Government Debts and Treasury Bonds – Neither Keynesian or Inflationary

Update II: In the post below I had in mind the historical conditions of Central Banks as private banks, then nationalised, which lend to governments and funded this through issuing bills of exchange.  I contrasted this with conventional bond issuance which as a transfer payment does not add to money, whereas a loan from a central bank does.  This essential difference remains.  I made the mistake in the post however of trying to make a distinction between Central Bank issued bonds and treasury issued bonds, this is the wrong way of looking at it it is not the source of bond issuer which matters but the source of debt.   Both Central Bank issued (modern) bonds and treasury bonds are equally deflationary because they both require drawing down of private reserves to pay for the bonds, as Neil Wilson points out.  If however a central bank creates money and then buys treasury bonds, or creates money transfers the money to a treasury and then creates bills of exchange, both are expansionary involving the endogenous creation of money.  I don’t agree with Neil however that one can consolidate the treasury and central bank accounts as this loses the dynamic relationship between creditor and debtor over time.  One can only do this if you ‘close’ both accounts and sweep everything to equity, perfectly acceptable in accounting terms but this conceals the dynamics – a small but important difference I have with MMT.  As Marc Lavoie says ‘Central Banks matter’.  The essential insight of bonds being (net) deflationary remains, as does the insight that Keynes was not talking about such funding in the GT.  This is important because bond finance can only have a velocity/accelerator multiplier effect whereas debt finance can also have a ‘excess reserve’ (Kahn) multiplier effect.  This helps resolve one of the great debates in PK economics over Moores view of the multiplier, ill blog on this shortly – warning wonkish and a lot of maths.

I want to share the essence of a recent correspondence with Professor Steve Keen on the impact of different form of government bonds issues on effective demand.

The background is a recent debate initiated by Frances Coppola on whether QE is deflationary.  Professor Keen has also published a model of QE where it has a neutral effect on demand.  I queried this model on two grounds, firstly it did not model the income stream from Coupon payments that the treasury would otherwise have paid the private sector and now in effect it receives itself via dividends from a Central Bank, secondly we cannot know whether or not this is deflationary or inflationary until we model the ‘policy off’ position of bonds issued and held by the private sector (and the Central Bank through conventional open market operations).

This got me thinking whether the model, implicit or explicit, by those few economists that thinks about financial mechanics is an accurate model of modern government debt management.  For example Professor Keen’s own earlier model of bond issuance (from last years MMT/MCT seminar) assumed a central bank to fund a fiscal deficit would create money endogenously then purchase bonds from a Treasury.  This is certainly how Keynes envisaged government deficits should be financed, but it is not how they are financed today.

Let me explain, the current separation of Central Banks and Treasury is something of an historical accident in most major economies.  Originally most Central Banks were private bodies used by governments for debt issuance and financing.  Gradually these were taken over by states.  Historically central banks issues bonds which it then sold on, it then paying on a dividend to its owner (nowadays the State).

For a number of decades now states have separated out debt management offices from the central banks, these then auction bonds which may or may not be brought by central banks.  Now central banks purchases of bonds have two functions, firstly (in a sovereign currency issuer) acting as a backstop in buying any failed auctions to ensure that the state is guaranteed financing, secondly as a financial policy instrument to control the interest rate through open market operations in bonds.  Under pressure from the IMF (which termed central bank bills financial repression) most of the world has shifted towards debt management office/treasury issuance of bonds rather than central banks.   Indeed as part of the ‘Paris Deal’ writing off  much third world debt  the IMF insisted on this separation in countries receiving relief.

This shift is important and rarely commented on.  This is the difference between ‘central bank bonds and ‘treasury bonds.   This is not to say that Central Banks will not buy bonds and hence create money to do so (hence increasing base money supply) – a bond being effectively a loan to the treasury – rather they now mainly do so through open market operations and QE rather than through issuance of central bank bonds.

This matters because treasury bonds are exactly like corporate bonds, these are in the first instance transfer payments between balance sheets of the existing monetary stock, unlike bank (including central bank) money which involves money creation through crediting of accounts.

