Wednesday, 12 April 2017

Budget challenges: Money debt & other myths

This is an address to a breakfast meeting of the Burnie Chamber of Commerce & Industry on 12th April 2017.

I’d like to advance the proposition that most of what is commonly believed about money, government spending and debt is wrong. Seriously wrong....and it’s stopping us from sensibly moving forward.

You may remember the Queen in 2008 going to the London School of Economics to open a building as I recall. Referring to the GFC (global financial crisis).... Lehman Bros had just collapsed....she was famously captured on camera saying "Why did nobody notice it?" Their models were wrong that’s why. Money wasn’t in the models. Banks were assumed to be passive intermediaries lending funds from patient savers to willing borrowers. That may have been the situation pre 1971 before President Nixon abandoned the 1944 Bretton Woods agreement which incorporated the gold standard and underpinned bank lending practices. The world changed after that .....and economics didn’t keep up.

Put simply...a lot of economists don’t understand accounting.

The reality of how money is created today differs from the description found in most economics textbooks. The standard textbook loanable funds theory is nonsense in the modern world.

What I’m about to say is based on a recent Bank of England paper about Money creation in the modern economy .

·       The central bank does not fix the amount of money in circulation, which is then ‘multiplied up’ into more loans and deposits.

·       Banks don’t simply receive deposits which are then lent out.

Money is created out of thin air. Loans create deposits. Deposits are money.

Almost all money in the economy is created this way.

A deposit in a bank vault is not a prerequisite for a loan.

A loan creates a deposit. Both sides of a bank’s balance sheet simply increase. No funding is required.

What happens is the balance sheet becomes a little unbalanced. The loan might be for 30 years, but the deposit on the other side of the ledger might be at call. There’s a maturity mismatch.

Funds are needed to fix the bank’s balance sheet ....not to lend out.

What happens when a government spends? Say it makes a payment to you. Private persons don’t have accounts at the Reserve Bank (RBA) which is the government’s bank, so it has to be a two stage process. Each bank has a reserve account at RBA which handles transactions with the government on behalf of its customers. At the RBA the government reduces its account and credits your bank’s reserve account. Your bank then credits your individual bank account. That’s how government spending occurs.

Spending increases bank reserves and deposits.

When the government raises funds by taxing or borrowing, reserves are reduced. They are transferred back to the government’s account at the RBA.

Banks also use reserves to settle amongst themselves. For example if you spend money with someone who operates an account at another bank reserves are used to settle on your behalf....  reserves are the chips in the system .....electronic chips which circulate between banks as part of settlement activities on behalf of customers. Reserves aren’t lent.

Only the government can create reserves.... by spending ......and only the government can remove reserves.... by taxing or issuing bonds.

Can a government spend if there’s not enough in the government’s RBA a/c? Yes. Japan UK and US do it.

Take US as an example. Quantitative easing or QE has been used since the GFC to provide liquidity to US banks. It does this by swapping bonds for reserves. When a bond is issued in the first place.... a bond ....a government  IOU swapped for bank reserves. Under QE the swap is reversed. It's all done with the click of a mouse.

QE happened because it was thought greater reserves would lead to greater lending which would get the US economy moving. But reserves aren’t lent. They simply provide more liquidity. Loans are created out of thin air not by lending reserves or deposits.

Why issue the bonds in the first place? Why not just spend and create a few more reserves. Pay interest on reserves rather than swapping the reserves for a bond which then pays interest

Bonds are debt. Reserves aren’t.

The point I’m trying to make is that the government doesn’t need to raise taxes or issue bonds before spending....there’s a third way. It can spend and create deposits in private banks in the same way as private banks create deposits out of thin air by making private loans.

Governments can create deposits just like private banks do instead of its self imposed budget constraint to raise funds from taxes or borrowings before spending. But it’s even better.... think of it this way....the government in effect can run an overdraft with the RBA which if it gets repaid is immediately returned to the government as a dividend because it owns the RBA..... and if it doesn’t get repaid so what? The government owns the RBA so if it owes money to itself so what? The traditional argument against this is that it would be inflationary. Right now that is not a problem.

Another alternative could be to require a small portion of the $2.2 trillion in superannuation to be held in the form of bonds... like the old days  ... the pre 1985 30/20 rule..... say require pension funds to hold some funds in bonds... paying interest on the bonds would be a splitting of the budget  pie and could be integrated with the retirement income system and would complement that system. The current cost of that system comprises the cash cost of the age pension at about $50 billion per annum and the non cash costs (so called tax expenditures) of the superannuation system at about $30 billion per annum.

