Lesson 2, Topic 7
In Progress

7. What role do government bonds play in deficit spending?

Lesson Progress
0% Complete

Government bonds are promissory notes issued by the state. The state turns its debts into securities and sells them to banks and private individuals. Why does it do so? In the orthodox understanding of money, it does so to acquire the money it needs for government spending. From the MMT point of view this is a misapprehension due to a lack of technical understanding of our two staged monetary system. 

If the state is the one with the currency monopoly and an inexhaustible central bank, then why would it need to get money from private agents that don not have this currency creation privilege? And on top of that, from where would banks and investors have the money to finance the state? Especially considering the fact that one cannot buy government bonds with the banks’ deposit money. Government bonds are exclusively available with the state currency, which is the central bank money, that nobody but the central bank can create. 

Government bonds lead us on the wrong track. In fact, government bonds do not have the purpose of raising money for the state, as the state is the one with the money monopoly. Government bonds have technical functions in the financial and economic system. Most importantly, the central bank needs bonds to regulate the amount of money in the central bank money cycle. We have seen above (in question 6) that in a two-stage monetary system, government spending must be translated by the banks into deposit money, resulting in double money creation. 

In the case of government deficit spending however, this money is not expiring through an equal amount of tax paying. Deficit spending therefore results in a permanent rise of money in both money cycles; but only the rise of deposit money in the accounts of households and companies is intended. On the contrary, the increase of central bank money in the banking system is an undesirable side-effect that interferes with the central bank’s ability to set its targeted positive key interest rate. 

If banks could keep the central bank money they receive in the course of their ‘money translation service’, they would cease to depend on constant short term credits from the central bank at the current key interest rate. To avoid this result, deficit spending is accompanied by the issuance of government bonds. Sold to the banks they function as a “money sponge”, absorbing the excess central bank money created in the banking system throughout the translation process. Thanks to this detraction of liquidity the banks are forced to continue to regularly ask the central bank for loans at the current key interest rate.

The key interest rate has long been the primary instrument for pursuing the monetary policy of central banks. In a zero-interest rate phase, like the current one in the era of COVID-19, government bonds would be dispensable for the central bank. However, many stakeholders are still hoping for a return of positive interest rates in the future and the comeback of a “normal” monetary policy. Even more so as it is hard to imagine the financial system without government bonds. They are the safest possible form of investment and an indispensable part of the business model of institutional investors such as banks and insurance companies. 

Private savers also appreciate bonds as they represent a safe investment; and this is where another aspect of the story comes into play. In economically prosperous times, government bonds which are sold to private individuals help to prevent inflation by reducing demand. Private individuals will buy them with their deposit money from the government, again with the ‘translation’ of the banks in the middle of this transaction. In this case, the bonds absorb the extra central bank money as well as a part of the deposit money created by the deficit spending. The ordinary people exchange their liquid deposit money for a permanent asset, thereby postponing their consumption for a predictable time, keeping the demand in the real economy stable, counteracting the risk of inflation.  


× Chat with us! Available from 10:00 to 18:00 Available on SundayMondayTuesdayWednesdayThursdayFridaySaturday