Government Borrowing and Interest Rates

I have posted a comment/question from a reader called 'Lemming' below, who is clearly not an ignoramus (as the poster said of him/herself - I suspect Lemming may be an economist feigning lack of knowledge):

'I know it wasn't your intention to write an Elementary Economics course but, for ignoramuses like me, could you quickly explain how a central bank's interest rates are related to government borrowing?

I had assumed that the central bank set domestic interest rates to create a feedback loop to keep the amount of money in its own economy at the 'correct' level i.e. to regulate inflation. I didn't think the rest of the world cared, as whatever happened, the exchange rate for the currency would reflect its true value.

I am a bit hazy on government borrowing. I assumed that a government could borrow 'money' on the financial markets at the cost of paying it back with interest (at a rate set by... some international committee or other) - like a business borrowing money within a country's economy. I have no idea in what currency this loan would be made (as I say I am very ignorant!)

The borrowed money would be used to boost short term cashflow, with the assumption being that it could be repaid in future due to improved economic circumstances, or when 'investments' reduced costs in the future. (And as a bribe to the electorate, no doubt.)'

Sadly, there is no quick answer to this question, but I will do my best in the short time I have for this post. It really requires a long answer, so I hope I will not confuse issues in a quick review.

Lemming is quite right that interest rates are set (as a target) to govern the money supply in the economy (through open market operations in the UK primarily through the London Interbank Offered Rate). The control of the money supply is managed by either buying or selling securities such as second hand government debt (e.g. bonds), or by lending to or borrowing money from banks.

However, I think Lemming is wrong to say that the 'world' doesn't care about the interest rates, as has been illustrated by the example of the 'Carry Trade' and New Zealand (see here for an academic paper which gives a useful introduction). In this case money was being borrowed in low interest countries such as Japan and being utilised in high interest New Zealand. In doing so money was flooding into New Zealand, resulting in even higher interest rates, and creating demand for the New Zealand currency, and thereby pushing up the value of the New Zealand dollar. An extreme example, but you should be aware that the UK has also been a destination for the carry trade.

Onto government borrowing....

Government borrowing results in increasing the money supply in an economy. As such, in targeting interest rates, a central bank needs to include consideration of the amount of money that a government is pumping into the economy through borrowing. The more the government borrows, the more the money supply in an economy expands. On the other hand, if a government spends revenue, the effect on the money supply is largely neutral. Instead of individuals spending the money, the government takes it from them and spends it.

If a government borrows money, it also needs to offer a yield that will exceed (expected) inflation and also be attractive against risk in changes in the value of the currency. However, as a government borrows, it will expand the money supply, raise inflation, and thereby will need to offer higher returns to compensate investors. To add to this, if there is high inflation, then a currency will devalue, further raising inflation, and creating further requirements for higher yields on government investments. The level of the impact of government borrowing will depend on how close the economy is to capacity - the closer to capacity, the greater the impact upon inflation and therefore the greater the impact on interest rates. In addition, if the government is borrowing and thereby indirectly raising interest rates, the central bank will raise interest rates restricting the money supply to business......which I will discuss for a moment..

Another reason why government borrowing is influential is best illustrated by a simplification. I am an individual investor and wish (for whatever reason) to make an investment in £GB. I will be faced with a range of choices for where I might to wish to put my money. For example, I may wish to lend into the consumer markets (e.g. putting my money into a building society account where it will be used to provide mortgages), or invest in companies (e.g. stock market), or I can lend to the government (e.g. bonds) and so forth. In each case I must make an assessment of risk and reward. If we take the example of lending of money to the government through the purchase of bonds, these kinds of bonds are considered to be 'no-risk' (a misnomer - as they do have risk) and therefore are highly competitive in the respect that they are relatively very safe investments (in some cases they even allow for inflation). By comparison non-government lending looks pretty risky.

In this situation, my investment decision would, if all investments were offering the same yield, be to go for the government bonds. Why take a risk on putting my money into unsafe instruments such as consumer lending. As such, non-government competitors must offer me a premium over lending to the government in order to give me an incentive to invest my money in their asset. As such the government becomes a formidable competitor in the market for where I invest my money, and set a benchmark on the minimum yield I will accept. In doing so, they are distorting the markets, and setting an effective minimum interest rate in the market.

So far so simple. However, life is never simple.

For example, Lemming mentions that the government wants to control inflation with interest rates. As the example of New Zealand shows , no country is a financial island, and the problems of New Zealand illustrate the problems of central banks very clearly (it is a good example because it is a small economy, and the effects can be seen more vividly as a result). On the one hand you have high interest rates to try to damp down inflation (in particular house inflation - though this is no longer an issue), but on the other hand such high interest rates are attracting the carry trade. Furthermore the carry trade is leading to the appreciation of the $NZ as there is high demand for the currency, and this means that imports are cheaper, pulling down inflation, but at the same time making New Zealand goods and services relatively expensive to imports. How can interest rates be set to manage such a situation? The answer is that it is a choice between a rock and a hard place.

Going back to government borrowing setting the minimum yield on investments. This situation means that all investments are measured relative to a baseline of lending to the government. The question to then ask is what would happen to investment decisions without such a base to measure them against. In this case each individual investment could only be measured on its merits compared with other investments.

At this point it should be noted that when lending to the government, this lending goes towards government spending. I have discussed elsewhere that we can not reasonably say that a government invests money, as there is no way of measuring the return on the investment, and no way to separate spending from investment. However, if we lend to the government, we are individually making an investment as the government provides us (as individuals) a measurable return.

As has been mentioned, an investment in the government is actually in competition for other investments. Some of these other investments might be invested into productive activities, such as company expansion and so forth. More than this, the higher the government yield offered to investors, the higher the yield needed to offer a competitive return for other investments. As such higher government yields impact across the economy. As such, if you are a company raising money, then you will need to offer a greater return than would be the case if your company were not in competition with the government. In doing so the government is indirectly raising the cost of doing business, and is also taking away sources of investment from business. With less investment finance available, this will also have the effect of raising the cost of borrowing for business, as there will be less supply of finance.

If we actually think about government borrowing, it really does not make sense. In reality there is no real justification for it, excepting in the case of national emergency (e.g. war). As soon as a government borrows, it pushes up the cost of borrowing for potentially productive uses, as well as having a whole series of effects that are indirect. As such, even in a downturn, a government borrowing will have a negative impact, as it will redirect resources away from potentially productive investments, or raise the cost of borrowing limiting the 'bang per buck' of the money borrowed (as the cost of the money will be greater).

In short, government borrowing is just a hiding place for sloppy management of the resources available to government, and represents general sloppy management of a country. It allows for government to act irresponsibly at the cost of the economy as a whole. As such, yes it is a bribe for the voters.

Note: I hope that I have not made too much of a hash of this explanation, and that it starts to illustrate the point. I have only covered some of the elements that are necessary for a full discussion, as there are so many complex interdependencies and positive and negative feedbacks in economic systems, and it is almost impossible to strip out a few isolated effects. I will welcome feedback from Lemming in particular, as I suspect that he/she may be an economist.