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.

Economic inequality

I have long thought about the causes, nature and effects of economic inequality amongst people. It includes inequality of income, wealth and opportunity. My first essay on this matter was written in September 2005 (available here). It attempted to forecast two long term paths of evolution possible as regards inequality. One was the utopian path where inequality dwindles with increasing average level of prosperity – due to reducing population, increasing stock of capital and increasing productivity. The other was dystopian path where inequality is forced down by uprising amongst the have-nots, but the overall prosperity on the decline. I had then taken no stand regarding which one was more likely.

The topic was brought forward in my thinking by what was probably an interesting set of co-incidences. Firstly, I recently came across and bought two books on inequality namely "Price of Inequality" by Joseph Stiglitz and "The Winner Take All Society" by Robert H. Frank, Philip J. Cook. One talks of the general increase in inequality in US in particular and its likely ill-effects on the American society. The second talks of the institutions which have evolved in the modern society – mostly informal, some formal – that make for a winner-take-all situation across most major walks of economic life.

Secondly, I happened to start reading "The General Theory of Employment, Interest and Money" by John Maynard Keynes, around the same time. I am still on the first few chapters. It is clear from this part already that Keynes was fairly unorthodox in his approach and wrote the book primarily to question the classical economic theory assumptions, and proposing an alternative. Part of the theory relates to the full employment ideology of classical economics and its theoretical limitations which make it so unlikely to observe in real life anywhere.

Thirdly, the latest issue of The Economist (link here and here), speaks of a progressive politico-economic system that attempts to reduce inequality without hurting economic growth. It echoes part of Stiglitz’s ideas including the claim that inequality now has reached a level that threatens prosperity of many (if not all, eventually) and is clearly sub-optimal. This is different from the typical neo-classical position that some amount of inequality is inevitable and probably even desirable to allow for genuine difference amongst individuals as regard their endowments, skills, risk appetite and some would say even luck. The desirability of inequality comes from its effect on entrepreneurial individuals who in the pursuit of individual riches end up enriching the society as well – through inventions, better run organizations, innovations, new products and so on. Some have now started wondering if the current level of inequality is well past the basic minimum required to get all these benefits.

My thoughts in this matter are driven by two independent starting points/positions. For one, I believe that the extent of opportunity, behavior of entrepreneurs, nature of institutions and intervention from government are not uniform across time and space to make any material statement about inequality which is general and universally applicable in nature. Coming to the specific question of current times, in advanced economies and in emerging economies, and especially in India, can we say that inequality is too high and is likely to start affecting collective well-being?

The west has it worse. The opportunities have gone down, corporations have started to become predatory, profit pursuit has pushed low end jobs out of the economies and service sector is reeling under real estate bubble burst and financial services crash. In the interim the capitalist institutions have made it difficult for all but the most innovative and lucky entrant to make it big (a Google here, a Facebook there but nothing else). The shortage of opportunities means that everyone is now looking to grab share from others rather than try to create new “pies”. The governments across the rich world are divided over their response. The left leaning ones (current US, France, Scandinavia) are using Keynesian fiscal intervention to boost falling incomes thus hoping inequality does not become worse. The right leaning ones (Romney’s US) are likely to go for lower fiscal spend and smaller government intervention. Beyond that though, as Stiglitz painstakingly details, rent-seeking on part of the established corporations is not always necessarily through explicit government largesse. A variety of other mechanisms persist. Depending on the relative strengths of the transparency-seekers (mostly NGOs and some individuals and rare politicians) on one hand and the rent-seekers (mostly large corporations in some industries) on the other this may play out to favor few or the many.

The emerging markets are not that badly placed. Growth has slowed down but not enough to warrant a grabbing of each other’s pie yet. There is a different problem that is starting to plague emerging markets though. The emergence of rentiers – connected with and benefitting from the government policies – is causing at worst loss of welfare and at best serious distraction from pursuit of prosperity by the general public and the well meaning companies.

The economic future of the emerging markets hence is likely to be strongly influenced by how the rentiers are handled. If they were to have a free reign, inequality will increase and to make matters far worse, people’s prosperity will not! The political and economic institutions in the emerging world hence have the nuanced task ahead of them – to leave the economic participants alone to pursue growth and prosperity while guarding against the most unscrupulous of the lot that is trying to grab economic rents (wealth without adding value).

The second starting point of my position is the relevance of wealth for individual well-being. Our global social evolution in last few years is towards the milieu of supremacy of money and wealth as the ultimate and overarching drivers of well being. This trend has been more pronounced in Anglo-Saxon world (US, UK), BRICs and Middle East while considerably attenuated in Western Europe and probably Japan. In general though, we have started implicitly or explicitly agreeing with the money income and consumption being the most important drivers of individual well-being.

