One thing that I observed is that my manuscript has a lot of complaints about “hard money types” expressing scepticism about official economic data. However, segments of the online left also drifted in that direction. The whole “vibecession” sub-theme of the Biden Presidency has not entirely gone away — in online discussion, at least. My feeling is that this is a function of social media rewarding outrage and cynicism. However, this is a self-defeating stance for the left: if your politics are premised on government intervention in the economy, you have to have some confidence that the government can measure what is happening in the economy. As such, there is not going to be a lot of academic support for such a stance — unlike the case of libertarianism, which is premised on governments not being competent. However, I might scan my comments and perhaps adapt them to the changing vibes.

Currency Versus Money

In another online discussion, I ran into a new variant of Austrian thinking. The basic premise was one that I covered in my book — inflation is not really rising prices, rather it is an expansion in the “money supply.” (The rising prices is allegedly just a consequence of the money supply expansion.) However, the new angle was that I should not have written “money supply,” rather the “inflation is the expansion in currency.” I did not have the stomach to find out exactly what that person thought “currency” meant, but my understanding is that it is anything that can be used to purchase goods in that currency, which brings in a lot of credit instruments.

The immediate problem with using “currency” is that we already have a technical economic usage of the term — “currency in circulation” (e.g., dollar notes and coin). This is a subset of the “monetary base” (possibly M0, depending on which definition of M’s you use). Trying to widen to broader credit instruments is just a wider aggregate, like M4.

Although it was kind of neat to see a new variant of pop Austrian thinking on the internet, it is probably just a way of dodging the problem that things like the “k% rule” have no predictive power. It is just a way to revive the Quantity Theory of Money by adding fuzziness around the definition of “Money.” (If you do not have a precise quantity associated with money, the Quantity Theory of Money cannot be falsified.)

Fed Credibility

Other than concerns about oil storage and AI capital spending, the main economic chatter I seem to be running into revolves around credibility concerns at the Fed. Although these Fed discussions are somewhat entertaining, it still seems early for anything interesting to happen. My reading of the situation is that people are considering policy rate movements of only a couple quarter-point moves. The economy is not that sensitive to interest rates. We would need some chunkier inflation misses for this to be of interest to anyone other than the handful of people who are obsessed with the central bank. For bond yields, the intermediate-term trajectory over a span of a few years is what matters.

Oil prices have been reacting to the latest deterioration of the situation and the limited flow of oil through the Persian Gulf, but it remains to be seen whether the market can continue to brush off what appears to be a severe supply restriction. It also is unclear for how long countries will be willing to draw down strategic reserves given that diplomatic progress appears to be non-existent.

The problem with American diplomatic efforts is that none of the decisionmakers appear to have any understanding how targeted foreigners think, or their motivations. The focus is entirely on what the United States is doing, with the assumption that foreigners will give way to American demands if they are presented aggressively enough.

I have been unable to devote much time to this week’s blog entry, due to other projects and other distractions. I have also been editing my inflation manuscript, which may just need chart updates before sending to external editing.

This was already expected to happen, as this gives more negotiating space for the Americans to try to aggressively ram terms down the Canadian negotiation teams’ throats. That said, the Canadian Federal Government is not exactly in a mood for giving ground to the Americans, and the economic outlook for the Americans going into midterm elections is hardly great, and a renewed trade war might not be welcome outside of the White House.

It is possible that the Canadians could offer some concessions, but considering that Canadians are boycotting American goods, it is not clear how much concessions allowing greater access to Canadian consumers matters. The main industry at stake is automotive, with the American major manufacturers having sprawling supply chains that criss-cross the borders. However, those manufacturers are looking more and more to be dinosaurs that missed the boat on electric vehicles, which reduces the salience of the industry on a forward-looking basis.

It is unclear to me how much more damage Trump can inflict on the Canadian economy. The Supreme Court limited his ability to impose tariffs via social media post, so a sudden stop to trade appears less likely. The trade talks will be a source of negative headlines, but the global economic outlook is more important at this time.

I am unsure about the exact context of his original tweet, and it appears to have been a one-off comment. I am not going to attempt to delve into Polanski’s full views on bond markets are (it is clear that they get the usual suspects mad, but the summaries I do not have great issues with), rather I just want to comment on the discussions online that were provoked by that statement.

No Point in Worrying About Bond Markets

My unsolicited advice to the centre-left (particularly in the U.K.) is to not reinforce the “Bond Vigilantes are more powerful than the government” narrative that characterised the post-1990 neoliberal consensus. If you are a Green Party supporter, you are likely correct that the average bond market denizen is not a fan of your favoured policies. Realistically speaking, there’s probably a lot of other people in the U.K. that also do not like your policies. For example, I doubt that the fox-hunting set are fans either. This does not matter because it seems implausible that fox hunters have a veto on government policies. The problem with the focus on bond market vigilantes is that they do not have a veto on government policy either — you need to look at the “independent” arms of government policy, like the Bank of England.

The bond markets do not exist solely because they benefit rich bond market investors. They exist because they reflect economic, accounting, and financial fundamentals, and you would need to do something about those fundamentals if you want to make anything other than a cosmetic change to the situation.

One of the unfortunate side effects of the explosion of Modern Monetary Theory (MMT) on the internet is that it picked up some bad habits, that then transitioned to related online economic communities. For my purposes here, there are two concerns. The first is that the “Mint the Coin” episode became too much of a role model. (The idea was to mint trillion dollar platinum coins in the United States to get around the debt limit.) Although ingenious, this was a cosmetic change that only worked because the Debt Limit is just a stupid cosmetic rule. The second is that the emphasis on operations led too much importance to being attached to minutiae of money market structure. Although details matter, we cannot lose sight of economic and financial forces. The rest of the article explains what I mean by the previous sentence.

Why Bond Markets?

If we make some simplifying assumptions about the accounting, the central government’s net deficit in a year equals its emission of financial liabilities. (The simplification is that the government is not doing anything that generates/consumes cash flow that is not affecting the deficit; most of the time, the deficit is close to financial liability emission.)

The government could theoretically issue equity, but most governments do not have profit-making enterprises that they can sell minority stakes of to the private sector. To the extent that this is happening, this is “privatisation” and “Public-Private Partnerships,” which are of course, neoliberal.

This only leaves us with the two categories of liabilities: cash, and debt. That breakdown is from the perspective of the owners of the liabilities. The government can call them whatever they want, but what matters is what the people who hold them think about them.

“Cash” as I use it fits the definition as used in portfolio management: short-maturity debt instruments. Central governments issue a variety of cash instruments:

• banknotes and coins;

• deposits at the central bank (“reserves” in Economics 101 textbook-speak);

• short-dated debt securities (“Treasury bills”);

• repurchase agreements (“repos”), typically with the central bank;

• short-term loans to the government or central bank, including accounts receivables.

“Debt” is every other liability (excluding equity, which sometimes get lumped in with liabilities). Although governments could originate a variety of debts, they generally stick to bonds.

Given that there is a finite appetite to hold government-issued cash instruments (as discussed below), the bulk of deficit spending ends up expanding government debts, which are mainly bonds. Although one could theoretically issue other debt instruments than bonds, they would be economically equivalent to bonds from the perspective of the owners of that debt. Which means that you can either make a cosmetic change and relabel “bonds,” or you can run balanced budgets. Or you lock interest rates at zero, which is the only truly fundamental change you can make.

