Written by Philip Pilkington, Article of the Week from Fixing the Economists
Endogenous money advocates often think that a central bank is required in order to offset increases in government borrowing. The story goes: the central bank targets the overnight interest rate by buying up government securities; if the government issues more debt in the form of securities to increase spending the central bank will soak this debt up to maintain the target interest rate. Thus government spending cannot cause higher interest rates. Rather the interest rate is set by the central bank.
This is a nice story. I tell it myself sometimes. It is easy to communicate and it usually causes anyone arguing otherwise to pipe down. But there is a much simpler and more fundamental argument for endogenous money. It is the one that we can use to explain the historical statistics in various countries. Let us turn to these first.
Now, we know today that the central bank targets a rate of interest and buys government securities but it is not so clear that this is what happened in, say, Britain in the 19th century. They operated under a gold reserves system and the central bank had not yet articulated its own role as setting the rate of interest. Yet, the Bank of England have clearly shown in a fantastic paper entitled The UK recession in context — what do three centuries of data tell us? that government borrowing in the UK never really affected bond yields. Take a look at the graph below from the paper.
See that red circle? Well, that is an era in which government deficit-financing is rising enormously while the interest rate on bonds… falls! That seems somewhat at odds with the hoary old tale that rising government spending not backed by rising taxes leads to a ‘crowding out’ of investment and hence a rise in interest rates now doesn’t it?
So, how do we account for this? Well, it is quite simple really: when the government sells securities to the private sector the money that it receives gets spent back into the economy. This means that it accrues in someone else’s bank account. Thus the net amount of reserves in the system does not actually change. The effects on interest rates come from another sector entirely. Let us first look at the above statement in more detail.
