The role of debt management in monetary policy cannot be explained without a prior understanding of ...
The role of debt management in monetary policy cannot be explained without a prior understanding of the role of money in the economy. Unfortunately, the role of money in the economy is controversial, with widely divergent views between different economists. One view is that public policy should try to ensure that the price level is kept stable by maintaining a balance between the quantity of money and the quantity of goods and services.
The monetarist school associated with Professor Milton Friedman of Chicago University proposed that, in a growing economy, this objective can be achieved by using monetary policy to ensure that the quantity of money increases at roughly the same rate as the quantity of goods and services. This proposal is currently unfashionable in policy-making circles of English speaking countries, although it allegedly helps to guide the interest rate decisions of the European Central Bank just as it did those of the Bundesbank before the introduction of the single European currency.
More loosely, high and accelerating money growth is likely to be accompanied by buoyant economic activity and sooner or later - high inflation, while low and decelerating money growth normally coincides with depressed economic conditions and leads to low inflation or even falling prices. Some obvious policy prescriptions follow. In boom conditions policymakers ought to take measures which restrict money growth. At the very least, they ought not to take measures which increase money growth.
Today the money stock consists almost entirely of the paper liabilities of the banking system, including notes issued by the central bank and deposits which are liabilities of the commercial banks.
A crucial point follows. Whereas in the past the quantity of money could increase only through extra physical production of precious metals, in a modern economy the quantity of money increases by the extension of bank credit.
The time has come to review the application of ideas about debt management in practice. The following discussion relates mainly to the UK in the post-war period, but a reference is also made to the USA. Immediately after the Second World War the national debt was more than twice the UK's national output, while a significant portion of it was held by the banking system. In these circumstances a constant risk was that longer-dated government securities held outside the banking system would become attractive to the banks as they moved closer to redemption.
Higher money growth
The result would be higher money growth and inflation. This risk became known in the 1950s as 'the flooding problem'. The flood of maturing debt would overwhelm domestic monetary control, unless efforts were made to replace existing debt near to redemption by new debt with redemption dates far in the future.
Evidently, the monetary implications of debt management were a vital consideration to policymakers. By contrast, in the 1960s the Bank of England was concerned at times that aggressive sales of government securities to non-banks might hurt the market, leading to large price falls and increasing bond yields. It therefore pursued a policy of 'leaning into the wind', with the Government's agent in the gilt-edged market (the Government broker) prepared to buy back stock from the market at a price not too far from the current market price. This improved the liquidity of the gilt-edged market, but undermined the Bank of England's ability to control the quantity of money.
The expansionary fiscal policy under the Heath Government of 1970 to 1973 was followed by a deep recession in 1975. Extremely large budget deficits emerged, with the PSBR above 10% of GDP for a few quarters. Since the Labour Government of 1974 to 1979 accepted that control over money growth was needed to reduce inflation, the aim of debt management was to finance the PSBR as far as possible outside the banking system.
In the early 1980s, the gilt-edged market had become accustomed to absorbing large issues of new long-dated stock, often exceeding 3% of GDP. At the same time the growth of bank lending to the private sector was unusually rapid, as the Conservative Government under Margaret Thatcher removed restrictions on bank credit. By itself this credit boom would have caused unacceptably high money growth.
One of the monetary authorities' key responses was to sell government securities (mostly gilts) to non-banks in excess of the PSBR. This 'over-funding' allowed the Government to neutralise the monetary consequences of buoyant bank credit and was strongly defended in official statements.
However, over-funding was practiced on such a large scale that it stripped the banks of virtually all their public sector debt. The Government used the excess proceeds from the gilt sales to boost its deposit balance at the Bank of England. The sharp increase in the Government's deposit was matched on the other side of the Bank's balance sheet by very large holdings of commercial bills, an accumulation which became known as the 'bill mountain'.
In late 1985 a new rule of so-called 'full funding' was announced to place a limit on the bill mountain. In future, sales of public sector debt were not to vary with the requirements of the money stock target, but instead were to be kept close to the PSBR on an annual basis. The consequent abandonment of over-funding made it difficult for the Bank and Treasury to achieve their target for money growth, particularly in view of a continued extremely high growth rate of bank lending to the private sector.
The target for money growth was therefore also dropped. The decisions taken in late 1985 were the prelude to a sharp acceleration in money growth and so to the Lawson boom of the late 1980s, which was followed by inflation of over 10% in 1991. In retrospect, policy-makers' priorities deserve to be heavily criticised for their general conduct of macroeco
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