Money Creation … Government Debt

Very much the Keynesian choice!

Government Deficit.

Generally a Government keeps control of the creation of bank credit through the maintenance of a system of liquid asset requirements by the Banks, this ratio defines the level to which Banks are expected to hold Government Bonds, and is the primary form of money creation. The reason being that it is the main constituent of base money (M1) which defines the level to which bank credit can be expanded.

A Government deficit is generally financed by means of the Central Bank (in our case Bank of England) issuing Bonds. Usually these have a fixed “coupon rate” and are tendered for in the money markets which creates the effective rate as far as the Government is concerned (the amount actually raised will be greater or smaller than the face value of the Bonds depending on the tender price).

Where Banks are required to hold a liquid asset reserve, we will find Banks taking up these Bonds and in that way increasing their potential to expanding credit. Where the required liquid reserve ratio is low or non-existent we will find the bulk of these bonds being taken up by Pension Funds (which are required to hold a fairly high proportion of “liquid reserves” against their future liabilities), people of high wealth, traders in the money markets (as they need to be able to demonstrate their liquidity) and foreigners.

If we analyse a situation where an issue of a Government Bond is fully taken up by people from within the country, (the Pension Funds etc. mentioned above but excluding foreigners), we will see that this has no impact on money supply. While the Government expenditure, that is being funded by a Bond Issue, will result in result in a deposit into the Banking system there will also have been corresponding withdrawals from the banking system by the individuals or institutions that took up the bond.

The level of Deposits in Banks will not have increased and therefore the Banks should not be entitled to “create new deposits” by granting additional loans.
On the other hand, in a fractional reserve system the banking sector will always take up a proportion of the bond issue as this will allow them to expand their level of lending. For example if the fractional liquid reserve required to be held by the Banks is 20% they would effectively be allowed to increase their lending up to 5 times the amount of a new deposit. If however it is only 1% the banking system is able to effectively expand the money supply by 100 times the level of the initial deposit.

In the case of the UK the only new money that would be created out of a Bond Issue (because we have done away with a liquid reserve requirement), will be as a result of foreigners taking up the bond. In this way the current UK situation is analogous with the times of Keynes, in that, under the quasi-gold standard that existed in his time, the only way of truly increasing money supply was a favourable balance of trade. A situation that had existed throughout the 1800's and up to the First World War.

We are in a similar position today in that we are dependent on, either/ an international trade surplus or foreigners taking up our Bond issues to inject new money into the economy. For the Keynesian Government expenditure funded out of Government borrowings created new deposits … therefor money, which coupled with the Banks ability to lend up to 5 times the level of deposits, created a multiplier effect that had a much larger impact on the economy.


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