Does the government of the United Kingdom (UK) need to borrow money? No, as the monopoly issuer of the currency it does not. So what is meant by government ‘borrowing’, and is it really borrowing in the same way that we as currency users borrow?
How 'borrowing' works in modern economies
One of the most misunderstood concepts in macroeconomics is government borrowing, and the mere mention of it seem to immediately illicit fear of impending economic decline. A monetarily sovereign country like the UK, with its own central bank, currency and resources does not need to borrow, per se. In fact, what we currently describe as 'borrowing' is really a government accounting adjustment.
What is a bond?
Fundamentally, government bonds are interest-bearing pounds. When you buy a government bond you are guaranteed repayment of the original sum invested at a set future date with a set rate of interest every year. Bonds can be issued by both governments and private companies to help fund their investments. However, bonds are only really necessary for fundraising purposes if the institution concerned is a currency user. Unlike a currency-issuing government, currency users do have to "find the money” for further investment.
When a monetarily sovereign government issues bonds it coordinates this operation with its central bank, which oversees its currency transactions. Together, they coordinate the auctioning of government bonds to the financial markets - that is, how many bonds are offered and how long they should last.
From the outsider perspective it looks like the government is collecting up currency from taxpayers and bond buyers so as to raise funds for public spending. This framework of thinking can be described as (TAB)S – taxing and borrowing precedes spending.
A country with its own central bank and currency is not inhibited by this (TAB)S framework. When they issue bonds, they are creating a different type of money, an interest-bearing currency. Some economists refer to government currency as “green pounds/dollars/yen” and government bonds as “yellow pounds/dollars/yen”. Every year that the government runs a deficit, more green currency is going into our pockets and more yellow currency is being created and saved.
In our recent history, governments have chosen to sell bonds to match its deficit spending. Thus, if the UK government spent £50 billion into the economy but only taxed back £40 billion, the government would issue £10 billion worth of bonds. When it does this, the government is facilitating the transformation of their green currency into their interest-bearing yellow currency, which is stored very safely at the Bank of England. Moreover, the pounds required to buy bonds exist because of the UK government’s previous deficit spending. Countries that spend in their own currency are effectively self-financing.
What are the markets for selling bonds?
There are two markets for selling bonds - the primary market and the secondary market. The primary market, where the buyers are called “primary dealers”, is where the UK government first sells its bonds. The main buyers here are Santander, Barclays, Deutsche Bank, NatWest and Goldman Sachs International. These are big institutions that hold large amounts of capital. The secondary market is where buyers will include pension funds, hedge funds, local government pensions, insurance companies and foreign investors. To win, and therefore purchase government bonds in both markets, bidders will begin to compete with each other by offering reasonable yield rates to win the bid. The bidders that offer rates closest to the government target, which are usually low, always win.
There are two important points worth noting here. First, the primary market is established by the government, and therefore it is the government that is ultimately in control. So whatever interest rate the government sets, bond-bidders have to match it as closely as possible. Over one third of the current global bond market trades at negative rates, because central banks across the world set the rates and make it so.
Secondly, the government is not desperate to ‘borrow’. Bond-bidders are eager to secure a Triple A savings account at central banks and if they bid at an unreasonable rate, they risk the chance of losing out to others.
Would our government have to borrow from other countries?
Some commentators suggest that countries need to borrow from their neighbours because they will hold their currency and convert them into bonds. But let’s consider how this process actually works in the UK.
Recent data shows that the UK had a trade deficit of £24billion in 2019. This means that more currency is leaving the UK whilst it receives a surplus in imports. The UK pays for goods in pounds and those payments are credited to other country’s current bank accounts at the UK central bank, the Bank of England.
So, with regards to the pounds it has accumulated from the UK, the ‘rest-of-the-world’ has a few options. They could invest, purchase more UK goods or they could sit on them, but they will not earn interest. Therefore, the rest-of-the-world is inclined to shift their collected pounds from their current account to a savings account at the Bank of England - bonds.
The Bank of England simply subtracts numbers from the rest-of-the-world’s current (reserve) accounts and adds those numbers to its savings (security) accounts. Those pounds are still sitting there, but now the rest-of-the-world is holding those interest-bearing yellow pounds instead of green pounds. When the time comes to pay back the rest-of-the-world, the Bank of England reverses these accounting entries so the rest-of-the-world’s security accounts get marked down, and their reserve accounts are marked up. This is a simple accounting adjustment, which is performed using a keyboard and a spreadsheet at the Bank of England.
Monetarily sovereign countries do not need to 'borrow' from other countries. We should cease describing government accounting as if it were a currency-user, or as if the gold standard is still in use. Using the wrong language is misleading and underpins our misunderstanding of our modern monetary system. The only item owed is a bank statement.
