Government Spending Under Alternative Operational Arrangements in a Nutshell

Three previous posts (here, here and here) outlined the operational differences and similar macro effects of some alternative approaches to government spending; namely, bond issuance to the private sector, interest on reserves, and overt monetary financing. Since these posts were quite detailed, it might be worth spelling out the short answer to what is going on in each case. Further details can then be found in the earlier posts.

Bond sales to the private sector. This is the method that has been commonly adopted in most countries under “normal” circumstances, although in some countries central banks are currently paying interest on reserves.

From day to day, government expenditures occur. These entail crediting the reserve accounts of banks and the bank accounts of spending recipients. In aggregate, the effect of government spending is to add reserves. Meanwhile, taxes are getting paid. Taxpayers’ bank accounts are debited accordingly as are the reserve accounts of their banks. The aggregate effect of tax payments is to drain reserves.

On any given day, government spending is likely to differ from tax payments. If so, the central bank buys or sells already existing bonds to add or drain reserves as necessary to hit its targeted short-term interest rate.

If, over an extended period of time, government spending exceeds tax payments, the central bank needs to keep selling bonds to drain reserves. As a result, the central bank may go close to running out of bonds to sell. At this point, the fiscal authority (e.g. the Treasury) issues new bonds. This enables the central bank, indirectly, to obtain more bonds for the purpose of interest-rate management.

With the Treasury committed to issuing new bonds to the private sector, the central bank first needs to anticipate the effect of this on reserve balances. If the central bank did nothing in the event of a Treasury auction, there would be a depletion of reserves (as the private sector purchased bonds) and upward pressure on the short-term interest rate. The central bank prevents this by purchasing already existing bonds from primary dealers (in the first leg of a repurchase agreement). This adds reserves so that the Treasury’s new bonds can be purchased by the private sector without causing a reserve deficiency and interest-rate instability. By necessity, the central bank and Treasury communicate and coordinate their actions to ensure the process is conducted smoothly.

When the next round of government spending is scheduled to occur (which will add reserves), the central bank completes the second leg of the repurchase agreement by selling back bonds to primary dealers, neutralizing the effect of government spending on reserve balances. In this way, the level of reserve balances is managed to maintain interest-rate stability.

So, in a nutshell, the impact of ongoing government deficits is for the central bank to run out of the bonds it needs for interest-rate management. They are needed for monetary, not fiscal, policy. To address the situation, the Treasury then issues new bonds not to finance its spending but to enable the central bank to continue its method of draining reserves through bond sales as required to hit its policy rate.

Interest on Reserves. In the case of interest on reserves, the central bank no longer needs to buy and sell bonds to hit its short-term interest rate. Instead, it simply pays its policy rate on reserves. This does not prevent the Treasury from issuing bonds for other reasons; for instance, to provide safe forms of saving to the private sector. But these bond issues no longer need to be tightly connected to the pattern of government spending and tax payments.

Overt Monetary Financing. One way to perform this operation is for the Treasury to issue bonds directly to the central bank. These bonds might or might not be interest-bearing. If they are, the central bank returns any profit to the Treasury. As always, government spending in excess of tax payments will add reserves. Under overt monetary financing, the central bank can simply allow the short-term interest rate to fall to zero.

Share

20 thoughts on “Government Spending Under Alternative Operational Arrangements in a Nutshell

  1. Pete,

    Baltasar Gracián once said: good things, when short, are twice as good.

    Very good post, both on account of its content and of its brevity.

    One suggestion to make things easier for those not in the know: add a link to each one of the three previous articles.One link for “Bond sales to the private sector”, another for “Interest on Reserves” and so on.

    Thanks for another great post, Pete

  2. Thanks, Magpie. I added in the three links. Unfortunately, I couldn’t assign one link specifically to each approach because ‘interest on reserves’ and ‘overt monetary financing’ are discussed together at both the second and third links. However, the first link does specifically relate to ‘bond sales to the private sector’.

  3. Hi Ralph. I like that option as well. Either that, or ‘interest on reserves’ with the interest rate on reserves set to zero.

