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Is a federal Treasury bond a “debt” or not? – J.D. Alt

The following is an extract from a larger article entitled A Modern Money Explanation, posted by J.D. Alt in the blogsite New Economic Perspectives on August 12, 2019 [1]. The original was written in the context of the U.S. federal government but the principles are applicable to the operations of the Australian federal government, and so we have changed some of the terminology accordingly.

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A thought experiment can reveal some truths. Ask yourself: could the Treasury pay for things – like, say, Medicare expenses – directly with Treasury bonds instead of using reserves (exchange settlement funds) to pay the Medicare invoices? Assuming there’s no statute to prevent such payments, the only question is whether the Medicare providers would accept the Treasury bonds as payment. If they were, in fact, willing to do that, then the Treasury, when it created a bond, would not be creating a “debt,” but would be creating “money,” as it was needed, to fulfil the spending assignments appropriated by the federal legislature. But why would a Medicare provider — or a climate mitigation contractor, or a community college administrator, or a pre-school daycare operator — agree to accept a Treasury bond for payments promised, instead of currency?

The answer is that federal Treasury bonds have a liquidity that is virtually equal to currency: anyone who receives a Treasury bond as payment can easily and quickly trade it for dollar currency. This interchangeability is unique to federal Treasury bonds. Corporate bonds or municipal bonds do not have the same liquidity for the simple reason that they each entail some level of real risk that the entity issuing the bond will be unable to redeem it or make its promised interest payment. Why do the Treasury bonds and corporate municipal bonds differ in this regard?

To see why, consider that corporations and municipalities – like small businesses and households – must earn the dollar currency necessary to redeem their bonds. If things do not go as planned – if corporate profits fall, or local tax revenues decline – then the future revenues that the bond redemption depends on fail to materialize, and bondholders lose all or some of their investment. The corporation or the municipality cannot simply issue new currency as necessary to make the bond good. Which is precisely what the central bank (in Australia the RBA) can and does do, without fail, in the case of federal Treasury bonds.

The federal government, then, does not have to collect tax revenues in order to redeem Treasury bonds. It does NOT depend on “future revenues” to repay its “debts.” If you want proof of this, simply consider that over the course of history, the federal government has issued and redeemed a vast quantity of bonds which have not been repaid with tax revenues. How can the federal government do this while our society’s families, businesses, corporations, and local governments cannot?

Our thought experiment shows: When the federal Treasury issues its bonds, it is issuing new “money”. Whether that “money” is spent directly to suppliers of goods and services — who then trade it for currency from the banking industry — or is traded first to the banking industry for currency — is an example of Albert Einstein’s “equivalence principle”: if you can’t tell the difference between two things, they are the same thing. Federal Treasury bonds, then, are nothing more than “future currency” that have value today precisely because their future value, and the interest premium they bear, is the most ironclad, risk-free, guarantee that exists in the modern world today. And the federal Treasury is authorised to create this “future currentcy” as needed, to pay for any expenditures authorised by the legislature.

For all of that, our thought experiment turns out to be unnecessary because a very simple operation – coordinated between the federal Treasury and the central bank – makes it possible for the Treasury to spend today the future currency it creates with its Treasury bonds. I’ll make this short:

  1. Federal Treasury issues a new bond.
  2. The central bank keystrokes new reserves – equal to the value of that bond – into a commercial bank reserve account in exchange for collateral.
  3. The bank trades the new reserves to the Treasury in exchange for the bond.
  4. The central bank returns the bank’s collateral in exchange for the bond.

End result: The federal Treasury has freed up some fiscal space, allowing it to spend new money equal to the value the Treasury bond just issued. The bank is returned to the same position it originally held. The central bank has on its balance sheet (i.e. within its assets portfolio) the newly issued Treasury bond. The central bank now “owns” something it logically doesn’t need at all, ever — future currency. If you want to run your own thought experiment, I’ll leave it to you to think that one through. (Hint: why does it need something it creates, as needed with keystrokes?).

The federal Treasury has created the money it needs to buy (from the people themselves) the non-profitable goods and services that the legislature has determined, through its democratic processes, are in the best interests of the nation.


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