Paul Krugman’s reply to Antonia Fatas makes me think that he – and presumably others – are missing something important about government revenues,banks, bond markets and operating in your own currency

Here is Fatas

At the end of the day, default, taxes or seignorage are three ways to pay for the spending governments have already done. They are not that different conceptually. In a closed system there is no way to avoid grabbing resources from your own citizens – in some sense deciding between the three choices is simply a redistribution decision.

Here is the crux of Paul’s response

the proposition that countries without a printing press are subject to self-fulfilling crises in a way that nations that still have a currency of their own are not. The point is that fears of default, by driving up interest costs, can themselves trigger default — and that because there’s a crossing-the-Rubicon aspect to default, once a country crosses that line it will probably impose fairly severe losses on creditors. A country with its own currency isn’t in the same position: even if it is pushed into some inflation, there’s no red line that need be crossed.

So, there are a couple of things going on here. I might makes some points that are obvious to some but I think ground needs to be laid.

First, in closed system the public debt and interest on it – as crucially opposed to the primary deficit – does not represent any extraction of real resources. Whether a government repays its debt or even services its debt has no direct effect on public vs. private claims on resources. In other words, it is not as if the government is in anyway extracting or returning resources to the private sector.

Public Debt management is fundamentally simply shifting around claims on existing private sector resources. The public debt and interest on it, is everywhere and always a distributional matter – not a real resource extraction matter.

With that under our belts we have to think about the ways we can manage the distribution of these claims.

Direct taxation: We impose, under coercive threat, that Citizen A relinquish his claim on some set of resources to Citizen B. We call Citizen A a taxpayer and Citizen B a bondholder.

Seigniorage: We reduce the value of the claims on real resources represented by cash. This free ups claims some real resources. We then distribute those resources to bond holders.

Default:. We refuse to give bondholders claims on real resources. Some people think of this as transferring claims on real resources from bondholders to the public at large. But, thinking like this confuses the matter. A bond should not be thought of as a claim on real resources. A bond is a promise to provide a claim on real resources.

Bank Extraction: This is the key way in which countries with their own Central Banks, in fact, manage this issue. The Central Bank prevents private borrowers from taking claims on real resources which savers relinquish. These leaves room for bondholders to take those claims.

To see this imagine that a saver decides not to relinquish his claim over real resources to a bondholder. Instead, that saver deposits his cash in a bank. This causes the total quantity of bank reserves to rise. This in turn causes the Overnight Interbank Lending rate to fall. The Central Bank will then step in sell government bonds to the bank in exchange for reserves.

The saver has relinquished his claim on real goods and services but no private borrower has expanded his claim on real goods and services. Thus there are free goods and services.

How do these get to the bondholder?

The bondholder simply sells his bond to the bank. In exchange the bank provides the bondholder with cash. The bondholder now has increased his claim on real goods and services.

However, the decrease in cash will tend to drive up the Overnight Interbank Lending rate. The Central Bank then steps in and buys the the bond from the bank for reserves, increasing the total quantity of reserves and driving the Overnight rate back down.

In the end the saver has relinquished his claim on real goods and services and the bondholder has taken a claim on real goods and services. However, because the saver did not want to buy the bond directly it now sits on the balance sheets of banks balanced against the savers savings account.

Now knowing that this will be the end result banks simply stand ready to buy and sell government bonds at the Overnight target rate. They anticipate that the Central Bank will adjust its holdings of bonds and the quantity of banking reserves to make this optimal.

Notice though that this process does not depend on seigniorage or even the threat of seigniorage. It depends on the fact that savers connect to borrowers through the banking system. As long as this holds, government bondholders are always “first in line” to acquire claims on real resources from savers and no active management of the public debt is necessary.

Advertisements