For laypersons unfamiliar with monetary policy, or for those who believe in its “healing powers”, allow me to set the record straight. Today, the RBA is busy trying to stimulate growth in the Australian economy by shifting around dollars that already exist. Monetary policy is a blunt instrument that does not add needed dollars to the economy, but merely shifts around what was previously added by fiscal policy. Monetary policy will change a portfolio composition from all liquid dollars to some liquid and some bonds and vice versa, but will not “add” dollars to the system. Why is this?
Policy-makers place all of their faith, hopes and dreams in a neoliberal monetarist fantasy that the RBA controls the money supply, which then leads to a ridiculous conclusion concerning government spending and inflation. In reality, the RBA doesn’t control the “money supply”. It controls the price of money, or in more familiar terms, it controls the interest rate. What the RBA cannot do is do both at the same time and right now, the RBA is charged with setting a target rate and defending that rate, therefore, it cannot control the money supply. To clear up mass confusion caused by policy-makers, let’s examine their fantasy in depth and then understand the reality.
The Quantity Theory of Money (QTM) says the following:
M(V) = P(Q)
Where the money supply (M) times the velocity of money (V) equals the price level (P) times output (Q). There is nothing wrong with this statement. However, QTM makes some ridiculous assumptions concerning certain variables, which then leads to a ridiculous conclusion. In other words, when variables are modified to suit a particular ideological argument, the result is pure fantasy.
The first false assumption is that the RBA controls (M). The second false assumption is that (V) is constant. The third false assumption is that (Q) is constant. So, the RBA controls the supply of money, the velocity of money is constant and Australia is always at maximum output (full employment). If the money supply increases, (V) cannot increase and (Q) cannot increase, then the only thing that can increase is the price level (P). The reality is the RBA doesn’t control (M), the velocity of money is not constant and Australia is never always at maximum output. To any Australian who is unemployed, the assumption concerning (Q) should be obvious. One needs no background in macroeconomics to detect the nonsense of the claim. Let us now set aside the false notions of QTM and digest something meaningful: reality.
The “money supply” is determined by demand for bank credit. To understand this concept, we need to examine where Australian dollars originate.
The unit of account (Dollars, Pounds, Yen) is defined by the national government which then levies a tax payable in that unit of account and issues currency so the tax liability can be satisfied. In the simplest terms possible, the Australian Government issues the Australian dollar and when the government demands a tax payable only in Australian dollars, a demand for that currency is created.
The currency-issuing national government has a monopoly over its product. No private entity can issue currency. Using its monopoly power over its own product, the particular national government in question both funds and regulates the market and the national economy. The general public uses the term “money” in, well, a very general way. The definition of money is quite vague, but for the purposes of our discussion, we will narrow down the concept to define two distinct forms: Currency and Credit.
The “money” issued by the federal government is a net financial asset. It is an asset that has no equal liability attached to it. In other words, when the government gives you $4,000, you don’t have to pay it back. Australian dollars are created and destroyed by transactions between the federal government and the non-government sector, which we call “vertical transactions”. Credit, on the other hand, is “money” that private banks create. Contrary to the orthodox opinion, banks do not lend customer deposits. Banks lend their own IOU, which is then denominated in the government’s unit of account, allowing those IOUs to act as “money” which must be paid back. Hence, unlike currency issued by the federal government, bank credit money is an asset with a corresponding liability attached to it. Credit “money” is created and destroyed through transactions within the private sector, which we call “horizontal transactions”. These transactions occur inside the private sector and so, are “endogenous”. Endogenous, being defined as having an internal origin. It is here where the “money supply” so often discussed by the general public and policy-makers, comes in to play.
Again, contrary to orthodox opinion, the “money supply” is an endogenous phenomenon, determined by demand for bank credit. When demand for credit (loans) expands, the “money supply” expands and when those loans are paid back, the “money supply” contracts. The quantity of “money” is outside of the RBA’s control, because the RBA sets the price of money, or in layman’s terms, it sets the interest rate.
