MMT perspectives on rising interest rates

by
Lars Pålsson Syll
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from Lars Syll

The Bank of England is today wholly-owned by the UK government, and no other body is allowed to create UK pounds. It can create digital pounds in the payments system that it runs, thus marking up and down the accounts of banks, the government and other public institutions. It also acts as the bank of the government, facilitating its payments. The Bank of England also determines the bank rate, which is the interest rate it pays to commercial banks that hold money (reserves) at the Bank of England …

The interest rate that the UK government pays is a policy variable determined by the Bank of England. Furthermore, it is not the Bank of England’s remit to bankrupt the government that owns it. The institutional setup ensures that the Bank of England supports the liquidity and solvency of the government to the extent that it becomes an issuer of currency itself. Selling government bonds, it can create whatever amount of pounds it deems necessary to fulfil its functions. Given that the Bank of England stands ready to purchase huge amounts of gilts on the secondary market (for “used” gilts), it is clear to investors that gilts are just as good as reserves. There is no risk of default …

The government of the UK cannot “run out of money”. When it spends more into the economy than it collects through taxes, a “public deficit” is produced. This means that the private sector saves a part of its monetary income which it has not spent on paying taxes (yet). When the government spends less than it collects in taxes, a “public surplus” results. This reduces public debt. That public debt to GDP ratio can be heavily influenced by GDP growth, which explains the fall in the public debt to GDP ratio in the second half of the 20th century …

So, do rising interest rates in the future create a problem for the UK government? No. The Bank of England is the currency issuer. There is nothing that stops it from paying what HM Treasury instructs it to pay. Gilts can be issued in this process as an option. The government’s ability to pay is not put into doubt since the Bank of England acts as a lender of last resort, offering to buy up gilts on the market so that the price of gilts can never crash. Higher interest rates cannot bankrupt the UK government.

Dirk Ehnts

One of the main reasons behind the lack of understanding that mainstream economists repeatedly demonstrate when it comes to these policy issues is related to the loanable funds theory and the view that governments — in analogy with individual households — have to have income before they can spend. This is, of course, totally wrong. Most governments nowadays are monopoly issuers of their own currencies, not users.

The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credit, determined by supply and demand in the same way as the price of bread and butter on a village market. In the traditional loanable funds theory the amount of loans and credit available for financing investment is constrained by how much saving is available. Saving is the supply of loanable funds, investment is the demand for loanable funds and assumed to be negatively related to the interest rate.

There are many problems with this theory.

Loanable funds theory essentially reduces modern monetary economies to something akin to barter systems — something they definitely are not. As emphasised especially by Minsky, to understand and explain how much investment/loaning/ crediting is going on in an economy, it’s much more important to focus on the working of financial markets than staring at accounting identities like S = Y – C – G. The problems we meet on modern markets today have more to do with inadequate financial institutions than with the size of loanable-funds-savings.

A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities. This is seriously wrong.  There are always (at least) two parts in an economic transaction. Savers and investors have different liquidity preferences and face different choices — and their interactions usually only take place intermediated by financial institutions. This, importantly, also means that there is no “direct and immediate” automatic interest mechanism at work in modern monetary economies. What this ultimately boils done to is that what happens at the microeconomic level — both in and out of equilibrium —  is not always compatible with the macroeconomic outcome. The fallacy of composition has many faces — loanable funds is one of them.

All real economic activities nowadays depend on a functioning financial machinery. But institutional arrangements, states of confidence, fundamental uncertainties, asymmetric expectations, the banking system, financial intermediation, loan granting processes, default risks, liquidity constraints, aggregate debt, cash flow fluctuations, etc., etc. — things that play decisive roles in channeling​ money/savings/credit — are more or less left in the dark in modern formalisations of the loanable funds theory. Thanks to MMT that kind of evasion of the real policy issues we face today, are now met with severe questioning and justified critique.