So I thought I'd do a few scenarios to show what happens when different types of private sector actors buy and sell government bonds.
Firstly, let's look at primary issues. Government issues sufficient bonds to sterilise its entire deficit spending. This is normal fiscal behaviour.
Primary issue: bonds entirely bought by banks
I'm going to consider the banks in aggregate here, rather than as individual entities, and I'm going to assume that the same banks also intermediate government spending. As I noted in my previous post, in the absence of pre-funding, governments will run overdrafts at commercial banks when paying private sector agents. In practice, governments usually pre-fund spending commitments with bond issuance. So there are two versions of this scenario.
Spending precedes bond issuance: Government runs overdrafts at the banks. The proceeds of bond issuance pay off these overdrafts. But in this scenario, the banks that have granted the overdrafts also buy the bonds. This is an asset swap for the banks: it replaces loan assets (drawn overdraft facilities) with bonds. There is no change in the banks' liabilities. So M3 rose* when government drew on its overdrafts, as explained in the previous post, but it did not fall when the banks replaced loan assets with bonds. The government's deficit spending is NOT sterilised.
Bond issuance precedes spending: banks buy bonds from government instead of granting overdraft facilities. The proceeds from the bond sale go into the government's deposit accounts (which therefore have POSITIVE balances). Government then draws on that funding to meet spending commitments. This is exactly the same as lending to government and the accounting is identical. Banks create new deposits to the value of the bonds, which raises M3. When the government spends the money created, the liabilities move from bank to bank but there is no change in the aggregate liabilities of the banking sector. So M3 is created as a consequence of bank lending to government (bond purchases), not government spending.
In summary, a primary auction bought entirely by broker-dealers does not sterilise government deficit spending. It is simply an alternative version of bank lending to government, which raises M3.
However, there is a complication. In some versions of primary issuance via banks, banks pay the central bank for their purchases from their reserves, and the central bank reimburses the fiscal authority via its account at the central bank. This is a drain of M0 (the monetary base), not M3**: the commercial banks exchange reserves for government bonds, leaving their liabilities unchanged, and the transfer of reserves to the government's account takes them out of circulation. However, because private sector agents to whom government makes payment don't have central bank reserve accounts, government must still make those payments via commercial banks. In this mechanism it does so via the central bank, which credits the reserve accounts of the payees' banks: the banks then create deposits on behalf of the payees to the amount of the transferred reserves. Both M0 (reserves) and M3 (deposits) therefore rise. The combination of reserve-funded bond purchases and reserve-funded government spending leaves M0 unchanged, but banks still have to sell government bonds to non-banks to sterilise M3.
Primary issue: bonds bought entirely by non-banks: Again, we have two versions - bond issuance after spending, and bond issuance prior to spending.
But there is an additional complication. Non-bank asset purchases are always intermediated through banks, and non-banks may borrow from banks either to finance the purchase itself (unlikely, admittely) or to fund other spending as a consequence of bond purchases. So let's look at how this works.
Spending precedes bond issuance: Government has drawn overdrafts at banks. When non-banks buy the bonds, they pay from their own deposit accounts into government accounts, extinguishing the drawn overdrafts. If non-banks make these payments from existing funds (i.e. balances on their deposit accounts were positive prior to payment and either positive or zero afterwards), then the extinguishing of government overdrafts reduces M3 in exactly the same way as paying off any other bank loan does.
But if non-banks themselves borrow from banks, then the reduction in M3 from the extinguishing of government overdrafts is offset by the rise in M3 due to new lending to non-banks and there is no change in the broad money supply.
As M3 rises initially when the government draws its overdrafts (because banks create money), this means that debt-financed (leveraged) purchases of government bonds by non-banks do not sterilise government spending, but purchases from existing funds, say by cash-rich pensioners (Government pensioner bonds, for example) do.
Bond issuance precedes spending. As before, when non-banks buy the bonds, they pay from their own deposit accounts into government accounts, increasing the balances in those accounts. Government then has positive balances in its bank accounts and subsequent spending has no effect on M3. But whether M3 is raised by the non-bank bond purchases depends on how they are financed. If non-banks borrow from banks (including temporary overdraft facilities) to fund the purchases, then M3 rises due to new bank lending and government spending is not immediately sterilised, though it would be when the non-banks extinguish the loans or overdrafts. If non-banks fund the purchases from existing funds, it is simply an asset swap for the private sector, payment is intermediated through the banking sector without affecting the size of its aggregate balance sheet and there is no change in M3.
For government spending to be fully sterilised by bond issuance, therefore, bonds must be issued to NON-banks and paid for with existing funds. In practice, primary issuance is primarily bought by banks, so does not sterilise spending.
Central bank monetisation of deficit spending: If the government borrows directly from the central bank to fund deficit spending with no bond issuance, then both M0 and M3 rise ***. The central bank creates new reserves (M0), which initially go into the government's account at the central bank but are then disbursed to reserve accounts at payees' banks as the government spends. Alternatively, the central bank simply creates the reserves as the government spends, placing them in the appropriate reserve accounts and creating an equivalent loan asset (overdraft) for the government. The loan asset is simple balance sheet accounting between two parts of the government, which disappears in consolidated accounting, but the monetary base increase is real. As before, when the new reserves are distributed to bank reserve accounts by the central bank on behalf of government, the banks create deposits in payees' accounts, which increases M3.
