In this blog, we consider the debt question (again) with streamlined language to ensure it is accessible to all who choose to read it. Yesterday I asked whether future taxes will be higher, which is now being claimed by conservatives who are running a relentless political campaign against the demise of neo-liberalism. Today, the partner claim: will we be paying higher interest rates because of the borrowing? Answer: no! Whether interest rates are higher or lower in the future will have little to do with the movements in today’s budget balance. It is possible that voluntary arrangements set in place by the Australian government in the past will drive interest rates up. But if that occurs it will because the Government wants higher interest rates rather than having anything to do with the net spending that is being engaged in to stop employment growth falling off the cliff. So time to discuss bond markets a bit.
First, to repeat … but you can never say it enough … the notion of a “government budget constraint” only applies ex post (after the fact), as a statement of an accounting identity that has no significance as an economic constraint.
In an accounting sense, it is certainly true that any increase of government spending will be matched by an increase of taxes, an increase of high powered money (reserves and cash) and/or an increase of sovereign debt held. But this does not mean that taxes or bonds actually “finance” the government spending. They do not!
Government might well enact provisions that dictate relations between changes to spending and changes to tax revenues (a balanced budget, for example); it might require that bonds are issued before deficit spending actually takes place; it might require that the treasury have “money in the bank” (deposits at the central bank) before it can issue a cheque; and so on. These provisions might constrain government’s ability to spend at the desired level. However, economic analysis shows that they are self-imposed and are not economically necessary – although they may well be politically necessary.
As I have mentioned in previous blogs (and extensively in my published academic work) … while a sovereign government is not financially constrained it still issues debt to control its liquidity impacts on the private sector. Government spending and purchases of government bonds by the central bank add liquidity, while taxation and sales of government securities drain private liquidity. These transactions influence the cash position of the macroeconomic 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 the central bank, which targets the level of short-term interest rates as its monetary policy position. Budget deficits result in system-wide surpluses (excess bank reserves).
An important point to be made regarding treasury operations by a sovereign government is that the interest rate paid on treasury securities is not subject to normal “market forces” unless the government voluntary chooses to do so (as in Australia with its auction system – more about which later).
The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward whatever rate the central bank offers to pay commercial banks for excess overnight reserves. If the RBA decided not to pay any support rate (it currently pays commercial banks just below the official rate) then the Treasury could always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero).
This accentuates the point that a sovereign government with a floating currency can issue securities at any rate it desires – normally a few basis points above the overnight interest rate target that the central bank has set. There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero). But it is simply false reasoning that leads to the belief that the size of a sovereign government deficit affects the interest rate paid on securities.