The Unlimited Financial Capacity of Currency-Issuing Governments

Policy responses to the COVID-19 pandemic, much like policy responses to the global financial crisis and Great Recession of a decade ago, carry a couple of clear macroeconomic lessons for anyone who cares to learn them:

1. A currency-issuing government faces no revenue constraint.
2. A currency-issuing government dictates the terms on which it issues debt.

It is not only electorates that, understandably, have been slow to appreciate these aspects of reality. Plenty of economists, perhaps with less excuse, also exhibit little understanding. The lessons had better be learned fast, or austerity will be applied once the situation attenuates on the spurious grounds of “paying for” the fiscal deficits of the present period. While fiscal restraint, in some measure, may turn out to be appropriate, depending on the presence or absence of inflationary pressures, “paying for” past deficits can never be a legitimate justification for a tightening of fiscal policy.

The first lesson – that a currency-issuing government faces no revenue constraint – follows from the fact that, in a sovereign currency system, government spending (rather than tax revenue or bond sales) comes first. Government spending is the initiating act in a sovereign currency system and is what makes the payment of taxes or bond purchases possible. The second lesson – that a currency-issuing government dictates the terms on which it net spends – follows from the fact that the central bank can control the rates of interest on public debt through its secondary market operations. The significance of this is not financial, since the currency issuer faces no financial constraint, but concerns any inflation risk that interest payments on public debt might carry through their impacts on consumption spending as well as any distributive impacts of the interest payments.

1. Government spending comes first in a sovereign currency system

Logically – and, in fact, temporally – the spending of a currency-issuing government precedes tax payments and bond sales. Since taxes and bond auctions only settle in money that the currency-issuing government alone can issue, government spending must occur before members of non-government can pay taxes or purchase bonds. A currency-issuing government’s spending is constrained by the real resources available to it, never by finance.

The point is most easily understood by considering a sovereign currency system at its inception. The government, by imposing taxes in its chosen money of account, and by specifying that taxes and other payments to government can only be settled in ‘money things’ of the government’s choosing (in practice, reserves), ensures a demand for the currency. Non-government is compelled to obtain the currency in order to pay taxes. From inception, it is obvious that this will be impossible until government has actually issued the currency.

Currency is issued whenever the government spends. In the act of government spending, the fiscal authority instructs the monetary authority to credit the reserve (i.e. exchange settlement) accounts of banks at which spending recipients have accounts, and the banks are instructed to credit the accounts of spending recipients. With government money now issued, it is possible for taxes to be paid, these payments being settled through the debiting of reserve accounts.

If the government taxes less than it spends, the difference will be left as reserve balances. If it wishes, the government can issue bonds (issue public debt) by offering a rate of interest somewhat higher than the rate paid on reserves (which can be zero or, for that matter, negative). The purchase of bonds, just like tax payments, will be settled through the debiting of reserve accounts.

In short, government spending creates reserves, while taxes and bond sales destroy reserves.

More generally, the government can also lend reserves into existence. Once the system is up and running, and the government has spent more money into existence than it has taxed out of existence, the deficits, if matched by public debt issuance, will leave non-government in possession of government bonds. The government can then contrive a sequence of actions in which it appears to borrow from non-government (auction off bonds) before it spends. However, the appearance is misleading. For one thing, it is only possible for the fiscal authority to auction off bonds because reserves are already in existence as a result of past government deficits. For another, if there are insufficient reserves in existence for the primary auction to proceed without causing interest-rate instability, the central bank must first advance to non-government the reserves that are needed to enable the auction to clear without causing the interbank rate to deviate excessively from target. In advancing reserves, the central bank requires non-government to provide government bonds as collateral, and these bonds can only exist, as just noted, because of prior government spending in excess of taxes.

2. Currency-issuing governments dictate the terms on which their debt is issued

When government elects to match its fiscal deficits with bond sales, the terms of issue (including the bond’s time to maturity and rate of interest) are entirely at the discretion of government. In particular, the interest rates applying to public debt are completely within the control of the central bank.

At present, many central banks are ensuring low rates of interest on public debt through the exercise of their unlimited capacity to purchase bonds in secondary markets. By committing to purchase bonds at a particular price, ostensibly for liquidity management purposes, a central bank signals to primary dealers that any bonds purchased at a primary auction on slightly better terms can be sold to the central bank for an easy capital gain.

These central bank purchases of bonds in the secondary market are conducted simply by crediting reserve accounts; in other words, by issuing government money in the form of reserves. Since the central bank can issue this form of money without limit, the interest rate on public debt is a policy variable. The whims of the private sector are irrelevant to the outcome.

If the government desired, the rate of interest on public debt could be set to zero permanently. In fact, if the government desired it, the rate of interest on public debt could be maintained at a negative rate simply by applying a still more negative rate to reserve balances. Banks, in aggregate, are powerless to rid themselves of unwanted reserves via transactions among themselves. The reserves can only be eliminated through transactions with government. If the central bank chose to apply a negative rate to reserves (which would essentially amount to a tax on reserves), banks would be willing to exchange reserves for short-term government bonds carrying a higher (even if still negative) rate of interest (since it would essentially reduce their tax burden).

Considering that the central bank dictates the rate of interest on reserves, and considering also that the central bank can purchase government bonds in the secondary market without limit, the private sector is powerless to inflict on a currency-issuing government an interest rate on public debt that the government itself does not in fact wish to pay. Therefore, talk of a currency-issuing government possibly “losing control” of interest rates on public debt is without basis. Any positive interest paid on public debt is always the result of a voluntary (and, arguably, dubious) decision by government to provide such a subsidy to the private sector for the holding of risk-free assets. The very reason the bonds issued by a currency-issuing government are risk free is because such a government faces no revenue constraint.