Government Debt Placement Essay

Custom Student Mr. Teacher ENG 1001-04 17 November 2016

Government Debt Placement

If a central bank has this responsibility, it is expected to place government debt on the most favourable terms possible. Essentially, a government can instruct the central bank to raise seigniorage income43 through a variety of methods, which include a reserve ratio (requiring banks to set aside a certain percentage of their deposits as non-interestearning reserves held at the central bank – an implicit tax), interest ceilings, issuing new currency at a rate of exchange that effectively lowers the value of old notes, subsidising loans to state owned enterprises and/or allowing bankrupt state firms that have defaulted (or failed to make interest payments) on their loans to continue operating. Or, the inflationary consequences of an ongoing liberal monetary policy will reduce the real value of government debt.

This third objective is important in emerging markets, but by the close of the 20th century has become less critical than the other two functions in the industrialised world, where policies to control government spending means there is less government debt to place. A notable recent exception is Japan, where the debt to GDP ratio is 145 and rising (2002 figures). In emerging markets, central banks are usually expected to fulfil all three objectives – ensuring financial and price stability, and assisting the government in the management of a sizeable government debt. While all three are critical for the development of an efficient financial system, the central banks of these countries face an immense task, which they are normally poorly equipped to complete because of inferior technology and chronic shortages of well-trained staff.

The Bank of England had a long tradition of assuming responsibility for all three functions, but in 1997 the Chancellor of the Exchequer announced the imminent separation of thethree functions, leaving the Bank of England with responsibility over monetary policy the FSA44 regulates financial institutions, including consumer protection and prudential control of the banking sector. The Japanese government created the Financial Supervisory Agency in 1997, to supervise banks and other financial institutions. Part of the Prime Minister’s office, this Agency has taken over the job previously undertaken by the Ministry of Finance and Banking of Japan.

The United States assigns responsibility for prudential regulation to several organisations including the Federal Reserve, Comptroller of the Currency and the Federal Deposit Insurance Corporation. The Federal Reserve also sets an independent monetary policy. Until France became part of Euroland, the 20 000 plus employees of the Banque du France played a dual role: implementing monetary policy and regulating/supervising the banking system. In Germany, since the advent of the euro, the Bundesbank has lost its raison d’?etre, and has lobbyied hard to assume a regulatory role.

There are potential conflicts if one institution is responsible for the three objectives of price stability, prudential regulation and government debt placement. Given the inverse relationship between the price of bonds and interest rates, a central bank with control over government debt policy might be tempted to avoid raising interest rates (to control inflation) because it would reduce the value of the bank’s debt portfolio. Or, it might increase liquidity to ease the placement of government debt, which might put it at odds with an inflation policy.

Consider a country experiencing a number of bank failures, which, in turn, threaten the viability of the financial system. If the central bank is responsible for the maintenance of financial stability in the economy, it may decide to inject liquidity to try and stem the tide of bank failures. It does this by increasing the money supply and/or reducing interest rates, so stimulating demand. The policy should reduce the number of bankruptcies (personal and corporate), thereby relieving the pressure on the banking system.

However, if the central bank’s efforts to shore up the banking system are prolonged, this may undermine the objective of achieving price stability. Continuous expansionary monetary policy may cause inflation if the rate of growth in the money supply exceeds the rate of growth of national output. The central bank may be faced with a conflict of interest: does it concentrate on the threat to the financial system or is priority given to control of inflation? The dilemma may explain the recent trend to separate them. If the central bank is not responsible for financial stability, it can pursue the objective of price stability unhindered.

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