The Myth of Crowding Out

This is the final blog post of the Deficit Spending 101 series, it immediately follows the Central Bank Role blog.

We now know that it is a myth to perpetuate the idea that a currency-issuing government is financially constrained. This myth underpins arguments by orthodox economists against government activism in macroeconomic policy. There is another persistent myth that needs to be dispelled – that government expenditures crowd out private expenditures through their effects on the interest rate.

We have seen that the central bank necessarily administers the risk-free interest rate and is not subject to direct market forces. The orthodox macroeconomic approach argues that persistent deficits reduce national savings … [and require] … higher real interest rates and lower levels of investment spending. Think back to the 7.30 Report transcript I provided.

Unfortunately, proponents of this logic which automatically links budget deficits to increasing debt issuance and hence rising interest rates fail to understand how interest rates are set and the role that debt issuance plays in the economy. Clearly, the central bank can choose to set and leave the interest rate at 0 per cent, regardless, should that be favourable to the longer maturity investment rates.

While we have seen that the funds that government spends do not come from anywhere and taxes collected do not go anywhere, there are substantial liquidity impacts from net government positions as discussed. If the funds that purchase the bonds come from government spending as the accounting dictates, then any notion that government spending rations finite savings that could be used for private investment is a nonsense. A financial expert in the US, Tom Nugent sums it up like this:

One can also see that the fears of rising interest rates in the face of rising budget deficits make little sense when all of the impact of government deficit spending is taken into account, since the supply of treasury securities offered by the federal government is always equal to the newly created funds. The net effect is always a wash, and the interest rate is always that which the Fed votes on. Note that in Japan, with the highest public debt ever recorded, and repeated downgrades, the Japanese government issues treasury bills at .0001%! If deficits really caused high interest rates, Japan would have shut down long ago!

As I have previously explained, only transactions between the federal government and the private sector change the system balance. Government spending and purchases of government securities (treasury bonds) by the central bank add liquidity and taxation and sales of government securities drain liquidity. These transactions influence the cash position of the system on a daily basis and on any one day they can result in a system surplus (deficit) due to the outflow of funds from the official sector being above (below) the funds inflow to the official sector. The system cash position has crucial implications for central bank monetary policy in that it is an important determinant of the use of open market operations (bond purchases and sales) by the central bank.

Here is another diagram that I have drawn to help you put together this part of the argument. You might like to click it to show it in a new window and print it out for reference to make the argument easier to follow.

You can see the individual functions of the arms of government are summarised: (a) The Treasury runs fiscal policy which we summarise as government spending and taxation which on any day has some net impact on the economy – either a surplus (G > T) or a deficit (G < T); and (b) The RBA conducts monetary policy through setting an interest rate target. It also has to manage the system-wide cash balances to keep control of its target rate. It does this by selling/buying government debt to influence the reserve positions of the commercial banks.

So why does the government issue debt if it is not to finance spending? Well it is rather to maintain these bank reserves such that a particular overnight rate can be defended by the central bank. You can see from the diagram that G adds to reserves and T drains them. So on any particular day, if G > T (a budget deficit) then reserves are rising overall. Any particular bank might be short of reserves but overall the sum of the bank reserves are in excess. In Australia, overnight reserves earn less than the target rate (whereas in some countries they earn nothing). So it is in the commercial banks interests to try to eliminate any unneeded reserves each night. Surplus banks will try to loan their excess reserves on the Interbank market. Some deficit banks will clearly be interested in these loans to shore up their position and avoid going to the RBA’s discount window which is more expensive.

The upshot, however, is that the competition between the surplus banks to shed their excess reserves drives the short-term interest rate down. But, if you understood the discussion above about horizontal transactions (they all net to zero!) then you will appreciate that the non-government banking system cannot by itself (conducting horizontal transactions between commercial banks – that is, borrowing and lending on the interbank market) eliminate a system-wide excess of reserves that the budget deficit created.

What is needed is a vertical transaction – that is, an interaction between the government and non-government sector. In the diagram you will see that bond sales can drain reserves by offering the banks an attractive interest-bearing security (government debt) which it can purchase to eliminate its excess reserves.

That is, the bond sales (debt issuance) allows the RBA to drain any excess reserves in the cash-system and therefore curtail the downward pressure on the interest rate. In doing so it maintains control of monetary policy. Importantly:

  • budget deficits place downward pressure on interest rates;
  • bond sales maintain interest rates at the RBA target rate;

Accordingly, the concept of debt monetisation is a non sequitur. Once the overnight rate target is set the central bank should only trade government securities if liquidity changes are required to support this target. Given the central bank cannot control the reserves then debt monetisation is strictly impossible. Imagine that the central bank traded government securities with the treasury, which then increased government spending. The excess reserves would force the central bank to sell the same amount of government securities to the private market or allow the overnight rate to fall to the support level. This is not monetisation but rather the central bank simply acting as broker in the context of the logic of the interest rate setting monetary policy.

Ultimately, private agents may refuse to hold any further stocks of cash or bonds. With no debt issuance, the interest rates will fall to the central bank support limit (which may be zero). It is then also clear that the private sector at the micro level can only dispense with unwanted cash balances in the absence of government paper by increasing their consumption levels. Given the current tax structure, this reduced desire to net save would generate a private expansion and reduce the deficit, eventually restoring the portfolio balance at higher private employment levels and lower the required budget deficit as long as savings desires remain low. Clearly, there would be no desire for the government to expand the economy beyond its real limit. Whether this generates inflation depends on the ability of the economy to expand real output to meet rising nominal demand. That is not compromised by the size of the budget deficit.

Here is a summary of the main conclusions of this blog.

  • The central bank (RBA) sets the short-term interest rate based on its policy aspirations. Operationally, Budget deficits put downward pressure on interest rates contrary to the myths that appear in macroeconomic textbooks about crowding out. The central bank can counter this pressure by selling government bonds, which is equivalent to government borrowing from the public.
  • The penalty for not borrowing is that the interest rate will fall to the bottom of the corridor prevailing in the country which may be zero if the central bank does not offer a return on reserves, For example, Japan has been able to maintain a zero interest rate policy for years with record budget deficits simply by spending more than it borrows. This also illustrates that government spending is independent of borrowing, with the latter best thought of as coming after spending.
  • Government debt-issuance is a monetary policy consideration rather than being intrinsic to fiscal policy; and
  • A budget surplus describes from an accounting perspective what the government had done not what it has received.

In short, we should reject any notion that the emerging federal deficits are damaging and will indebt the future generations. The government has chosen to maintain a positive short-term interest rate and that requires the issuance of debt if there are downward pressures on that rate emerging from the cash system.

Bill Mitchell

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