The Bond Market Doesn’t Control Anything; the Currency-Issuing National Government Does

The mistakes made by the public with regard to public debt (national debts) are threefold. In the first instance, the public relies heavily on politicians and the media to tell them what to think. Secondly, the assumption is that the national government is no different than a household, and so, if the government goes into debt it must earn enough income to pay off that debt with interest, or it will become insolvent. This mistake is known as “the Fallacy of Composition” wherein the person is assuming that what is true for them in their individual case (the micro-level) must also be true for everyone including the national government (the macro-level). Thirdly, the assumption is that treasury bonds are issued to conduct fiscal policy; that is, to fund deficit spending.

The truth of the matter is that, though they are not aware of it, much of the politics-following public is utterly unqualified to assess any information given to them by the media concerning treasury bonds and national debts. The media feeds them information based on false assumptions and the conclusion that the public reaches from these errant ideologically-driven foundations can be summarised by the following commentary:

“We are 20 trillion in debt because both the Democrats and Republicans find it easier to spend in hopes of gaining votes then to show financial restraint. This is also a reflection of how many Americans handle their own finances. Future generations will pay for this dearly…”

As we can easily see, all three assumptions are present in the above comment:

1.) The person follows politics to some degree and has been “educated” on the subject of public debt by the media and politicians.

2.) The person clearly assumes that the US government’s finances are just like a household’s (fallacy of composition).

3.) The person assumes that treasury bonds allow the US government to spend more than it earns.

If we follow this errant thinking to its totally absurd conclusion, we conclude that since most national governments have a national debt, and that since private debt levels are rising higher each year world-wide, then the whole world is in debt up to its eyeballs. We must then ask, “The whole world is in debt to whom?” and then the mass delusion reveals itself. Who can the entirety of the Earth’s human population, including corporations and governments, be in debt to? The Moon? The Oort Cloud? Perhaps, Pluto is lending Earth money and that’s why NASA was so adamant about a nine-year voyage to the planetoid – The world needed to drop off an interest payment before Pluto “called in the debt” and the world wanted to negotiate for more money.

Other earth-based international absurd conclusions are reached as well. For instance, the assumption is that since both the US government and the UK government have huge national debts, they are both broke. Yet, the assumption is also that somehow the broke UK government is lending the broke US government money at interest. Furthermore, it is assumed that China is lending the broke US government money at interest and that China does so knowing full well that the US government will spend that money to build up its military.

It is all pathetic nonsense, the lot of it. Yet, the public cares not because in the pacifying environment of the mass consumption era of neoliberalism, the public, on the whole, is more interested in exciting drama than boring reality. And so, as our goal here is reality and not drama, this particular discussion of mine will either fall on many deaf ears, or it will elicit absurd commentary from people who are utterly unqualified to assess the information that I am providing. Since we are talking economics, these folks need zombies, death, doom, fiscal collapse, and financial armageddon on the horizon to be involved in the storyline, or my lecture is boring, and therefore, it is wrong. If we are lucky, we might even witness commentary such as: “If the national debt isn’t a debt, then why do they call it a debt?” – a comment that is obviously the product of many hours of deep thought.

To save time, we will dispense with a look at the basics. For background information with regard to what currency is and the purpose of national government taxation, see my lecture “State Currencies and Modern Monetary Economies: Part 1” posted here: http://elliswinningham.net/index.php/lectures/state-currencies-modern-monetary-economies/

I: What a Treasury Bond Is

The blunt truth is that a national government which issues its own free-floating, inconvertible sovereign currency does not need to issue treasury bonds whatsoever. Bonds serve absolutely no financing purpose. For a state or provincial government, or for a local government, municipal bonds do finance spending for that particular government. The difference between the national government and a state/local government is one of status: The national government is the monopoly currency issuer, and the state/local government is a mere user of the national government’s currency. The issuer has authority and access that is denied the user. The currency user is, therefore, subject to the currency issuer.

In the modern era, a treasury bond is an obsolete debt instrument that is issued by the national government for the singular purpose of declaring a particular interest rate and seeing that rate prevail. Nothing else. In simple terms, treasury bonds today conduct monetary policy, not fiscal policy. It is for reasons of political expediency that Congress/Parliament declare that treasury bonds finance fiscal deficits. For instance, in the US, Congress demands that if the government will deficit spend, it must also issue treasury bonds. The demand is wholly unnecessary and inefficient, but it is not useless from the standpoint of politics and ideology. The demand causes the public to believe that the government is borrowing money from private entities to finance its spending, thus perpetuating the neoliberal “free market”-based mythology of “there is no alternative” (TINA) whilst the bond market gets more toys to play with and businesses get more corporate welfare.

