I have all that much time today to write this up and it is going to be one of those multi-part blogs given the depth of the historical literature I am digging into. So this is Part 1. The topic centres on an agreement between the US Federal Reserve System (the central bank federation in the US) and the US Treasury to peg the interest rate on government bonds in 1942. What the agreement demonstrated is that a central bank can always control yields on government bonds, which includes keeping them at zero (or even negative in the current case of Japan). What it demonstrates is that private bonds markets, no matter how much they might huff and puff about their own importance or at least the conservatives who are ‘fan boys’ of the bond markets), the government always rules because of its currency monopoly
There is a rich set of documents now available, which help us understand what the 1942 agreement was all about.
There was also a special edition of the – Economic Quarterly, a quarterly publication put out by the US Federal Reserve Bank Richmond branch in the Winter of 2001, which “commemorated the 50th anniversary of the Accord”.
It is very interesting to read through the historical documents and the more recent (2001) interpretation of them.
On December 7th, 1941, the Japanese bombed Pearl Harbour, which provoked the US to formally enter the World War 2 conflict in an allied alliance with the United Kingdom and the Soviet Union.
On December 11, 1941, war was declared between Germany and Italy and the US.
In April 1942, as the US ramped up the prosecution of its War effort, the Treasury Department requested that the US Federal Reserve Bank use its monetary policy operations to maintain:
… a low interest-rate peg of 3/8 percent on short-term Treasury bills. The Fed also implicitly capped the rate on long-term Treasury bonds at 2.5 percent.
That is, control yields on government debt across a broad maturity range. By controlling the short-end of the yield curve (the structure of interest rates by maturity of the debt), the central bank would condition the longer term rates.
And they could directly control the longer rates, which would then influence the cost of investment type borrowing by the private sector.
All in a day’s work for a central bank that works in harmony with the fiscal authority.
The aim of the US Treasury was:
… to stabilize the securities market and allow the federal government to engage in cheaper debt financing of World War II …
The President, Harry Truman and the Secretary of the Treasury John Snyder were both, not only motivated by a desire to keep the ‘cost’ of borrowing down for the Government, but also, importantly, “to protect patriotic citizens by not lowering the value of the bonds that they had purchased during the war”.
What did they mean by that?
To fully understand that, we need to briefly understand how bond markets operate.
Ignoring specific nuances of a particular country, governments match their deficits by issuing public debt. For Eurozone Member States this is a funding operation, for other fiat currency issuing states it is a reserve draining operation.
What needs to be understood that in this fiat currency era where nations can float their exchange rates at will (if they issue their own currency), the act of issuing debt is a totally voluntary act for a sovereign government.
The only purpose debt-issuance serves is when it is used as part of a monetary operation (to maintain central bank control over target interest rates). And even then, it is unnecessary because the central bank can just pay a competitive return on excess reserves.
It does not have to drain them via open market operations (selling debt in return for extinguishing reserves).
But what we clearly know is that for a currency-issuing government, the debt issuance is entirely unnecessary for its spending decisions.
The practice of debt-issuance gives the impression that the borrowing is funding the spending but that is a chimera. The arrangements that motivate that perception are ephemeral and can be altered by the government should it have the will to do so.
Which is what happened in 1942 in the US.
To understand bond market auctions etc, we distinguish between a primary market and a secondary market.
Governments (more or less) use auction systems to issue debt. The auction model merely supplies the required volume of government paper at whatever price was bid in the market. Typically the value of the bids exceeds by multiples the value of the overall tender.
The primary market is the institutional machinery via which the government sells debt to a select group of nominated banks and financial institutions, who ‘make the market’.
The secondary market is where existing financial assets (that were previously issued in the primary market) are traded by interested parties. This is where the speculators live.
So the financial assets enter the monetary system via the primary market and are then available for trading in the secondary.
Clearly secondary market trading has no impact at all on the volume of financial assets in the system – it just shuffles the wealth between wealth-holders. In the context of public debt issuance – the transactions in the primary market are vertical (net financial assets are created or destroyed) and the secondary market transactions are all horizontal (no new financial assets are created).
Please read the following introductory suite of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3 – for basic Modern Monetary Theory (MMT) concepts.
The way the auction process works is simple. The government determines when a tender will open and the type of debt instrument to be issued. They thus determine the maturity (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds).
The issue is then put out for tender and demand relative to the fixed supply in the market determines the final price of the bonds issued. Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.
Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations. In this case, the bond is unattractive and so they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.
