Thursday, February 5, 2015

A Simple Model for Government Borrowing

Brian Romanchuk has an interesting post on government debt. Brian's model describes 'reserves' and goes into the mechanics of government-to-payee transfers of deposits at a bank. I think this complexity obscures the true nature of government debt and the subsequent valuation of that debt. This post will describe a model that is much easier to understand.

At the Mechanical Money Blog, the goal is to build systems beginning with base components that the reader can understand as being sequentially plausible. Brian's much more complex model can be built from this base with little effort.

For purposes of this post, if the actions, cooperation, or trades COULD occur, pretend that they actually do. Then judge at the end to see if a reasonable, plausible financial model has been described.

Remember, we are discussing fiat money without physical backing (such as gold) to establish valuation.

Notice the importance of the Central Bank in the discussion. Remember that banks create money when a loan is made. Restated, a bank loan is always accompanied by a bank deposit in favor of the borrower. Remember also that a Central Bank needs no capital of it's own to perform a money making event. [1]

The Model

In the United States, we have a central bank (CB), the Federal Reserve Bank, that acts under charter from the Federal Government. It can be considered as an arm of the Federal Government. It produces a green money product labeled a “Federal Reserve Note”. This money product is available in both brief-case-compatible and electronic versions.

The United States Government has a Treasury department which acts to fund government. One of the functions of the Treasury is to borrow by issuing bonds whenever government funds threaten to become inadequate.

Periodically, a representative of the CB will meet with a representative of the Treasury and the two will exchange products. The representative of the CB will come to the meeting with Federal Reserve Notes and leave with Treasury Bonds. The representative of the Treasury will come to the meeting with Treasury Bonds and leave with Federal Reserve Notes.

Following the exchange, the CB will hold a bond and the Treasury will pay the obligations of government.

The reader can see that the CB has a risky asset but it paid nothing for it (except for the cost of printing). Government is happy because it can pay obligations.

Establishing Value

The reader must admit that the basic sequence modeled can occur and MUST occur in the broad scheme of macroeconomics. How is VALUE established?

The model states that government pays obligations with Federal Reserve Notes. It follows that all who accept the notes for payment are paid in full. The initial valuation of the notes is the prices negotiated by government with the private economy, the price to be paid in Federal Reserve Notes. For example, a week’s work as a secretary is traded for one week’s pay in Federal Reserve Notes.

The CB needs to set a valuation on the bond it holds. While the bond cost was only the cost of printing the Notes, any bank knows that this product trade can not go on for long unless the bond (to borrow a phrase from current Greek bond discussions) "is investment grade”. If the bond is investment grade, it can be sold to the private sector, which, in turn, creates conditions that allow the CB to buy and sell bonds from the private sector in an effort to control the value of the bonds.

How can the bank make a bond “investment grade”? The bank is a secondary player here. It issued the Notes and has a promise for return of the Notes, probably with interest. The CB is dependent upon government to fulfill that promise.

On the other hand, government has made a near impossible pledge. It is very difficult to return all the Notes. The first thing government did was to scatter the Notes into the economy where they can be held indefinitely or even destroyed. Yes, government can recover the Notes with taxation but that takes an indefinite period of time.

One possible path to investment grade bonds is for government to establish a credible pattern of taxation adequate to service the bonds. It follows that credibility could be lost by government refusal to tax or make any effort to actually repay the bonds.

Government has a choice of lenders

Following the initial sequence of money creating events (an exchange of products and government spending), government has two potential lenders as sources for future loans. It can meet with a representative of the CB (again) or it can borrow from the private sector. The choice will depend upon how government wishes to manage money supply, interest rates, foreign exchange, and a host of other practical concerns. And yes, maintaining an investment grade bond rating will be part of the consideration.

Today’s News

We can apply this model to today’s news about Greece. The European Central Bank (ECB) has just announced that they will no longer accept Greek bonds as collateral. The bonds are no longer “investment grade”.

The ECB is a bank that creates money by creating deposits. The ECB product, the euro, was established by trading euro’s (both briefcase and electronic versions) for government debt. The Greeks then destroyed the drachma and substituted the euro. The exchange was nearly without cost. Because each nation did this proportionally, the euro became a commonly traded currency in all participating nations.

Now, following today’s ECB announcement, a Greece Treasury representative will not be able to expand the euro money supply by meeting with an ECB representative and making a product exchange. The Greek Treasury still has the option of borrowing from the private sector.

Conclusion

Simple models have the great advantage that they can be easily understood and mathematically described. If there is basic validity, an accurate simple model can be expanded into real situations with added complexity. This simple model seems to pass that validity test.

[1] The European Central Bank began with "five billion euro in capital held by the member national central banks of the member states as shareholders". The shares "are not transferable and cannot be used as collateral". (quotes from the linked reference)

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