  4. Pete

    Utterly off topic, but you might be interested, anyway.

    Prof. William Darity, Jr. on policies to address wealth/income inequality in the US, either aiming specifically at the disadvantages facing blacks in particular or at different minorities:

    “If you buy the black dysfunction story, then the key is for young black men to pull up their pants or the equivalent,” he says. “But that’s a very different policy from saying, well, we should assure all Americans a human right to work. Or even if we don’t talk about an employment guarantee, then at least the basic income guarantee.”

    “If we’re concerned about black-white disparities specifically and we want to have a race-specific policy, then I think we have to start talking about a program of reparations [for slavery].” (Darity and his wife, Kirsten Mullen, are currently completing a book that details how a reparations program might be executed, due to hit the shelves by mid-2017).

    “If we are not willing to pursue race-specific policies,” Darity argues, “then we need universal programs that are race-conscious in the sense that they will disproportionately benefit the most disadvantaged groups even though they are programs that everyone is eligible for.” One such program would be a Federal job guarantee.

    https://www.ineteconomics.org/perspectives/blog/heres-what-economists-dont-understand-about-race

  5. Hello,

    I am trying to learn MMT and I am totally confused by something. It’s commonly said in MMT (including this blog) that deficit spending adds to private savings. But the way I understand this shows that government is simply recycling funds from surplus units to itself as a deficit unit which does not increase the money stock:

    1. Government sells 100 bonds to the private sector
    2. Private sector receives 100 in bonds
    3. Government receives 100 in currency
    4. Government spends 100 in currency into the private sector

    So the private sector gets 100 back which is exactly what it had at the beginning before the bond purchase. The stock of currency has not increased, unless you count the bond. So how does deficit spending increase the supply of money?

  6. Hi mmt student. You are correct that the ‘stock of money’ (defined as currency plus deposits) will be unchanged as a result of government deficit spending matched by bond sales to the private sector. So, I think your uncertainty is only caused by thinking the MMT conclusion is different from what it is. MMT suggests the following impacts of government net spending matched by bond sales to the private sector:

    – increase in real output and real income, provided the economy is below full employment so that output (and not just prices) can adjust to the spending;
    — increase in net financial assets, which will be held by non-government in the form of bonds;
    — no change in the stock of money, defined as currency plus deposits.

    You may find this earlier post helpful:

    Critique of Riedl on Government Spending

  7. Hi Pete

    Thank you for clarifying. Another thing though:

    As deposits remain unchanged from deficit spending, do reserves also remain unchanged? Effectively, banks lose reserves from bond sales and then regain them when the government spends? Leading to the level of system wide reserves not rising during deficit spending?

    If so, do reserves only rise when the central bank conducts open market operations (ignoring QE) which not only increases reserves but also deposits?

  8. Mostly spot on, mmt student. There are further details at this link:

    Exercising Currency Sovereignty Under Self-Imposed Constraints

    As deposits remain unchanged from deficit spending, do reserves also remain unchanged?

    Yes.

    Effectively, banks lose reserves from bond sales and then regain them when the government spends? Leading to the level of system wide reserves not rising during deficit spending?

    Yes. This is the case when government net spending is matched with bond sales to the private sector.

    To flesh it out a little more, the order of key operations is:

    1. The central bank does a reserve add. This is the first leg of a repurchase agreement. The central bank adds reserves in exchange for already-existing bonds. Here, it is accepting the bonds as collateral. The reserve add offsets the depletion of reserves that will occur when the bond auction proceeds.

    2. Bond auction. This depletes the reserves initially added by the central bank in step 1.

    3. The central bank reverses the operation in step 1. The central bank debits reserve accounts and returns the bonds held temporarily as collateral. This subtracts reserves so as to offset the addition of reserves that will occur with the government spending.

    4. Government spends. This adds reserves.

    Scott Fullwiler has identified six steps in the process in the US case. They include the above four steps. They are discussed at the link provided above.

    If so, do reserves only rise when the central bank conducts open market operations (ignoring QE) which not only increases reserves but also deposits?