The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.
When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).
When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.
So for new bond issues the government receives the tenders from the bond market traders which are ranked in terms of price (and implied yields desired) and a quantity requested in $ millions. The government then issues the bonds in highest price bid order until it raises the revenue it seeks. So the first bidder with the highest price (lowest yield) gets what they want (as long as it doesn’t exhaust the whole tender, which is not likely). Then the second bidder (higher yield) and so on.
In this way, if demand for the tender is low, the final yields will be higher and vice versa. There are a lot of myths peddled in the financial press about this. Rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this).
But rising yields on government bonds do not necessarily indicate that the bond markets are sick of government debt levels. In sovereign nations (not the EMU) it typically either means that the economy is growing strongly and investors are willing to diversify their portfolios into riskier assets. It is also usually a time that the central bank pushes up rates and bond yields more or less follow.
The point is that if the central bank pushes up the demand for extant government bonds in the secondary market, it will, other things being equal, push up the price and the yields will fall (even though the coupon is fixed).
So it was a simple monetary operation by the central bank to control yields at whatever level they desired. In doing so, there were allegations raised (by conservatives and central bankers) that the central bank was being politicised.
This came to a head during the Korean War and conflict between the Treasury and the Federal Reserve saw the 1942 peg scrapped. More about that in Part 2.
But the whole ‘politicisation’ ruse is interesting because the original legislation establishing the Federal Reserve Bank system in the US (the Federal Reserve Act 1913) clearly allowed the the Federal Reserve Banks to buy unlimited amounts of Treasury bonds directly from the Treasury.
In 1935, the Federal Reserve Board was “renamed and restructured”.
Prior to 1935, that power to by unlimited amounts of US Treasury bonds directly from the Treasury was used regularly. The first time this was used was in 1917.
There was an article in the New York Times (March 28, 1917) – Reserve Banks Lend M’Adoo $50,000,000 – which said that:
To maintain the working level of the general fund of the Treasury, Secretary McAdoo has borrowed on Treasury certificates from the Federal Reserve Banks $50,000,000 at 2 per cent per annum … The Federal Reserve Banks subscribed with such promptness that at 3 P.M. today the entire amount had been taken.
The Secretary of the Treasury Mr McAdoo said that the “twelve Federal Reserve Banks … are fiscal agents of the Government”.
Part of the funds went to pay the sale price of the Danish West Indies, now the US Virgin Islands.
The other interesting aspect of the ‘loan’ was that the private bond markets were not interested in the deal and a spokesperson said that “other institutions would not care to invest their funds in these securities at the very unattractive rate”.
The prevailing market rate at the time on short-term Treasury certificates was 3 per cent.
So the principle was clear. At a time when competitive market rates were deemed higher than the government wanted to pay on any debt it issued, the solution was simple – get the central bank to buy the debt.
In 2014, Kenneth D. Garbade published a Federal Reserve Bank of New York Staff Report – Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks – which recounts the way the central bank in the US could purchase unlimited amounts of treasury debt by creating funds out of thin air and how that capacity was eventually constrained.
Garbade documents how the Federal Reserve Board has some reluctance to purchase directly and considered “that the normal services of the Bank as fiscal agent will best be rendered by assisting in distributing Government securities rather than by acting as a purchaser of them.”
That is, buying government bonds in the secondary markets (once they had been issued via tender) from non-government bond holders.
Eventually, the growing central bank consternation about direct purchases led to a legislative change.
In 1935, the 1913 Federal Reserve Act was qualified by the the Banking Act of August 23, 1935, which meant that the Federal Reserve Banks could only purchase government bonds “in the open market” – that is, the secondary market.
The upshot of this new legislation was that the “proviso explicitly prohibited direct purchases of Treasury securities by Federal Reserve Banks.”
So a voluntary financial constraint was imposed on the relationship between the central bank and the US treasury despite history telling us that the central bank direct debt purchases from the Treasury between 1913 and 1935 had gone “without incident”.
It was conservative antagonism that led to the 1935 constraints. So we understand them to be purely ideological and political.
The debates at the time made it clear that the legislators knew there was smoke and mirrors at work here.
It was observed by the US House of Representatives Committee on Banking and Currency, which was overseeing the legislation that:
There is no logic in discriminating against obligations which, being in effect obligations of the United States Government, differ from other such obligations only in that they are not issued directly by the Government.
