As discussed in the previous post, the net impact on balance sheets of the various approaches to government spending – (A) overt monetary financing, (B) sale of bonds to the private sector and (C) interest on reserves – is the same. There is a direct and immediate increase in net financial assets held by non-government as well as a creation of income. Both effects are equal in size to the amount of government spending. But in the case of method B, these effects are achieved in an inefficient and convoluted way that obscures the origin of government money, which in reality is created through the act of government spending or lending rather than being “borrowed” from the private sector. Even so, the practice of auctioning bonds to the private sector has often been rationalized on the supposed grounds that methods A and C are more expansionary in their demand effects than method B, and so are claimed to carry a greater inflation risk. In truth, there is no significant difference between the three methods when it comes to the expansionary impact or inflation risk of government spending. If anything, method B might carry marginally more, not less, inflation risk to the extent that bonds attract higher interest payments than reserves (inducing slightly more consumption), but any such difference will be minimal. If, in comparing effects, it is assumed that the same interest rate applies under each method, then the choice of method will affect the composition of net financial assets but make no difference to the expansionary effects of the government spending.
Government spending has two immediate and direct macro effects. It:
- adds to the net financial assets held by non-government;
- creates income equal to the amount spent.
This is the case whether the central bank is (A) permitted to purchase government bonds directly from the fiscal authority (‘overt monetary financing’) or instead (B) is required to buy them from the private sector (currently the procedure under “normal” circumstances in many countries). It is also true if (C) the government simply spends without issuing bonds and pays its policy rate (which can be zero) on reserve balances.