As the federal government is both the currency issuing and regulatory authority, it can choose to exercise control over either the supply of money, or the interest rate, but it cannot do both at the same time. In order to exercise control over the money supply, the federal government would have to declare bank credit illegal and in doing so, the RBA would then lose its ability to set the interest rate, which is part of monetary policy.
First of all, as we’ve discussed, bank loans are IOUs, not reserves being lent out. Further, bank loans are made regardless of what a bank might have in reserves. Should a bank find itself short of reserves later on, it can borrow from another bank. If the entire banking system is short of reserves, the bank has two choices:
1. Sell bonds to the RBA
2. Borrow reserves from the RBA
If the bank must borrow, then if the difference between the rate the bank pays and what it can profit from lending is acceptable, the bank will continue to lend. Therefore, should a bank expand its lending to the point that it becomes short of reserves, the bank might stop lending if the price it would have to pay for reserves is too high. In other words:
Bank lending is not reserve constrained, but rather, it is constrained by expectations of profit and solvency. Thus, we understand that banks neither lend out reserves, nor are they constrained by such as is suggested by orthodoxy.
Secondly, we can also clearly see that the RBA does not expand the “money supply” through open market operations either. The purchase of bonds from the market by the central bank will add reserves, true, but banks do not lend out reserves. Banks will lend reserves to other banks on the interbank market, however, the resulting competition will push the overnight rate down. If it wishes to maintain control over monetary policy the RBA must intervene and drain off any excess reserves that it injected through open market operations.
Since the RBA clearly sets the interest rate, it cannot control the “money supply”. The “money supply” is determined by demand for bank credit, which in turn determines the monetary base and so, the orthodox viewpoint collapses.
The Australian government issues the Australian dollar by fiat. The dollar is free-floating and non-convertible. Given this condition, the supply of dollars available to the Australian Government is always equal to infinity. In terms a layperson can understand, this means that the Australian Government can always afford to purchase whatever is for sale in Australian dollars. It never requires an income like a household, because it is the issuer of currency, unlike a household or business which is a user of the government’s currency. The Australian Government can never go broke, because it manufactures the dollar. You can go broke, because you do not issue currency. If then, the Australian Government has an infinite supply of its own currency, the insight is that it doesn’t tax to fund spending.
When you have $5,000 and the government comes along and taxes you $2,500, how do you feel?
You’re a bit angry, aren’t you? Just think of all you could buy with that $2,500 and now it’s gone. And that’s the first point: Taxes control spending power.
Judging from your disappointment over losing $2,500, we can also assume that you like those dollars. In fact, you want more; as many as you can get ahold of don’t you? And that’s the second point: Taxes create a demand for the currency.
Federal taxation within the framework of a modern monetary economy:
1. Creates a demand for Australian dollars.
2. Controls spending power, thus reducing inflationary pressures.
3. Discourages behaviour the nation finds unacceptable.
amongst other things, but what taxation does not do is fund national spending. Every programme, from universal healthcare to military is paid for when the Australian Government authorises the spending. Taxation is the mere reverse of spending – the destruction of dollars.
Thus, our enquiry into reality also demonstrates what fiscal policy is: The addition and subtraction of Australian dollars to/from the economy, or more precisely, government spending deposits dollars into the economy and taxation withdraws dollars from the economy. Monetary policy cannot achieve such a thing. It can only move around what fiscal policy added to the economy. The RBA cannot and will not achieve necessary and desirable growth through monetary policy.
Therefore, in most simple terms possible, the Australian Government is fiddling whilst Australia burns.
The Australian Surplus Fetish
There is an intolerable delusion sweeping through Australia – the budget surplus fetish, the pursuit of which is strangling the economy and it must come to an end. The persistence of the fetish is the direct result of misinformation concerning budget deficits.