This is the key because a ‘Central Bank bond’ adds to monetary base and so the net credit induced demand {change in debt  – change in saving)(this is a simplification as any increase in bank lending may require additional capital which requires saving which must then be leveraged) whereas a treasury bondis simply a transfer payment, there is no net increase in money or effective demand.  There is no net change in the monetary base – the increase in debt is exactly offset by the increase in saving to purchase the bond.

So under central bank bonds there is both a Keynesian multiplier effect and potentially an accelerator effect from the spending.  Under treasury bills however there is no net money creation only a differential accelerator effect from the difference between what the private sector money would have been spent on and what public spending is spent on.  So MMT here is only half right.  It is only correct to say public deficit=private surplus, rather a better accounting identity would be (private spending+public deficit-private saving on purchasing treasury bonds)=private surplus.   The shift towards treasury bonds then may explain the empirical reduction in the Keynsian multiplier from the 1980s onwards.

At least this would be the case in a closed economy where all tax receipts were immediately spent.  But there is always a time lag between money being received by the Treasury and money being spent.  Of course money is being received by the treasury all the time and government departments and agencies spend continuously throughout the year, it is necessary however to maintain a buffer, a kind of monetary inventory, reserves for unexpected spending.  The size of these reserves (which must be proprtional to the overall budget)  causes a slowdown in transactions and is deflationary.  Treasury bond financing therefore is deflationary, and, ironically, the higher the amount of deficit spending relative to GDP the more deflationary it is.  Under normal times this effect is likely to be offset by the expansion in private bank credit, but this becomes exposed when private credit expansion slows down.

Update I:  Thanks to Frances Coppola for stressing that bonds drain bank reserves if seen independently whilst government spending tops them up. If there was no givernment balances (i.e. just in time spending) the two effects would of course cancel out.  I don’t think it is useful to see these in isolation though as the need for financing only comes about because of a shortfall in financing spending, they need to be seen as part of a system.

None of this is to deny that the primary impact of effective demand and hence growth is private debt, and that it is lack of growth which is the primary driver in increase in public debt.  Rather it suggests a secondary channel, that where there is high public debt, and this is financed by treasury bonds, this can act as a deflationary dreg, whilst such bond financing has no Keynesian multiplier effect, in effect such countries, like Japan, can get stuck in a deflationary rut.  The separation of debt management from monetary policy in effect forces the a parallel monetary policy if there is use of fiscal policy.

This is not to suggest that there are no purchases by the Central Bank of bonds, indeed a large proportion are so held, and the endogenous creation of money to purchase them through conventional open market operations (rather than QE) does case a positive change in debt and hence a positive increase in effective demand.  Of course central bank issued bands also need to be paid for through savings, but the effect of the expansion of money is, in that great Keynsian insight,  to create the savings necessary to pay for them, hence they are net expansionary.

Is this contra Keynes to say that deficits paid for by Treasury  bonds are not expansionary.  Does it not undermine MMT and all of Post-Keynsian and Keynsian economics?  Is this not just Hawtry’s discredited Treasury View?

To that I would say no, yes it is Hawtrys’s Treasury view, this view was correct, but Keynes got around this by suggesting a wholly different form of bond financing – bonds bought from bank created money.

This might seem curious, after all the Keynesian view of history, as set down in the 50s, by for example AJ Youngston say the Treasury view as a ‘mystery’ and its omission of the keynsian multiplier a ‘culpable omission’

The treasury view was not a mystery and referred explicitly to cases where there could be no Keynsian Multiplier.  For this was have the benefit of David Glasnet’s recent history of Hawtry’s formulation of the Treasury View.

Hawtrey starts by assuming that the government borrows from private individuals (rather than from the central bank), allowing Hawtrey to take the quantity of money to be constant through the entire exercise, a crucial assumption. The funds that the government borrows therefore come either from that portion of consumer income that would have been saved, in which case they are not available to be spent on whatever private investment projects they would otherwise have financed, or they are taken from idle balances held by the public.

He quotes Hawrtry directly

We assumed that no additional bank credits are created. It follows that there is no increase in the supply of the means of payment.

Hawtry relied on a complex formulation involving cash balances.  With Keynsian identities we need no such complexity, any increase in saving will decrease effective demand.

In these circumstances there is no error in the ‘treasury view’, there can be no multiplier because there is no net increase in effectual demand.

