British House of Lords inquiry into the Bank of England’s performance is a confusing array of contrary notions
On November 27, 2023, the Economic Affairs Committee of the British House of Lords completed…
On August 10, 2015, the Library of the Canadian Parliament released one of their In Brief research publications – How the Bank of Canada Creates Money for the Federal Government: Operational and Legal Aspects – which described the operational interactions between the Bank and the Canadian Treasury that facilitate government spending in some detail. It allows ordinary citizens to come to terms with some of the essential capacities of the currency-issuing Canadian government, which Modern Monetary Theory (MMT) highlights as a starting point towards achieving an understanding of how the monetary system operates. The description is in contradistinction to the way the mainstream macroeconomics text discuss this part of the economy. It leads to an analysis where we learn that the Bank of Canada holds a significant stock of government debt which it is allocated at auction time on an non-competitive basis. And that this capacity is unlimited and entirely within historical practice. In other words, we learn the operational way in which the government is free of financial constraints.
The background for the Library Paper was a decision made by the Canadian government in June 2011 to introduce a “prudential liquidity plan”, which would was designed to increase the deposits held by the Treasury at the Bank and other financial institutions, to provide for a buffer “to meet payment obligations in situations where normal access to funding markets may be disrupted or delayed”.
The decision was accompanied by a Bank of Canada announcement that it would:
… increase from 15% to 20% its minimum purchases of federal government bonds … the Bank of Canada’s purchase of federal government bonds is a means by which the Bank creates money for the Government of Canada.
We learn that:
1. “The Bank of Canada helps the Government of Canada to borrow money by holding auctions throughout the year at which new federal securities (bonds and treasury bills) are sold to government securities distributors, such as banks, brokers and investment dealers.”
2. “the Bank of Canada itself typically purchases 20% of newly issued bonds and a sufficient amount of treasury bills to meet the Bank’s needs at the time of each auction.”
3. “These purchases are made on a non-competitive basis … it is allocated a specific amount of securities …” by the Government.
4. The bonds are recorded as assets by the Bank and creates a deposit entry in the Government’s account at the Bank.
5. “the transactions consist entirely of digital accounting entries.”
6. “Since the Bank of Canada is … wholly owned by the federal government, the Bank’s purchase of newly issued securities from the federal government can be considered an internal transaction. By recording new and equal amounts on the asset and liability sides of its balance sheet, the Bank of Canada creates money through a few keystrokes. The federal government can spend the newly created bank deposits in the Canadian economy if it wishes.”
7. Private banks also create ‘money’ – “every time the banks extend a new loan, such as a home mortgage or a business loan. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”
One difference between the two types of money creation is that there is no external limit to the total amount of money that the Bank of Canada may create for the federal government … In contrast, the amount of money that a private commercial bank is permitted to create depends on the amount of the bank’s equity relative to its assets. The limiting rules, known as “capital constraints,” are set by the banking regulator in guidelines … Another difference is that the creditworthiness of the borrower is the key factor in the decision by a private commercial bank to provide a loan to a private entity, while this is not a factor in the Bank of Canada’s decision to lend money to the government.
They do note that the Government might voluntarily impose “internal government constraints” to limit the Bank’s capacity to create ‘money’ but there are no intrinsic financial constraints.
So what does this mean?
The institutional structure of Canadian public finances sets out that if the government wants to spend beyond its tax revenue then it borrows through auctions where the ‘primary dealers’, who make the market (in the jargon) put in bids (quantity of bonds they want and the yield they expect).
This makes it look as though the bond auctions are providing the funds that enable the government to spend.
While the accounting structure set up might require funds to go in via the auctions before the spending can occur, this imagery is somewhat fictional given that the funds to purchase the bonds ultimately reflect untaxed past government deficits anyway.
But, moreover, the Bank of Canada
The following area graph shows the breakdown of the Bank’s total assets from January 1960 to November 2019.
The next graph shows the proportion of total Bank of Canada assets that are held as government bonds.
The Bank’s reporting (August 21, 2019) – Background information on the Bank of Canada’s Balance Sheet – tell us that:
1. “Almost all the assets held on the Bank’s balance sheet consist of Government of Canada bonds and bills, acquired on a non-competitive basis at auctions”.