This trend has meant a vigorous pursuit of higher incomes and consumption at the cost of much else. While the liberal position on this matter is to leave people alone to decide their preferences, the real life society knows that it influences the thinking and value system of its constituent individuals. Hence while everyone is free to believe what she thinks is right, she has to start some place in deciding this – and that’s where the social set up she finds herself in exerts the most powerful and yet most subtle effect. In the context of individual pursuits hence most individuals in the modern world are under a fair bit of pressure to earn more and spend more. There are more opportunities to earn and there are more avenues to spend.

The less heeded part of the equation though is that the link between consumption and well being is not linear. At low levels of consumption, more is definitely better. At higher levels, more is neither necessarily better nor worse. The rich are not miserable at all, but they are not happier as a rule. An empirical graph I came across in this connection showed a very low variation amongst individuals at the lower end of this consumption-wellbeing curve. This means at low levels of consumption, as income and consumption grows, most people become better off. Hence one can be confident of a trend. At high level of income and consumption the variation balloons. Now there is no trend. Some individuals get much better off with more income while others are unaffected and many become worse off.

If we took away the emotionally charged titles of the x and y axis and showed the scatterplot to any student of statistics or econometrics, she would tell us that these variables are not correlated – there is no statistically significant relationship between them. Hence it is most likely that at these levels of income people are better off or worse off because of entirely other factors – health, fame, meaning etc.

What does that have to do with inequality? Well, the optimizing optimist in me thinks that the informal institution of unlimited wealth pursuit that we as a society have established is in complete contrast to what our nature allows us and offers us in terms of well-being. Inequality, from the standpoint of a grand population level optimization, is irrelevant when it is relatively small but is terribly sub-optimal when it is large. It gets worse because of the constant reinforcing feedback it provides to the sub-optimal institution of unlimited wealth. Solutions? That is a long path! (The Economist’s special report on true progressivism might be good starting point, though)

Quantum mechanics and a revision of epistemological belief

I have signed up for a course on Quantum mechanics and quantum computation at coursera.com – a very interesting site for a wealth of short courses from 18 of the world’s best universities. As I went through the course, I came across a very intriguing characteristic of quantum mechanics namely the nearly untrue mathematical abstractness of it all.


To be fair, the greatest minds in quantum mechanics had always maintained that there is nothing intuitive about quantum mechanics. Consider this quote of Niels Bohr for example,

“If anybody says he can think about quantum physics without getting giddy, that only shows he has not understood the first thing about them.”

As I went through some of the basic principles, I realized how true this was. Coming to the more direct impact on my thinking though, I have been forced to revise my near-religious faith in the “trueness” of the theories of physics. From a rational point of view I have always believed (after the first year at IITB, post the course in introduction to philosophy) that no knowledge is certain, no theory is “right” (but many are wrong!) and there is no finality to any of our understanding of the world. Everything is tentative and subject to refinement – not only in calculation and observation but also in the very model of reality we have constructed on the basis of it.

However, emotionally I was always a believer in our current model of the universe – however incomplete it might be. The belief was that it was in the generally correct line – and needed refinement. As I think more objectively, it is qualitatively no better than the worldview few centuries ago (and I might even go a step further and say many thousands of years ago as well).

Why is that? Well, for one, quantum mechanics is a reaction to the various paradoxes observed at the atomic level (e.g. the wave-particle duality of photons). It does not seem to answer why nature is organized a certain way, it only aspires to describe its working in a manner consistent with observation. That in itself is an ambitious goal no doubt. The abstractions required to achieve “explanability” in quantum mechanics sometimes robs one of any intuitive feel for it.

That is an absurd criterion for something being right, I understand. Intuition is a faculty evolved in human beings for purposes entirely different from understanding the nature of reality. Hence intuition does fail very often while considering phenomenon far removed from day to day life in terms of size, complexity and duration. That does not make these phenomena non-existent or inexplicable. The description of such phenomena will hence remain a story legible to our rational minds but not to our intuition.

So far so good! But that also means I have no way of knowing if the theory is any closer to truth than the earlier one. It fits experimental observations better – but that is a very indirect and circumstantial evidence. One may point out that that is pretty much all on offer in the current organization of our present universe. However, that is tantamount to saying – this is life, live with it. It does not make the theories more accurate. Hence the abovementioned revision in my faith in physics.

What is the revised thought then? It goes as follows. Physics and allied sciences are human endeavours to understand the way nature works. They are supported by human faculties of analysis and imagination as also apparatus for making measurements to an appropriately desired level of accuracy. The models of reality produced by these endeavours are working prototypes of the way we see the world. Like any other models the following basic truth applies to them – “all models are wrong; some are useful!”