Michal Lerner

In this article I compare the role of the central banks in government spending in two large capitalist states, the UK, the US.  I have chosen these two states because they are both states which are the monopoly issuers of their own currency.  In a later article I will look at the role of the central bank in Japan.

The Role of the Central Bank in Government Spending in the UK

In the UK, government spending is ultimately authorised politically rather than constrained by the availability of money. To see how this works in practice, I examine the roles of Parliament, the Bank of England (BoE), the Treasury and the Debt Management Office (DMO), as well as the policy conventions that affect their interaction.

The Bank of England

Although originally established as a private joint-stock company in 1694, the Bank of England was nationalised in 1946 and reconstituted as a statutory corporation, with the Treasury as the single shareholder.   While it operates with statutory operational independence, this independence is delegated by Parliament and could be altered by legislation.

The rate of interest

We will argue below that changes in monetary management were much driven by the desire of the BoE to retain effective control of the rate of interest.  The BoE is a firm believer that there is a strong correlation between inflation and unemployment, that to reduce inflation it will need to increase unemployment.  It believes that if it increases the rate of interest it can reduce demand in the economy and so increase unemployment and therefore reduce inflation.  We shall not consider here the truth of this theory, merely make note of it.

Parliamentary authorisation

The government can only spend amounts that have been approved by Parliament through Votes of Supply. These votes provide the legal authority for expenditure. They do not, however, involve the government first collecting money or securing funding in advance in the way that a household or firm must.

How government spending is executed

Once spending has been authorised, payments are carried out through the Bank of England (BoE), which acts as the government’s banker. When the government purchases goods or services from the private sector, it initiates payment via the BoE. The recipients of these payments hold accounts at commercial banks (such as NatWest or Lloyds), not at the BoE itself. The suppliers’ commercial banks credit the suppliers’ deposit accounts, increasing the liability side of the commercial banks’ balance sheets. In settlement of this payment, the BoE credits the reserve accounts that those commercial banks hold at the BoE, increasing the asset side of the commercial banks’ balance sheets. 

Operationally, the Bank of England does not verify the existence of pre-existing funds in a government account before making these payments. Instead, it creates the necessary reserves as part of the settlement process. The result is an increase in private sector bank deposits and the level of reserves held by commercial banks, equal to the amount of government spending injected into the economy.

This does not imply that the Bank of England operates without constraints or independently chooses to monetise government spending. The BoE is operationally independent and acts within a framework agreed with the Treasury and Parliament. However, within that framework, the Bank of England is legally required to create the reserves necessary to ensure that authorised government payments clear without disruption to the payments system.

Government revenue and debt issuance

At roughly the same time as government spending takes place, an agency of the Treasury, called the Debt Management Office (DMO), estimates the difference between total government expenditure and total government revenue, the latter consisting largely of tax receipts and revenue from government bond sales. When government spending is greater than revenue, this difference is commonly referred to as the government deficit.

Under current policy conventions, the DMO issues government bonds, known as Gilts, to match any deficit. Gilts are financial instruments that promise interest payments and the repayment of principal at specified future dates. They are sold to the private sector via auctions, with the price determined by investor demand. In this process, the government acts as a price taker.

In practice, cash management, reserve levels, and gilt issuance are carefully coordinated between the Treasury, the DMO, and the Bank of England. Issuance is planned in advance and adjusted to maintain orderly financial conditions. At a system-wide level, the purpose of gilt issuance is to drain reserves that have already been created through government spending.   It is not to provide the government with the money required to spend in the first place.  

The practice of auctioning Gilts, equal in value to the deficit, reflects what is known as the full funding rule, introduced in 1985. Under this rule, bond issuance works to drain an amount of reserves broadly equivalent to those reserves created by government spending in excess of taxation, as part of the management of liquidity and interest rates. Importantly, this rule is a matter of policy rather than law, and could be altered or abandoned by political decision.