Now let's look at the effect on broad money of trading in the secondary market.
Secondary market effects
Trading in the secondary market does not change the quantity of bonds issued, unlike a primary auction. But it does affect the broad money supply. This is because actors in the secondary markets include both non-banks and banks, and bank trading activity changes the money supply: banks create money when they purchase assets and destroy it when they sell them.
The chief benefit to a bank of buying bonds from government rather than lending directly is that the bonds are liquid. They can be sold, to other banks or to the general public. When banks do this, the broad money supply changes, as I explain in the following examples. To keep things simple I'm going to pretend that all trades are OTC and bilateral.
Bank buys government bonds from another bank: This is simply an exchange within the banking sector and there is no net change in assets & liabilities. The buying bank increases M3 when it makes the purchase, because it creates money to do so, but the selling bank decreases M3 because a loan obligation (the bond) has been extinguished. The balance sheet of the buying bank increases, that of the selling bank shrinks. There is no net change to the aggregate balance sheet of the banking sector and therefore no change in M3.
Non-bank buys government bonds from a bank (and pays for them from existing funds): The size of the selling bank's balance sheet is unchanged, since the government bond is replaced with an equal cash asset (an asset swap). The size of the non-bank's balance sheet is also unchanged, since a bond purchase from existing funds is also an asset swap. However, the liabilities of the bank from which the non-bank makes the payment reduce, as do its reserves. Overall, therefore, the balance sheet of the banking sector shrinks and M3 falls.
Non-bank buys government bonds from another non-bank: This trade is intermediated through banks. As far as the non-banks are concerned this is simply an asset swap on both sides and there is no change in the aggregate non-bank balance sheet. Importantly, if the purchase is made from existing funds (no leverage) there is no change to the aggregate balance sheet of the banking sector and therefore no change to M3. But if the purchaser borrows from the bank to fund the purchase, even temporarily, M3 rises and remains elevated until the temporary loan is extinguished.
Summary and conclusion
When banks purchase primary bond issues from government, government spending is not sterilised. Sterilisation of the monetary effects of government spending happens when banks sell on government bonds to non-banks, unless non-banks borrow from banks to fund the purchases or cover consequent shortfalls.
In practice, government spending does increase the broad money supply even if it is fully covered by bond issuance. Bond issuance cannot wholly sterilise it, because banks don't sell their entire holdings of government bonds - they retain a substantial proportion as collateral for repo funding. Opportunity costs for non-banks, too, may lead to incomplete sterilisation due to higher bank lending to non-banks. So it is probably fair to say that bond issuance is not a very effective way of sterilising the monetary effects of government deficit spending. Taxation is the only fully effective means, and even then only if it is efficient, which most tax systems are not. Over time, therefore, we would expect persistent government deficit spending to increase the broad money supply.
Whether or not the increase in broad money arising from incomplete sterilisation of government deficit spending - or even outright monetisation of government deficit spending by the central bank - is inflationary in my view depends on how the money is distributed and the purpose for which it is used. I think it is fallacious to assume that increasing the quantity of broad money, whether through central bank money creation, government deficit spending or simply through higher bank lending, necessarily raises consumer price inflation. Looking at the quantity theory of money equation:
MV = PY
with M defined in this case as M3, we can see that an increase in P (inflation) is only one of the possible consequences of a rise in M. There could be an increase in output (Y) with no effect on inflation, or there could be no effect at all because people just sit on the money (V falls). Or, not shown in this equation, asset prices could rise.
I don't propose to discuss this any further here. Better folk than me have had endless debates about it. At JP Koning's suggestion, I refer those who are interested to Tobin's theory of reflux, Yeager's refutation of it, and more recently the extended argument between David Glasner, Nick Rowe and many others. The causes of inflation are endlessly puzzling and supply-of-money theories are hopelessly inadequate. As ever, in monetary economics, it just isn't that simple.
The fiscal theory of monetary expansion
Printing clever weird stuff - aka money - Principles & Interest
When wonks get things wrong - Pieria
Inflation is always and everywhere a political phenomenon - Pieria
Money creation in the modern economy - Bank of England (pdf)
* Throughout this post I've used M3 to mean broad money. US readers should mentally change this to M2 as the Fed no longer produces M3 figures. All the money creation I discuss in this post would form part of M2 as well as M3 - indeed much of it would be M1.
** The use of reserves to buy government bonds in a primary issue was omitted from my previous post. Thanks to all those who alerted me to this alternative.
*** I got this wrong in my last post:
"An alternative to bond issuance for draining M3 is borrowing from the central bank. Yes, I mean it. If a government borrows from the central bank to pay down a commercial bank overdraft, M3 falls. The monetary base M0 rises as a consequence of this borrowing, but this does not affect the economy unless commercial banks increase their lending to households & businesses or the central bank prints more physical currency."