Some commentators argue that financial markets can sell off the assets of monetarily sovereign countries in order to drive down the price for bonds and increase the interest yield on them. Those who attempt to force sharp changes in the prices and interest of financial assets are normally referred to as ‘bond vigilantes’. Greece is held up as an example of what happens to countries that don't accept the will of financial markets, but are monetarily sovereign countries really at their mercy ?
The short answer is no, and we can use the UK as an example. First, since the rest-of-the-world has a trade surplus with the UK it cannot avoid accepting pounds sterling. The only way to do that would be to flip their trade surplus with the UK into a trade deficit. This cannot happen overnight and it is unlikely to happen anytime soon, especially since the UK has mostly run a trade deficit for the last twenty years.
Second, countries with their own currency would not be in the same situation as Greece. When Greece abandoned the drachma in 2001, it lost its monetary sovereignty to the European Central Bank. This meant that Greece’s debt is redenominated into a currency that it is not the monopoly issuer of, therefore Greece is forced to use taxation and bond issuance to raise funds for additional government spending. Anyone who purchased Greek bonds was taking a risk not faced by countries with their own currency – a default risk. This is because Eurozone countries can literally run out of Euros and when such a risk exists, financial markets will demand a premium when lending to a state that cannot guarantee a return. This was a problem faced by many EU countries during the 2008 financial crisis, which was then followed by the 2009 Eurozone crisis.
During the 2008 financial crisis Greece suffered huge job losses, declining tax revenues and a spike in demand for welfare protection. Greece was forced to push the country’s government deficit to 15% of GDP in response, which is well above the arbitrary 3% rule of the EU. NB - These rules are more accurately described as recommendations for monetarily sovereign countries within the EU, since they don’t face the same harsh financial fines. As Greece no longer controlled its own central bank, they could not clear all its payments. Thus lenders were unwilling to buy Greek bonds unless they yielded high interest. From 2009 to 2012 the interest on 10-year Greek government bond increased from 6% to over 35%. This is what resulted for a European country that was forced to accept the (TAB)S framework.
A monetarily sovereign country like the UK did not face the same risks as Greece because it uses the S(TAB) framework – spending precedes taxing and borrowing. The UK government deficit increased to 10% of GDP in 2009, but the interest on 10-year UK government bond decreased from 3.6% to 1.8%. A similar decrease was observed in most monetarily sovereign countries who can always meet the payments denominated in their own currency. This reassured the financial markets that they would see a return when they created savings accounts with these country’s central banks - bonds.
Financial markets also accept that monetarily sovereign countries have control over their interest rates and the main interest rate that central banks focus on is the overnight rate. As macroeconomics Professor Stephanie Kelton states – “They rigidly fix this rate and then allow longer-term rates to reflect market sentiment about the expected future path of the short-term policy rate. That means that the interest rate that’s paid on the longer-term government bonds is related to the overnight rate that its own central bank is setting.”
Some countries go even further to control their long-term interest rates and the Bank of Japan has recently created bonds that yield interest at almost zero percent. To do this, the Japanese government sold ¥6.9 trillion of Japanese Government Bonds directly to the Bank of Japan in June of 2019. Japan achieved simply by using their monetary levers - this is something that all monetarily sovereign countries can do. So, whilst financial markets have some influence over the interest rate that monetary sovereign countries must pay on bonds, the government is ultimately in charge.
Can we meet the interest payments on bonds?
Clearly, a monetarily sovereign government can always issue its own currency to pay the interest on its bonds and that creates an income for the bondholder, but will this create inflation and subsequently reduce the purchasing power of the bondholder? It is true that inflation is a primary economic factor that a monetarily sovereign government should focus on. However, the inflationary risk through interest on bond payments is relatively small.
Consider the population demographic who hold bonds. The macroeconomic term - 'Marginal Propensity to Consume' (MPC) refers to how the extra currency we receive through tax cuts or pay rises will be spent into the economy. MPC data reveals that the bonding-holding demographic, who are the wealthiest in society, have already consumed what they need and most of what they want. So instead of investing money directly into the economy via spending, they will purchase shares, stocks and property. So whilst there is no sudden increase in ordinary price inflation, as measured by the Consumer Price Index (CPI), there is an increase in asset inflation.
Secondly, recall that the UK currency is going to the rest-of-the-world through the trade deficit. However, the foreign beneficiaries of these UK bond interest payments have a limited impact on the real economy as measured by the CPI. This does, and has presented new challenges, as increasing the value of assets may lock-out regular consumers from certain markets. The obvious example is property, which is currently used as a speculative vehicle. However, these problems can be resolved in multiple ways, such as targeted tax increases, maintaining low interest rates or creating a government body such as a Scottish Foreign Investment Review Board. But whatever challenges come our way, a monetary sovereign country can always pay interest on their bonds.
NB Many traders may use third parties such as Transmate to convert their currency before making any trade.
Kelton S, The Deficit Myth. 1st ed. London: John Murray; 2020