From the BoE perspective, reserves should be drained so that it can retain control over the rate of interest.  Excess reserves would have caused the interbank rate of interest to drop below what the BoE thought was the required rate of interest to control inflation.  The BoE believed this in the period from 1985 to 2006.  In 2006 the BoE introduced payment of interest on all the reserves in a reserve account (called reserve remuneration).  In the post 2006 world, excess reserves are, as we shall see, less problematic.

Contrast with the Pre-1985 Monetary and Fiscal Regime

Prior to 1985, the UK operated under a markedly different framework for coordinating fiscal policy, debt management, and central bank operations. While government spending still required parliamentary authorisation, the mechanisms used to manage deficits and liquidity did not rely on the full funding rule or on the appearance of market discipline.

Under the pre-1985 regime, the government determined the terms on which Gilts were issued, including their price. If the private sector did not purchase sufficient quantities of Gilts to cover the government’s deficit, the remaining shortfall was financed directly through the Bank of England. This financing took the form of an increase in the government’s Ways and Means account at the Bank.   The Ways and Means account is essentially a limitless overdraft facility that the government has at the BoE.

In this framework, gilt issuance was not treated as a prerequisite for government spending, nor was it required to match the deficit. Instead, bond sales were used flexibly as a tool for monetary management, while the central bank ensured that authorised government payments cleared.  In this context, monetary management means, largely, controlling the rate of interest.  Bond sales drained reserves and gave the BoE more control over interest rates.  Note, the BoE only pays interest on a part of the money in reserve accounts before 2006.  So it makes more sense to invest unused reserves in interest paying government bonds rather than leave them earning no interest.

Importantly, this pre-1985 arrangement did not result in operational instability or the breakdown of monetary control. The Bank of England kept the ability to manage interest rates and liquidity through a range of instruments, while fiscal policy remained what the elected government of the day wanted it to be. The existence of direct central bank financing made explicit that a currency-issuing government is not financially dependent on private sector saving in order to spend.  The bond vigilantes were nowhere on the horizon.

The shift in 1985 marked a significant change in the political framing of fiscal policy. By requiring deficits to be fully matched by gilt issuance at market-determined prices, the full funding rule re-cast government spending as dependent on market confidence. This institutional change reinforced the narrative that public and private sectors compete for financial resources, and that public sector spending can be limited by external discipline.

In contrast, the pre-1985 regime treated markets as participants in, rather than arbiters of, fiscal policy. Government debt issuance supported monetary operations but did not define the limits of fiscal policy.   The move away from this framework simplified the BoE’s task of controlling the rate of interest while introducing the idea of market based limits on the fiscal policy decisions of the elected government].  The bond vigilantes had arrived.

Payment of interest on full balance in reserve accounts

Although the full funding rule reduced the likelihood of persistent excess reserves, the Bank of England later decided it wanted even tighter control over short-term interest rates. In 2006 it introduced payment of interest on reserve accounts at the Bank rate (called remuneration of reserve balances at Bank Rate). Once reserves earned Bank Rate, they became a risk-free asset yielding exactly the policy rate.

Henceforth, no commercial bank would rationally lend overnight at less than Bank Rate when it could earn that rate simply by holding reserves. In effect, paying interest on reserves created a firm floor under the overnight interbank rate. The Bank no longer needed to fine-tune the scarcity of reserves to keep market interest rates from drifting below target.

In that sense, reserve remuneration largely eliminated the operational need to worry about “excess reserves.” That proved fortuitous after the dramatic expansion of reserves during the Global Financial Crisis and the Covid pandemic. Despite the enormous growth in reserve balances, the overnight rate did not drop below Bank rate, because reserves themselves earned Bank Rate.

This development raises a natural question. If one historical purpose of issuing gilts was to drain reserves so that the overnight rate did not fall to zero, what is the point of issuing gilts once reserves are remunerated?

The answer is that gilts are not simply a mechanism for parking surplus reserves. They serve broader and deeper functions. Gilts provide safe long-term assets for pension funds and insurance companies, high-quality collateral for financial markets etc.

