The purpose and function of Treasury bonds

Ellis Winningham

There are really only two reasons for Treasury bond issuance in any nation that issues a free-floating, inconvertible currency: one primary reason and one secondary, and neither are a necessity whatsoever.

The primary reason for bond issuance relates to the mechanics of establishing and defending a particular benchmark interest rate, and the secondary is to provide a risk-free savings vehicle for investors which is a consequence – a by-product – of the primary reason.

Because a bond acts as an interest- bearing savings account, it allows bond issuance to be used for political purposes (corporate welfare). Since the secondary reason is quite obvious, I’ll explore the primary reason. To understand the function of bonds as they relate to interest rate management, we need to understand the use of bonds in a former era. But first, let’s be clear that Treasury bonds, regardless of the era being considered, are a defence mechanism and are not a financing mechanism.

During the gold standard era, Treasury bonds were employed as a means to defend the supply of gold available to the national government. How bonds achieved this feat is relatively simple to understand. The government would issue bonds with various maturity dates, and offer to pay interest to anyone that held the bond; the interest payment being crucial because it acted as the incentive to entice holders of currency to buy bonds. There is a big reason why the government would want to entice currency holders to buy bonds which I will explain momentarily.

If the government wanted to participate in the gold standard, it simply had to exchange its currency for gold on demand, otherwise, the gold standard wouldn’t work. The government would “fix” an exchange rate by officially declaring that one unit of its currency was equal to a certain amount of gold. The government would then exchange its currency presented to it for gold at that fixed exchange rate. At no point in time could the currency-issuing government run out of its own currency, or said in common speak, it couldn’t run out of “money”, but it could run out of gold to exchange its currency for. Such a thing is highly problematic since gold acted as the price anchor, and if the government wished to deficit spend, it certainly couldn’t just print money under these conditions because doing so would increase the amount of circulating currency above the amount of gold in supply. In other words, there would be more dollars/pounds out there than the government could exchange gold for at the fixed exchange rate. So, to deficit spend, the government had two choices: Print more money and risk the negative effects, or offer bonds as a

means to entice currency holders to delay conversion to gold. The interest incentive is straight-forward: Either choose to take gold now, or buy a bond, wait for a for a few years and be given more currency via interest earned to exchange for even more gold in the future.

So, the national government would “borrow” back its own currency from those who purchased bonds and in doing so, the government halted attempts by currency holders to obtain gold for a time, and, thus, it defended the gold supply. But, unlike today’s fiat regime where the government always controls the amount of interest that it pays across the entire yield curve, during the gold standard, market forces determined the government’s “cost of borrowing”. The reason why is simple.

In a fiat regime, the government does not agree to exchange its currency for anything but its own currency. If you give Treasury a $10 note, it will only give you $10 in return as currency. With a gold standard there is a commodity involved here, that the government cannot produce or control, which can be exchanged for currency. That situation complicates matters.

In a fiat currency regime, if you don’t want to have dollars, well, that’s too bad. That’s all there is. But, with a gold standard, if you don’t want dollars, well, the government will give you some of its gold. All the government can do here is try to entice people not to convert from dollar currency to gold. That leaves the amount of interest the government must pay in the control of the market. Say the government offers 2% interest but the currency holders say, “Nah. I’d rather have the gold now, thanks.” In this situation the government must offer a higher rate of interest to entice currency holders to give up wanting to convert.

And so – it goes – if investors are deter- mined to obtain gold from the government, then no rate of interest offered by the government, no matter how high, will stop the demand for conversion – the government’s “cost of borrowing” takes off like a Saturn V rocket bound for the moon. All the government can do now is to officially end the gold standard by ending convertibility.

Incidentally, this is where the nonsense comes from that you hear from “wise”, “respected” orthodox US economists like Paul Krugman and Larry Summers concerning the government’s “cost of borrowing” skyrocketing if investors become displeased with the government’s spending habits. However you can safely ignore their narrative – it’s anti-knowledge. Pay it no mind.

So, defence of the gold supply was the purpose of treasury bonds during the gold standard. In today’s fiat regime, bonds play yet another defensive role – defending the central bank’s target interest rate.

Sovereign currency-issuing national governments today are determined to rely on monetary policy as the primary aggregate demand management tool. The idea behind monetary policy is to rely on bank lending rather than government spending to drive the economy.

To accomplish that, the central bank establishes the price of bank credit by setting a target interest rate. This is done by declaration. The problem, how- ever, is that you cannot just declare a target interest rate and all is well – you have to also defend the rate from a fall in the overnight rate (in the US, it is called the FFR “Federal Funds Rate”) which happens because of competition between banks for excess reserves in the banking system. The central bank uses the bonds to drain off excess reserves, halting the competition, and just like the government defended the gold supply, the government now defends its selected target interest rate.

But, since the legislature in the US – the Congress – forbids treasury to sell bonds directly to the central bank (note: this is not the case in Australia and most other countries –Ed), accounting acrobatics are required to achieve the defence: Treasury issues bonds into the primary market, the primary market pawns them off to investors in the secondary market and then, once in the secondary market, the central bank can obtain the bonds via open market operations. In this manner, Congress provides the public with the grand illusion that the bond market is financing government deficit spending. And on top of that, by Congress demanding that treasury issue bonds when the government deficit spends, and since bonds act as interest-bearing savings accounts, Congress also provides an endless corporate welfare gravy train for corporations and the wealthy.

Three cheers for political baloney: Huzzah! Huzzah! Huzzah! But none of this structured game-playing is necessary for a sovereign currency-issuing government to operate a monetary economy.

The government has two choices other than bond issuance completely at its disposal:

1.) The government could uselessly continue to rely on monetary policy and instruct the central bank to pay interest on reserves (IOR) which achieves the same objective as the issue of Treasury bonds: It defends the target interest rate by enticing those banks with a surplus of reserves to hold on to them rather than lend them to other banks on the interbank market, thus preventing competition for excess reserves and, therefore, the Treasury could stop issuing bonds altogether, or

2.) The government could put an end to its monetary policy fetish and instead rely on fiscal policy to manage aggregate demand by directing the central bank to maintain a zero percent interest rate target, which would allow Treasury the option ending the issue of bonds altogether.

The effect of doing this being straight- forward. In a zero percent interest rate policy regime, when competition for excess reserves on the interbank market causes the overnight rate to fall, there is nothing to defend. Which means that a zero percent interest rate policy does the same thing that Treasury bonds do – it defends a target rate of zero.

Source: Facebook posting, 12 Mar 2019 https://www.facebook.com/ellis.winningham/posts/2221930797865756