Why Not Just Issue Cash/Money?

The immediate response I would expect to the previous statements is that the government can just issue “money” (deposits at the central bank, presumably). Of course, they already do. The problem is that the private sector is already at the limit of the amount of 0% interest rate money it is willing to voluntarily hold. One of the wackier theories that you can run into online is that there is “an infinite demand for money,” which is not true. There is perhaps an infinite demand for wealth, but the consensus of every serious attempt to model economies is that money holdings are determined by a portfolio balance argument (including transaction demand, including the underground economy).

Since the whole point of money is that it is easily exchanged for other goods and services, it is difficult to get the private sector to hold it involuntarily. The only scheme that worked in practice is forcing banks to hold required reserves against deposits. However, this is a tax on the regulated part of the financial system — tilting the playing field towards non-traditional bank finance (“shadow banks”). (Note that real-world banks in practice are generally holding companies that include traditional banking and shadow banking subsidiaries. Favouring “non-bank finance” just means which subsidiaries are favoured within the “bank.”)

Any attempt to extend who gets stuffed with 0% money has the effect that the stuffees “sell their money” to buy government bonds — driving bond yields to 0% as well. Which means that the policy is economically equivalent to saying “let us lock the risk-free yield curve at 0%.”

You could try to escape this by paying interest on “money” — which is what central banks did in the aftermath of the ZIRP (“Zero Interest Rate Policy”) era. They had bought too many bonds, and banks were stuffed with deposits at the central bank. This was not an issue when the policy rate was at 0%. However, to raise interest rates, they needed to pay interest on central bank balances. Which means that we have just made a somewhat cosmetic change: interest-bearing bonds were replaced by interest-bearing deposits at the central bank. People can generate pretty much the exact same “markets will punish the government” story, since these stories already have a loose grip on reality even with a conventional bond market.

So Why Not Lock Interest Rates at 0%?

Locking the government yield curve at 0% is a MMT policy proposal. But if you look at online discussions and critiques of MMT, it is nearly impossible to find anyone who actually tackles the subject. All you will find are arguments about “printing money.” And it is not even necessary to “print money” to get to the 0% state: Warren Mosler floated a proposal was to issue Treasury bills at an extremely low fixed interest rate (for example, 0.25%) to soak up money creation (which is the role of bonds and bills). Although 0.25% is not exactly 0%, it is close enough for government work — and that rate could be fixed by statute, so there’s no “Treasury bill vigilante raising rates” story to spin.

From my perspective, there are three good political reasons to not waste political capital on the project of locking rates at 0%.

1. The vast majority of economists are against the policy. This even includes Post-Keynesian economists who theoretically should be politically aligned with progressive MMT economists. The idea is so far out of the world view of conventional economists that they barely can wrap arguments around it when “critiquing MMT.” You would also be taking on central bankers, who have a very large political presence in financial media.

2. Locking the government benchmark curve at 0% blows huge holes in the economic position of the pension and insurance industries. This is not just an issue for fat cats: insurance and pensions are critical components of the broad middle class.

3. Given that nobody else supports the policy, you are always one election away from the policy being reversed.

Realistically, if you wanted to go for a “permanent 0% rate policy” in a democracy, you would need to build a supporting bloc of at least more than a half dozen economists who show up in financial media in the country. Furthermore, to build such a supporting bloc, you would need to convince people that interest rates are not critical to the regulation of the economy. Running around telling people that bond market vigilantes secretly run everything in the economy is exactly 180 degrees out of phase with that objective.

Concluding Remarks

The demise of incumbent governments after the pandemic inflation spike is yet another major set of data points confirming that voters hate inflation. Containing inflation puts constraints on fiscal policy (although some progressives are coming up with regulatory schemes to fight inflation). But the political solution for progressives is straightforward: taxes are the price you pay for a civilised society, so they need to go up. The fight is to avoid listening to the worriers who would set them too high and strangle growth.

The worst political strategy for progressives is to emulate the brain trust of the Starmer Labour Party and embrace the bond vigilante story line, as that story line will always be invoked in a way that almost only constrains the left — right-wing parties have to do something extremely stupid (e.g., Liz Truss) to end up facing revolting bond markets.

However, if you are actually paid to invest in bonds, the “bond vigilante” narrative is a trap. Government bond markets are boring, technical markets, and you do not want to get wedded to some directional thesis just because it feels good. You end up wasting part of your valuable risk budget on duration bets — which in practice almost nobody in fixed income has a track record of consistently making money on.

The Truss/Kwarteng Episode

Vince Gomez has an article on the 2022 gilt market scare in the U.K. when it had the hapless leadership of Prime Minister Truss and Chancellor of the Exchequer Kwarteng. As I wrote at the time, this episode is now highlighted whenever the possibility of loosening fiscal policy in the U.K. is raised.

However, the mythology around the episode ignores key points that are discussed in the article (and I discussed earlier). Although the incompetence of the Truss government helped trigger the panic, the panic was the result of U.K. pension funds somehow managing to completely hose the liquidity management of the derivatives portion of their Liability Driven Investment (LDI) strategies in 2022, just over a decade after the 2008 Financial Crisis demonstrated the importance of liquidity management. Given all the hand-wringing about systemic financial risk by regulators and central banks since that earlier crisis, the rather flat-footed response by the Bank of England to the 2022 panic is puzzling.

The article has a useful graph that shows that gilt yields tracked U.S. Treasury yields, and that without labelling the episode, the Truss Crisis does not stand out on the time series. One could argue that this was the result of the Bank of England intervention before things got too ugly, so I would be cautious about arguing that point.

The Full Funding Rule

The Gomez article argues that the “Full Funding Rule” used by the U.K. Debt Management Office is misguided. As stated in the 2025-2026 report (link):

An overarching requirement of debt management policy is that the government fully finances its projected financing requirement each year through the sale of debt. This is known as the ‘full funding rule’. The government therefore issues sufficient wholesale and retail debt instruments, through gilts, Treasury bills (for debt financing purposes), and NS&I products, so as to enable it to meet its projected financing requirement in full. [page 8]

This rule is designed to aggravate fans of Modern Monetary Theory (and Positive Money, which has a following in the U.K.). However, it is effectively meaningless. The consolidated U.K. central government “finances” its net deficit by the issuance of liabilities, which are both gilts and the expansion of the monetary base (“money”). (I used “net deficit” loosely as a synonym for “financing requirement” as there might be a gap between the fiscal deficit and net cash expenditures.) Since the balance sheet of the Bank of England is balanced, it needs assets to cover its increased monetary liabilities — and it owns gilts. Which means that the gross issuance of gilts has to match the increase in governmental liabilities.

Under “standard’ operating procedures, the only way to not have gilt issuance match its “financing requirement” is for the Bank of England to break double-entry balance sheet accounting. [As noted in a correction by Neil Wilson, the central government could use an overdraft facility at the BoE - which the DMO document rules out. An overdraft is a de facto bank loan, and thus replaces a gilt liability with a bank loan liability. However, this distinction is cosmetic, since the government can get the exact same economic outcome by the BoE buying gilts in the secondary market seconds after an auction.]

