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2011-12-01 07:04:45
In yesterday s blog If only the citizens knew what was going on! I noted
that it makes very little sense from a flow of funds perspective to consider
the central bank not to be part of a consolidated government sector along with
the treasury. The notion of a consolidated government sector is a basic Modern
Monetary Theory starting point and allows us to demonstrate the essential
relationship between the government and non-government sectors whereby net
financial assets enter and exit the economy without complicating the analysis
unduly. This simplicity leads to many insights all of which remain valid as
operational options when we add more detail to the model. However, it still
seems that readers are confused by this and somehow think that the
consolidation is misleading. So for today s blog I aim to explain in more
detail what this consolidation is about. It should disabuse you of the notion
that the mainstream macroeconomics obsession with central bank independence is
nothing more than an ideological attack on the capacity of government to
produce full employment which also undermines our democratic rights.
Regular readers will have seen this diagram which appeared along with
discussion in the blog Deficits 101 Part 3 but was originally presented in
my book Full Employment Abandoned: Shifting sands and policy failures which was
published in 2008.
You should also read the blog Deficits 101 Part 1 to refresh your memory of
the vertical relationship between the government and non-government sectors
whereby net financial assets enter and exit the economy.
The diagram sought to elaborate on the vertical transactions between the
government and non-government sectors and to explain the importance of them for
understanding how the economy works? It was intended as a vehicle to help
people connect the pieces of the monetary system in an orderly fashion and to
re-educate those who have been poisoned by mainstream macroeconomics textbooks.
vertical_horizontal_relations
You will see that this diagram adds more detail to the diagram presented in
Deficits 101 Part 1 which showed the essential relationship between the
government and non-government sectors arranged in a vertical fashion.
Focusing on the vertical train first, you will see that the tax liability lies
at the bottom of the vertical, exogenous, component of the currency. The
consolidated government sector (the treasury and central bank) is at the top of
the vertical chain because it is the sole issuer of currency and the
transactions that the treasury and the central bank make with the
non-government are able to alter the net system balance (which I will explain
presently).
The middle section of the graph is occupied by the private (non-government)
sector. It exchanges goods and services for the currency units of the state,
pays taxes, and accumulates the residual (which is in an accounting sense the
federal deficit spending) in the form of cash in circulation, reserves (bank
balances held by the commercial banks at the central bank) or government
(Treasury) bonds or securities (deposits; offered by the central bank).
The currency units used for the payment of taxes are consumed (destroyed) in
the process of payment. Given the national government can issue paper currency
units or accounting information at the central bank at will, tax payments do
not provide the state with any additional capacity (reflux) to spend.
The reason we take a consolidated approach to government in the first instance
is because the two arms of government (treasury and central bank) have an
impact on the stock of accumulated financial assets in the non-government
sector and the composition of the assets.
The government deficit (treasury operation) determines the cumulative stock of
financial assets in the private sector. Central bank decisions then determine
the composition of this stock in terms of notes and coins (cash), bank reserves
(clearing balances) and government bonds with one exception (foreign exchange
transactions).
The diagram also shows how the cumulative stock is held in what we term the
non-government Tin Shed which stores fiat currency stocks, bank reserves and
government bonds.
I invented this Tin Shed analogy to disabuse the Australian public of the
notion that somewhere down in Canberra (our national capital) there was a
storage area where the national government was putting all those surpluses away
for later use. This is a constant misperception that pervades the policy
debate. Even the mainstream macroeconomics textbooks call budget surpluses
national saving .
The reality is that there is no storage because when a surplus is run, the
purchasing power embodied in the net outflow of financial assets from the
non-government sector to the government sector is destroyed forever. However,
the non-government sector certainly does have a Tin Shed within the banking
system and elsewhere.
Any payment flows from the government sector to the non-government sector that
do not finance the taxation liabilities remain in the non-government sector as
cash, reserves or bonds. So we can understand any storage of financial assets
in the Tin Shed as being the reflection of the cumulative budget deficits.
Taxes are at the bottom of the exogenous vertical chain and go to rubbish,
which emphasises that they do not finance anything. While taxes reduce balances
in private sector bank accounts, the government doesn t actually get anything
the reductions are accounted for but go nowhere.
Thus the concept of a fiat-issuing Government saving in its own currency has no
meaning. Governments may use its net spending to purchase stored assets
(spending the surpluses for instance on gold or in sovereign funds) but that is
not the same as saying when governments run surpluses (taxes in excess of
spending) the funds are stored and can be spent in the future. This concept is
erroneous. Please read my blog The Futures Fund scandal for more discussion
on this point.