In other words, it was flim flam to prohibit the central bank from purchasing debt from the Treasury directly when it could simply signal to the private bond markets that upon issue, it would buy unlimited quantities of bonds from them (indirectly).
These sort of accounting ruses dominate government fiscal operations today and place a smokescreen over what is really the intrinsic nature of the monetary system.
It is also the way that the ECB is getting around the Treaty of Lisbon constraints, which prevent bailouts of governments.
If the central bank is creating demand for financial assets (bonds) in the secondary market then people can be tricked into believing that it is the private sector that ‘funds’ government, despite the reality being that it is the same government that issues the currency in the first place and has to spend it first before it can borrow it back.
Of course, the effect of pointless exercises like that are that they provide the neo-liberals with ammunition by linking government deficits with public debt buildup and then all the rest of the nonsense about ‘mortgaging the grandchildrens’ futures’ and the like are wheeled out on a largely ignorant public to engender political support for austerity-type fiscal stances.
It is all a total ruse and the US House Committee in 1935 clearly knew that.
But their colleagues in the US Senate changed the legislation to prohibit “direct purchases of Treasury securities by Federal Reserve Banks” although the Senate Banking Committee “did not explain the reason for the prohibition”.
Kenneth Harbade cannot find a clear answer to why they introduced this prohibition against the wishes of the Treasury at the time, which considered it essential to have that direct capacity in times of emergency.
The obvious reasons are entertained in the Report.
First, “direct purchases may have been prohibited to prevent excessive government expenditures”.
Second, to prevent “chronic deficits” and force the government to the “test of the market”. As if the private bond markets have the interests of the entire nation at their hearts.
In relation to these motivations, it is clear that the neo-liberal expression of this over the last three decades has overwhelmingly imposed massive political restrictions on the ability of the government to use its fiscal policy powers under a fiat monetary system to ensure we have full employment.
In Europe they took the constraints to one higher level of idiocy by banning any ECB bailout (since violated) and imposing the Stability and Growth Pact. But in other monetary systems where the national government still issues the currency, the voluntary constraints are also oppressive.
We now accept very high unemployment and underemployment rates as a more or less permanent feature of our economic lives because of the ideological constraints imposed on government.
The collapse of the Bretton Woods system in 1971, which freed currency-issuing governments of any financial constraints, did not prevent the logic that applied in the fixed exchange rate-convertibility days from being imposed despite the economic fact that it does not apply in the fiat currency era.
As a result, governments impose voluntary constraints on themselves to satisfy the dominant ideological demands of the elites.
However, the 1935 shifts were not to last very long. The 1935 prohibition of direct central bank purchases of US Treasury debt were relaxed in 1942, which is where I began.
From 1942, the Treasury borrowed “huge sums of money” from the central bank as part of its war effort.
In this blog – Time for fiscal policy as we learn more about monetary policy ineffectiveness – I considered some of the views of the Federal Reserve Bank Chairman Marriner Eccles in 1935.
Mariner Eccles wrote at the time that by allowing direct purchase of debt by the central bank the nation could:
… avoid the necessity of having the Treasury offer Government obligations for sale on the open market at a time when the market is demoralized and an additional public offering might add to the confusion and demoralization of the market and do incalculable harm to the Government’s credit and to the holders of outstanding Government obligations.”
Eccles went further though and believed that the Treasury should never be at the behest of the private bond markets. He said:
If the market situation happens to be unfavorable on any given day when a financing operation is up … the Federal Reserve System should be in a position where it can take care of it by a direct purchase from the Treasury of an issue of securities.
Whether a government buys debt directly from the Treasury or indirectly makes little difference in this respect. The former avenue is always preferable from a Modern Monetary Theory (MMT) perspective because it cuts out the corporate welfare element inherent in exclusive primary issuance to non-government dealers.
The 1942 amendment allowed the central bank to buy debt directly from the Treasury but only up to a certain limit ($US5 billion).
In Part 2, we will examine the breakdown of the pegged arrangement as central bank politics overcame the pragmatism of the US Federal Treasury.
Reclaiming the State Lecture Tour – September-October, 2017
For up to date details of my upcoming book promotion and lecture tour in Late September and early October through Europe go to – The Reclaim the State Project Home Page.
I have run out of stock of the discounted book offer. I might have some more in mid-October. But you can still purchase the book at various bookshops including Amazon, Pluto Books, Barnes and Noble, Dymocks, Readings etc.
That is enough for today!
(c) Copyright 2017 William Mitchell. All Rights Reserved.