II: The Function of Treasury Bonds in a Former Era

During the gold standard days, the national government fixed its currency to a particular amount of gold for the purposes of using gold as a price anchor. The act necessitated the government agreeing to convert its currency to gold at the fixed exchange rate, and so, the government was forced to maintain a supply of gold on hand. In committing itself to using gold as a price anchor, the government was required to defend its gold supply at all costs. To defend the supply of gold required the government to maintain a certain level of currency in circulation so as not to allow more notes to exist than could be converted to gold at the fixed exchange rate. In addition, it had to ensure that level didn’t drop so significantly that mass unemployment resulted. The latter condition was more prevalent than the former. The two tools that enabled the national government to manage the currency level were taxation and borrowing.

Taxation withdrew a certain amount of currency from the domestic economy and when the national government spent the same number of notes again, there was no change in the net money supply. For example, if there were £20 billion circulating and the government taxed £5 billion, the total pounds remaining in the domestic economy would be £15 billion. When the government then spent £5 billion, the level of currency in circulation returned to £20 billion again. Thus, it can easily be seen that during the gold standard, it wasn’t a case of “tax to spend”, but rather, a situation of “tax to defend” the gold supply. At all times, the currency-issuing national government could spend if it so chose without collecting a single dollar or pound in tax or borrowing. The operation was what was known as “printing money”.

Printing money was a spending method conducted by the national government when it wanted to spend beyond what it collected in taxes or borrowed. Without regard for the gold reserves on hand, the government printed notes and introduced them into the domestic economy through spending, which increased the amount of currency in circulation. By printing money, the government placed itself into a position where there was more currency available to exchange than the gold supply could handle at the fixed exchange rate. Quite naturally, the action could result in severe consequences were people to demand conversion. Another means at its disposal was to devalue the currency by officially declaring a reduced fixed exchange rate. This then allowed the government to increase the number of notes circulating.

Like taxation during this era, treasury bonds weren’t so much of a financing means for government deficit spending as they were a means to help the government to defend the gold supply when it needed to deficit spend to address domestic economic issues. The main function of treasury bonds during the gold standard era was to provide the government with a means to entice currency holders to hold off conversion to gold. The holder of currency had a choice: 1.) take the gold now, or 2.) bid on a bond with the promise of earning more currency now and converting it later on down the road for even more gold. Hence, the national government would offer interest payments as the incentive to entice currency holders to buy treasury bonds, and thus, conversion to gold was prevented.

III: Understanding Interest on Treasury Bonds During the Gold Standard

Because the national government’s currency was “pegged” to gold, the situation left the control over interest rates in the hands of the market and not the national government. The reason being is that the rate of interest that the government paid on bonds was entirely dependent on currency holders preferring to take interest payments now rather than gold. So, if currency holders preferred gold conversion right away to the currently offered interest rate, the interest rate would have to increase to entice people to forego conversion. Therefore, the government’s “cost of borrowing” would go up. As a critical side note, this is precisely where the “cost of borrowing” nonsense you hear today from the media, economists, and politicians comes from. In today’s, free-floating, inconvertible fiat regime, the government, not market forces, controls the interest paid on bonds.

So, during the gold standard era, the national government could face a situation where no amount of interest on offer would prevent holders of currency from demanding immediate conversion to gold. The government’s so-called “cost of borrowing” would then skyrocket. Although the national government was the currency-issuer, it couldn’t just “print money” to pay the interest because to do so would only add fuel to the fire – it would increase the level of currency in circulation, and, therefore, deposit even more currency into the hands of people who wanted gold immediately rather than interest payments. Facing a run on the gold supply, the national government would have little choice but to suspend gold conversion altogether.

So, section II and III in sum, during a former era the national government issued bonds because it had an exchange rate to defend. No such condition exists in 2018 for the UK, US, Australian, New Zealand, Canadian and Japanese governments to name a few. Now that we understand the function of treasury bonds and interest payments in an era long gone, let’s take a look at them today.