Government debt is not the burden on future generations as is often portrayed. What’s forgotten is that our children and grandchildren will own the debt. They’ll be paying interest to themselves. Sure, some foreigners may own some debt but they will be paid interest in $AUD which one of our grandchildren will have to swap for whatever currency the foreign bondholder wishes to take offshore. The interest will stay here. There will be a minor foreign exchange swap to effect not a burden on an entire generation.

Future generations will always consume what they produce. How they distribute it is their problem. That’s the perennial problem debt or no debt.

Government debt is rarely repaid. It’s rolled over.

The Howard Costello surpluses were an aberration... Menzies ran deficits in 16 out of 17 years.

Say a government ran balanced budgets as it is told would be best practice that would imply no retained earnings. No issued capital either because governments unlike companies don’t have issued capital. And if it didn’t have borrowings it would be a pretty skinny balance sheet.

Imagine BHP without retained earnings of $80 billion, issued capital of $2 billion and borrowings of $35 billion. It would have assets of $40 billion instead of $160 billion.... 25% the size.

By not spending now we are placing an even greater burden on our grandchildren. We have unemployed resources particularly our youth. Not to use them will have long term ramifications far greater than the supposed burden of higher government debt.


·       Go ahead and borrow and treat borrowings as the government’s issued capital ... a perpetual interest paying security.......... equity in the nation’s future. Even require super funds to hold some of the debt in consideration for their generous tax breaks.


·       Spend, create more reserves and pay interest on reserves rather than issue bonds and lessen the chance of people freaking out that their grandchildren are going to be burdened.

Or do a combination of the two

Now just to summarise a few myths.

Myth 1 : Governments must raise money before spending WRONG. If a government has to raise money by draining reserves it has to create the reserves by spending in the first place. Spending is a precursor to taxing not the other way around

Myth 2: Government surpluses are good.... deficits are bad. WRONG (or at least not necessarily right). Government surpluses mean private deficits. This is the iron law of macro accounting. Some consider the Howard Costello surplus years an immense achievement but the surpluses meant ballooning private sector debt. The financial economy which runs alongside the real economy has further added to private debt, as we all know from the current affordable housing discussion. The private domestic sector is now hopelessly over geared. It relies on the real economy to service that debt. If the government runs a surplus then private debt will increase. Nothing else is possible. The government is between a rock and a hard place. But allowing private debt to grow as it has done successive governments have left little policy room to fix things. So the can keeps getting kicked down the road.

Myth 3: Government debt reduces national savings WRONG Deficits increase savings. People are surprised by this fact. As we’ve seen spending creates deposits. On the other hand surpluses reduce private savings.  Who would have thought? If the government ran huge successive surpluses private financial assets will shrink.

Myth 4: Government surpluses will create a buffer for the future WRONG The government will have the same options regardless.

Myth 5: Savings are needed before investment WRONG Loans for investment can be created out of thin air. Loans will create deposits and savings will increase.

Myth 6: Government debt will crowd out private debt. Governments should step aside and leave room for the private sector. It’s the so called crowding out thesis WRONG It’s based on the loanable funds theory which is false. Loans are created out of thin air to worthwhile customers.

Myth 7: As a nation we need to live within our financial means WRONG The ‘living within our means’ concept is something that applies to households, local and state governments. When applied to the federal government which can issue its own currency it’s an ideological statement not an accounting truism.

Living within our means should refer to using our available resources. We should close the output gap......the gap between actual and potential output... use our unemployed resources labour and capital a lot better than we are now doing. We have the means to do so. That’s what living within our means should mean. Not to do so means we will fail future generations.

Take the health system. We have the knowhow. If we don’t have enough labour it can be readily trained. And there is unmet demand. We are constantly told we don’t have sufficient financial resources. My view is this reflects ideology not accounting reality for a currency issuing government.

The same argument is applied to education, housing and so on.

Then there’s infrastructure spending. This is one area of capital spending where more people, one would expect, would be more comfortable if the RBA/government expanded its balance sheet and got on with the job.

Across the political spectrum from left to right they all believe the ‘living within our means’ myth.  With minor differences of emphasis they all accept the myth. And the other six myths I discussed.

No doubt you’ve all heard of Donald Horne’s The Lucky Country. A lot of you have probably read it. I remember reading it as an impressionable 17 year old in Year 12 just before I left home and went off to university.

Australia is a lucky country run mainly by second rate people who share its luck. It lives on other people's ideas, and, although its ordinary people are adaptable, most of its leaders (in all fields) so lack curiosity about the events that surround them that they are often taken by surprise.

1 comment:

  1. Thanks John for an interesting article - it starts to make sense after about the third reading!