MMT vs the bond market

Why do governments borrow from the bond market? Is there a better way for governments to finance their deficits than this? If so, what economic factors should determine where governments need to look for finance? These are questions that I have been asking myself over the past few months and years, but I seem to be in a minority. Certainly most mainstream economists don't seem to be that bothered, but I think they should be because it is becoming pretty obvious that the old ways don't work any more.

This week the Bank of England cut interestrates to 0.25% and embarked on a new wad of quantitative easing (QE) in a bid to head off recession. Now I pointed out a few years ago that lowering interest rates to near zero will have practically no effect on stimulating extra demand for credit and so will not create new demand via increased consumer spending in the real economy either. Only a fiscal stimulus will do that but this government has set itself against doing anything that remotely resembles Keynesian interventionism. But as I pointed out last time, even governments that are supposed to believe in Keynesian economics have consistently failed to apply sufficiently large fiscal stimuli during major recessions.

Yes they increase welfare spending, but only because unemployment has increased and that has forced their hand. Meanwhile, they compensate by cutting spending in other areas to try and minimise total borrowing. These cuts often further increase unemployment and lower GDP. This leads to the austerity that we have been familiar with over the last eight years, and while welfare spending has still increased, it has often been undertaken grudgingly and parsimoniously. Consequently, while government spending increases, it does not increase fast enough to reverse the effects of the recession. The result is the recession is longer and deeper than it needed to be and chancellors like George Osborne continuously miss their deficit targets.

So while the government may claim that their actions are Keynesian because they are increasing spending and borrowing in the recession, their actions cannot in any way be considered to be within the spirit of Keynesianism because they make no attempt to restore the economy to full employment or maximum output. But this failure to adhere to Keynesian orthodoxy is not totally ideological. As I pointed out previously, the last Labour government was almost as obsessed with deficit reduction post-2008 as the Tories have been. What drives this fiscal trepidation is fear and loathing about debt. In the aftermath of the 2007 crash the worry was all about debt to GDP ratios and sovereign default. We were bombarded with threats to our credit rating from the very credit agencies that partially created the financial crisis in the first place. We were told that if we borrowed too much we would end up like Greece. But all this was bogus economic scaremongering for two reasons.

Firstly, unlike Greece we had control of our own currency, and secondly all our debt was denominated in our own currency. No developed country has ever defaulted on its sovereign debt when that debt has been denominated in its own currency. But there is another more important point that needs to be appreciated when it comes to sovereign debt. Who you borrow from matters just as much as, if not more than, how much you borrow.

To see this consider these two examples. Greece currently has a debt to gdp ratio of 180%. As a result most economists consider Greece to be essentially bankrupt and incapable of paying back what it owns. Most expect it to default sooner or later. Japan on the other hand has an even higher debt to gdp ratio of 230% but no-one expects Japan to go bust. Why?

The answer is because Greece owes virtually all its debt to foreign creditors (ECB, IMF, German and French banks) in a currency that it cannot print, cannot control, and cannot devalue. Even if Greece left the euro its new currency would devalue and its economy shrink relative to its economic competitors, but its debt would not. So its debt to gdp ratio would skyrocket even further.

Japan's debt on the other hand is owned mainly by its own citizens and domestic banks and corporations and is also denominated in its own currency. The Japanese government can never fail to repay its debts because it can always raise taxes on the people it owes money to in order to pay them the money it owes them. As a result it can never run out of money and the money it pays out in interest and maturity repayments never leaves the Japanese economy. The only risk to the Japanese government is loss of confidence by the public in the government and a rush to liquidate the bonds they hold, but this can be avoided in two ways. Either the government can impose fixed maturity dates on the bonds or savings, or it can borrow from itself in the form of its central bank (like QE). This latter mechanism is the essence of what is known as modern monetary theory or MMT, which I will discuss further in a future post, and what this and previous posts are intended to provide the justification for.

What this shows is that when it comes to national debt, borrowing from within your own currency area is more sustainable than borrowing from outside it. In short, countries that borrow internally instead of externally from the bond market can never go bust. This is one major reason why countries should shun the bond market, but there are other good reasons as well.