2. “Interest revenue generated from the assets backing the bank notes in circulation … provides a stable source of funding for the Bank’s operations, ensuring the Bank’s operational independence and supporting the execution of its responsibilities … the Bank remits its surplus to the Receiver General for Canada and does not hold retained earnings.”
In other words, they play a sort of fictional game where the Finance Department pays interest on debt Government debt that the Bank holds which covers its costs of operation and the Bank sends bank any surpluses to the Finance Department.
Imagine you are just transferrring cash from one pocket to another and declaring the pockets to be independent of each other.
In terms of the components:
1. Canada Mortgage Bonds are self explanatory.
2. Advances aremade “under its Standing Liquidity Facility as collateralized loans to LVTS participants to cover a negative end-of-day cash position.” LVTS stands for the – Large Value Transfer System – which is the core of the Canadian payments system and banks settle with each other on a daily basis via this structure.
If there is a shortage of reserves in the system on any day, the Bank of Canada provides the funds to individual banks at the so-called “Bank Rate”.
3. Repos are “Securities purchased under resale agreements” so the Bank of Canada will buy assets from the bank’s in return for reserves under an agreement to reverse the transaction at some future date.
They can be overnight arrangements – designed “to reinforce the Bank’s target for the overnight rate” – which means to ensure there are sufficient (and only sufficient) reserves in the system to clear all inter-bank transactions and provide for desired reserve holdings.
Further, the Bank of Canada conducts “bi-weekly operations … to acquire assets on a temporary basis for its balance sheet”.
You will notice a major hump during the GFC in purchases of repos by the Bank of Canada. They say that “repos may be used to inject extraordinary amounts of liquidity into the financial system and support funding conditions for financial institutions, as seen during the global financial crisis.”
There was a recent article in the Canadian Money Saver magazine (January 2020 edition) – Modern Monetary Theory In Canada – by Brian Chang under the broad heading of “Debunking Economics”. The magazine is behind a paywall and I don’t intend to promote it.
The Magazine sells itself as providing “Independent Financial Advice for Everyday Use” and the fact that it runs articles on MMT tells us how far the ideas we have developed are now penetrating the everyday discourse among citizens.
We have escaped the ‘lofty’ heights of the ivory tower!
But recognising that the Bank of Canada has been purchasing an increasing and significant portion of the government debt in Canada, the article concludes that:
What few people realize is that no country currently engages in MMT-like operations quite to the extent that Canada does, with “monetary financing” routinely conducted by the Government of Canada and the Bank of Canada as part of regularly scheduled bond auctions.
I don’t intend to eviscerate the article for its rather inaccurate depiction of MMT.
For example, in the introduction it talks about “MMT’s liberal advocacy of unrestrained government spending” but then a few paragraphs later says that under an MMT understanding “only real limitation on government spending is inflation”.
A simple proof read should have picked up that inconsistency.
The point is the article recognises that:
1. “the Bank of Canada is currently a large and regular buyer at government bond auctions” and has no limits on how much “money” it can produce.
2. There is a fundamental difference between the Bank of Canada recording the debt as an asset and crediting the Government’s bank account (which it spends out of) and selling debt to the private markets:
… as a crown corporation of the federal government, the Bank of Canada is required to return its revenue (including all interest payments on the assets it holds) to the Government of Canada. Effectively, the government pays interest to the Bank of Canada on its loan, and the Bank of Canada simply turns around and returns the interest to the government.
One pocket to the other!
The article suggests that Canada is unique because it “operates without a fence around its Central Bank”, unlike other nations where the governments have laws that “explicitly forbid their central banks from directly financing government spending”.
However, this is also somewhat of a smokescreen.
The ECB, for example, is prohibited from directly purchasing Member State bonds, but it purchases massive quantities in the ‘secondary’ markets once they have been issued.
The impact is the same – government deficits persist.
The article infers that this means that:
Canada is effectively the poster child for MMT-like operations in the developed world, with no current barrier preventing the Bank of Canada from effectively funding one hundred percent of government spending if it so chooses.