IV: Treasury Bonds in Today’s Free-Floating, Inconvertible Fiat Currency Regime

As stated at the beginning, in the modern era, a treasury bond is an obsolete debt instrument that is issued by the national government for the singular purpose of declaring a particular interest rate and seeing that rate prevail. No gold, nor other commodity, nor a foreign currency is pegged to the currency in question as a price anchor, and so, there is no supply of the commodity or foreign currency maintained by the government that requires defending. The currency is left to float freely on an exchange and its value relative to other currencies is determined by market forces. This means that the national government no longer must maintain a certain level of currency in circulation through taxation and borrowing, save for the consideration of the real production ability of the domestic economy, because there is no peg to defend. The purpose of borrowing radically changes in a free-float, inconvertible fiat regime, going from one of gold supply defense to assisting the central bank with the defense of its target interest rate – a totally unnecessary thing. As our focus here is the purpose of treasury bonds, we will ignore the function of interest on reserves paid by the central bank.

The central bank conducts monetary policy. To do so, it sets a benchmark rate, or otherwise known as the target interest rate. This target rate must be defended by the central bank. Defense is required because the overnight rate can threaten the target rate. Should it do so and the central bank not act to control the situation, the central bank will inevitably lose control over monetary policy. The issue that is central to this situation are excess reserves in the banking system.

Whilst commercial banks do not lend out reserves to customers, they do offer them up to each other on the interbank market. Commercial banks who are short of reserves will head to the interbank market to obtain reserves from banks who have a surplus. This activity results in competition for excess reserves which drives the overnight rate towards the bottom of the corridor. If the central bank does not act to halt the competition, then, as I mentioned, it will lose control over monetary policy. The central bank uses treasury bonds to drain off these excess reserves.

The central bank will replace reserves with a bond, destroying the reserves, and in turn bringing a halt to the competition which threatens its target interest rate.

And that’s it. That’s the purpose of treasury bonds in the year 2018. As a by-product of this activity, treasury bonds today act as interest-bearing savings accounts for the holders of treasury bonds, much like bank certificates of deposit with the exception that a commercial bank can go broke and the national government cannot. These are entirely risk-free investments offered by the national government and managed by the central bank.

V: The Treasury and the Central Bank are the Consolidated National Government

Next, we must understand that both the treasury and the central bank work in constant cooperation to conduct both fiscal and monetary policy. In the case of fiscal policy, the central bank plays a subordinate but necessary role. Here, all government spending is first determined by the order of the legislative branch of government. Once spending is approved, the treasury will begin crediting bank accounts and issuing cheques, and the central bank will then supply the necessary reserves to the banking system to ensure that the payments clear.

As described in the previous section, with regard to monetary policy, the central bank plays the leading role and treasury supports the central bank’s efforts through bond issuance, allowing the central bank to defend its target interest rate.

Neither entity can do its job without the other in the current system set-up. One certainly could merge the central bank with the treasury, but the result would still be the same – as to fiscal policy, accounts would be credited, cheques written, and reserves injected to clear the payments, and as to monetary policy, a target interest rate would be set and bonds issued to defend it. So, as we can see, the central bank is the national government, and the national government uses the central bank to control the interest that it pays to bond holders. The stories that you hear from the media about investors holding currency-issuing governments hostage is nothing more than a pleasant fiction.

VI: Central Bank Demand and Interest Paid on Bonds

We now come to the crux of this discussion where we will soon understand that AAA ratings of government debt by ratings agencies mean absolutely nothing, and also that the bond market and investors do not and cannot hold the national government hostage. Firstly, to shut down those US-based doomsayers who persistently cry that the national government could one day find itself with no buyers for its debt if its credit rating falls, a quick word on primary dealers is in order.

Clearly unbeknownst to these drama queens is a thing called primary dealers. It is a list of entities that are obligated to bid on treasuries at auction and create markets for the bonds. “Obligated” is the key word here – they are forced. For the current list of primary dealers and their function, please see this link to the Federal Reserve Bank of New York – https://www.newyorkfed.org/markets/primarydealers

(As a side note, disciples of Richard Werner who will inevitably respond to the link with, “That’s Fed PR” are hereby ignored for obvious reasons.)

Next up – More fun information. The government denominates its bonds in its own unit of account and then gives them a face value. The bonds are then issued by treasury into the primary market through the auction process. Once the bonds have entered the primary market, then investors trade them in what is called the secondary market. In other words, they play with them and the price of a bond can rise above or fall below its face value based upon supply and demand. It’s called the secondary market for a reason: This activity is secondary and, thus, subordinate. Treasury bonds can be issued by the government and every last one snapped up even if not a single private investor wanted one. Investors do not call the shots; the government does. Here’s why.