But Hawtry did concede that where government deficits are financed by bank credit not treasury bonds they could be expansionary:

In the simple case where the Government finances its operations by the creation of bank credits, there is no diminution in the consumers’ outlay to set against the new expenditure. It is not necessary for the whole of the expenditure to be so financed. All that is required is a sufficient increase in bank credits to supply balances of cash and credit for those engaged in the new enterprise, without diminishing the balances held by the rest of the community. . . . If the new works are financed by the creation of bank credits, they will give additional employment.

The difference with Keynes was as follows

 expenditure on public works, if accompanied by a creation of credit, will give employment. But then the same reasoning shows that a creation of credit unaccompanied by any expenditure on public works would be equally effective in giving employment.

Of course Keynes argued that at the ‘Zero Lower Bound’ (hicks term monetary policy was ineffective, but Hawtrys own theory of ‘Credit Deadlock’ came to thesame result and in the 1950s Hawtry conceded that in these cases fiscal policy was more appropriate.

Let us now turn to the General Theory and how Keynes argued deficits should be financed.  Ironically there are no no discussions of government deficit financing in the General Theory.  There are many references however to the expansionary natuture of investment funded by bank credit.

In chapter 16 of the GT however Keynes is clear

after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the  sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a  test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at at a nominal rate of interest.

Perhaps this was not noticed because the GT was not altogether clear on the monetary generation process and the relative roles of exogenous and endogenous money.  At times the GT states that the supply of money is fixed or set by the monetary authority./  Elsewhere he talks of the expansion of money through bank credit.  Crucially however on effective demand

There is… just as much reason for adding current consumption to the rate of increase of new bank money in reckoning the flow of cash becoming available to provide new ‘finance’, as there is for adding current saving

Of course after the GT was published Keynes was clearer on the role of endogenous money when talking of the ‘finance motive’.

The overall conclusion here though is that Keynes specifically talked of bank credit finance (which can include Central Bank purchases of bonds) when describing expansion of incomes through investment, not of treasury issued bonds.

This is even clearer when we come to Keynes specific recommendations on financing such as this memo from 1939 on how to pay for the war

modern representative money and a modern banking system, we know that the necessary ‘finance’ can be created by a series of ‘book’ or ‘paper’ transactions. The Treasury can ‘pay’ in effect by ‘book’ entries and the book entries can be transformed into a regular loan at a much later date. (CW XXI, p 540)

From Geoff Tily

A new instrument – the Treasury deposit receipt (TDR) – was devised to support the creation of these book transactions. The instrument brought together debt management policy, that followed from store of value considerations, and an extension to the system to support means of exchange considerations, in this case government expenditure.
Under the TDR system, retail banks were obliged to lend to government, and hence create credit – alternatively: create a “deposit” for the “Treasury”, in exchange for a “receipt” – to finance directly government expenditure. These instruments were added to Treasury bills as part of the floating debt. The new instrument was required because of the traditional role of Treasury bills, which was that they could be discounted at the Bank of England to support an expansion of credit. So an expansion of Treasury bills to support government expenditure could then lead to a further expansion of credit to the private sector. TDRs were therefore not marketable and could not be reserved at the Bank of England against further credit creation.
…
His systems had addressed concerns about “monetising” government debt, and potentially causing inflation, by breaking the direct link between floating debt and credit creation. Outside banking mechanisms, any substantial increases to the floating debt as a result of accommodating liquidity preference for shorter-term instruments were due to savings not spending considerations and therefore were also not inflationary.

Annex

The balance sheet terms (excluding the none bank sector) of treasury bond funding  looks (broadly) like this

Treasury

Assets +taxes +treasury bond sales +central bank dividends

Liabilities –public expenditure –treasury bonds (coupon +redemption) –central bank bonds (coupon +redemption)

Central Bank

Assets +Treasury Equity (charter Value) -central bank bonds (coupon +redemption)

Liabilities – private bank reserves in central bank –Treasury dividends –Central Bank Bond Sales

Equity -Treasury Equity +Treasury dividends

Private Banks

Assets +Treasury Equity (charter Value) + private bank reserves in central bank +private loans (interest +premium repayment)

Liabilities -Private Reserves –loans granted

Equity –Owners Equity – private bank reserves in central bank