Finally, payments for bond sales are also accounted for as a drain on liquidity
but then also scrapped.
What are the implications of all this?
You will have heard of the term the monetary base which appears in most
macroecoomics text-books as the precursor to outlining the erroneous concept of
the money multiplier. Please read my blogs Money multiplier and other myths
and Money multiplier missing feared dead for more discussion about why
there is no money multiplier.
The concept of the monetary base is a very narrow concept of what economists
misleadingly call money. We will use the term net financial assets because it
is less problematic.
The monetary base is comprised of:
The currency (notes and coins) held by the public and issued by the
government);
The deposits that the commercial banks have with the central bank the
so-called reserves;
The liabilities the central bank has to the non-bank financial intermediaries.
The term base is loaded (excuse pun) because it is seen by the mainstream as
the base on which banks lend from. Of-course bank lending is not reserve
constrained so the term lacks meaning in this context. Please read the
following blogs Building bank reserves will not expand credit and Building
bank reserves is not inflationary for further discussion on this point.
The following table captures the relationship between the monetary aggregates
but in no way supports a money multiplier interpretation of the linkages.
The Table helps to sort the vertical transactions (1 to 4) from the horizontal
(6 and 8).
National government budget impacts
In isolation, a national government budget deficit, which results from the
government spending more (via crediting bank accounts and/or posting cheques)
than it drains via taxation revenue from the non-government sector, results in
an overall injection of net financial assets to the monetary system. This
boosts the monetary base.
Conversely a national government budget surplus, which results from the
government spending less than it drains via taxation revenue from the
non-government sector, results in an overall withdrawal of net financial assets
from the monetary system. This reduces the monetary base.
However, if the government also issues debt $-for-$ to match its deficit then
the impact on the monetary base is neutralised. Mainstream textbooks think this
is a funding operation, whereas from a MMT perspective it is a bank reserve
operation which allows the central bank to effective conduct its liquidity
management tasks.
Please read my blog Understanding central bank operations for more
discussion on this point.
Foreign exchange transactions
The external position of a nation impacts on the monetary base if there is
official central bank foreign exchange transactions.
A nation s currency is demanded in foreign exchange markets to facilitate the
purchase of its exports by foreigners; to pay interest, profits and dividends
to residents who have foreign investments; and to faciliate foreign direct
investment in local companies.
Conversely, a nation s currency is supplied to foreign exchange markets to
facilitate the purchase of imports from other countries; to pay interest,
profits and dividends to foreign investors; and to faciliate lending to foreign
companies.
Ordinarily, where there is a balance of payments deficit the demand for a
nation s currency in foreign exchange markets will be less than the supply of
that currency and there will be downward pressure on the exchange parities.
When there is a balance of payments surplus the demand for a nation s currency
in foreign exchange markets will be greater than the supply of that currency
and there will be updward pressure on the exchange parities.
So exchange rate movements can arise from the real sector and the financial
sectors with the latter increasingly dominating in the era of financialisation.
That situation is one thing that needs to be changed if we are to restore
stable growth with full employment but that is the topic of another blog.
A floating exchange rate system allows these supply and demand imbalances in
currencies to resolve themselves via exchange rate movements with no impact on
the monetary base.
However, under a fixed exchange rate system, a country with an external deficit
(supply of currency greater than demand) would face downward pressure on its
parity and the central bank was committed to easing that quantity imbalance by
conducting official foreign exchange transactions. So in this case it would buy
its own currency in the foreign exchange markets by selling foreign currencies
until the demand and supply of the local currency was equal and consistent with
the fixed exchange rate being targetted.
These transactions would drain the local currency from the economy (the foreign
exchange market is considered part of the monetary system) and so the monetary
base would shrink.
If the nation had an external surplus (supply of currency less than demand) it
would face upward pressure on its parity and the central bank had to sell its
own currency in the foreign exchange markets by buying foreign currencies until
the demand and supply of the local currency was equal and consistent with the
fixed exchange rate being targetted.
These transactions would inject the local currency from the economy (the
foreign exchange market is considered part of the monetary system) and so the
monetary base would increase.
In a pure floating regime with no official central bank intervention, there is
no change in the volume of a nation s currency as a result of the foreign
exchange transactions. As an example, assume an exporting firm in Australia
earns $USDs and seeks to convert them into $AUDs. It will sell them to a
foreign exchange dealer who brokers a deal with a counterparty who desires to
hold $USDs and already has $AUDs (perhaps an importing firm).