Fed Independence

Hopping to the other side of the pond, I periodically see hand-wringing about Fed Independence. Earlier in the Trump II regime, he was bulldozing the limits on Presidential power, and one could have imagined him installing some 20-year old sycophant as the rate-setting authority in the Federal Reserve. However, the ongoing political disasters due to bad decision-making by the White House makes such scenarios less likely. (The current projected line up for the 250th American Anniversary concerts currently consists of Vanilla Ice and somebody else, which is a humorous statement of the political momentum behind Trumpism. I am hoping that Vanilla Ice does not back out, as that is the funniest possible outcome for those of us who were in our peak music listening years in the early 1990s.)

Even if Trump installs lapdogs at the Fed, those lapdogs still need to win the votes on rate policy. With midterms coming up and President Trump approval ratings in the 30s, it is going to be hard to get people to commit career suicide by doing something really stupid with interest rates.

More realistically, they might be able to get the policy rate 50 basis points lower than otherwise. The economy is not that sensitive to interest rates, and that would not really matter for anything other than betting on money market forwards.

And even if Trumpists can surpass that 50 basis point level, we cannot ignore our friends, The Bond Market Vigilantes. Even though financial market participants are going to cut Republican Presidents a lot of slack, are the bond markets really going to ignore an inflationary accident? All it would take is a weekend of scary financial market prognostications to cause the President to panic and flip course. Even though I do not take the Bond Market Vigilantes seriously, there is no reason to believe that is not going to be true of the White House.

Which explains why I see little value in worrying about Fed Independence for anything other than tactical rate positioning (which is admittedly a popular side-line for rates investors).

Going Quiet Shortly

On an editorial note, I have been distracted by finishing a consulting project and springtime renovation projects before I head out for a couple of weeks. I might be able to get a piece off next week, but will likely be quiet thereafter (unless there is breaking Vanilla Ice news).

The angle appears interesting in that we have a pro-free markets person arguing that we should not need to worry about the American government defaulting on its debt. Given that there is a Republican in the White House, it is perhaps timely for free marketeers to pivot away from debt worrying. The author has fun skewering the professional government debt worryers that dominate “serious” fiscal analysis in the United States.

Too Much Reliance On Market Efficiency?

The following quote (from page 19) is a key argument of the book:

How, if the United State is bankrupt, can it borrow so much now, and according to the CBO, well into the future? Hopefully the answer to this question is a little bit clearer at this point. The answer is that — love or hate government borrowing — the United States is not bankrupt. Quite the opposite. Since exceedingly few throw away money or disdain potential returns, there’s no way the United States could keep borrowing trillions a year now and into the future if it were bankrupt. Sorry, but there’s not nearly enough dumb money in the world to fund all the United States’ borrowing.

This is one of the few times that I am aware of a pro-free market person pointing out that the same people who argue that markets are efficient are also prone to arguing that government bond markets are wildly mispricing the risk of default.

(Note that there might be better expressions of his this view in the book, but the text has a tendency repeat the same points, so I picked the first example I found when I started writing.)

Although I do not disagree with the sentiment, it faces an obvious rebuttal. Historically, the American government listened to the debt doomsayers, and so it did not push the bounds of fiscal propriety in peacetime. (In World War II and its aftermath, the U.S. government used “financial repression” and rationing to allow government war finance to function.) As financial disclaimers say, past performance does not guarantee future results.

The argument also ignores the obvious reality that some governments borrowed for extended periods peacefully then succumbed to financial crises. (These crises tend to be tied to currency pegs, which is a point that proponents of Modern Monetary Theory (MMT) would highlight.)

Equity Finance

The book is filled with an inappropriately large discussion of the financing of start-up firms. These anecdotes allow the author to offer flowing tributes to the entrepreneurial genius of rich people, but do not tell us much about government finance.

Tamny’s point can be summarised that the rate of interest does not matter to entrepreneurs at start-ups, as their businesses are so risky that they can only get equity finance. Since most large firms were originally small, one could try to argue that equity finance is the only thing that matters in capitalism. since it is at the root of growth.

However, even cursory knowledge of the national accounts tells us that equity financing is not relatively important within the national economy. (Equity market capitalisations are large — but the amount of financing raised is typically a very small proportion of market caps.) The modern favouring of stock buybacks means that net equity financing is typically negative. Meanwhile, established firms and the household mortgage market have extremely large gross and net debt financing flows.

Start-ups might be largely decoupled from interest rate markets, but they are small, and thus have a small economic weight (even if they catch the imagination of the financial press). So we cannot use their experience to say much about the effects of interest rates on the business cycle.

Pre-Keynesian Economics

The reason why I decided to not position this article as a review is that the theoretical basis of the discussions appear to be a variant of pre-Keynesian economics. Rather than trying to find compact quotes, I will just paraphrase the arguments as best I can.

The argument is made that only supply matters — demand (which are treated as equivalent to “desires”) is unlimited. This would be a plausible way of viewing the economy if production was always at full capacity, so we have a fixed real output that has to be allocated amongst “agents” in the economy.

A related point is that money is seen as being “real,” as exchange is always “goods for goods.” (Think of “money” as being gold — which needs to be mined and refined, as opposed to electronic entries on banks’ computers.) The U.S. dollar is real money because of the success of the American economy (and the ability of the American Federal Government to tax that ever-growing economy), while Russia and other dubious states like North Korea allegedly use American dollars because their economic prospects stink. (Business people supposedly do, but what about the rest of the economy?)

Although real goods matter, my argument is that we cannot ignore monetary constraints. Wages are paid in dollars, sales are made in dollars, and debt contracts are denominated in dollars. Dysfunctional monetary situations can happen independently of what is happening to real production. Given the gulf between my views and Tamny’s on this basic theoretical point, it would take an inordinate amount of my readers’ time to cover his theories in detail.

MMT Gets Mentioned (Yay?)

One reason that the book caught my eye was its title. A book entitled “The Deficit Delusion” released five years after Stephanie Kelton’s best-selling “The Deficit Myth.” I assumed that there had to be a call back to Kelton’s book, but nope. That said, MMT gets mentioned, but the previous theoretical issues shows up. He summarises the MMT position relatively well, but he dismisses it due to his views about money. That is, if you believe that money is a real object, that is incompatible with the MMT/Functional Finance view that the value of money is driven by convention and existing monetary contractual obligations, not real constraints. Even though governments now try to keep inflation at a target level, that does not guarantee that money can be treated as a real commodity in analysis.

Concluding Remarks

The book is written at an introductory level, which may benefit some readers. The problem is that the author is so busy giving us anecdotes about how rich people became rich that he failed to cover even the basic objections to his theory that the American Treasury market is always efficiently prices and there is no prospect of risk-taking preferences changing.

That said, free marketeers who want to have any shred of intellectual integrity might want to start changing their thinking along the lines suggested by this book. Screaming that the Treasury market is going to explode in a ball of flames due to the deficit when Obama is President and then wrack up record deficits under President Trump and arguing that everything is going according to plan is obviously incoherent. That said, I see little hope for intellectual coherence to come back into fashion any time soon.

