Gary Stevenson has produced a long video explaining, he claims, bond markets and why he thinks they now dominate government policy.

There is some material in this that I agree with:

• He is right to argue that wealth concentration has shifted political power.
• He is right to warn that governments believe that they have become increasingly beholden to financial interests.
• He is also right that taxing income and gains from wealth more is important if democracy is to be restored.

But he also gets some fundamental things wrong. Those mistakes matter because they lead him to conclude that governments are financially dependent on bond markets. They are not.

The problem is not that his politics are wrong. It is his explanation of how government finance actually works that is wrong, because it is very incomplete.

Governments do not borrow because they need money

Gary presents the conventional story:

• Government spends
• Taxation covers the cost of part of that spending, and
• Government borrows the money needed to pay the rest by issuing bonds.

The story might be conventional, but this is not how a currency-issuing government works. The reality is:

• The government spends first.
• In doing so, it creates deposits and reserves within the banking system.
• Taxation then removes some of that money from circulation in the economy.
• What is left, the deficit, is simply the money that the government has spent but has not yet taxed back.

The money used to buy government bonds is, therefore, money that government itself has already created. Gary never comes close to explaining where those funds come from. That is a major oversight.

As a result, he fails to point out that the government is not borrowing money that existed independently of its own spending.

Bonds do not fund government

In that case, anyone buying a newly issued gilt or government bond does not provide the government with spending power that it previously lacked. Instead, the purchaser exchanges one government liability for another.

In accounting terms, this is simply an asset swap:

• A bank deposit backed by central bank reserves is exchanged for
• An interest-bearing government bond.

The government has not acquired new money. It has merely altered the form in which part of its liabilities are held. It is indisputable that this is the case. This is what happens.

The Bank of England is largely missing from the story

Gary correctly explains that a higher Bank of England Bank Rate leads to higher gilt yields, but what he never asks is why the Bank Rate is where it is.

Nor does he examine the role of the Bank of England in shaping today's bond market through decisions on interest rates, the payment of interest on reserves, quantitative easing or quantitative tightening, and yet all of those are government policy choices.

Before concluding that “the bond market” is disciplining government, it is reasonable to ask how much of that discipline has been created by decisions made by the Bank of England itself.

QE and QT scarcely appear

These are perhaps the most surprising omissions from Gary's video.

Quantitative easing (QE) fundamentally changed the gilt market. The Bank of England purchased hundreds of billions of pounds of government debt, replacing privately held gilts with reserve balances.

Now it is reversing that process through quantitative tightening (QT). QT increases the amount of government debt that private investors must absorb and may therefore contribute to higher yields.

It is impossible to understand today's gilt market properly without understanding QE and QT, and their role on interest rates, but Gary almost ignores them.

Reserves hardly feature

Modern government finance revolves around reserve accounts held at the Bank of England.

Those reserves are the balances held by banks and other financial institutions with the Bank of England, used to settle balances owed between these institutions within the banking system. Yet they barely appear in Gary's explanation.

Without understanding reserves, it is impossible to understand what happens when government spends, taxes, issues bonds or redeems them.

Gary said his video would answer all questions on bonds, and then missed most of the key issues.

The repo market also disappears

Gary persistently describes government bonds as investments in his video, but that is only part of the story.

Government bonds also underpin the financial system because they are widely used as collateral in the City of London repo markets. Banks, investment firms and other financial institutions rely upon them to manage liquidity and finance their own activities. Without bonds, banking in the City of London would fall apart.

The City does not simply do the government a favour by buying gilts.

The City absolutely depends upon a continuing supply of gilts for its own business model to work. That makes the relationship one of mutual dependence, not one-sided dependence.

Gary ignores that.

Foreign investors do not create sterling

Gary does note that foreign investors buy British government bonds. What he never explains is where those investors obtain the sterling needed to do so.

They cannot create sterling. Instead, they acquire it through trade or capital transactions before deciding how to hold it.

At that point, they choose among different sterling assets, including bank deposits (which are not safe, as far as they are concerned), corporate securities, and government bonds.

They are choosing how to hold sterling. They are not supplying the government with money that did not already exist.

Trade is missing from the story

The UK's persistent current account deficit helps explain why overseas investors accumulate sterling financial assets.

Government bonds are simply one of the ways in which those balances can be held.

That important connection between international trade and government debt receives virtually no attention in Gary's video.

Risk

There is another reason why government bonds are so important, and Gary barely touches upon it.

Gilts are regarded as the closest thing the financial system has to a risk-free asset.

That is not because governments are morally superior borrowers. It is because a government that issues debt in its own currency can always settle that debt. It can never be forced into default by a shortage of sterling.

Bondholders know this. They may worry about inflation reducing the real value of their investment, but they do not worry that the UK government will simply run out of pounds.

That confidence is precisely why gilts are treated as the safest sterling asset available and why they underpin so much of the banking and financial system.

Fiscal rules are treated as if they were natural laws

Gary argues that governments are constrained by bond markets.

There is truth in that, but only if governments want to believe that is the case. What Gary never considers is the extent to which governments have voluntarily created those constraints through fiscal rules and institutional arrangements.

Markets influence governments because governments have allowed them to do so.

Those arrangements can also be changed.

The Treasury and the Bank of England are analysed separately

Throughout the discussion, the Treasury and the Bank of England are treated as though they were independent actors.

Operationally, they are both parts of the state. It is pointless to pretend otherwise. It is just an artifice that they are supposedly separate.

Analysing them together rather than separately changes the way government finance is understood.

That is one of the central insights of modern monetary theory.

The biggest omission

Perhaps the most important point missing from Gary's analysis is one simple accounting identity, explained by the sectoral balances.

These show that the accumulated financial wealth of the private sector is, to a considerable extent, the accumulated financial deficit of the government.

The money used to buy government bonds originated with government spending. Once that fact is recognised, the central question changes. Instead of asking:

Who funds government?

We should ask:

Why does government choose to convert reserve balances into interest-bearing bonds?

That is a very different question.

In summary 

For a supposedly comprehensive explanation of government bonds, Gary missed out a great deal and got almost all the basic economics of the bond market wrong.

So, what did Gary get right?

None of this means Gary's wider political analysis should be dismissed.

He is right that governments have sold public assets.

He is right that wealth has become increasingly concentrated.

He is right that concentrated wealth brings concentrated political power.

He is also right that governments have become excessively responsive to financial interests.

But none of those conclusions requires the belief that governments need wealthy investors to finance their spending.

Governments create the money they spend. No one else can, or does

The private sector accumulates it.

Government then offers bondholders the opportunity to exchange one public liability for another.

Bond markets undoubtedly exercise political influence today.

But that influence is not a law of economics.

It is the result of institutional choices, monetary arrangements and political decisions. Those choices can be changed. And taxing wealth need not be a component in that decision-making process, not least because the gains on many of these bonds will fall outside tax because of who owns them and where.

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