How the Bond market began

In the past (prior to 1982), a tap system operated where the government would set the interest rate and then supply bonds to investors up to demand. Sometimes investors did not take up as much as the Government desired. The extra funds came from contra entries in the RBA-Treasury accounts (the government borrowing from itself!).

This system was attacked in the early 1980s by the conservative government and the financial community as they all developed their neo-liberal credentials. What transpired was the development of the The Australian Office of Financial Management (AOFM) which in its own words “is a specialised agency within the Treasury portfolio responsible for management of Australian Government debt. The AOFM’s activities include the issue of Treasury Bonds, Treasury Notes, management of the Australian Government’s cash balance, and management of a portfolio of debt and investments.” The creation of the AOFM was largely cosmetic – it is still part of the consolidated government.

The tap system was severely criticised by neo-liberals. To get an idea of the historical debate you might want read this speech, which was the text of a presentation made by Peter McCray, Deputy Chief Executive Officer, AOFM in 2000. In terms of the fact that the tap system sometimes led to the government lending to itself, McCray says that this would be

breaching what is today regarded as a central tenet of government financing – that the government fully fund itself in the market. It then became the central bank’s task to operate in the market to offset the obvious inflationary consequences of this form of financing, muddying the waters between monetary policy and debt management operations.

First, this so-called central tenet is just one of the bits of ideological baggage that have constrained governments from creating full employment. There is no foundation in economic theory for it. It is a political statement.

Second, the statement “obvious inflationary consequences” is also not based on sound modern monetary theory nor is it evidence-based. Once again it is a political statement reflective the free market ideology. It is not obvious when you have persistently high unemployment that net government spending not accompanied by reserve drains (bond issues) will be inflationary. It is highly likely that it will not be! But at any rate it is an empirical question. Statements like this from the senior AOFM official just show how captive this part of the public service became under the neo-liberal fist!

The neo-liberal era demanded that tried and tested social democratic practices give way to privatisation, outsourcing and a primacy of the capitalist market-place in allocating resources. It demanded a diminution of the role of government. We are now living through the costly aftermath of following that route. But at the time it changed the way the Government behaved in terms of debt markets.

First, I had no problem with them floating the exchange rate. Unlike what many so-called progressive economists think, this was in fact a beneficial development because it restored the full potential of fiscal policy with a sovereign currency. Under the fixed exchange rate system, central bank intervention (buying and selling AUD in the foreign exchange markets) was used to maintain the exchange rate at the agreed parity. So, given we typically run current account deficits (which mean the supply of AUD  exceeds demand for AUD in the forex market), there was often downward pressure on our exchange rate. The RBA then had to buy up the excess demand of AUD (take liquidity out of the economy) and this caused interest rates to rise and domestic spending to fall. So our domestic economy was always adjusting to the needs of the fixed exchange rate and fiscal policy was captive. Any time it tried to improve economic growth (which increased imports), monetary policy would have to contract to defend the exchange rate. So with flexible rates, the adjustment to supply and demand imbalances in the forex market on any particular day is done by the AUD and the domestic economy can then, potentially, move to and sustain full employment with appropriate fiscal policy settings (typically via budget deficits).

Second, the Federal government of the day, in concert with many national governments all increasingly coming under the neo-liberal sway, considered it necessary to make further voluntary or self-imposed changes. Foreign banks were allowed in and banks were deregulated which made them more risky because what had traditionally been a reliable retail banking service morphed, virtually overnight, into a globalised wholesale banking service with little staff development to support this shift. So in the early days several failed – State Bank of South Australia, for example and many customers were burned by borrowing in foreign currencies after being encouraged by ill-trained bank staff. Remember all the Swiss Franc loan failures and farm repossessions in the 1980s? It was clear this deregulation was going to eventually come unstuck in a broader way – as it has now – but the dominant voices in the media, business, government, the academy – were all neo-liberal. Mostly because they were reflecting vested interests who stood the most to take short-term profits and run.

McCray’s (senior AOFM offical) take on this was:

… there is no question, from a perspective that now encompasses nearly twenty years of evolution and reform in the Australian financial system, that the exercise – which remains ongoing – has paid handsome dividends, significantly enhancing financial sector competition, consumer choice and operational efficiency.

That position cannot be maintained now the whole house of cards has crumbled.

Anyway, the Federal government also invoked stupid reforms to the way government bond markets operated. While the detail is interesting, you should understand that these policy choices and changes to the “operations” of the bond markets were all voluntary choices by the Government based on ideology. There is nothing essential about the changes. Further, they are largely cosmetic.