    Basically, the central bank uses open-market operations to negate any undesired impacts on reserves that would otherwise arise as a result of transactions between government and non-government.

    In the US case, there is a complication that the Treasury holds ‘tax and loan accounts’ with banks. Whenever it shifts funds from its account with the Fed to one of its tax and loan accounts, it has the effect of adding deposits and reserves. Whenever it does the reverse, it has the effect of subtracting deposits and reserves. The Fed uses open-market operations to offset these effects. In practice, the Treasury and Fed coordinate their actions to smooth out the impact on reserves.

  9. What is the point of the repo agreement in this scenario? Can’t the exact same thing be achieved by the treasury selling bonds directly to primary dealers without a repo agreement? So:

    1. Treasury credits securities accounts of primary dealers at the central bank with new bonds
    2. Treasury debits reserve accounts of primary dealers by the same amount and credits its own reserve accounts at the central bank
    3. Treasury spends its new reserves by crediting the primary dealers reserve accounts at the central bank when it spends
    4. Primary dealers now have their reserves back plus the bonds.

    Doesn’t this just achieve the same same outcome but without the need for a repo agreement? Or is the repo done for reasons not relating to finance but operations (e.g. not disturbing the banking reserve system)?

    Sorry to keep pestering you like this!

  10. No need to apologize. It’s a good question. If you haven’t already, though, it’s probably worth following the three links provided in the intro to the post.

    There are at least a couple of aspects to the answer. Keep in mind, in what follows, that from an MMT perspective, the whole charade is an inefficient and unnecessarily complicated exercise. To the extent that it is not just a relic of history, the motive is presumably to deceive the public into believing that the government has to borrow from the private sector in order to spend. (In that regard, it seems to be highly successful.) Since this is an obvious nonsense to anyone who stops to think about it — how can the currency issuer be reliant on others for its currency? — pulling off the deception requires muddying the waters so that the idea does not appear to be nonsense, or, even better, seems to be self-evident.

    Since the government has (needlessly) required itself to sell bonds to the private sector, it needs to make sure the auction succeeds. The first leg of the repo not only offsets the effect on reserves of the bond auction (described in the post) but also ensures that the auction (a) can and (b) will go ahead (discussed at the links provided).

    (a) From inception of a state money system, government spending or lending must occur before government bonds can be purchased (or taxes paid). The repo, by adding reserves, ensures that there are sufficient funds available with which the private sector can purchase the government bonds. The repo is an advance to the private sector, with the central bank requiring already-existing bonds as collateral. Far from the government borrowing from the private sector, it first lends to the private sector to ensure the bonds can be auctioned. Clearly, if there had never been previous government net spending, the private sector would possess no bonds to serve as collateral. Private-sector possession of bonds is evidence of prior government net spending.

    (b) The repo creates a demand for the new government bonds about to be auctioned. By adding reserves to the system, which earn little or no interest, private-sector agents have a clear incentive to swap the reserves for newly issued government bonds. Provided the government bonds offer somewhat better terms than reserves, the auction will succeed.

    As Kalecki observed on at least one occasion (I don’t have the text to hand to quote exactly), the government can always issue bonds pretty much at whatever interest rate it wants simply by creating the necessary financial conditions. In the present example, the necessary financial conditions are created by the reserve add (first leg of the repo). This both finances the private-sector purchase of government bonds and creates a demand for those bonds, including at a low interest rate. Of course, the effect on reserves of the first leg of the repo then needs reversing later.

  11. A sentence from my previous comment could do with some elaboration::

    Provided the government bonds offer somewhat better terms than reserves, the auction will succeed. (emphasis added)

    The phrase “somewhat better terms” is necessarily vague, because under an auction, the actual rate set will be determined by the last successful bidder (the marginal bidder). So, there is potential for the interest rate to drift up if demand is weak.

    However, this still is no problem for the government.

    In countries such as the UK, where the central bank is allowed to purchase bonds directly from the Treasury, the central bank can do so to the extent necessary to control the interest rate.