At any point in time, the central bank can enter the market and begin buying up treasury bonds. The difference between a million investors buying up issues and one central bank doing it is one critical fact: The central bank itself can outbid all investors combined at any time. If the central bank announces that it will stand ready to purchase bonds from investors at a fixed price, then the word is out that investors have a guaranteed option to sell.

Investors know full well that the central bank can buy every issue in existence without hesitation at a fantastic price – guaranteed. In other words, the central bank (the national government) establishes the price because the government is the monopoly issuer of the currency. Therefore, investors sell issues they possess to the central bank and, in turn, the central bank takes the bonds onto its balance sheet, then creates the reserves (money) necessary to buy the bond and pays the bond holder. The investor derives a cozy profit, the central bank holds the bonds, and the market has fewer bonds to play with. The central bank can continue in this vein until it literally begins starving the market for bonds, or buying up all of the bonds entirely and the market can’t do anything about it but stomp its feet and cry in its bedroom. In other words, what I am telling you is that the national government is playing a game with these petulant little children called investors that people think have the power to hold the government hostage.

The national government places treasury on one side of the investors and its central bank on the other. The treasury issues the bonds into the primary market and says, “Children! Look what I have!”, the children begin playtime in the secondary market, having all sorts of fun with the bonds, and then the central bank offers the children lots of candy and takes the bonds away from them. The funny part begins when the children eat the candy but then don’t have anything left to play with. They look at the central bank and say, “Hey, we don’t have any more bonds to play with”, and the central bank says, “LOL! Tough shit for you. Sit down, eat your candy and shut up”, “But, we’ve already ate the candy you gave us”, “That’s your problem, not mine”.

Don’t think this happens? Have a look at Japan. Is the Government of Japan bankrupt? Nope. Does Japan still exist? You bet. Will investors buy bonds at extremely low yields? Absolutely. Will investors even buy bonds at negative yields? That, they did!

Tough shit for the market, I guess. The government can always find buyers for its debt. And it is tough shit for the market because the national government itself creates the market for its bonds. There’d be no bond market if the government didn’t issue them for investors to play with, or better put, to snort up their noses like coke. Yeah, what I’m telling you is that bonds are used by politicians as a form of corporate welfare. They are narcotics and the national government is the only supplier in existence to feed the habit of these addicts. At any point in time, the government can take away the drugs and the market will begin going through withdrawal symptoms. Don’t believe me? Check out Australia.

In the early 2000’s, the Australian government’s idiotic pursuit of a budget surplus starved the market of bonds to such a degree that the children people refer to as “the market” stomped their feet and demanded more bonds from the government. Now, if you had an actual parent in charge of these spoilt children, the answer would have been “no”. But, unfortunately, the parents in Australia’s case were weak, spoiling their kids to no end and so they said, “Ok. We will give you more bonds. Just don’t destroy your bedroom, ok?” It’s like Willy Wonka and the Chocolate Factory where that annoying little, spoilt girl Veruca Salt endlessly screamed, “I want this! I want that! I want it now!” and her wimpy father gave her whatever she wanted. Unfortunately for Australia, Willy Wonka wasn’t in charge because what happened to Veruca would have happened to the bond market. This scenario had nothing to do with central bank demand. I’m simply mentioning it because it clearly demonstrates to you who is in command here.

Anyway…

Believe it or not, next we will hear from the delusional doomsayers that the government would be in debt to the central bank. Clearly, they either weren’t paying attention when I discussed the treasury/central bank consolidation in section V, or they skipped past section V altogether because their ideology and childish need for drama won’t allow reality a foothold. Yes, the actual mechanics takes all the drama out of economics. These delusional creatures are the very zombies that they inject into the subject: “Uhhhhhhg! Uhhhhhhhhhg! Drama! I found this boring and difficult to read. Need drama! Need dramaaaaaaaa! Uhhhhhhhg! There’s no evil Blofeld! Where Blofeld? Uhhhhhhhg! Fiscal collapse! Uhhhhhhhhg! Need villain. Banks control the government! Uhhhhhg!”

Furthermore, QE demonstrates something else to these delusional people as well – the actual purpose of treasury bonds in a free-floating, inconvertible fiat currency regime.

