Government spending with increasing risk: sovereign debt, liquidity preference, and the fiscal-monetary nexus

Abstract

During financial and economic crises, government expenditure is a potential source of liquidity and replacement for private demand; this expenditure, in turn, generates more deposits and spending in the economy at large, potentially increasing the endogenous supply of money and overall liquidity in a given economy. Governments may also require liquidity support during crises, if bond market activity constrains access to funding. This paper introduces government activity to Mott’s elaboration of Kalecki’s theory of increasing risk, and its implications for endogenous money creation, especially during periods of heightened liquidity preference. Some governments are likely to face greater obstacles in providing liquidity and accessing funding in times of economic uncertainty, whether due to their issuance of a non-sovereign currency, their position in the global currency hierarchy, or both, while others may find their ability to provide liquidity is bolstered by popular perceptions of their credit worthiness. Recent crises illustrate the importance of understanding the monetary and financial factors that may constrain governments’ abilities to fund deficits, especially given the importance of fiscal expenditure as a stabilizing economic force, or as a potential driver of development.