In other words, once interest is paid on all reserves, gilt issuance is no longer essential for short-term rate control. But it remains central to the structure of financial markets, institutional portfolio needs, and the overall functioning of the monetary system.

The pandemic and government spending

During the UK pandemic roughly a fifth of the workforce was furloughed. Without the scheme many would likely have become unemployed. The government paid up to 80% of wages, and when those payments were made the Bank of England created the corresponding reserves in the banking system. Although gilts were issued to match the higher deficit, the Bank of England’s expanded QE programme absorbed a very large share of that issuance through secondary market purchases.  It was a real-world demonstration that, when required, the UK state can mobilise monetary and fiscal coordination at scale.

In summary: In the UK, government spending is enabled by parliamentary authority and operationally supported by the central bank.  The issuance of government debt under the full funding rule reflects a political and institutional choice about how fiscal and monetary policy are organised, rather than an economic necessity.  Understanding this distinction is essential for informed debate about the role of government, markets, and the state in managing the economy.

The Role of the Central Bank in Government Spending in the US.

The Federal Reserve is the central bank of the United States, created by Congress in 1913 under the Federal Reserve Act. It has a distinctive federal structure that combines public authority with regional representation.

At the centre is the Board of Governors in Washington, D.C. The Board consists of seven members appointed by the President and confirmed by the Senate. Governors serve long, staggered terms (14 years), which are designed to insulate them from short-term political pressure. The Chair and Vice Chair are selected from among the governors for renewable four-year terms.

Alongside the Board are twelve regional Federal Reserve Banks located across the country (for example, in New York, Chicago, and San Francisco). These Reserve Banks carry out operational functions such as supervising banks, providing payment services, and implementing monetary policy operations.

Monetary policy decisions are made by the Federal Open Market Committee (FOMC). The FOMC consists of the seven Governors, the President of the New York Fed (a permanent voting member), and four other regional Fed presidents who vote on a rotating basis.

Although the Reserve Banks have a quasi-corporate structure and member commercial banks hold shares in them, ultimate authority rests with Congress, which created the system and can amend its powers. The Federal Reserve is therefore operationally independent, but constitutionally subordinate to Congress.

When discussing government spending in the UK we emphasised the fact that once spending is approved by Parliament nothing can stop that spending happening.  Can the same be said of the US?

The Federal Government can only spend money that has been approved by Congress.  Once such spending has been approved the government instructs the Federal Reserve to pay the people from which it is buying goods and services.  However, unlike in the UK, the Federal Reserve does not immediately do that.

The 1913 act that set up the Federal Reserve stipulates that government payments can only be made if there are sufficient funds in the government account at the FR known as the Treasury General Account (TGA).  Before instructing the FR to make a payment, the Treasury must therefore insure that it has sufficient funds in the TGA account.  If there are not sufficient funds then the Treasury must use taxation and/or bond sales to increase the amount in the TGA account to the required level.

The preferred method is bond sales.  However, this can raise a problem because Congress also controls something called the ‘debt ceiling’. The modern debt ceiling originates from later legislation.

Before 1917, Congress authorised federal borrowing on a bond-by-bond basis. During World War I, Congress passed the Second Liberty Bond Act of 1917, which introduced aggregate limits on certain categories of federal debt. Over time, those limits were consolidated into a single overall statutory debt limit in 1939.  The debt ceiling is therefore a separate statutory mechanism governing Treasury borrowing authority, not part of the original Federal Reserve framework.

So Congress can authorise expenditure and at the same time use the debt ceiling to limit the ability of the government to spend.

During debt ceiling episodes

When the statutory debt limit has been reached, Treasury cannot issue new debt. It then uses “extraordinary measures” to conserve cash and manage the TGA balance. But it still cannot cancel congressionally mandated spending on its own authority.  Payments may be delayed — not legally cancelled.  

It’s an odd situation.  The existing debt is the level of debt which previous Congresses have brought about.  So, in a way, the current Congress is making an implied criticism of previous Congress decisions by refusing to increase the debt ceiling.

