This article continues the sequence of articles on central banks as banks. This article was as brief as possible because it overlapped with my book Understanding Government Finance (available for sale at low prices in online bookstores, and I stress that this would be an amazing Christmas gift for friends and/or enemies (depending on what you think of my writing)). I may need to expand on the less obvious points here if this text makes it into my book manuscript.
Central banks largely evolved as they did because of the demands of wartime financing. The central government needs to control its financial operations in wartime, and any attempt at interference by the private sector would be considered tantamount to sabotage. For a freely floating state (and exchange rates are usually broken during major wars), the system ensures that financial flows will continue to flow.
As I discussed in Understanding public finances, the system is relatively simple, but it is not intuitive if we start from the false idea that the objective of public finances is to allow the government to “raise funds” from the private sector. Instead, the system simply allows the government to follow archaic accounting standards while ensuring payment flows remain circular.
Wholesale Payment System Summary
I will assume for simplicity that we have a wholesale payments system whose counterparties are only private banks and the central government, which we divide between the financial branch (“Treasury”) and the central bank. (Since the central bank acts as an agent of the Treasury, it is actually the central bank that is the counterparty, but we need to separate the Treasury for this discussion to make sense.) If the government opens the wholesale payment system to non-bank entities for any reason, we simply assume that non-banks must follow the same conventions as private banks. We also assume that private bank payment system balances will match balances held at the central bank.
We will also assume, for simplicity, that private banks would have to maintain their end-of-day balance with the $0 payment system (the pre-2020 Canadian system). If the system had positive reserve balances, then the goal ends up being that positive balance, which doesn’t really change the discussion here – there’s just a change in the level of the goal.
Under the reasonable assumption that the number of private banks is limited, the previous assumption implies that the total private sector net balance with the payment system ultimately is $0. Since the payment system is zero-sum, this implicitly implies that the consolidated balance of the central government is also zero (since it is the remaining counterpart of the entire private banking system).
This then implies that the net money inflow/outflow from the consolidated central government is $0 each business day. (It may be out of balance during the day, but it should be restored by the end of the day.)
Central government has cancel the Treasury
The implication is that if the Treasury has a net financial flow during the day, the central bank must undertake transactions that generate the opposite flow. (If the target for reserve balances is other than zero, the central bank must ensure that the change in the consolidated public balance corresponds to the change in the target level, if any.)
Let’s imagine that the government one day spent and taxed transactions that turned out to be zero, but the Treasury issued $10 billion in bonds. This means that the Treasury receives a monetary influx of $10 billion from the private sector – the bonds must be paid for by private banks, possibly under the instructions of clients who were the ultimate buyers of the bonds. Implicitly, the central bank has have a cash outflow of $10 billion for the balance target to be achieved. If the only assets the central bank holds are central government bonds/papers, it must sell $10 billion of old securities (or repurchase transactions) to match the $10 billion of new issues.
In other words, the central government did not attract “new money” from the private sector, it simply issued new securities in exchange for old ones.
It sounds strange, but that’s how math works.
No, the private sector did not “create” the money
One of the wild anti-MMT ideas is that the private sector “creates the money” that finances the issuance of the bonds. Yes, bank loans create banks, and these deposits can allow a non-bank customer to place an order in bond auctions. However, you could imagine a strange intermediary company that would allow its customers to exchange sausage cutlets for bonds at auction. This does not imply that government bonds are “paid for by wiener schnitzel”, but rather that there is a middleman who decides he likes wiener schnitzel. The intermediary itself must transfer “government money” over the wholesale payment network to the Treasury (technically, the central bank, since it usually holds auctions) to pay for the bonds, and the intermediary then deducts the deposit (wiener schnitzel) of his money. customer by agreement.
The private sector always begins the day with a balance of $0 public money – there is no reserve of “money” to drain to pay obligations; the central bank must provide “the money”.
Well, where do bonds come from?
An attentive reader will have noticed that the bond auction created exactly zero net holdings of government bonds during the day – the old bonds sold to pay for the new ones cancel the issue. So, where do the bond holdings (which are non-zero) come from?
The answer is not something like “When a mom bond and a dad bond love each other…” rather we need to abandon the hypothesis of canceling taxes and spending. If the Treasury runs a deficit in payments during the day, it sends money into the hands of the private sector. The central bank must reverse this – by selling the bonds it owns. This creates the net flow of bonds to the private sector.
As expected, the size of the budget deficit will determine the increase in public debts in the hands of the private sector (some of which could be bank notes, which must be paid by transferring money to the central bank).
Conventional accounting
So far, the analysis has been limited to the private sector, which is the counterpart of the consolidated central government. If we divide the Treasury and the central bank, we must also track the balance of the Treasury at the central bank. A sane society would argue that this balance is purely an accounting construct and can be ignored, but we don’t live in that society. Instead, we find that issuing bonds increases the Treasury’s balance with the central bank. Subsequent deficit spending will tend to lower this balance, and new issues are therefore necessary to maintain the positive balance.
As long as the central bank keeps interest rate markets functioning well – that’s literally its job – the Treasury will always be able to issue new bonds to keep its balance positive. at a certain price. (That is, if bond yields rise, interest rate spending increases.) Default is practically only possible if the central bank decides to force default. (Why “pretty much” – we can imagine non-financial reasons for default.)
Why issue bonds in the first place?
Anyone writing about this topic on the Internet will be faced with comments from MMT fans claiming that there is no need to issue government bonds, which allows the company to avoid the complex financial game described above. I will now review the conventional justifications for issuing bonds without endorsing them.
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It is necessary to respect arbitrary accounting rules (a positive balance at the central bank). It is not an economic necessity: changing the rules makes it disappear. I see this because some people refuse to accept that governments can unilaterally change regulations.
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It creates a yield curve to allow the private sector to benchmark its borrowing. While this is useful, it is a niche concern.
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The yield curve allows interest rate policy to control the economy. The usefulness of interest rate policy is an ongoing controversy between MMT supporters and almost everyone else.
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It provides assets without credit risk that are extremely useful for pensions and private insurance. Given that governments have pushed a significant proportion of voters towards private pensions (defined benefit and defined contribution), it is not easy to reverse such a policy at this stage.
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Having credit risk assets stabilizes the financial system. Private sector bond prices melt during a financial crisis; only central government bonds have any hope of retaining their value.
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Ending the issuances would put “bond vigilantes” and people who write about government bonds out of work. (As I am semi-retired, this is not a major concern for me.)
Concluding Remarks
Central banks were not created as charities to employ economists with delusions of grandeur, they are there to ensure the smooth running of public finances. The system is configured to allow extremely large transactions to be carried out. Making sure everyone can afford cheese poufs at the corner store is an afterthought.
With this article finished, I can turn away from the structure of central banks and begin to discuss some of the many controversies about them.