As I believe I noted before, one of my “hobbies” in university was reading up on international relations theory and diplomatic history. The current situation appears somewhat bizarre from the perspective of that theory. The usual story from the Realist perspective was that diplomacy since the Peace of Westphalia was determined by national interests. Since nations’ interests are determined by material facts, we do not need to enquire too deeply into the inner workings of countries to understand their international behaviour. We have reverted to an earlier mode of affairs, as many key governments are acting as neo-Royalist entities, where the interests of the ruling clique determine national policy. (Neo-Royalism has been the term recently floated by a few academics to explain the dynamics of the Trump administration.)

From the traditional perspective, the American intervention in Iran has been an unmitigated disaster for the American national interest. However, from the neo-Royalist perspective, the direct impact on President Trump and his colleagues has been muted so far.

The neo-Royalist perspective offers an explanation of how the United States can extricate itself from the war — since the national interest does not matter, walking away and leaving Iran in control of the Strait of Hormuz is not a concern. There are a few snags to the “chickening out” scenario.

1. The leadership of the Israeli government (as well as some Arab states) feels that it is in their interest to drag the United States into a wider war against Iran.

2. President Trump appears to be locked into his views from the 1980s, and has a strong fear of nuclear weapons. Ending Iran’s nuclear programme is therefore a personal concern.

3. He also first floated the idea of seizing Kharg Island in the 1980s, and the idea remains stuck in his head. Fighting wars to “take oil” represents the peak of his geopolitical thinking.

4. He dislikes the political ridicule associated with losing a war.

The common thread is that all of the analysis revolves around the personal situation of President Trump and his compatriots. Despite these negative factors, it appears that he understands that the conflict is disastrous for his Presidency, and therefore wants to get out. So long as American troops are not in direct contact with Iranians on the ground, the exit door is open and inviting. However, anything that leaves American troops in range of Iranian drones and missiles (which includes occupying the gulf islands) risks turning into a quagmire as troop casualties drive the logic of escalation.

(One possibility is that all the peace talks are just cover to give time for American troops to arrive in the theatre of operations. I believe that exit is still possible, but if the conflict expands, there will be an attempt to paint the situation as following a political plan that probably does not exist.)

The problem that the rest of the world faces is that there does not appear to be a mechanism to force a fast resolution. American energy markets remain orderly, so domestic pressure on the White House is limited. Problems in Asia and Africa with commodity prices are not a factor in their decision-making. The saving grace is that there are reports that ship traffic is starting to flow through Hormuz.

It will take months for the inflationary shock to work its way into economic data. We are going to see parts of logistical chains fail due to inadequate inputs, and they will then work their way downstream. Although neoclassical theory suggests that “expectations” should short-circuit the physical lags, the problem is that very few people know what to expect. To the extent that inflation can be driven by expectations, it needs to be a broad-based economic shock, like a collapse in the exchange rate.

It is also too early to have much insight into the reaction of central banks. It is very easy for central bankers to give tough rhetoric about not allowing inflationary psychology to sink in, actually hiking rates when an economy is imploding is harder to do.

In my view, the usefulness of such banks depends upon conditions in the country. It may be just as easy to mandate private banks to offer minimal standards of service without the challenges of attempting to replicate the information technology investments required. In countries where private banking has spotty coverage, such banks may be useful.

Nevertheless, I have run into a variety of arguments by progressives that the government should get deeper into the banking business. The usual focus of arguments is the power of “money creation” — which I argue below is somewhat of a red herring. Money creation by banks is a power that solely exists because of the standard definitions of “money” that include bank deposits in the M1 or wider monetary aggregates (the narrowest monetary aggregate M0 consists solely of governmental liabilities). Once we accept that there are a great many “cash” instruments that are used in liquidity management that are not bank deposits, we realise that all lending transactions create mirrored financial assets and liabilities out of thin air (ex nihilo).

If the government wants to intervene in lending, they can do so without needing to own a private bank analogue — and they do.

This article only discusses the topic from the perspective of a central government; the situation for a sub-national government is different. I hope to cover sub-nationals in a later article.

Lending to Businesses

Governments quite merrily lend to businesses. They are happy to do so since nobody in the business press complains — although the editorial stance is against governmental interference in markets, an exception is made for corporate welfare. “Consistency is the hobgoblin of small minds, &c.”

Examples include:

• The Export-Import Bank of the United States (EXIM). URL:

  https://www.exim.gov/. As suggested by the name, the focus of EXIM is on providing financial support for international trade.

• Business Development Bank of Canada (BDC). URL: https://www.bdc.ca/en. BDC is a Federal Crown Corporation (a government-owned business), but is run on a “financial sustainable” basis. It has a wide mandate.

• The United Kingdom has an export finance arm (URL: https://www.ukexportfinance.gov.uk/) and at the time of writing has a scheme for start-up financing for small businesses (URL: https://www.gov.uk/apply-start-up-loan).

Since governments like to improve their country’s export competitiveness, they tend to set up agencies to support finance for international trade. Trade finance is trickier than financing domestic sales. There are longer travel times, and firms are much less happy to have accounts receivables due from foreign companies.

Meanwhile, governments will often make ad hoc loans and loan programmes based on current needs.

Lending to Consumers

Outright lending to consumers by governments is less common, but there are cases of massive intervention in consumer lending markets. The two main areas are student loans for post-secondary education, and in the mortgage market. Furthermore, there can be interventions via the income tax system, such as making mortgage interest tax deductible (which acts as a de facto interest rate subsidy).

Student loan frameworks depend upon the jurisdiction. One strategy is for the government to manage the application process and guarantee the loan, while a private bank (or other lending entity) manages the debt repayment. In this case, the government is not directly creating the loan, rather acts as a guarantor to allow the private sector to make a loan that would otherwise not have been funded.

Mortgages are the largest form of household debt, and governments can end up with large interventions.

In the United States, there are few Federal programmes, but the dominant form was via the “government-sponsored enterprises” (GSE’s) such as Fannie Mae and Freddie Mac. They existed in an in-between world where they were theoretically private yet people believed that they had an “implicit guarantee” from the Federal Government. (In fact, I used to own fixed income textbooks that referred to this “implicit guarantee.) Another GSE — Ginnie Mae — was always purely governmental. However, the “implicit government guarantee” ran into reality during the Financial Crisis of 2008, and Fannie and Freddie ended up in conservatorships. These enterprises are not directly lending — they purchase mortgages from banks and then bundle them into securitisations. That is, they do not “create money” by direct lending, but they allow banks to do so because the banks can get the mortgages off their balance sheets.

The Canadian system is cleaner (although I have been critical of some past decisions). The Canada Mortgage and Housing Corporation (CMHC) acts as a guarantor for mortgages. Under Canadian law, any household taking a mortgages with an initial down payment below 20% must also pay for mortgage insurance. The CHMC dominates the mortgage insurance market, although the private sector has the theoretical right to compete. The CHMC receives the mortgage insurance payment, and in return guarantees the mortgages. These insured mortgages are then often sold into National Housing Association (NHA) mortgage-backed securities (MBS), with the CHMC managing that process. Since the CMHC is a full faith and credit obligation of the Federal Government of Canada, those NHA MBS are effectively Federal Government securities, albeit less liquid than Canadian Government Bonds (CGBs), and thus show up in the Federal component of Canadian bond indices.