Every time a government borrows from overseas it is adding to the current account deficit. The UK gilts created are in effect exchanged for foreign currency which can then be used to purchase additional goods from overseas. This happens without an equal amount of production having taken place inside the UK and then exported. Alternatively, the foreign currency is first converted to sterling in order to buy the gilts, thereby leading to a strengthening of sterling on the currency markets. Neither of these effects is desirable.

So what is clear is that conventional methods of government borrowing come with a significant sting in the tail, and yet as QE has shown, these stings are often unnecessary and could be avoided. So why does most of the mainstream economic community not appear to get this? Why don't they recognise that there might be better ways for governments to finance their deficits and to run the economy?

Well one reason that they continue to use the bond market is perhaps because that is what they have always done. In the times before fiat currency and free flows of capital governments needed to physically borrow other people's money in order to spend it. Money creation was not possible. But I think there is a deeper problem. Economists don't think like physicists. A physicist will always tackle a problem by simplifying it to its core. This means first considering a closed system problem and then looking at system leakage as a perturbation to that initial system. Economics on the other hand seems obsessed with open systems, globalisation and free trade.

What I think MMT could do is allow a government to more effectively internalise its economy and protect its currency. It could enable it to borrow unlimited funds (from its own central bank) in a recession in order to enact a proper Keynesian response to a financial crisis. This in turn could be used to fund investment, job creation or helicopter money which would be far more effective than cutting interest rates to zero or providing QE for banks. The result could be much greater macroeconomic control and shorter and shallower recessions.

The Big Lie #1 - Austerity is needed to appease the bond markets

It is often said that truth is the first casualty of war. It could equally be the first casualty of politics as well. Given the extent to which politicians have appeared to play fast and loose with language and semantics in recent times it is perhaps unsurprising that their collective credibility and reputation, both at home and abroad, appears to be following the same trajectory as that of a test firing of a North Korean rocket. Whether it is politicians being "economical with the actualité", or Orwellian doublespeak of the type invoked by David Cameron recently where the term austerity has been magically redefined to mean "efficiency", the first casualty of UK political debate now always seems to be the English language. Of course none of this is accidental. It is all designed to disguise the reality behind a particular policy or action so that the voters are hoodwinked into believing in an illusion. 


One of the biggest fictions we are currently being expected to swallow is the one regarding the necessity of the current coalition government's deficit reduction measures and their apparent success. The argument that has been advanced by those on the Right on an almost daily basis since the last general election in 2010 is that the only way the Government can finance its deficit is if it can establish the confidence of the bond market. And the only way it can do that is if it slashes spending. And the central piece of evidence used to corroborate this claim has been the yields of government bonds or gilts. 


Gilt yields are currently at historic lows despite the Government running up record budget deficits over the last four years. Now we are told that these low yields are a direct result of the confidence that the bond market has in the Government's economic strategy. We are told that the Government cannot, or dare not, borrow any more money to stimulate the economy otherwise gilt yields would rise dramatically. We are told that our economy would then go the same way as that of Italy, or Spain, or worse still Greece! But how much of this is really true? The answer is hardly any of it. The reality is that our gilt yields are low because our borrowing has been almost completely self-financed over the last four years. That self-financing has come in the form of Quantitative Easing (QE). 


Up until April 2002 the last Labour government ran a financial surplus in its accounts. Then over the next six years this turned into a modest deficit of approximately £35bn per annum. While not ideal, these deficits were nevertheless sustainable in the long term as they typically increased the national debt by a smaller proportion than the corresponding annual increase in GDP due to economic growth. As a result the debt-to-GDP ratio was actually declining after 2006 despite the nominal debt level still increasing, and as a result it was actually more serviceable. It is therefore economic fantasy to suggest, as some on the Right have done, that these deficits caused the financial crash. The real cause was the set of economic policies implemented by the Thatcher and Major governments in the 1980s and 1990s, particularly with regards to the liberalization of consumer credit, laissez-faire bank deregulation and a wholly disfunctional housing policy. The result was the worst recession in living memory and a national debt that has increased to £1022bn. Of this total, over £500bn has been added since the start of 2008 - almost half the total. So why have gilt yields remained so low when the supply of gilts from the Government to the bond market has been so huge? The answer is QE. 


