RE: unlimited bond issuance and the interest rate

["Richardson, David (DPL)" <David.Richardson@xxxxxxxxxx>]

Greg Nowell wrote

> There is probably nothing more basic to economics than
> the law that increasing supply decreases price for a
> given demand curve.
>
> Consequently we would expect that a rapid increase in
> the production of bonds would decrease their price
> (raise the interest rate).  This has nothing to do with
> whether "there is enough money" to "fund" bonds.  It
> simply has to do with the price people are willing to
> pay for something which whose supply is increasing.
>
Since there has so far been no response I thought I might have a go.

It just sounds like ordinary economics to suggest that the more of
something there is, the lower will be the price.  Hence it just seems
crazy to suggest that the government could issue more of something
without seeing its price fall.  In the case of a government bond, any
reduction in its price means an increase in its yield.  That will
necessarily increase the ruling interest rate.  Hence the apparently
obvious proposition that government deficits/debt increases interest
rates.

We would all expect that the above would be a fairly close description
of what might happen in the case of a salt producer, to use Nowell's
example.  However, government debt, including money as a special case of
government debt, comes into being under very unusual circumstances that
also need to be spelt out.  Additions to government debt, or at least
additions to the nominal value of government debt, come about as a
result of government deficits, an excess of government spending over
government revenue.

By failing to spell out the context in which government debt comes into
existence we can fail to appreciate that the analogy with a salt
producer breaks down.

A government deficit can only come about in a closed economy (to keep
the example simple) if the private sector is willing to save sufficient
of its income to "make room" for the government deficit.  Otherwise
national income will grow until sufficient savings are generated and/or
higher taxes on the higher national output eliminate the deficit anyway.
This is just the ordinary unfolding of the multiplier process.  The main
point is that if there is still a budget deficit, it means that savers
are making equivalent savings - plus any needed to cover the difference
between corporate investments and savings.

It is also worth noting that the spending by government normally means
the payment by the government in cash (or a claim on the central bank,
which amounts to the same thing).  Hence the recipients of government
expenditure find they have additional financial assets.  They may save
the additional assets, either in the original form they are received, or
swap them for something else with a financial intermediary of some sort,
or they may spend them, leaving the next recipient of that money with a
new choice of how to dispose of the money/financial asset.  Of course,
revenue raising exercises present the equal and opposite scenario.  If
we have a government deficit we have an excess of those receiving
money/financial assets from the government and so we can concentrate on
them for the purpose of exposition.

Let us abstract from the corporate sector, just like we have with the
external sector, to keep things uncomplicated.  That would mean savings
in the private sector are equal to the budget deficit.  Now the budget
deficit represents the borrowing task, the value of the bonds and other
financial assets the government must "sell" to finance the deficit.  It
just so happens that is also exactly equal to the net financial assets
the private sector needs to find in order to park its savings.  I
emphasize the word "net" because we could have a level of financial
intermediation in which case the government issues bonds worth $100,
banks accept deposits from savers of $100 and put that money to work by
purchasing $100 in government bonds.  The net position of the banks is
unchanged, but individuals now hold greater financial assets and the net
liabilities of the government have increased.  Of course in principle we
could have many levels of financial intermediation between the
government's bond issue and the savings vehicle of the ultimate savers.
The important thing is that at the end of this process the net worth of
the private sector increases by $100 while the debt of the government
increases by $100.

The interesting outcome of all this is that the same multiplier effects
that bring savings into line with the budget deficit also have the
effect of bringing the demand for financial assets into line with the
supply of financial assets.  (At this point we could quote Keynes
extensively to show that he appreciated this point and, indeed, may have
been rather frustrated that few others seemed to follow the point at the
time.  That is rather a diversion, however, if anyone wants to follow
that up, I made reference to Keynes's views on this point in the
Cambridge Journal of Economics (1986) in a response to an earlier
article by Asimakopulos.)

So far in the story there is little for interest rates to do.  The
demand and supply of financial assets are brought into line through the
Savings = Investment identity.  Quite apparently if the private sector
accepts an excess of payments over receipts from the government, it will
thereby also be accepting the additional financial assets that creates.
At the current interest rate the amount held by (past) savers in
financial assets must necessarily be the amount issued by government and
other debtors.  If people hold more than they wish to - a possibility
that seems to be implied by notions of excess loanable funds, interest
rates will not necessarily fall to persuade them to hold the financial
assets.  Instead people will merely spend the excess, generating further
income for third parties, until eventually the "excess" finance is held
by people who want to hold the assets.  If in any sense one felt their
financial holdings are greater than they want, there are many ways of
dissipating that wealth. It is hard to imagine a disequilibrium that
might get a change in interest rates going.  Putting that differently,
whether I chose to spend my receipts rather than save them, there is
little consequence for interest rates.

Of course none of this is to suggest that interest rates will not
change.  Clearly transactions motives and other motives to hold money
are brought into play by the situations we have been discussing.  But
those changes would come about as a result of changes in income etc that
unfold over time.

All of the above follows from a government deficit.  This needs to be
carefully distinguished from a situation in which the composition of the
outstanding government liabilities is subject to change.  Central banks
can and do alter interest rates by changing the proportions of different
financial assets held by the private sector, especially the proportion
of interest bearing to non-interest bearing assets.  But this is usually
playing around with the different types of government debt, exchanging
bonds for cash, rather than being a question of the total debt
outstanding.  The two should be treated as distinct issues.  It is
likely that false conclusions are the result of confusing the total
government debt with the composition of that debt.

You would not want to generalise from any of the above arguments to
suggest it is always the case that the "government can ... set the level
of demand via an unconstrained issuance of bonds, with no effect on
interest rates or the value of money per se."  However, if there are
substantial interest rate effects and changes in the value of money
(inflation), it is not the issuance of debt that is likely to be the
problem.  We should instead round up the usual suspects.

We would want to conclude that debt is a case that violates "the law
that increasing supply decreases price for a given demand curve" perhaps
because we cannot insist on a given demand curve in the present context.


Sorry this posting is getting a little long, but Nowell has raised
important issues.






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