Correctly defined, a federal budget deficit is:
When the Australian Government’s spending is greater than that which it taxes.
We can express this mathematically as (G > T) or (G – T > 0) where Government Spending (G) minus Taxes (T) is greater than zero. While the Australian Government is the centerpiece in a modern monetary economy, there are three total sectors to the economy which we must consider and each can be mathematically expressed as the Sectoral Balances Equation.
The Three Economic Sectors
The three sectors comprising the economy are: Government, Domestic Private and External. Expressed mathematically:
(G – T) is the government sector.
(S – I) is the domestic private sector.
(X – M) is the external sector.
The domestic private and external sectors comprise the “non-government” sector, because they exist outside of government. We can distinguish between the government and non-government sectors in a form of the sectoral balances equation like so:
(G – T) = (S – I) – (X – M)
Or in layman’s terms:
(The Dollar Issuer) = (Dollar Users)
In this form of the sectoral balances equation, on the left side we see the government at the head and whatever it spends goes into the non-government sector on the right and whatever it taxes is removed from the non-government sector. Understanding this, let’s look at the function of federal deficits.
The Function of Deficits
In macroeconomic terms, the purpose of a federal budget deficit is to inject net financial assets into the non-government sector. In layman’s terms, the purpose of a deficit is to add more dollars to the economy. The reverse of this process is called a federal budget surplus. Applying the sectoral balances equation, we uncover the reality behind federal deficits. We will assume that the Australian Government spends $2 trillion and taxes $1 trillion. So then,
(G – T) = $2 trillion – $1 trillion = $1 trillion
Now then, whatever the government spends, the total amount of dollars spent can be divided up between the private domestic and external sector in many ways. It doesn’t necessarily have to be equal. For instance, if the government spent $2,000, the domestic private sector received $1,000 and the external sector received $1,000. Each sector can receive different amounts. What matters here is that the total amount spent by the government will be found in the other two sectors.
(G – T) = (S – I) – (X – M)
($2 trillion – $1 trillion) = ($1 trillion)
then we understand that a $1 trillion federal budget deficit equals a $1 trillion surplus for the non-government sector.
(Federal Deficit) = (Non-Government Sector Surplus)
What we can now see clearly, is that a federal budget deficit cannot and does not create a deficit for you and I. Such a condition is impossible. To create a private, non-government deficit, the government needs to run a federal budget surplus and to do that, the government must tax away more than it spends.
We will assume that the government spends $1 trillion and taxes $2 trillion. So then,
(G – T) = $1 trillion – $2 trillion = – $1 trillion
(G – T) = (S – I) – (X – M)
($1 trillion – $2 trillion) = (- $1 trillion)
then we understand that a $1 trillion federal budget surplus equals, a $1 trillion deficit for the non-government sector.
(Federal Surplus) = (Non-Government Sector Deficit)
A federal budget deficit adds dollars to the economy and a federal budget surplus extracts dollars from the economy. Let us now turn to deficit spending and understand how deficits work.
Rather than Treasury managing spending, taxation and the banking system, another government agency called the RBA, or quite simply, the Central Bank of Australia handles the banking system. The RBA is not a private bank. It is a government agency. Commercial banks attach themselves to the government agency, the RBA, which then allows them to hold reserve accounts. These reserve accounts contain dollars which always remain at the RBA and ensure that the payments system will function properly. For instance, if you have an account at Bank A and wrote a cheque for $500 to someone who has an account at Bank B when that person deposits the cheque, Bank A’s reserve account held at the RBA drops by $500 and Bank B’s rises by $500. Hence, the payment cleared. Again, at no time do these reserves ever enter the economy. They always remain at the RBA, merely shifting back and forth between different accounts.
