Over at Worthwhile Canadian Initiative, Nick Rowe wonders how much of a deficit would need to be money-financed as opposed to bond-financed. I say it doesn’t matter how you finance the deficit, what matters is the time path of interest rates (which is independent of how the deficit is financed).
To see why, assume that in one scenario, a government sells B bonds, sold as short term bills. Each period, the debt will compound by (1 + r_i), where r_i is the nominal rate in that period. That debt will continue to compound until the government decides to pay it off (say with a lump sum tax).
On the other hand, suppose that the government sells B bonds, and then the central bank purchases those bonds, holding them as excess reserves. Now for the central bank to maintain a positive interest rate, it must pay interest on reserves at a rate (1 + r_i) each period, and those reserves will compound just at the same rate as if the government issued bonds.
Nick suggests that currency demand will ultimately reduce the excess reserves to zero — e.g. banks will purchase currency with their reserves as NGDP grows, decreasing the quantity of interest paying reserves and increasing the quantity of non-interest bearing currency. The issuance of non-interest bearing currency is seignorage income, but the Government could just as well use the same seignorage income to retire a portion of the bond debt, by having the central bank gradually expand its balance sheet and purchase a portion of the debt as currency demands increase. If the currency demand comes from high inflation, then it makes no difference whether a debt is inflated away, or whether excess reserves are converted into currency as a result of high prices. The same drawbacks apply to both approaches.
When will currency demand a.k.a. seignorage income really eliminate all the excess reserves? Currency demand should grow at most as fast as NGDP, i.e. at a real rate of g. This means that the crucial test is the difference r – g, where r is the real rate. This is exactly the condition for whether government debt must be paid off or whether we can ‘outgrow it’. And as the seignorage income can be equally applied to retire the government debt or to retire the excess reserves (or to provide for goods and services if no action was taken), the present value of the future taxes necessary to eliminate the excess reserves is the same as the present value of the future taxes necessary to eliminate the debt.
But will the time path of interest rates be higher if the central bank replaces an interest bearing bill with interest bearing reserves (both paying the policy rate)? Why should a household care if it holds a bill or a deposit paying the same amount? I.e. if the act of selling the debt causes interest rates to settle on a rate r, then buying the debt with reserves that pay an interest rate of r is not going to cause the equilibrium rate to change.
I think the confusion stems from a belief that central banks issue currency (which does not pay interest) rather than reserves. When the interest rate is positive, there is an incentives for banks to deposit their currency with the central bank, converting the currency into reserves and earning a positive interest. This makes banks compete for currency and deposits belonging to households. In this way, even if the central bank were to make all of its QE purchases with $2 Bills, as soon as rates become positive all of the bills would end up back at the central bank converted from currency into interest bearing excess reserves. Therefore whether rates are positive or negative, there is no difference between reserves and short dated bills, and so there is no difference between financing a deficit by issuing more short dated bills or financing a deficit by issuing more reserves.
It’s very odd how nervous commentators are about the central government expanding its balance sheet yet the same group enthusiastically urges the central bank to do whatever it takes. The bank can just keep paying more and more interest on reserves that swell geometrically in size with no concern about whether r > g, no discussions of “sustainability”, “future generations”, etc. In other words, functional finance applies only to the bank, not to the government, even though both are under the same constraints — pay interest of r_i each period on your liabilities net of seignorage income.