Since 2008 the Bank of England (BoE) has "printed" an additional £325bn of new money in the form of Quantitative Easing and used this money to purchase UK gilts. Irrespective of the fact that this was done through the secondary bond market, the net result is that 65% of all the new gilts issued by the Government since 2008 have in effect been acquired by the BoE. That means that only about £180bn have actually been purchased by the private sector, or £45bn per annum. That is only fractionally more than were purchased each year prior to the crash, and this has been going on for nearly four years now. In fact QE has been operating for so long now that the financing of government deficit spending has become semi-detached from the bond market to such an extent that it is almost operating in a parallel economic universe. That is partly why yields are so low and as you can see it has nothing at all to do with the international financial markets supporting the deficit reduction plans of the coalition. 


But that is not the whole story, for one of the additional consequences of the financial crash is that UK banks are now forced to hold more assets to strengthen their balance sheets. As a result UK banks have needed to buy more UK gilts themselves in order to increase their own financial stability. It is therefore highly debateable if there has been any significant increase in the purchase of UK gilts by overseas investors in recent years, yet capital flight from the PIIGS (Portugal, Ireland, Italy, Greece and Spain) has driven up the relative demand for UK gilts.


Only yesterday did we see further worries about the Spanish economy driving yet more capital away from the Eurozone and forcing it to look for safer havens elsewhere. The result was a further drop in UK gilt yields. And all of this is happening at a time when the supply of UK gilts, contrary to popular opinion, has actually been significantly reduced, or has at least been far less than the headline figure of the UK government deficit. So, given these two complementing drivers, it should hardly be any surprise that UK gilt yields are so low, irrespective of the general state of the economy, which in case you had missed it, is lurching from one recession to another. That is hardly the sort of performance that is usually associated with inspiring the confidence of international investors. 


You can of course look at all this from another perspective: that of the balance between supply and demand and its effect on market prices. Low gilt yields are an indication of excess demand and insufficient supply. Consequently they represent a market price signal that says: "The market wants more!" In which case why should we not supply more gilts to the market, particularly when we can put those gilts to good use? Those who believe in the power of markets, and the price signals that they send, cannot have it both ways. If high yields are a sign that government borrowing is too high, then low yields can be a sign that it is too low. And as I pointed out previously, when it comes to low interest rates you can have too much of a good thing. Ultimately banks, including central banks, cannot push money out into the economy when there is no demand, or no cost to holding it. In such circumstances monetary policy is like pushing against of piece of string and a coordinated and complementary fiscal policy is then also needed. 


Of course the real tragedy is that despite having access to what has effectively been free money for four years, both the last Labour government and the current coalition have failed to do anything effective or imaginative with it. Rather than using it to stimulate a programme of infrastructure investment, it has instead been used to refinance the banks, and indirectly to prop up house prices. Once again successive governments and the Bank of England have shown that they are more worried about negative equity than they are about unemployment; that they prize inflated asset values over real economic growth. As a result, all this free money has in effect been used to insulate the rich from the consequences of their own mal-investment rather than improving and protecting the lives of the poor. 


The choice of austerity is therefore a political choice not an economic one. Just because there is a lot of debt in the economy does not mean that there is no money at all. It just means that all the money is in the pockets of the wrong people. The current government with its tax cuts for the rich and its attacks on the incomes of the poor clearly wishes to keep it there.

Why a zero interest rate equals zero lending

Adam Posen is an American economist who currently sits on the Bank of England’s (BoE) Monetary Policy Committee (MPC). This is the committee that sets the UK’s interest rates in order to control CPI inflation, or at least that was the original idea behind the formation of the MPC in 1997 when Gordon Brown was Chancellor of the Exchequer. I mention this because a couple of weeks ago Mr. Posen was quoted in an article by Philip Aldrick in The Daily Telegraph as described British banks as “reluctant, risk-averse jerks”. He may be right, but is that such a bad thing, particularly given the reckless lending that preceded 2007? I thought we all wanted banks and bankers to be boring again. Obviously not!