Before the central bank conducts QE operations, it first sets its target interest rate at or near zero. Why? Recall our discussion from section IV. The central bank uses treasury bonds to drain away excess reserves to halt the competition so that it can defend its target interest rate. With regard to QE, the central bank knows that it will begin building reserves to excess. By setting the target interest rate at or near zero prior to conducting QE, there is nothing to defend, and so, the central bank does not need to intervene with bonds. The central bank begins snapping up bonds, replacing them with liquid reserves (money) that it creates at will, and the reserves begin building up in reserve accounts held at the central bank where they just sit there, rotting away. Meanwhile, the long end of the yield curve is manipulated in the process, demonstrating clearly to everyone that the national government, not the market, controls the interest that it pays on its debt.

To summarise this section, because the central bank has an unlimited capacity to generate central bank liabilities (reserves, government money) which is the only thing anyone can use to purchase bonds, the central bank can literally buy up all bonds issued by treasury and once in possession of them, hold them indefinitely on its books, or simply retire all of them from existence. Understand me clearly here – Just because a bond was issued into existence does not mean that it must exit from existence in the hands of a private investor at maturity. The central bank can acquire it and simply retire it without treasury paying the central bank anything because the treasury and the central bank are the consolidated national government.

Ratings agencies are a scam, a flim-flam, a put on, a sham. Moody’s and S&P and their ratings of government debt are 100% useless, meaningless bullshit. At no point in time has a downgrade of government debt by these agencies ever resulted in “increased borrowing costs” to sovereign currency-issuing governments, nor have they deterred investors from buying up government debt either. Even if we were to pretend that such a thing could occur just for argument’s sake, the government would simply instruct the central bank to buy up the bonds and that, as they say, would be that.

VII: Treasury Bonds Should No longer Be Issued

As we discussed in section IV, treasury bonds serve absolutely no financing purpose for the national government and are issued exclusively to defend a particular target rate of interest. Monetary policy is a blunt, ineffective tool, which relies on the manipulation of interest rates to “encourage” the economy whereas fiscal policy is a direct manipulation of the economy. As a policy tool, monetary policy is indirect and thoroughly imprecise as it cannot target regional problems. For instance, if Yorkshire were to experience a decline in production leading to a regional downturn, monetary policy cannot address that problem directly. All that it can do is adjust interest rates and hope that the more favourable rates induce investors to borrow from banks to invest in Yorkshire at some point. If investors/businesses do borrow to invest in Yorkshire, the lag time between investment and any potential recovery is far too great to be of any immediate relief for Yorkshire. On the level of the entire economy, the same applies: monetary policy cannot reverse a large-scale collapse in aggregate demand because its effects are not immediate, nor are they even guaranteed to induce the necessary activity. In other words, a house is on fire and the fire brigade’s response is, ‘We should try making water less expensive and see if the cheaper cost induces people to come running with buckets of water to put out the fire’.”

So, whether typical, through the manipulation of interest rates, or atypical such as Quantitative Easing (QE) and a Negative Interest Rate Policy (NIRP), monetary policy is wholly ineffective in reversing a large-scale drop in consumer spending for the precise reason that, empirically, monetary policy is not government spending. Fiscal policy, on the other hand, is government spending. It directly impacts the economy on the whole, it can be used to target recessed regions, and its effects are immediate. Given this fact, the question becomes why continue to rely on monetary policy when fiscal policy is always superior? The answer to that question is that we shouldn’t. But even if we were to forego reason and continue to rely on monetary policy, treasury bonds are not required. The central bank can pay interest on reserves which has the same effect on interbank market competition as bonds. Rather than draining reserves, the central bank pays interest on reserves to entice banks to hold on to reserves, thus bringing a halt to the competition and defending the central bank’s target rate.

Since bonds are nether required for monetary policy or fiscal policy, treasury bond issuance should cease immediately. The best, most efficient method to do so is to direct the central bank to maintain a zero interest rate policy. Here, the central bank sets its target rate at zero and leaves it there. In doing so, there is nothing to defend and since there is nothing to defend, neither paying interest on reserves or conducting reserve drains with treasury bonds is required. From this point, the national government relies on fiscal policy for aggregate demand management, directly targeting its net spending at a public purpose social agenda which will result in sustained prosperity without treasury issuing bonds.

VIII: Concluding Remarks

Stated plainly for the benefit of the public, without the national government issuing bonds and without the national government also giving investors the money to purchase the bonds through deficit spending, the bond market would not exist. The bond market exists only because the national government causes it to exist. As the national government is the monopoly supplier of currency for the nation, and as that currency is inconvertible and floats freely on an exchange, if the national government chooses to issue treasury bonds, then it alone controls the interest that it pays on its bonds, not the bond market. However, as we now understand, treasury bonds in the modern era are an anachronism and currency-issuing national governments should cease issuing them.