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.

The Budget 2012: Should George Osborne learn from Barack Obama?

This was the question that Larry Elliott asked on The Guardian's Economics Blog yesterday. He was of course referring to fact that the USA has implemented a major economic stimulus package whereas the coalition government here has instead (with the tacit encouragement of the Treasury) been implementing a policy of cuts and austerity. As a result the USA has had falling unemployment for most of the last year whereas in the UK unemployment is still rising. In the USA economic growth is well over 1% and approaching 2%. In the UK it is barely above zero. So has Obama got it right and Osborne got it wrong?

To answer this we must first take stock of what it is exactly that the US government has done. Its stimulus package has in fact been in three parts. First it reduced its short-term policy rate (just as the Bank of England did). Then it introduced Quantitative Easing (QE), just as the Bank of England did. Then last autumn it launched Operation Twist. This involved buying long-dated bonds to bring down long-term interest rates and replacing them with short-dated bonds, but as Operation Twist is such a new initiative can it really be held responsible for a US recovery which has been underway for over a year now? Probably not, and as Larry Elliott suggested in his column, it is difficult to see how Operation Twist could really effect aggregate demand. So is the real explanation for the difference in recovery rates between the US and the UK just down to the size and length of the stimulus. Perhaps not.

Perhaps the real reason that the US economy is growing faster is not just down to the federal stimulus. A point that is too often overlooked has been the scale and the effect of the housing crash in the US over the last four years. Unlike in the UK where house prices fell by only about 20% from their 2007 peak and are still at historically high levels, in many parts of the US the fall has been much more dramatic. Could this be part of the reason that the US economy has seen a better speed of recovery?

In case you had forgotten, it was the boom in the housing market in both the USA and Britain (and Ireland and Spain for that matter) that led to the financial crash in 2007, rather than just a failure of bank regulation. In all of those countries mentioned the housing bubble was the result of either rising inequality or increasing economic imbalances and, in the case of the US and UK, stagnant growth in real wages for the less well off as well. As a result an excess of investment funds got misdirected into creating bubbles in asset prices (i.e. property) instead of being use to create new means of production.

What is different about the US response to the crisis, compared to the UK one, is that the US allowed their housing bubble to implode. We did not. In fact government policy in the UK is still more concerned about supporting house prices than it is about keeping people in work. That is the big mistake. Negative equity is only an economic problem if people start losing their jobs.

In the USA by contrast, by allowing the housing market to crash the policy makers have forced the debt holders to take a "debt haircut" and thus allowed the economy to partially reset itself. Thus the USA has benefited from a combination of a debt haircut and a stimulus. In the UK we have had a weak stimulus primarily for the banks but no haircut. In the Eurozone (e.g. Spain and Ireland) they might get a small debt haircut but no stimulus. Thus it is the combination of stimulus and debt write-off that is the necessary remedy. Those countries that only take half the medicine either take much longer to recover, or don't recover at all.

However it is not just about the size of the stimulus either. It is also about the shape of it. The correct economic response to the current crisis is not just to provide a stimulus, but to direct that stimulus towards correcting the original cause of the problem, namely the housing market. By building more social housing the government would not only have created jobs, it would also have reduced house prices and private sector rents and thereby increased disposable incomes for the majority of families. That would have magnified the effect of the stimulus and helped to eradicate the core problem. Instead we are having to endure an economic policy that protects the haves at the expense of the have-nots. That is just a repeat of the very economic policies that caused the whole sorry problem in the first place.