Mainstream macroeconomics tells us that governments need to sell bonds to fund their spending. That is, they obtain money by selling bonds. This removes liquidity and “sterilizes” the impact of inflation by giving investors a longer duration instrument. Or so the theory goes….
Some heterodox schools like the increasingly popular Modern Monetary Theorists (MMTs) say this is all backwards. They argue that the government issues bonds to help achieve a target interest rate and that the government has no need to issue bonds or tax in the first place because they can simply print money when they want to spend.
I think both of these theories are wrong. I will explain why in this brief post.
The MMT advocates are correct in that the government does not need to sell bonds to fund spending. They could simply credit bank accounts when they spend if they wanted to. After all, the government has its own bank and they have the ability to create money so why would they need to sell bonds to get money? In this sense, I agree with the MMT advocates that bond issuance is unnecessary. In fact, I think that the early iterations of QE proved that there is no meaningful difference between issuing deposits and bonds. After all, QE is ultimately a form of turning bonds into money in what is essentially the equivalent of the government issuing a deposit directly. And what we discovered during the post financial crisis iterations of QE was that inflation went DOWN despite this “debt monetization”. The composition of government financial assets isn’t what matters most. It is the quantity of government assets that matters most for inflation.
The Monetary Realism view on this is that the government issues various forms of financial assets with very high levels of moneyness. T-Bills, for instance, are considered cash and cash equivalents because they’re virtually indistinguishable from deposits. T-notes and bonds can be thought of as forms of longer maturity savings accounts. In other words, when the government issues T-Bills, notes or bonds they are issuing ultra safe money-like instruments that the private sector considers to be near equivalents to money. In fact, when the government funds spending by issuing lower interest bearing assets like T-Bills they reduce the interest income to the private sector relative to longer maturity instruments. This might explain why QE didn’t cause inflation. Despite there being money “money” in the economy the private sector’s net worth was unchanged and in their eyes nearly equivalent in terms of net worth. However, their aggregate income went down.
The conclusion from this is that the mainstream theory is wrong. Issuing bonds does not sterilize money because investors are largely indifferent to holding something like T-Bills versus deposits because both are nearly indistinguishable on a scale of moneyness.
Being able to issue cash/deposits, however, does not mean that the US government does not need to fund itself. After all, even if you can issue deposits there is still a real price for those deposits reflecting the demand for those deposits (the inflation rate). So even in a scenario where the government credits bank accounts directly when running a deficit, they still rely on the non-government demand for that money at a real price to sell it. Said differently, issuing money does not create its own demand for money relative to real resources.
This is where the MMT narrative goes wrong. Governments are not “self funding” even though they can issue their own money. Any entity in a credit based monetary system needs and benefits from income because it reflects the sustainability of their balance sheet and directly impacts the cost of expanding their balance sheet (if necessary).
For example, the USA and Somalian governments both have printing presses and the ability to tax and enforce laws. But the US government spends trillions of dollars a year while the Somalian government can only spend millions. The primary difference here is that the US government has a private sector that produces trillions of dollars per year in domestic income and resources. And so the government benefits from this by being able to leverage those resources and income into public spending. If the Somali government tried to spend as much as the US government they’d have to print trillions of dollars (as opposed to being able to tax AND print). This would result in hyperinflation because they don’t have the resources and domestic income to support that level of spending. In fact, the US government doesn’t even need to print money to spend trillions of dollars every year because they can simply redistribute existing money while the Somalian government doesn’t even have the option to print trillions without collapsing their currency. Said differently, it’s incoherent to say that taxes don’t fund spending because taxes reflect domestic resource production and domestic income and are directly linked to how much the government can ultimately leverage its balance sheet without causing a currency collapse.
But let’s be a little more specific here to clarify the matter. For instance, let’s pretend that XYZ Corp, a US based corporation, invents a world changing technology. As a result of this technology the firms gets revalued at billions of dollars and they subsequently pay out millions of dollars of income every year. This is endogenous value creation and income that can now be taxed. It’s value and income that wouldn’t otherwise exist. If a similar firm in Somalia invents a competing technology that fails because it is an inferior technology then the Somalian government has that much less domestic income and resources to leverage into public spending. Both governments can theoretically print trillions to fund spending. But the USA has a much more sustainable operating position because they can redistribute existing money by taxing the existing value of XYZ Corp and its income. If Somalia wants to spend the equivalent amount they have to print new money that isn’t supported by underlying resources. The USA isn’t better off because it has a better government or a better printing press. It is better off because it has better and more valuable private entities/resources that allow the government to leverage income and resources into more public spending.
Governments are unique in that they create the currency. This gives them the unique ability to create that currency from thin air (without having to sell bonds). But it does not mean that they do not need or benefit from having income. After all, in a credit based monetary system income is a reflection of the resources that support the capital structure. And a government with a bigger tax base has a more flexible balance sheet primarily because they can afford to spend money without having to expand their own balance.
In sum, government bond issuance is an antiquated process that does not sterilize money. On the other hand, direct issuance of cash would still be reflected in the rate of inflation as a real-time auction price. And that rate of inflation is directly related to whether that entity has abundant resources and needs to expand their balance sheet and vice versa due to a scarcity in domestic income. Therefore, although the government does not need to sell bonds to obtain money it still relies on income and non-government demand to fund its spending.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.