The exporting firm s holdings of $AUDs rises as the counterparty s holds fall.
There is no change in the volume of AUDs on issue.
Clearly, things are different in a pure fixed exchange rate system as noted
above. A floating exchange rate system thus does no hamper monetary or fiscal
policy in the same way that monetary policy is forced to defend the parity in a
fixed exchange rate system.
In reality, the central bank still conducts official foreign exchange
transactions even if the currency mostly floats. So when the currency is weak
(and the central bank fears an inflationary spike coming via increased import
prices), it may intervene and buy foreign currency and vice versa when the
currency is strong (and there is a fear that the competitiveness of the trading
sector is compromised).
The following graphs show the scale of that intervention in Australia since
1973. The data is available from the Reserve Bank of Australia. The left-panel
shows the total official FX transactions in $A millions (which include gold and
foreign exchange less net overseas borrowing of the national government), the
middle panel shows the change in reserve assets due to valuation in $A
millions, while the right-panel shows the total change in reserve assets.
You can see the scale of the transactions has increased over time and there are
huge swings in short periods of time.
I plan to write some more about the capacity of foreign exchange markets to
wreak havoc on a nation, a point that some commentators seem to have become
stuck on recently. I would note that Australia is an extremely open economy
with litle industrial base. Our export sector is largely based on primary
commodities and agriculture.
We have huge swings in our exchange rate. For example in September 2001, the
$AUD was selling for 0.4923 $USD and all my US mates were laughing about how we
were now the half-price country. By March 2007, it was back over 80 cents. In
1987, we lost about 10 per cent of our nominal GDP in valuation effects due to
currency depreciation and terms of trade swings in two quarters! These are huge
swings. Our standard of living was barely impacted.
Government bond sales
The impact of national budget outcomes and central bank official intervention
on the monetary base can be offset by government bond sales/purchases. Why
would the government desire this offset?
The fundamental principles that arise in a fiat monetary system are as follows.
The central bank sets the short-term interest rate based on its policy
aspirations.
Government spending is independent of borrowing which the latter best thought
of as coming after spending.
Government spending provides the net financial assets (bank reserves) which
ultimately represent the funds used by the non-government agents to purchase
the debt.
Budget deficits (and official foreign intervention which adds to the monetary
base) put downward pressure on interest rates contrary to the myths that appear
in macroeconomic textbooks about crowding out .
The penalty for not borrowing is that the interest rate will fall to the
bottom of the corridor prevailing in the country which may be zero if the
central bank does not offer a return on reserves.
Government debt-issuance is thus a monetary policy operation rather than
being intrinsic to fiscal policy, although in a modern monetary paradigm the
distinctions between monetary and fiscal policy as traditionally defined are
moot.
To understand these points we need to understand the concept of a system
balance which relates to the daily liquidity in the banking system. The system
balance is another term for the monetary base. It is important to understand it
because it impacts on the ability of the central bank to maintain its desired
monetary policy stance which involves setting a particular overnight interest
rate.
Every day, official transactions are occurring (Items 1 to 3 in the Table
above) and they impact on the system balance or the money market cash position.
Governmments spend and tax continuously and the central bank regularly conducts
official foreign exchange transactions. Further public debt matures regularly
and the central bank may conduct repos and rediscount treasury notes before
their maturity date is reached.
When the flow of funds that accompany the vertical transactions is in favour of
the government sector, we say the system balance is in deficit (or the system
is undersquare ) and vice versa (surplus or oversquare).
You can thus appreciate the particular transactions and balances that will
deliver a system surplus or a system deficit.
A budget deficit, for example, will result in a system surplus or oversquare
position. There will be excess reserves in the accounts held by the banks with
the central bank.
If there is no support rate paid by the central bank on these excess reserves
then the commercial banks will try to lend then on the interbank market. The
possible borrowers will be other banks who lack reserves at the end of the day.
But these horizontal transactions are incapable of clearing the overall system
overall. All they do is shuffle which banks are carrying the excess.
In trying to chase a return on the excess reserves, the competition in the
interbank market drives the overnight rate down to whatever support rate is in
place (which might be zero). Effectively, if there was no central bank
reaction, the official policy rate being maintained by the central bank would
become irrelevant as the interbank rate fell.
The central bank can drain the excess reserves simply by selling government
debt. Accordingly, debt is issued as an interest-maintenance strategy by the
central bank. It has no correspondence with any need to fund government
spending.
The analysis should be easily understood in the case of the impacts of budget
surpluses and the impact of official foreign exchange transactions that add
reserves and those that drain reserves.