An important advantage of government mortgage insurance is that it acts as a macroeconomic stabiliser. Modern developed economies are rich, and the household sector can sustain mortgage debt/income ratios that are high when compared to pre-World War II norms. This means that mortgages end up as a large weighting in private debt portfolios. This is fine until there are concerns about mass defaults. To the extent that mortgages are stuck in the hands of leveraged investors (including banks), they pose systemic risk to the financial system. Having the lowest credit quality mortgages backstopped with a guarantee of a floating currency sovereign dampens this risk. Although Canadian mortgage lending evolved to alarmingly weak standards, a crisis has been avoided (so far) by the CMHC guarantee. (The Canadian system also dodged the bullet of the 2008 Financial Crisis courtesy of the fact that the real collapse in lending standards only dated to the late 1990s, which is not-coincidentally house prices adopted the “hockey stick” price trajectory. The lateness of Canadians to the lax mortgage lending standard game meant that exposures were too bad in 2008.)

What I would highlight about these programmes is that these support loans for particular categories of expenditures. Furthermore, these expenditures are supposed to support public objectives — the borrowers enhance their education or purchase their own home. I have not done an exhaustive examination of government lending programmes worldwide, but within the English-speaking world, there may be less political support for the government offering lending for arbitrary purposes. For example, I think it would be a hard sell to push for government to lend people $1000 on Friday night so that they can take a taxi to a casino and test their new system for beating roulette — which could be financed via a private credit card or line of credit.

There is one large expenditure-specific form of household lending that governments tend to stay clear of — auto lending. It is unlikely that doing so makes much sense. The automakers offer financing incentives as a way to sell their product. You do not want to be competing with lenders that have an incentive to offer lending terms that are below market rates.

Aside: Are These Lending Programmes a Good Idea?

Although I am not too much of a fan of invoking supply and demand curves, the reality remains that if the government allows for massive borrowing against certain expenditures, the associated prices will eventually move.

If we look at the two favoured forms of lending — student lending and mortgages — we see two categories of prices that heavily outstripped the other components of the CPI since 1990 in the United States. (Other countries have more government intervention into university tuition, although rising house prices is a generic developed country problem). The loosening of CMHC mortgage insurance standards in the late 1990s were drastic, and the associated price rises were similarly drastic (although house price trends are slower-moving).

If you offer one household a loosened lending standard, you are (perhaps) doing them a favour — they have greater capacity for bidding for one house. If you loosen the lending standards for everybody, everybody can bid more, and that is exactly what ends up happening (and thus prices go up). The end result is that all the house buyers are worse off, while existing homeowners get a windfall gain.

I am in the camp that the infiltration of politics by real estate people has been disastrous — they view high house prices as being good for the country. (Older homeowners — like myself — are also part of the problem.) The dismal state of thinking on the topic is that almost every solution offered by politicians has been to make it easier to marshal spending power to allow households to pay more. (At the time of writing, there has been some movement towards pushing for greater rates of construction of new housing. Unfortunately, local politics often stymies such efforts.)

No Money Creation — So What?

Over the years, I have seen many versions of the argument that governments should “take advantage of the power of money creation” and replace banks as a source of lending. However, the people arguing this never pay any attention to the lending programmes that exist, and which are massive. For example, the CMHC had $440 billion of insurance-in-force in 2024 (which corresponds to 14% of Canadian GDP).

Central governments already create a significant amount of “money”: the monetary base. In the absence of forcing banks to hold government money via “quantitative easing,” government money holdings are driven by liquidity and portfolio management concerns (as well as the size of the underground economy). Otherwise, the government drains government money from the system via issuing bonds and bills. The existing government lending programmes skip the need to build liquidity management functions and instead piggy back off the Treasury/Ministry of Finance liquidity management. Since that is already how the central government operates, why should its lending activities behave differently?

The only way the lending operations would expand “government money” holdings is for a public bank to meaningfully expand its market share at the expense of private banks. However, offering banking services to the unbanked (the usual audience for postal banks) is not going to meaningfully grow demand deposit share. Almost by definition, unbanked people do not have a great deal of money. In order to grow market share, the public bank is going to have to offer a full range of financial services. Growing expertise and reputation is going to take time, while risking that entire operation is one election away from being privatised.

Postal banks can draw in a reasonable amount of long-term savings (as seen in the case of the Japanese postal bank). However, these savings are not interest-free demand deposits, the are instead interest-paying investment vehicles for risk averse individuals, or people with insufficient means to invest with private investment funds (which no longer appears to be a major concern). Countries like Canada and the United States issue “savings bonds” to serve such individuals. These savings vehicles are economically equivalent to substandard government bond investments, and so offering them does not really give the government any new financial flexibility.

In summary, the only reason to expand public banking to include lending activities is the desire to create a public sector bank that is competing head-to-head with private banks. Arguments about “public money” are by themselves meaningless, since governments already issue money in an efficient fashion.

The Problem with Lending Is Getting Paid Back

From the perspective of a professional politician, the problem with expanding lending to individuals outside of “approved” activities is that the government is stuck with the politically awkward problem of enforcing the debt contracts. One of the reasons that banks are unpopular is that they foreclose on people who miss payments, and politicians generally want to avoid situations that force them to make unpopular actions.

The political challenge is straightforward: the same people who might support an expansion of public banking are also the most likely to be squeamish about forcing repayment. One of the divisive issues of the doomed Biden presidency of 2021-2024 was an amnesty for student debt payments. The issue generated far more attention than it deserved. Nevertheless, the political reality is that handouts to households are an easy target for the financial and right-wing commentators, and lending money without enforcing repayment is in fact a gift.

Concluding Remarks

At the central government level, there are already schemes that support lending. These schemes do not attract attention — which partly explains why they still exist. They do not directly create “government money” (or “public money”), but that has no real economic impact. Central governments already create money, so they instead can just worry about providing support for borrowing for targeted purposes in an efficient way. Although some might wish that governments compete head-to-head with private banks, there is no need to do if the only objective is to expand opportunities to borrow.

References and Further Reading

• CHMC 2024 Annual Report. https://assets.cmhc-schl.gc.ca/sites/cmhc/about-cmhc/corporate-reporting/annual-report/2024/cmhc-annual-report-2024-en.pdf

Assuming that commodities start flowing through the Strait of Hormuz soon, the “worst case” outlooks have been invalidated. Nevertheless, it will take time for commodities to sail, and shuttered wells to be reopened. Energy prices are going to be higher than they were pre-war for some months, which may still be enough to create recessionary conditions.

The obvious political risk is that Trump will rotate to his next military adventures after this “victory.” We also have the re-negotiation of the three-way North American “free trade” pact to contend with.

I am midway through another article on public banking, should be published either Thursday or Friday.

This is an unedited draft section of my banking primer. My inflation manuscript is looking at Brent Crude price charts and sobbing.

The Traditional Postal Banking Model

Postal banks arose in the mid-nineteenth century, along side the rise of the industrial working class that replaced subsistence agriculture. Great Britain first offered postal savings in 1861, followed by other countries. Subsistence farmers only have limited contact with the monetary economy, but workers with wages are largely integrated. Postal banks gathered savings from poorer workers that traditional banks largely ignored.

The reason that these are “postal savings banks” as the bank’s “branches” are post offices, which were spread throughout the country. That is, on top of offering postal services, it was possible to do basic bank transactions at the post office.