The Treasury maintains accounts as well, but these accounts sit outside of the private banking sector. The RBA acts as the banking arm of the Australian Government, or quite simply, the RBA handles the day to day financial transactions between the Government and the Non-Government sector. All fiscal spending originates via government budget decisions and further, all federal spending occurs prior to federal taxation. The government determines what it wants to buy and therefore, allocates how many dollars will be issued to “pay for” these things. Once approved, the Treasury will then credit the bank accounts to obtain the goods and/or services for anything it determines appropriate. Through keystrokes, the Treasury accomplishes spending. For instance, if government decided that Bob Jones was to receive $1 million for being a really nice guy, the Treasury would go into Bob’s bank account and type the number:
And one million dollars would suddenly exist. The reserve account of Bob’s bank then rises by $1,000,000 and Bob’s account shows the number 1,000,000. Should Bob wish to spend $10,000 to buy a car, then the reserves would shift from Bob’s bank to another bank. The RBA manages everything, keeping track of who has what at all times and stands ready to add reserves to the banking system should the need arise, to prevent the payments system from collapsing.
On a daily basis, as the government is spending, it is also collecting tax payments. This means that dollars are flowing out of the banking system. When the Treasury collects taxes, it removes reserves from the private banks in question, thereby destroying those dollars. In other words, the dollars shift out of the banking system entirely and exit the economy. If the government taxes less than it has spent, more dollars remain in the banking system than have been removed and what remains is the amount of dollars added to the economy for you and I to use, or in short, a federal budget deficit exists. Therefore, we understand that since all Australian dollars come from the Australian government and that the economy needs those dollars to pay workers to make goods and perform services, then we also understand that when the federal deficit is too low, unemployment will be the result. Related to unemployment and deficits that are too low, is the concept of automatic stabilizers and their effect on the economy and the deficit. So, let us explore how deficits can automatically rise without any action from the government.
Automatic Stabilizers and The Federal Deficit
The economy employs mechanisms to prevent a dramatic fall in aggregate demand, which can lead to a recession or depression. Two of these mechanisms are welfare and Unemployment Insurance. When the economy is doing well, welfare and unemployment insurance payments drop as more people are working. When the economy experiences a stall or downturn, these claims begin to rise automatically as people turn to these programs for help with meeting living expenses. As a result, the federal deficit automatically begins to rise. This explains why it seems that in an economic downturn, the rising federal deficit is causing the downturn, but it is not. What actually happened was that the deficit was too low to begin with. Consumer spending contracted and the economy stalled, jobs were lost and people began applying for and receiving assistance and the deficit began to automatically rise in order to prevent aggregate demand from falling further. So, what we understand is that rising federal deficits in the face of recessions are not the cause of the recession and such thinking is illusory.
The Government of Australia Must Expand Its Deficit
Australia maintains a current account deficit of around 4% of GDP. So it becomes clear that the pursuit of a budget surplus will force the domestic private sector to accumulate private debt which then finances consumer spending resulting in job creation, creating the illusion that intentional deficit reduction results in a good economy. However, such a plan is highly unstable as private debt cannot expand indefinitely.
As the government pursues deficit reduction towards surplus, eventually the domestic private sector will not be able to sustain spending more than its income by taking on private debt and spending will contract, ending in rising unemployment and recession. In short, the continued pursuit of a budget surplus by the Australian Government is needlessly burdening the private sector with debt and will ultimately result in a recession unless the government reverses its fiscal position, expanding its deficit towards full employment and the public well-being.
The current plan to reduce taxation on business to achieve growth will fail miserably, as did the Tasmanian initiative. Consumer spending drives job creation. You do not reduce unemployment by providing handouts to business. You reduce unemployment by government putting dollars into the hands of consumers which is achieved by expanding the deficit towards the goal of full employment. The best way full employment can be achieved and maintained in Australia is through a Job Guarantee programmme, where government, using its currency-issuing power buys up all unwanted labour at a fixed minimum wage, putting it to work on vital community-level projects.
In summary, the Australian Government’s pursuit of a budget surplus is nothing short of madness.