    In countries where this action is prohibited or severely curtailed, such as the US, the central bank can signal to dealers that it is prepared to purchase an unlimited amount of government bonds in secondary trading at a certain price, and so control the interest paid on government debt.

    In other words any upward movement in the interest rate set at auction is at the discretion of government, because the central bank can always step in either at the primary issue (if permitted) or in secondary markets to control yields.

  12. >In countries such as the UK, where the central bank is allowed to purchase bonds directly from the Treasury, the central bank can do so to the extent necessary to control the interest rate.
    OK that’s very confusing. I thought the central bank couldn’t buy from the treasury in the UK which was why the whole gilt edged market makers existed to begin with. I’ll do some more reading into that.

    After going over your previous posts earlier I’ve tried to clarify the operations in my mind with the government has a spender first and taxes and bond sales coming later. I was hoping you could tell me if I’ve understood this correctly. I’m going to give a hypothetical example where the government wants to spend 10,000 with 8,000 coming from taxation and 2,000 coming from bond sales:

    1. government spends 10,000 in reserves into banking system
    2. private bank deposits go up 10,000, bank reserves go up 10,000
    3. private sector pays back 8,000 in taxation back to the government
    4. private deposits go down 8,000, bank reserves go down 8,000
    5. 2,000 in bank reserves still remain, 2,000 in private bank deposits still remain

    6. government sells 2,000 in bonds to private banks
    7. bank reserves go down 2,000 replaced with 2,000 in government bonds
    8. banks sell those 2,000 bonds to private sector (pension funds, insurance companies etc.)
    9. private sector bank deposits drop 2,000, private bank liabilities drop 2,000
    10. private sector ownership of bonds rises 2,000

    Is that correct? I’m just a bit unclear on steps 8-10. Why do private banks (primary dealers) gain for selling their bonds to the private sector? It it just the drop in liabilities or is there another incentive I’m not seeing here?

  13. Yes, ignoring the order of events and the unnecessary operational twists and turns, your points 1-7 outline the effects correctly.

    I think your points 8-10 are actually stuff that happens afterwards as the primary dealers trade the bonds in the secondary market. So, it is really separate from the balance sheet entries shown in the earlier posts.

    When the non-bank public is permitted to buy some of the bonds at the primary auction, this will reduce reserves and deposits, since it is a vertical transaction between government and non-government. But when the non-bank public obtain them later, in the secondary market, this is a horizontal transaction within non-government. The decrease in their deposits and increase in their bond holdings are offset by an increase in the primary dealers’ deposits and decrease in their bond holdings.

    The dealers will normally make some profit out of the transactions, which is largely why it is in their interests to be involved in the process.

    The primary dealers have privileged access to the Treasury auction (privileged access to risk-free financial assets) and get to act as market makers. They bid prices at the Treasury auction that they believe will leave them room to make a profit when they on-sell the bonds.

    The government bonds trade at a bid-ask spread. The bid price is the price the primary dealer is willing to pay for the bonds. The ask price is the lowest selling price the primary dealer is willing to accept from buyers.

    OK that’s very confusing. I thought the central bank couldn’t buy from the treasury in the UK which was why the whole gilt edged market makers existed to begin with. I’ll do some more reading into that.

    Yes, the whole circus is probably intended to be very confusing. 🙂

    If the central bank is permitted to purchase bonds directly from the Treasury, then basically there is a mix of ‘overt monetary financing’ and ‘bond sales to the private sector’.

    Actually, even in the US, the central bank is permitted to buy *some* of the primary issue, but this can *only* be for liquidity purposes, whereas in the UK the central bank can buy whatever is necessary to fix the yield at its desired level.

    Rather than getting too hung up on the minor institutional differences, the key point is that the central bank can always create the financial conditions needed to ensure the government bonds are auctioned at a price close to that desired by government, and can fix the price completely if it desires because the central bank (in all countries) can purchase bonds in secondary markets without limit. This means, if it really wants, the central bank can control *all* yields on government bonds of any maturity.

    A couple of old billy blog posts are very helpful on this topic:

    Who is in charge?