The postal banking corporation would then buy government bonds with the cash inflows from deposits. This allowed savings from workers to be recirculated to the rest of the financial system, as otherwise it would likely have been stuck in the form of hoarded banknotes.

Equivalent to Banking at Central Bank

One idea that was floated after the 2008 Financial Crisis was that households should have the ability to bank at the central bank due to the risk of bank runs. (Banking at central banks is not unheard of, the Bank of England used to take in some retail deposits.) A postal bank is financially equivalent to having a deposit account at the central bank. The deposits by households would add to central bank liabilities, and they would buy central government bond to match the liabilities.

Some could argue that they are not exactly equivalent, in the sense that the central bank is effectively immune to default. However, there is no practical difference if the postal bank is owned by the central government — both the central bank and the postal bank are subsidiaries of the Treasury (or local equivalent). Any default is going to hit all the entities. Furthermore, a postal bank of the traditional model which only has central government securities as assets is also equivalent to a Treasury bill fund, which is not a major default risk.

In practice, a central bank that would offer the public deposits is going to end up with the retail banking arm being a largely independent entity. Central banks have zero expertise in dealing with retail customers or offering retail payments. Furthermore, they lack a branch system. So it would have to be a completely new group handling that work, with almost no skill overlap beyond the internal information technology infrastructure. Since the main assets are to be used are post offices, it makes more sense to put the postal bank within the post office bureaucracy.

Japanese Post Bank

The Japan Post Bank has the most noticeable impact in global capital markets. It was founded in 1875, but the process of privatisation was started in 2007. In March 2025, it had 13.59 million accounts. It has an automated teller machine (ATM) network as well as an internet banking arm (Yucho Internet Home Service). It also has partners who offer services, as well as offering commercial services. The deposit base started at 20,000 yen in Fiscal Year 1875, and peaked at 249 trillion yen in Fiscal Year 2000. (Statistics herein are mainly from the 2025 Annual Report.)

The asset side balance sheet of the Post Bank is dominated by securities and lending to banks, and deposits are the main liabilities. In 2025, the non-consolidated balance sheet had 233 trillion yen in assets, with 41 trillion being yen bonds, 91 trillion foreign currency securities, 64 trillion lent to banks, and 35 trillion in “other” assets. On the liability side, deposits (both ordinary deposits and term) were 190 trillion, and 43 trillion in “others” (including equity). To put the size of the deposit base in perspective, it held 20% of total household deposits in Fiscal Year 2024 (as given by their website).

The large foreign holdings of the bank are representative of Japanese balance sheets — local investors recycled Japan’s current account surplus by holding foreign currency bonds rather than Japanese Government Bonds that historically had yields much lower than international peers. (The New Keynesian central bankers elsewhere fixed the persistent yield gap after the 2008 Financial Crisis.) Although this makes the Japanese Post Bank more exotic than other institutions, they still mainly have securities and wholesale bank lending as assets — not a loan book.

Similar Institutions

Postal banking is a reduced form of what I refer to as “traditional banking”: offering deposit-taking and payments services to (mainly) retail clients. However, it is missing the exciting part of traditional banking: lending operations to clients, which is what allows “money creation.” Instead, it is an asset-gathering operation like a mutual fund complex.

The private sector can do similar strategies.

One rare strategy is for a retailer with a large store footprint to set up banking services. In Canada, there is President’s Choice Financial associated with the major grocery chain Loblaw’s (which has the house brand “President’s Choice” — the chocolate chip cookies are great), which has a Schedule I bank acting as the banking agent.

A more common strategy now is an internet-based bank. Technology companies are already sticking their noses into payments systems, and there are some financial firms that just offer online banking. In Canada, the Dutch ING bank set up an internet bank with a high savings account, although that operation was later bought by a Canadian bank and operates as the stand-alone Tangerine financial. The advantage of an internet-based bank is that it skips over the need for a branch system, and can gather deposits from across the country.

Postal Banking Great… In the Old Days

Using the nation’s post offices to offer basic payments services is efficient, and is definitely a great idea if you are sent back to a point in time before the 1980s. The problem more recently is the technological leaps in banking. If you are trundling around paper cheques (“checks”) and banknotes, pretty much anyone can get people to carry sacks of paper around. However, paper cheques are largely extinct in most of the developed world. (They survive in Canada, although people just take photos of them to cash them in on their banking app.) People now expect safe and sophisticated electronic systems (as well as ATM’s to get cash), and building and maintaining those systems is a major effort. (The “technology” people in Silicon Valley keep trying to enter into mainstream finance, with varying levels of success.)

Unless one already has an existing postal banking system, it is very hard to justify building a new system from scratch in most countries. The banking system is already efficient, and the payments systems sophisticated. If the government is concerned about poor people without access to the banking system, it is going take less resources to mandate/subsidise accounts serving such people than trying to build a new system that will barely be used. You can just take in bids to offer services in post offices from existing players if you want to use them as branches.

The United States is quite probably an exception to the previous statements. The payments system is a mess, and the banking system balkanised. A new national system of postal banking could be a good use of resources. Of course, protecting such a system from being vandalised by an incoming administration that seeks to deliberately destroy state capacity is a much greater problem at the time of writing.

What About Public Money Creation?

This section discusses the traditional postal banking model — which are deposit-gathering operations. However, this opens up a response from progressives — we need to move beyond deposit taking, and have the public postal bank harness the power of money creation. That is to say, offering direct loans. That possibility will be discussed in a later section.

References

• English translation of the Japan Post Bank’s 2025 annual report: https://www.jp-bank.japanpost.jp/en/ir/financial/pdf/en2025_all_view.pdf

Since these articles are expected to be bound into a banking primer manuscript, I was going to need to cover some of these basics long before I got to a section on public banks. But I will cover the basics herein, and not worry about the manuscript logic. There are also some assertions about technical issues which I would have to reconsider and dig into if they stay in the manuscript.

Bond versus Loan Basics

Bonds can be thought of as “negotiable loans,” but they behave differently than loans. They are both types of credit instruments, and therefore both have the property of growing financial assets and liabilities “out of thin air” when created. However, bank loan creation is mirrored by deposit creation and bank deposits are considered “money,” so that “bank loan creation creates money,” while this is not true for bonds. Furthermore, traditional banks obviously have a privileged position in bank loan creation, but have no special privileges with respect to bond creation. Bonds have underwriters, which historically were investment banks. (The central bank is typically the “underwriter” of central government bonds, although the procedures are different.) With the collapse of the “pillar system” (and equivalents), bank holding companies may own traditional banking and investment banking subsidiaries. However, for my discussions, when I refer to “banks” I am referring to the traditional banking subsidiaries, and not the holding companies (since we might as well refer to “the financial sector” in that case, since the holding companies may have their fingers in every type of financial intermediary role).

Being a publicly traded security is not automatic. There are legal steps to follow, and the securities have to be priced on an arm’s length basis so that they acceptable investments for retail investors, who are assumed in securities laws to not be sophisticated. For our purposes herein, there is a presumption that bonds are widely marketed, so a single buyer is not buying up the bulk of the issue. (We can ignore such concerns when discussing central government bonds, as they are a special case within securities laws.)

