Saturday, January 19, 2013

The Redundancy of Issuance of Government Debt

Governments have been issuing debt since the 1693 issue of government bonds by Bank of England to fund England's war against the French. In the times when governments did not have seigniorage it made sense to borrow. After all the government was like any other entity such as firms or trusts. In the era of fiat money though, government debt issuance is redundant.
Here's why. The money that we take for granted in the day to day operations of the economy is not unicolored. There is so-called high powered money (HPM) and there is credit money. The most familiar form of HPM is cash (with Gandhiji on it!). However, there are other forms of HPM - probably more relevant in the modern economy. These are governments account balances with commercial banks and commercial banks' deposits with the central bank (RBI in case of India). Basically, all of government's transactions - capital or P&L - are settled in HPM of some form or other.
Credit money on the other hand is the money stock created by banks on the basis of their lending activities. Banks are constrained in their lending by the capital adequacy ratio. To the extent that they do lend though, they in effect create credit money. This money is used by all of us for transactions. Unless we cash out our deposits, most of our economic activities remain in the domain of credit money. Banks settle transactions amongst themselves using HPM and through the settlement mechanism offered by the central bank. However, insofar as the transactions are between two accounts of the same bank, there is no settlement and both account-holders are dealing in purely credit money of that bank.
When we pay taxes or buy government securities in the primary market or undertake any activity that requires us to pay some money to the government, the bank where we hold an account settles the transaction using HPM. In the mirror image, when the government pays for goods and services to private entities, the banks where the recipients hold accounts get HPM. In general the government receives as well as pays money around the year and the HPM balances with banks keep moving up and down within a band.
However, in most modern economies, banks are allowed to borrow HPM from the central bank - in India this is the repo mechanism. Banks borrow HPM by keeping government securities as a collateral. They are also allowed to keep money with central bank. In India this is called reverse repo when banks keep money with RBI. This is allowed to smoothen the HPM flows within the economy as government buys and taxes, borrows and repays and banks also settle accounts amongst themselves besides with government.

Now back to issuance of government debt. Think about what happens when government issues fresh debt. Let us assume for now that banks have no net borrowing from the central bank and all the HPM they have is already being used. With the issuance of debt monies have to be paid by private individuals buying the bonds to the government. They write cheques from their bank accounts. These banks as mentioned above have to settle this transaction with the government in HPM. In this case they have no spare HPM. Hence they will go and borrow it from the central bank at the repo rate. The central bank then credits the accounts of these banks with it with HPM. This HPM is then given to the government - through the government's account with the central bank. The government could have avoided the entire process and simply credited the accounts of individuals it wanted to pay (without "borrowing" elsewhere, thus creating new money). That amounts to "money-printing". This money is created out of thin air. However, one would notice that the HPM required to settle the government borrowing is also coming out of thin air - through banks borrowing afresh from central bank. M1 (same as HPM) has grown by the same amount in both cases. The issuance of debt has merely added additional tradable financial securities in the economy.

Since banks pay interest as per the repo rate to the central bank, the interest payment from government is mostly sent back to it through the interest payment on repo borrowing by banks. The process just ends up creating more transactions in a circle.

Would the permit to print money not let lose the scourge of hyperinflation? This is where the behavioral implications might seem to suggest some relevance for issuance of debt after all. When the government is printing money, it can start to abuse its powers (a la Second Wiemar republic). When the government is borrowing, the fact that this creates a longer lasting liability might deter it from doing so indefinitely. There could also be legislation about debt ceiling like one in US. The reality of course is that the liability created by the government is matched by the asset in the form of lending by central bank to commercial banks for HPM of the same amount - thus leading to no new net liability.

Money printing and debt issuance by government are effectively the same. There was a difference in the times of gold-backed currencies. HPM could not be borrowed indefinitely and the government's borrowing came out of a finite pot of savings stock limited ultimately by the amount of gold in the central bank lockers. In that context, money printing was anyway not on - beyond what was backed by real gold. In case of fiat currencies, government borrowing is same as printing money.

It would seem that the concepts of debt-issuance, money multiplier, money supply, crowding out are built on the foundation of a pre-1971 monetary system which no longer exists. The fiat money based monetary system of today's requires a completely new approach.