawls from private bank accounts affects total private lending.  If bank deposits see a net withdrawl to government balances then  there will be a net drawdown in bank reserves, slowly built back up over time as the bonds pay out.  At the moment we are in the worst possible time for reducing net bank reserves.  Bank lending is of course not reserve constrained – I would say it is profit constrained rather than equity constrained.  In fiat banking a bank will make assumptions about the rate at which its liabilities in terms of bank accounts will be paid back.  If the withdrawl rate from accounts is higher or lower than this the bank will have less cash on hand.  Without reserve requirements banks will always attempt to put cash on hand to produce use through profitable investments, and so reduce reserves to near zero, solely what they will need to terms of daily withdrawal projections.  If additional withdrawls send these negative then the bank in the short term will be required to undertake short terms financing at a cost and reducing profitability (and hence the ability to lend), or if persistent to delever less performing loans to restore positive cash flow.   So either way a withdrawl of reserves will have a negative impact on bank lending.  If the leverage ration is 20:1 then for each £1 of investment in such bonds then there will be up to a £20 deleveraging of private bank lending.  Now note I am saying ‘up to’ because clearly at the moment we have a problem in terms of a shortage of lending and banks are rebuilding their balance sheets.  But the point is the same, the last thing we should be doing at the moment is reducing aggregate demand and reducing the ability of banks to lend.  These bonds are a very bad idea, it is much better for the State to invest directly.

Note:  Those fmailiar with my writings will know I am applying a circuitist post Keynesian model of money creation here applied to a business model of banking and Steve Keen’s model of aggregate demand =existing money in circulation+change in debt+net change in income from assets (an old model used by Hawtry in modern mathematical form).