And that these monetary operations have been “taking place in Canada for the better part of a century”.
Canadian Money Saver magazine (January 2020 edition) article notes, in relation to Canada, that:
What few Canadians realize is that monetary financing of government spending has essentially been occurring continuously since the establishment of the Bank of Canada in 1934. While the level of monetary financing currently undertaken in Canada is a far cry from the peaks of the 1950s and 1970s, the Bank of Canada nevertheless continues to fund a considerable proportion of government spending today.
The following graph shows the proportion of total government debt outstanding held by the Bank of Canada.
It is somewhat misleading to refer to this component of government spending as “monetary financing”, given that all spending enters the economy in the same manner – the Department of Finance instructing the central bank to credit bank accounts in its favour (whether via digital adjustments or cheques working through the system).
The operations that might accompany this spending – taxation adjustments, bond sales to the non-government sector, bond sales to the central bank – do not fundamentally alter that reality.
Mainstream macroeconomics makes the distinction because it claims the inflation risk associated with the central bank purchasing bonds from the Finance department to match the spending injection is more inflationary than if debt is issued to the non-government sector.
They are wrong about that.
Please read my blog post – Building bank reserves is not inflationary (December 14, 2009) – for more discussion on this point.
In an historical sense, the practice via which the central bank would swap debt for credits with the government treasuries was widespread as nations rebuilt their economies after the Great Depression and then WW2.
The claims that such practices were inflationary are not backed by the evidence.
There were inflationary episodes but there was never a systematic relationship between these episodes and the way in which deficit spending was made operational.
The article asks the question in this context: “what exactly is the concern over MMT?” given the long-standing practice of central bank bond purchasing and “relatively benign inflation problems.”
Why should the Government restrict provision of essential “social programs” which improve the lives of its citizens on the basis that it doesn’t have enough spending capacity?
MMT tells us that the actual questions that need to be asked are:
1. Are there available productive resources that can be brought back into use through government spending? If Yes, then increased government spending is unconstrained and will improve societal welfare.
If No, then:
2. Who is currently using the desired productive resources and what means will be best to deprive them of that use so the government can deploy them for its programs, without generating inflationary pressures?
The PLMP program proved beyond doubt that the Bank of Canada can instantly create liquidity for the Government with a keystroke:
… the Bank of Canada simply acquired an extra $20 billion of government bonds with newly-created money, deposited the $20 billion payment into the government’s account at the Bank of Canada, and returned all interest payments made by the government back to the treasury … all essentially with zero cost of funds to government.
But, like all critics trying to deny the benefit of governments moving to operate more explicitly in this way, the Canadian Money Saver magazine article introduces a the “slippery slope of MMT” – as if MMT is a regime that Canada might increasingly shift to.
The reality is that MMT provides the framework for understanding what happens already on a daily basis in Canada. An MMT understanding tells us that government spending matched by central bank direct bond purchases if not likely to be inflationary if the spending growth is calibrated to the growth in non-government overall saving.
So this “slippery slope” is just the usual mainstream hype.
Arguments like – if government was to stop issuing debt to the non-government sector and instructed the Bank of Canada to credit accounts after receiving government debt as assets – then it might start “using the money for various social programs like health care, education, or employment insurance”.
What stops them doing this:
… self-imposed discipline of our elected government officials and the voting public they ultimately answer to.
The article cannot really get over the tension it creates with the reader – it argues that the Bank of Canada is already buying large quantities of government debt and this has not caused inflation but then the scale of this long-standing practice:
… has never been utilized in Canada even close to the extent that MMT proponents advocate.
But earlier, the article acknowledges that MMT economists are clear that the constraints on government spending are the real productive resources available (and the possibility of a demand-pull inflation occurring).
So we have a very strange, implicit sort of sociology and psychology being entertained.
That government officials know all this but will still go crazy with the ‘free money’.
Why would they do that?
The interesting aspect of the article was that it was published in a fairly low-level financial magazine that small investors are likely to read.
That tells us how far our work is now penetrating the public debate.
That is enough for today!
(c) Copyright 2020 William Mitchell. All Rights Reserved.