A Currency-Issuing Government Spends on its Own Terms

An alternative title to this post could have been, ‘The Interest Rate on Public Debt is at the Discretion of Government’. This remains true even though, in the neoliberal era, governments usually require themselves to follow various unnecessary rules on how their spending is to be conducted. These rules are voluntary and can be removed at a later time. But even while these rules are in place, they do not prevent government from dictating the terms on which it spends.

Consider a currency-issuing government that requires itself either to deduct taxes from non-government accounts or to issue debt to non-government before it spends. This is quite typical of governments today. At first glance, these requirements may seem problematic. From inception, it would clearly be impossible for a currency issuer to receive tax payments in its own currency or to auction off public debt in the form of treasuries in exchange for its own currency before the currency itself had actually been issued. The resolution to this apparent conundrum is that government can always (and currently does) advance to non-government the currency it requires to purchase newly issued public debt.

More specifically, the central bank, as the monetary arm of government, issues currency in the form of reserves (by crediting reserve accounts) while requiring collateral in the form of previously issued treasuries. Non-government is then in a position to purchase newly issued treasuries, with reserve accounts debited in settlement.

Typically, there will be a bidding process at a Treasury auction. The treasuries will go to the participants with successful bids – all those bids that offer an interest rate on government debt that is at or below the cutoff. If the central bank is prohibited from purchasing treasuries directly from the Treasury (which may or may not be the case, depending on the country in question), it will be necessary to auction off all newly-issued treasuries to non-government. In that case, the cutoff between successful and unsuccessful bids will be determined in the auction itself.

Considering that the sale of public debt is typically subjected to a bidding process, it may be wondered how government can nonetheless maintain control over the terms on which it spends. In particular, it may be unclear what prevents the rate of interest on public debt from rising above the rate that government actually wants to pay.

The answer is simple. The central bank can always purchase financial assets in the secondary market (the market for previously issued financial assets) so as to drive down the interest rates (yields) on those assets. The more the central bank’s actions drive down interest rates, the more attractive newly issued treasuries become in comparison. Since the central bank can credit reserve accounts without limit, there is never any risk whatsoever of the government somehow being forced to pay an interest rate on its debt that it is not fully prepared to pay. If the government wants the interest rate on newly issued treasuries to be lower than it otherwise would be, the central bank will simply inject more reserves into the system in exchange for financial assets purchased in the secondary market, thereby driving down the interest rates applicable to financial assets seen as close alternatives to newly issued treasuries.

Since both reserves and newly issued treasuries have zero default risk, and since reserves offer less interest than treasuries, there will be a willingness within non-government to exchange reserves for interest-bearing treasuries.