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 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 government bonds. Non-government is then in a position to purchase newly issued government bonds, with reserve accounts debited in settlement.

Typically, there will be a bidding process at a Treasury auction. The bonds 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 bonds 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 debt 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 public debt in the secondary market (the market for previously issued bonds) and signal an intention to do so at a particular price. This means that official bond dealers participating in the Treasury auction know that bonds purchased in the primary issue can be sold to the central bank in the secondary market. It also means that the central bank can control interest rates on all government debt (of varying duration) by purchasing as much of each type as necessary in the secondary market. This pushes up bond prices and lowers yields, making newly issued bonds more attractive than otherwise. Since there is no limit to the central bank’s capacity to create reserves, it can always drive interest rates on public debt lower through secondary-market transactions.

Since the debt of a currency-issuing government has zero default risk, and since reserves offer less interest than bonds, official dealers will always be willing to exchange reserves for interest-bearing bonds.