Further, the idea that governments would simply get the central bank to
monetise treasury debt (which is seen orthodox economists as the alternative
financing method for government spending) is highly misleading. Debt
monetisation is usually referred to as a process whereby the central bank buys
government bonds directly from the treasury.
In other words, the federal government borrows money from the central bank
rather than the public. Debt monetisation is the process usually implied when a
government is said to be printing money. Debt monetisation, all else equal, is
said to increase the money supply and can lead to severe inflation.
However, as long as the central bank has a mandate to maintain a target
short-term interest rate and does not pay a support rate on excess reserves,
the size of its purchases and sales of government debt are not discretionary.
Once the central bank sets a short-term interest rate target, its portfolio of
government securities changes only because of the transactions that are
required to support the target interest rate.
The central bank s lack of control over the quantity of reserves underscores
the impossibility of debt monetisation. The central bank is unable to monetise
the federal debt by purchasing government securities at will because to do so
would cause the short-term target rate to fall to zero or to the support rate.
If the central bank purchased securities directly from the treasury and the
treasury then spent the money, its expenditures would be excess reserves in the
banking system. The central bank would be forced to sell an equal amount of
securities to support the target interest rate.
The central bank would act only as an intermediary. The central bank would be
buying securities from the treasury and selling them to the public. No
monetisation would occur.
However, the central bank may agree to pay the short-term interest rate to
banks who hold excess overnight reserves. This would eliminate the need by the
commercial banks to access the interbank market to get rid of any excess
reserves and would allow the central bank to maintain its target interest rate
without issuing debt.
From a MMT perspective it is far preferable to eliminate the debt-issuance
machinery altogether and pay a support rate on reserves if the central bank
wants to target a non-zero short-term interest rate. But even more preferable
is to allow the short-term interest rate to drop to zero by not issuing public
debt or paying a support rate on excess reserves. Then the interbank market
will compete the rate down to zero each day and fiscal policy would become the
principle counter-stabilisation tool and the most effective means of
disciplining price pressures in specific asset classes.
Please read the following blogs Operational design arising from modern
monetary theory Asset bubbles and the conduct of banks and The natural rate
of interest is zero! for further discussion of the preferred MMT position.
Conclusion
The vertical transactions which add to or drain the monetary base that I have
outlined here are transactions between the government and the non-government
sector. I note some people think the distinction between government and
non-government is confusing but you should see it as an essential starting
point to understanding the nature of the vertical transactions.
These transactions are thus unique they change net financial assets in the
economy.
All the transactions between private sector entities have no effect on the net
financial assets in the economy at any point in time.
Anyway, we have now explicitly considered the impact of official foreign
exchange transactions (which might include gold sales and purchases as well as
straightforward currency deals).
Australian Federal Election
Tomorrow is our national election.
We are forced to vote here. Some democracy. The choices between the major
parties are either bad or very bad. The Greens who are the third main party
have no understanding of macroeconomics. Some democracy.
The Government may change tomorrow given the polls and Julia Gillard our first
female prime minister will then have the record of the shortest prime minister
in history. The Government should have kept the stimulus going and taken some
hard decisions on climate change and stopped locking refugees up in prisons
(including their children). They did not take any major progressive decisions
in their term of office and were beguiled by their neo-liberal pretensions.
They deserve to be tossed out. But that is not to say that the conservatives
deserve to be voted in. They are a disgrace and will seek to implement
pernicious policies on the disadvantaged just like they did when they were in
power last time (1996-2007). They deny climate change and want to make it even
harder for refugees. They never deserve to be in government of a progressive
forward-thinking nation.
The only policy that is separating them is on the construction of the national
broadband network. The Government is promising to continue building a
technology that will serve us well into the future whereas the conservatives
want to keep us back in the past. All discussions about costs in that regard
are irrelevant because the only costs that matter are the real resources being
used and the Government s plan is probably not much more costly than the
status quo.
Most importantly, both major parties want to run surpluses without knowing what
that means. They do not understand that at this stage of the business cycle
even larger deficits are required. They will both run a macroeconomic strategy
that will be detrimental to the unemployed and their families and then they
will both turn on these same people and introduce punishing welfare-to-work
changes that will just make the lives of the miserable even worse.
There is not much choice down here! I am not allowed under existing electoral
law to encourage voters that instead of voting they should write essays on
their ballot papers outlining why all major parties have lost the plot.
Saturday Quiz
The Saturday Quiz will be back sometime tomorrow. It national election day in
Australia so I might have some questions relevant to that event! Our democracy
is in a sad state.
That is enough for today!