It occurs to me, however, that one of the issues that both the Daily Telegraph article and Adam Posen’s recent comments apparently fail to highlight is the possible causal effect that low interest rates can have in reducing bank lending. The point that virtually no-one in economics and the political media has so far cottoned onto is this: when base rates are high banks are forced to lend virtually all the deposits they receive in order to pay the interest that they owe to their savers, but when base rates are low there is no such necessity. To understand why, consider this simple example.

In normal economic times bank base rates may be about 5%. So, suppose a bank receives deposits of £1m for which it must pay interest at a savings rate of 4.5%. If the bank is required to maintain a capital adequacy ratio of let's say 10%, it will only be able to lend out 90% of its deposits. But it must also lend sufficient money at a sufficiently high rate of interest so that it can bring in enough revenue through loan interest repayments in order cover the interest it owes to its depositors. At the very least that means it must lend all of the available deposits (£900,000.00) at a rate of 5% just to break even. It could of course lend out less (say £750,000.00) but then it would need charge a higher loan rate in order to make a profit (in this case over 6%).

When you add in the effects of competition between banks, that competition will have two effects. Firstly, it will force down loan rates (or force up saver rates); and secondly, that will then force banks to lend more and more of their available deposits in order to cover costs and maximise profit. This inevitably means that banks will be unable to sit on deposits. Instead they will be incentivised to make those deposits work as hard as possible, possibly to the extent where some banks try to circumvent the rules on capital adequacy. That of course was what happened during the credit boom with disastrous consequences. But that is not what is happening now.

Today base rates are anchored at 0.5% and look like staying there for several more years to come. As a result savers typically receive an interest rate of about 0.2% if they are lucky. Yet most loan rates still exceed 4%, while for credit cards and unsecured loans they are much higher still. Under circumstances such as these banks would only need to loan out about 5% of their total deposits in order to break even. The net result is that they can pick and choose with even greater selectivity than before who they choose to lend to, and how much they choose to lend. The credit market therefore becomes highly skewed in favour of the lender. So that would appear to explain, at least partially, why current levels of bank lending are apparently so weak. In which case is Adam Posen right to criticise the banks in this way? Or should some of the responsibility for this lack of lending also lie with Adam Posen and his colleagues on the MPC? After all, it is they who set the BoE's base rates and, as I have shown, it is those base rates that help to drive bank lending.

With UK interest rate policy set as it currently is, what has in effect happened is that lending rates have become decoupled from savings rates. Once you realize that then it becomes apparent that having base rates at 0.5% serves very little purpose as far as the wider economy is concerned. It certainly has no effect in stimulating increased loans to small businesses, and while that may not be the only reason for the poor lending record of banks, it is probably a contributory factor. The result is a credit crunch or liquidity trap where those with spare cash refuse to either lend it or spend it. The critical issue here is the same one you get in price deflation in a depression. Both are caused by the tendency of the rich to hoard cash when there is no financial penalty for doing so.

Normally, hoarded cash loses it value through inflation. That is why a small amount of inflation actually benefits the economy as it helps to drive the circulation of money through spending, investment and consumption. Similarly, un-loaned bank deposits normally lose value for the banks due to the costs of interest they incur that must be paid by the banks to their depositor customers. When inflation and interest rates are negative, however, these conditions no longer apply, and the cash or credit stops flowing. In short, when savings rates are close to zero the banks effectively have access to free money.

Of course there are other reasons for the general lack of lending to small businesses. One of the main ones is the competition for funds from house-buyers via the mortgage market. In the period immediately prior to 2007 over 75% of bank lending was on mortgages, with only about 6% being made available to small businesses. This represents a classic case of "crowding out". That is why part of the long-term solution has to be the establishment of a network of locally based investment banks in the UK based on the German model of financial support to its Mittelstand. What is clear is that the more choice banks have over where they lend their money, the less likely they are to lend it in support of the real economy. It is simply a question of reducing the number of options or degrees of freedom banks have. As Adam Posen is also quoted as saying: "We've got to change the competitive pressures on them, change the rules on them so they're forced to do the job right."

What the above statistics also show, though, is that like most of the UK's economic problems, the ongoing problem of underinvestment by UK retail banks in the rest of UK business is intrinsically linked to the perennial UK problem of property speculation and house price inflation. So you will never solve the investment problem unless you also solve the housing problem.