“Private debt” are fixed income instruments where the investors are all presumed to be large, sophisticated institutional investors, and the deal is structured with less safeguards. They do not qualify as public securities under securities law. At the time of writing, there is hand-wringing in the financial press about private debt. Since private debt are expected to be illiquid, I am biased to not worry about them until defaults are realised.

Underwriting, No Public Bank Purchase

We will now imagine a city issuing $900 of municipal bonds via a single underwriter, which is an investment bank that handles municipal bonds. (Yes, $900 is comically small for a bond issue, but I want nice easy numbers to visualise.)

What happens is that the lawyers at the underwriter set up the contracts for $900 in bonds, which represent $900 in debt for the municipality. It will then attempt to sell the $900 in bonds to the underwriter’s clients, although it will keep a certain amount of bonds for its own account on its trading books, as other clients may wish to buy some bonds later. If there is difficulty in finding clients willing to commit to buy, the pricing (e.g., the coupon rate on the bond) may need to be adjusted so as to bring in more sales.

Once the pricing is set and committed investors pay, the investment bank will wire the municipality the proceeds of issuing all the bonds ($900) less the fees that are charged to pay all the hard-working, salt-of-the-earth investment bankers and sales people (plus the investment bank’s profit). That is, there is a wedge between the proceeds received by the municipality and the par value of the debt, which is presumably amortised as an additional interest expense over the life of the bond.

If we ignore the fees paid for the bond issuance, the municipality grows its balance sheet by $900. It has $900 in bond debt added to the liability side of its balance sheet, and receives $900 in cash inflows from the underwriter.

If we assume that the city is using a public bank as its bank, the public bank gets $900 wired via the payments system as a new asset, but has an increase of $900 in deposit liabilities (held by the city). It cannot safely buy illiquid assets with that $900, since the city presumably did not borrow just to plop money into its bank account, it will spend down its cash balance.

Underwriting With Public Bank Purchase

We then imagine that the public bank buys $100 of the city’s bond issuance. Since there is a new, big buyer, the underwriter could increase the size of the bond issuance by $100 to $1000.

However, it appears unlikely that the public bank can just say to the underwriter “give me $100 of the bond issue, I will settle it up with the city directly” instead, it would need to pay the underwriter $100 to be allocated a piece. If there is any lag between the payment to the underwriter before the city is paid, the public bank has an immediate liquidity outflow that is then reversed by the $1000 inflow (less fees) to the city. (My original article assumed that there was such a lag.)

Once all the transactions associated with the bond issuance settle, we have the following situation.

• The city has $1000 in new deposits, which it will presumably spend.

• The public bank has a $900 net settlement balance change, plus a $100 in relatively illiquid municipal bond. Since the city is unlikely to spend the entire amount immediately, the settlement balances would likely be re-allocated to other higher-yielding assets.

Although the bond issuance improved the liquidity position of the city (and the public bank), that is due to the fact that it drew in $900 of cash from third parties. In order to get those inflows, the bond issue has to be seen as legitimate. Nobody sensible would want to buy into a bond issue where a subsidiary of the issuer (which is what the public bank is) is effectively drawing down 50% of the issue (for example). If the subsidiary needs to sell, the price of the bond in secondary market trading will tank — destroying the market value of the holdings of the other bond holders.

It should be noted that the public bank is now in a worse liquidity position than the previous case. In both cases it gets a deposit inflow. In the first case this is entirely matched by a settlement balance inflow, in the second, some of those settlement balances are replaced by illiquid municipal bonds. Since the city is probably not going to spend 100% of the proceeds immediately, this is manageable.

If the idea is that the public bank is going to offer lending support to the city, it is probably going to have to provide loans. However, those loans would run into concentration limits, never mind concerns about non-arm’s length dealings. Central governments do not worry about such rules when they deal with their central bank because they are the ones who set and enforce the rules.

Could the Public Bank be an Underwriter?

One natural idea to those who advocate public banking is for there to be a public municipal bond underwriter. This is not something that could easily be set up. To underwrite securities, you need highly paid legal and banking staff, and a sales team that can distribute the bonds to clients.

Although you might be able to find staff to handle the details of the bond issuance, it is very hard to conjure the client network out of thin air. There is a time cost to do due diligence on a new counterparty, so institutional investors are not eager to start dealing with a new small firm. Furthermore, the tax treatment of American municipal bonds makes the market fragmented — they are only attractive to entities that pay income tax in a particular state (which eliminates many institutional investors like pension funds that do not pay income tax directly).

Concluding Remarks

Even though bank loans and bonds are debt instruments, private banks have no special status for buying bonds. They need to wire funds to the entity selling the bond, like everyone else (although non-banks have their bank wire the funds on their behalf).

The only mitigating factor right now is that Iran is allowing some cargos to pass the Strait (particularly their own). To the extent that countries ignore the Americans and cut deals with the Iranians, there would be lessening of the strain on the global economy. However, flows are likely to be negligible until the end of the hostilities.

The only quick solution is that the United States and Israel stop bombing, and somehow convince the Iranians to stop shooting missiles and drones at ships. The issue is that Iran has no reason to believe that the bombing strikes are permanently finished. It appears that the Strait has not yet been mined to any extent — as that would end Iran’s ability to export. Mining would be an escalatory step that is likely to be taken if Iran’s ability to export oil is lost.

Military solutions are unlikely to open the strait within months. It would be necessary to occupy the cost around the strait and drive inland, and there are insufficient ground forces nearby to do that. Such a long stoppage puts us on a path to $200/barrel oil (with other resources like fertilizer also being squeezed). The global economy is staring at yet another recession initially caused by disrupted production chains.

The failure to get an international coalition to bail out President Trump was completely unsurprising. The help of NATO allies would not be minor — the U.S. pushed de-mining responsibilities to other allies (mainly those on the North and Baltic Seas, where Russian might hypothetically mine the waters). However, nobody is going to put their minesweepers in the path of Iranian missiles in the strait, so any such cooperation would only show up after there is a peace treaty (or the U.S. has occupied the coast).

This morning, Trump put out yet another post, this time threatening to abandon the war, leaving other countries the job of keeping it open. In other words, leaving Iran to dictate terms to other countries using the Strait. Saying this aloud is not going to help American credibility in the region.

Also on the news front this morning, the Producer Price Index was higher than expected. The White House’s hopes for rate cuts are about to run into considerable resistance. The rate cuts could materialise — if there are signs that activity has stopped dead.

The reasoning behind this somewhat random article was that I am considering a chapter in my future banking primer. My inflation primer manuscript is currently cowering in fear of Brent prices.

Public Banks

I will need to look at the literature to get a better handle on “public banks,” but I am aware of two models. The first is a national bank, often in the form of “postal banking” (a savings-oriented bank where you can use post offices as branches). The second are local banks owned by sub-national governments. The usual objectives for the government owning a bank is to ensure that banking facilities are open to all members of the public, that there be lending for publicly desired activities, and possibly general anti-bank populism.

For this article, I am only considering local banks, since postal banks are agents of national governments, and national governments have many tools to interact with sub-national finance.

How Many Bonds Could a Local Public Bank Buy?

The usefulness of a public bank for a state or municipality’s finances depends upon how many1 bonds it can buy. The amount is driven by the following equation (definition):

Amount of Municipals Bought = (Balance Sheet Size)×(Proportion of Bank Assets That are Municipals).

We can take these two components on the right hand side in turn.

