A fundamental flaw in interest rate adjustments.

Summary. The main way central banks cut interest rates is to print money and buy up government debt / bonds. But it can well be argued that government borrowing makes no sense, and thus that there should be no government borrowing. In that case central banks can’t cut interest rates!

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Warren Mosler¹ and Bill Mitchell² (the two co-founders of MMT) have argued that government borrowing makes no sense. Milton Friedman³ argued likewise.Plus I argued⁴ likewise.

Well now, if the above four individuals are right, then central banks will not be able to cut interest rates because the main way CBs cut rates is to print money and buy up government debt!

Of course CBs are able to buy corporate debt. But in the case of QE (at least in the UK, where I live) only a minute proportion of the total debt bought up was corporate as opposed to government debt, and quite right. Reason is that if a CB buys up corporate debt it is taking a commercial risk, and it’s not really to job of CBs to do that.

As distinct from interest rate cuts, there are interest rate increases. An absence of government debt does not stop a CB raising rates: it can wade into the market and offer to borrow at above the going rate, and then not do anything with the money borrowed. CBs in some countries may not actually be allowed to do that at present, but there’s no good reason they shouldn’t.

And that set up, i.e. where a CB can raise rates but can’t cut them does make some sense in that it’s compatible with Friedman’s ideas: Friedman claimed that governments should not borrow except in emergencies. The emergency that Friedman had in mind was war. But another possible emergency is a big outbreak of irrational exuberance which needs to be damped down via various deflationary measures. Tax increases or public spending cuts are one option, but if they proved insufficient, then the latter sort of interest rate increased implemented by a CB might be in order.


So why do governments borrow?

If, as suggested above, there are no good arguments for government borrowing, it is legitimate to ask why such borrowing takes place. The answer is: “political expediency”.

That is, politicians always prefer to fund public spending via borrowing rather than via tax because voters are painfully well aware of tax increases, whereas they tend not to attribute interest rate increases to government borrowing.

David Hume, writing about three hundred years ago, was well aware of the latter point. As he put it, “It is very tempting to a minister to employ such an expedient, as enables him to make a great figure during his administration, without overburdening the people with taxes, or exciting any immediate clamours against himself. The practice, therefore, of contracting debt will almost infallibly be abused, in every government. It would scarcely be more imprudent to give a prodigal son a credit in every banker's shop in London, than to empower a statesman to draw bills, in this manner, upon posterity.” That’s in his essay “Of Public Credit”.

Simon Wren-Lewis⁵ is clearly aware of that phenomenon: he calls it the “deficit bias”.


What’s the GDP maximising rate of interest?

Having argued that the GDP maximising rate of interest is obtained where the state (government and CB) issue a liability (zero interest yielding base money) but do not pay interest on any of that money, there is actually another point which supports that argument, which is thus.

When governments borrow rather than simply print money and spend it, essentially what they’re doing is saying to themselves, “let’s print and spend, though in order to damp down the inflation that might result from that printing, we’ll borrow back some of the money we printed.”

Now issuing enough base money go give us full employment without exacerbating inflation too much clearly makes sense: it maximises GDP. But to print too much money, and then deal with the inflationary consequences by borrowing some of it back is an obvious nonsense. That is clearly not a strategy which will maximise GDP: reason is that it results in interest rates being artificially high.


Conclusion.

The entire conventional wisdom on government borrowing is nonsense, or at least that’s what I’m claiming!

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References.
 
1. See 2nd last paragraph of Mosler’s Huffington article, “Proposals for the banking system.”

2. See Mitchell’s article “There’s no need to issue public debt”.

3.  See Friedman’s article:   “A Monetary and Fiscal Framework for Economic Stability”, American Economic Review. See his para starting “Under the proposal….”.
 
4. Musgrave. See article entitled “The Arguments for a Permanent Zero Interest Rate.”

5. Wren-Lewis. See his article entitled: “Budget deficits, fiscal councils and authoritarian regimes”