John Fairhall asked this question on the blog yesterday in response to my post on bond sales feeding off themselves (and I have edited it slightly):
Thanks for the post and the infographics.
I am being extremely dense, so excuse me.
I get that buy a government bond 30 years at 6%, that's a steady fixed rate of interest for 30 years. When it matures I get my money back.
If interest rates go to say 10% on the face of it I should sell and try to buy the 10% government bond.
I may not be able to sell my bond for my cost price ( say £1bn) and make a loss of say £300mn. If this is my only capital is not a sensible strategy. I need to keep my capital. So I sit it out.
What I find difficult grasping is how does the secondary market in government bonds affect interest rates when no new money is being ” created”?
To me it seems to be just “clever financial stuff” that makes a lot of money for the City. With the usual City risk of no one has any idea what is going on and there will be crisis at some point.
Why should the UK issue new government bonds at a higher rate of interest due the secondary market swings, when it can just sit the “game” out?
Has the UK government committed to a policy that is daft?
I have been asked to share my response more widely, as some people thought it was useful. This is what I wrote, although I have expanded one section here to emphasise the choice that the government can make:
You are not being dense. You have asked an important question about the government bond market.
Your understanding of your 30-year bond is correct. If you hold it to maturity, you receive the promised interest and your capital back, assuming the government honours its obligations. What happens to its market price in the meantime need not concern you.
The secondary market is different. Existing bonds are traded between investors, and their prices change according to what buyers are prepared to pay. When prices fall, the yield to someone buying those bonds rises. No new government money is created by that transaction. It is simply a transfer of an existing financial asset.
The problem arises because the government uses secondary-market yields as a benchmark when issuing new bonds. Investors will not normally buy a new bond offering substantially less than they can obtain on an equivalent existing bond. The government is therefore asked to offer higher yields on new issues.
But your final question is the crucial one. Why must the government accept those terms?
The answer is that it does not have to, as a matter of monetary necessity. Government spending creates money. Bond issuance then offers savers an alternative way of holding financial wealth. The government does not need to obtain money from bondholders before it can spend.
The UK has chosen institutional arrangements that link government financing to bond issuance and market pricing. Those arrangements could be changed, although doing so would require decisions about monetary policy, interest rates and inflation management. In particular, the government could decide not to issue bonds when interest rates are too high and borrow from the Bank of England instead, waiting for a more orderly market before issuing bonds again. Technically, nothing stops it from doing that. It does not do so by political choice alone.
So you have identified the fundamental issue. Why should the cost of government financing be dictated by secondary-market transactions when the government is the issuer of the currency in which those bonds are denominated?
That is exactly the question I think we should be asking. The government is not bound by the bond market. Since 1981, when Sir Geoffrey Howe, Thatcher's then Chancellor, introduced the so-called full funding rule, it has chosen to be so, but that decision could be revoked. The question is: why isn't that being done now?
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Of course the government doesn’t have to accept the secondary market price. QE was exactly that – okay, it was the government selling bonds to the BoE, rather than not issuing but it comes to the same thing.
However, QE had implications that we are still pondering…. and a new round of QE would have implications for inflation and FX.
Which ever way you cut it, tax must rise.
And the full funding rule must go.
As should the Bank of England’s independence.
But I think we agree on those.
The full funding rule was explicitly revoked during COVID and the 2008 GFC, proving it is a choice rather than a necessity.
I am not sure I agree. QE maintained the pretence.
Thanks again for incisive information.
Might the ever needed question, “Who benefits?” be relevant here?
Might if be that while politicians, senior civil servants and main stream media journalists “do not buy bonds on a trading platform, their retirement wealth is deeply tied to the performance of the bond market”? (AI Overview)
So if I may add a follow up dense question, is it correct to say that the change in price on the secondary market doesn’t affect the initial coupon rate and so this idea that “government borrowing costs” increase as the yield increases is fallacious?
Yes, you are right about the essential distinction, although there is one qualification.
When a government issues a conventional fixed-rate bond, its coupon is fixed for the life of that bond. If the bond subsequently falls in price on the secondary market, its yield rises, but the government does not pay any more interest on it. The change in yield affects the return received by whoever buys the bond at its new market price, not the government’s existing contractual obligation.
So when commentators suggest that rising yields automatically increase the cost of servicing all outstanding government debt, they are wrong.
The qualification is that higher market yields can affect the terms on which new bonds are issued, or existing bonds are refinanced at maturity. That is why governments that choose to continue issuing bonds may face higher interest costs over time.