1. The initial stumbling block to using a local bank to finance a municipality is that a new bank without a capital infusion starts out with $0 in assets. The municipality would presumably have to raise equity — which is a drain on the municipality’s finances. This means that the plan has to be long-term to allow the public bank to grow.

2. The asset weighting on a particular municipal bond is an important constraint for a bank. Municipal bonds are illiquid, and the issuer probably wants to have a much longer duration than a bank wants for assets. Banks are thinly capitalised, they cannot afford to take large losses adjusting their liquidity portfolio. Also, a public bank presumably has other mandates for its lending activities, which will consume the bulk of the bank’s asset mix. Finally, banks need to attract deposits — and the typical way to attract deposits is to make loans to the depositors and hope they stick around after they pay off the loan.

The liquidity issue is not trivial. If you are a major holder of a risky bond, any attempt to make major sales will move the market price — the other market participants know you need to raise liquidity, and they are not charitable institutions. Instead, they will exploit your weakness, and drop their bids on the bonds that you are trying to sell. This is generally not a feature of central government bonds due to the depth of the markets and the central bank backstop.

Suksawat & Ferguson Description Too Optimistic

If we look at the description in the article by Suksawat and Ferguson, they write:

Therefore, when a public bank purchases its own city’s municipal debt, the result is not a closed loop in which a finite amount of money is passed back and forth. Because the public bank actively generates money to purchase the debt, the operation dramatically enlarges the city’s fiscal space. In such an arrangement, the municipal government acquires funds in the short term to meet community needs. The public bank grows its holdings by receiving interest payments from the city. The loops, then, are not redundant; they are kinetic. Far from an inert circuit, a public bank that purchases city debt is a dynamic design that defies the artificial gravity of austerity.

The problem with their description is that they are describing the transactions at the point of purchase of the bonds, not the steady state. A municipality is not going to issue bonds so that it can build up its cash balances, they will need to spend that cash. Even if a municipality’s “subsidiaries” (library, fire department, etc.) bank with the public bank, their employees and suppliers will most likely not. The cash inflow would then turn into expected cash outflows. Which would then have to be met by selling the municipal bonds, which may be a problem.

For example, imagine that a city sells a convenient $100 in municipal bonds that are bought by the public bank. The public bank started with liquidity and capital ratios that were near its target. The public bank will end up with the following transactions (or some equivalent).

1. Sell $100 of liquid bonds (e.g., Treasurys) out of its liquidity portfolio to raise cash to pay for the municipals at “auction.” (The issuance of non-govvie bonds — the primary market2 — is typically via placements with dealers, which are less structured than the auctions for central government bonds. I will call this an “auction” for simplicity.)

2. Buy $100 in municipals. Although these might be placed in the “liquidity portfolio,” they are certainly less liquid than Treasurys. The city will deposit $100 into the public bank, allowing it to buy back $100 in Treasurys. It has expanded its balance sheet by $100, with +$100 assets in municipal bonds, and +$100 deposit liabilities.

3. Some time later, it will face up to $100 in outflows as the city (or “subsidiaries”) spend the raised cash. To avoid the transaction costs on the municipal bonds, it would likely sell Treasurys. The public bank’s balance sheet is back to its original size, but it has replaced up to $100 in Treasurys with municipals.

In order for the city to raise liquidity, it needs to issue municipal bonds to “outsiders” — which was exactly the situation without a public bank. The public bank bidding at the bond “auction” might help it go through at decent pricing, but that then pushes the problem of finding buyers in the secondary market — which is typically harder.

In summary, owning a public bank might help a municipality, but that public bank needs to be a profitable going concern before it would offer much help to the municipality’s finances. This underlying logic explains the structure of most financial subsidiaries of firms. They exist as a way of raising money to finance customer’s purchases, not to draw in deposits. About the only corporations that are interested in setting up deposit-gathering banking subsidiaries are ones with extremely large retail footprints (like some tech companies or even grocery stores). They have the equivalent of a branching network, so why not use it?

Why are American Municipal Bonds Illiquid?

The bond market for American state and local finance — collectively called “municipals” — is an illiquid mess. The reason for this is that it is separated from global fixed income markets by their tax treatment. For example, my job title at one point was analyst for a large Canadian provincial bond portfolio, but my team looked at sub-national bonds for other currencies as well — but American municipals were not looked at.

American municipal bond interest income are income tax free for residents. Which is a subsidy for the municipalities, and allows them to borrow at much lower rates. The reason is that the buyers are comparing the after-tax yield on other bonds versus the raw (tax-free) yield on the municipal. As a result, municipalities with decent credit ratings can typically borrow at rates below U.S. Treasury yields.

Although this subsidy is nice, it also means that municipals are effectively uninvestible for any entity that does not pay income tax in that local jurisdiction — which is most of real money fixed income investors. (There are some dedicated municipal bond funds.) This means that only a few local institutions and upper/middle class retail are buyers, and so the market is buy-and-hold investors. Which means that there is very little secondary market activity. Even if the municipal bonds get really cheap so that they have higher yields than other bonds does not help much — responsible bond managers have to do credit analysis before buying, and global investors do not have any American municipal bond experts on staff.

By contrast, Canadian provincial bonds have no special tax treatment, and provincial governments have a large economic footprint. As such, they have issuance departments that are as sophisticated as large corporations (for example, they issue foreign currency denominated bonds that are swapped back into Canadian dollars).

Pension Funds a Better Match

The problem with trying to place your bonds with banks is that they inherently have a short-term liquidity focus. You need buy-and-hold investors. On the institutional side, these are mainly life insurers and pension funds. An in Quebec, a model exists — a Caisse de dépôt et placement du Québec. It manages public pension plans, including Quebec Pension Plan — which was carved out of the national Canada Pension Plan (equivalent to Social Security in the United States). (It also manages some public liquidity portfolios and pension plans that would normally be private, such as for the construction industry after some financial scandals in the past.)

La Caisse is not just a garbage dump of provincial and municipal debt — it is more a fund manager that the depositors (weighted towards pension funds) have asset allocations to meet their investment needs. (E.g., depositors with liquidity portfolios are mainly money markets with some bonds, pension funds are mainly in risk assets.) Nevertheless, it is a large buyer of Quebec provincial bonds (and municipals3), and helps stabilise the market from the whims of the bond traders down the 401 Highway in Toronto. (This was a concern in the 1970s when separatism fears peaked.)

However, the tax treatment of municipals in the United States is likely a problem. (Please note that these comments are an educated guess on my part.) Pension funds are pass-through vehicles that are not directly taxed — the payments to plan members are taxed on their individual tax forms when funds are withdrawn (years after intermediate interest income was earned). As a result, municipal tax-free status does not appear to help pension funds holding them.

Risk

The problem with this type of strategy is that everyone involved is losing diversification risk. If the local economy goes into the toilet, the local public bank may face insolvency risk. At the same time, municipal finances would likely go all to heck. In such a situation, having the local public loaded up with local municipal debt would just be blood in the water for the financial sharks.

This is of course a problem for pension funds, which is why that allocations to local bonds is not going to be too large (unless the “local economy” is relatively large).

Concluding Remarks

The central government has a natural monopoly on currency issuance, in the sense that it is hard for competing currencies to gain market share. This applies to both private and sub-national government currencies.