The major shift was to ensure that all net spending was matched $-for-$ by borrowing from the private market. So net spending appeared to be “fully funded” (in the erroneous neo-liberal terminology) by the market. No: all that was happening was that the Government was coincidently draining the same amount from reserves as it was adding to them each day and swapping cash in reserves for government paper. The bond drain meant that competition in the interbank market to get rid of the excess reserves would not drive the interest rate down.

Budget deficits put downward pressure on the short-term interest rate. The bond sales maintained the specific interest rate. However, the specific arrangements that were chosen allowed the market to price the debt based on investor demand.

So many myths were paraded at the time. For example, McCray from the AOFM claims

Fundamentally, government debt management is about managing risk. In issuing debt, governments take on large exposures to market prices, creditworthiness and operational failure. The government debt manager’s approach to managing these risks can send signals to the market about acceptable standards of behaviour.

There is no risk in government debt issued by a sovereign government in its own currency. They can always pay it back by simply crediting a bank account the amount due. To suggest otherwise is deceptive or a reflection of ignorance.

Anyway, the tap system was replaced in 1982 with an “auction model” mainly because of the alleged possibility of a funding shortfall, a totally spurious concept of course. We should be absolutely clear about this. To construct the shortfall as a problem was a purely neo-liberal contrivance. They claimed it introduced uncertainty to the funding process. It did not in actual fact to anything like that.

What it meant was that investors had converted a desired amount of their reserves into government paper and were happy with their portfolios at the rate of return on the paper that the government was offering. That is all it meant.

The auction model merely supplied the required volume of government paper at whatever price was bid in the market. So there was never any shortfall of bids because obviously the auction would drive the price (returns) up so that the desired holdings of bonds by the private sector increased accordingly. However, McCray from the AOFM admits that “The move to bond auctions enabled “the authorities to sell large quantities of stock with minimal disruption to interest rates.” That is, interest rates did not get pushed up significantly. The reason: it was a reserve maintenance operation as previously discussed!

At that point the secondary bond market started to boom because institutions now saw they could create derivatives from these assets etc. We had stepped out onto the slippery slope.

The other major reason for introducing the auction method is well expressed in the following tract from McCray’s speech. He is talking about the so-called captive arrangements, where financial institutions were required under prudential regulations to hold certain proportions of their assets in the form of government bonds (or other high grade securities, such as bonds issued by the state governments) as a liquidity buffer.

… the arrangements also ensured a continued demand from growing financial institutions for government securities and doubtless assisted the authorities to issue government bonds at lower interest rates than would otherwise have been the case … Because such arrangements provide governments with the scope to raise funds comparatively cheaply, an important fiscal discipline is removed and governments may be encouraged to be less careful in their spending decisions.

So you see the ideological slant. They wanted to change the system to voluntarily limit what the Federal government could do in terms of fiscal policy. This was the period in which full employment was abandoned and the national government started to divest itself of its responsibilities to regulate and stimulate economic activity. The legacy is the mess we are in now.

The investment community were also pressuring government at the time to deregulate and allow them to operate more freely in the secondary markets. They won the battle and so began the derivatives spiral which has revealed itself in today’s calamities.

Prior to the establishment of the AOFM, the central bank handled all the debt management and issuance for the Commonwealth government. It was argued at the time that this blurred things – the monetary policy roles,  including liquidity management, and the debt management. It was clear then that the tap rate offered by the RBA was consistent with its monetary policy objective (some short-term interest rate).

The real reason for the shift to the auction model administered by the AOFM (which is really just an arm of Treasury) is provided by McCray in his speech to the ADB:

The reduced fiscal discipline associated with a government having a capacity to raise cheap funds from the central bank, the likely inflationary consequences of this form of ‘official sector’ funding … It is with good reason that it is now widely accepted that sound financial management requires that the two activities are kept separate.

Read it over: reduced fiscal discipline…that was the driving force. They were aiming to wind back the government and so they wanted to impose as many voluntary constraints on its operations as they could think off. All basically unnecessary (because there is no financing requirement), many largely cosmetic (the creation of the AOFM) and all easily able to be sold to us suckers by neo-liberal spin doctors as reflecting…read it again…“sound financial management”.

What this allowed was the relentless campaign by conservatives, still being fought, against the legitimate and responsible use of budget deficits. What this led to was the abandonment of full employment. And as they reduced the legitimate role of government before our very eyes and imposed huge costs on the most disadvantaged workers in our communities we applauded them and voted for more. And it got worse in the 1990s and beyond. But if these changes had not been as consequential in that regard as they have been…then anyone in their right mind who understood what was going on would not be able to stop laughing–the transparency of their motivation was so obvious!

Bill Mitchell

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