But that raises another question: why should a government that creates its own currency be obliged to issue bonds at whatever interest rate financial markets demand?
It is not. Bond issuance is a policy choice, and so is the decision to accept the interest rates demanded by investors.
The important distinction is between the interest the government has already committed to pay, which does not change with secondary market prices, and the interest it might choose to pay on future bond issuance.
Much commentary about government borrowing costs fails to make that distinction.
Richard, the mechanics are right; the conclusion isn’t.
Secondary trading creates no money, and new gilts do price off existing ones. But “borrow from the Bank instead” isn’t a free option. When the Treasury spends via Ways and Means or the Bank buys gilts, banks end up holding extra reserves, and the Bank pays Bank Rate on them. The state hasn’t escaped interest. It has swapped fixed long-term debt for floating overnight debt. That only saves money if Bank Rate stays below the gilt yields being refused. Taxpayers are covering the Bank’s QE losses precisely because that bet went wrong when rates rose.
Nor are long yields just City noise. A 30-year yield largely reflects expected future Bank Rate plus a premium for inflation and fiscal risk. Refusing to issue doesn’t change those expectations. Announcing you’ll bypass markets whenever prices displease you is likely to worsen them, weakening sterling and lifting inflation expectations. An independent Bank would then respond with higher rates. The constraint just moves from gilt yields to inflation and the currency, which MMT itself accepts is the real limit.
John’s “sit it out” logic doesn’t scale either. He can hold to maturity. The government must refinance well over £100bn a year, and many gilt holders (pension LDI funds, insurers, banks) are marked to market. That’s why 2022 spiralled.
If the aim is cheaper funding when long yields are high, the Debt Management Office already has the lever: shift issuance towards shorter gilts and Treasury bills. That carries rate risk, but it’s honest about the trade-off.
Bypassing the bond market doesn’t abolish its verdict, Richard. It just sends the bill somewhere else.
Again, you get things wrong.
There is no legal obligation to pay interest on reserves. I have long argued it should not, at least on their entirety.
You are so wrong.
Thank you Richard. I’m in agreement. The secondary bond market is about financial speculation. The “interest” on existing goverment debt (e.g. yields at issuance) do not change. Rather it pushes up the “interest” on future government bonds. As you say, there is no necessity for tbe UK government to issue bonds, as it can “borrow” from itself.
But Bailey is now making it the priority.
Agreed.
My answer to your final question : reflexive fear of hyperinflation from politicians and the general public that don’t (yet) understand MMT. Politicians that do understand are in the minority and likely afraid of major pushback. So we need to keep going like a broken record with the messaging that defecit spending to purchase the real resources (including labour) currently sitting idle (and put them to work in creating or enabling fresh supply) will not drive inflation. Hopefully it will cut through eventually. Real case studies may also help soothe some of the anxiety e.g. Bank of Canada direct financing 1945-1974. No hyperinflation there.
Agreed
Well done John & Richard.
I was not aware of what Howe did in 1981. I was questioning this in my post too.
So to me, looking at this with new eyes, this is essentially a form of privatization in my view. However, what is extraordinary is that this is essentially the privatization of a sovereign money supply. There is nothing natural about this, when one considers the history of money – Howe committed an ahistorical act.
Let’s be clear here: Power has been ceded to a market in the name of ideology.
As far as I am concerned, Thatchers’ government committed a seditious act against it own state, it’s own democracy. ‘The enemy within’ was her.
You have spoken a lot about choices Richard, and now – learning this – your point hits home hard. We have been betrayed – it’s as simple as that for me. They’ve essentially given away the whole ranch.
The ‘Full Funding Rule’. What an abuse of language. What an abuse of power. And New Labour got into power and did not rescind it? And Starmer tolerated it? Burnham?
Honestly, I’ve never pretended to know everything but I’m past angry about this. And please don’t anyone mention bollocks like ‘market/debt discipline’ or anything like that.
We been taken for mugs, the lot of us. And I don’t like that at all.
Much to agree with
Wasnt there some sort of change in the way Government Bonds were sold so Government went from being a price maker to a price taker?
Effectively, the full funding rule did that.
You would have thought that one of the Labour Chancellors, since Geoffrey Howe introduced the full funding rule in1981, would have thought to revoke it. I guess they weren’t very bright 🙁 . Sir Geoffrey must be laughing in his grave.
Agreed