While I realise this is an unusual article for most AIM readers, it nonetheless provides a priceless piece of information one can take to the neo-liberal boffins who think governments run their economies the same as we run our households.
With thanks to Professor Bill Mitchell, this is what actually happens: With all government spending, the Treasury credits the reserve accounts held by the commercial bank at the central bank. The commercial banks are where the target of the spending has an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made to the account destined for the deposit (e.g. my aged pension).
The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.
Further, the target of the fiscal initiative (me), enjoys increased assets (bank deposit) and net worth.
This means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate, so it needs to ensure that competitive forces in the interbank market do not compromise that target.
When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.
But, there is no nexus that demonstrates these debt sales have anything to do with “financing” government net spending. The sales are a monetary operation aimed at interest-rate maintenance.
What happens when there are bond sales? All that happens is that the banks reserves are reduced by the bond sales but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.
The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).
There is no difference to the impact of the deficits on net worth in the non-government sector.
Mainstream economists would say that by draining the reserves, the central bank has reduced the ability of banks to lend which then, via the money multiplier, expands the money supply.
The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.
So the banks are able to create as much credit as they can find credit-worthy customers to lend to, irrespective of the operations that accompany government net spending.
It might be argued that the subsequent income flow from the debt holdings increases the capacity of the non-government sector to spend. This is entirely true but has to be seen in that context of an evolving relationship between total spending from all sources and the available capacity of the productive sector to respond to that spending in real terms (that is, increase output of real goods and services).
So, if there was an ongoing output gap (that is, there was high unemployment), then a responsible government would further increase its spending anyway. In the context, it would take into account the future income flows arising from any debt it had issued and adjust its discretionary spending accordingly to avoid pushing the economy beyond its real capacity.
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