Typically Congress uses the debt ceiling to extract some other promises from the government that the government is reluctant to make.  Eventually some compromise is reached and the pantomime ends.  The United States is one of the few advanced economies that requires a separate vote to finance spending that has already been legally enacted.

In the UK system, the Treasury and the Bank of England operate within a different constitutional framework. There is no statutory debt ceiling comparable to the US one, and the executive (the government of the day) is drawn from Parliament, which makes spending control more unified politically.

At first glance this difference with the UK may seem significant.  But it’s not.  Because ultimately Congress controls spending and the ability to issue debt, like Parliament does in the UK.  

Once the debt ceiling pantomime is ended, bonds are sold, the TGA account reaches the required level and government spending can begin.

Suppose the market refuses to buy bonds or insists on a high interest rate on the bonds that it buys.  This is similar to the UK situation since the full funding rule was introduced.  In the UK the full funding rule is a government policy choice and could be set aside fairly easily.  

The 1913 Act already gives the Federal Reserve the right to create unlimited money.  It doesn’t give the FR the right to create money to buy government bonds that are being sold by the government.  But the FR can create unlimited money to buy government bonds that are being sold by other institutions.  This is why the FR could engage in QE in 2010 and 2020 with no change in statutes required.

The 1913 Act was enacted by Congress and it could change it to say that the Federal Reserve should be able to provide the government with an overdraft if the government did not want to sell bonds with the yield that the markets demanded.  That would be politically difficult since it would require an Act to be amended.  Abandoning the full funding policy in the UK would require no change in the law.  

Real and Political Limitations to Government Spending

The purpose of describing the mechanics of state spending in the UK and the US is to make the point that the limitations to state spending in currency-issuing countries are not primarily financial. The UK and the US are currency-creating states. No one can create pound sterling or US dollars other than these states acting through their central banks. In operational terms, they can create as much of their own currency as they choose.

However, creating currency should not be taken lightly and must be managed. Both states have established central banks to oversee the creation and pricing of money. The Bank of England and the Federal Reserve both have the power to create reserves in whatever quantity is required to purchase certain classes of assets — notably government bonds in the secondary market. At the same time, they are normally prevented from buying those bonds directly from the government. These arrangements reflect institutional design choices intended to structure fiscal and monetary interaction.

Both central banks are creatures of statute — the Bank of England nationalised in 1946, and the Federal Reserve created by Congress in 1913. Each system builds in its own checks and balances regarding how fiscal decisions are financed and how monetary policy is conducted.

Perhaps the biggest visible difference lies in the US requirement that a congressional decision to spend does not automatically provide the executive with the operational means to finance that spending. The Treasury must first ensure that sufficient funds exist in its Treasury General Account at the Federal Reserve, which in practice usually requires selling bonds. In the UK, no equivalent statutory debt ceiling exists.

Yet beneath these differences, the underlying reality is similar. When the legislature authorises spending, payments are made and reserves are created in the banking system. Government bonds are then issued largely to manage liquidity and influence interest rates — that is, to drain reserves and support the chosen interest-rate structure — rather than because the state must “find” pre-existing money.

At this point the real constraint becomes clear. As Stephanie Kelton argues in The Deficit Myth, the relevant question for a currency-issuing legislature is not “Where will we get the money?” but “Where are the real resources?” The true limit to public spending is not the stock of currency but the availability of labour, skills, technology, energy, and productive capacity. If spending pushes beyond those real limits, inflation follows. The discipline required is therefore macroeconomic and resource-based, not financial in the narrow accounting sense.

Congress could, if it wished, redesign the operating framework of the Federal Reserve. It created the institution and can amend its governing statute. The recurring debt-ceiling episodes reflect political design choices embedded in law, not a hard financial constraint imposed from outside the state.

In summary, in a currency-creating state, a legislative decision to spend will always be accompanied by the monetary operations required to make that spending possible. In the US these monetary operations are more complicated than in the UK.  But in both states the spending will eventually always happen because they are currency creating states.

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