    Things that bothered me today

    From the first of these posts:

    Two things that then arise from this:

    Can the bond markets dictate the cost of public borrowing?
    Can the bond markets close down a sovereign government?

    The answer to both questions is absolutely not! …

    The central bank can also control all rates along the yield curve (different maturities of investment assets) if it wants to. … [T]he central bank can announce explicit ceilings for yields on longer-maturity Treasury debt and enforc[e] those ceilings by committing to make unlimited purchases of securities (at those maturities) at prices consistent with the targeted yields.

  14. >When the non-bank public is permitted to buy some of the bonds at the primary auction, this will reduce reserves and deposits, since it is a vertical transaction between government and non-government.

    I wasn’t even aware that happened. I thought the non-bank public could only buy from market makers (primary dealers). That’s what led to me question why banks would sell those bonds downward to other institutions since interest bearing bonds are better to own than deposits.

  15. Hi Pete. I know this is an old(er) post but I was thinking about something you said above:

    “But when the non-bank public obtain them later, in the secondary market, this is a horizontal transaction within non-government. The decrease in their deposits and increase in their bond holdings are offset by an increase in the primary dealers’ deposits and decrease in their bond holdings.”

    Surely a horizontal sale of bonds between banks and non-banks does lead to an decrease in private deposits since primary dealers keep their deposits in reserves at the central bank (outside money) while the non-bank public keep their deposits in the private sector (inside money)? So by acquiring deposits from the public through bond selling, inside money shrinks?

  16. Hi mmt student. Good catch. If it is a bank selling treasuries to the non-bank public, I think you are correct. This won’t affect reserves, but will affect deposits, as you point out.

    But I think primary dealers have deposits at banks. So, if they sell treasuries to the non-bank public, it will leave both reserves and deposits unaffected.

    I double-checked a paper by Scott.

    Scott Fullwiler — Treasury Debt Operations: An Analysis Integrating Social Fabric Matrix and Social Accounting Matrix Methodologies

    He distinguishes between banks purchasing treasuries and primary dealers purchasing them. (For instance, see point 5 on p. 7.)

    The paper frequently mentions both reserve balances of banks and primary dealer’s deposits with banks.

    A couple of relevant excerpts (there are others in the paper):

    B. The Treasury’s auction settles as Treasury securities are exchanged for reserve balances (IP-2 to IA2-2), bank reserve accounts are debited to credit the Treasury’s account (IP-1 to IA2-2), and dealer accounts at banks are debited (IP-1 to IP-2).

    Notice, here, that there is explicit mention of both bank reserve accounts and dealer accounts at banks.

    Similarly:

    A. For the Fed’s repurchase agreement with dealers:
    i. Increase in Treasury securities held by the Fed (-TS) and decrease them for primary dealers (-(-TS)).
    ii. Increase reserve balances (RB) in bank reserve accounts (+RB for the Fed, -RB for banks).
    iii. Increase deposits for primary dealers (-Dpd for primary dealers, +Dpd for banks).

    Notice, again, in ii and iii the references to both bank reserve balances and deposits for primary dealers.

    See also points B and D on pp. 4-5 and Figure 2 on p. 5.

    The following Fed Reserve page on the Primary Dealer Credit Facility also explicitly mentions that “dealers participate through their clearing banks”:

    Primary Dealer Credit Facility: Frequently Asked Questions

    A few excerpts as examples:

    Primary dealers should contact their clearing bank to request PDCF funds …

    A primary dealer will be allowed to borrow up to the margin-adjusted collateral they can deliver to the Federal Reserve’s account at the clearing banks …

    The loans will be made available to a primary dealer’s clearing bank following the acknowledgment by the clearing bank that sufficient collateral has been placed in the New York Fed’s tri-party account at the clearing bank. This will take place around 5:00 p.m. each day.

  17. I was under the impression that primary dealers were banks though. As in, the firms who operate as primary dealers are indeed banks or subdivisions of banks. If they’re not the same thing, what’s the difference?

Leave a Reply

Your email address will not be published. Required fields are marked *