Memo: Right pocket to left pocket – don’t let anyone know what it going on in these trousers.

On Tuesday (November 3, 2020), the Reserve Bank of Australia made its monthly announcement with respect to the conduct of monetary policy. The governor Philip Lowe released this – Speech – to announce the decision. There were four elements to the decision, which I will explain. But the most significant aspects of the decision was to set the support rate on excess reserve balances to zero and increase their government bond buying program by 200 per cent. And the most significant aspect of that last decision was how much dodging and weaving went on to deny what they are actually doing. And, within the decision is a point that I would have expected State Premiers to be up and arms about but, instead, there was silence. All in a day of paradigm shift in economics.

The RBA are now employment champions – not!

The RBA told the Australian public on Tuesday that it was committed to doing “what we reasonably can, with the tools that we have, to support the recovery of the Australian economy.”

They said that they saw the “high rate of unemployment as a national priority and it wants to do what it can to support job creation”.

Well they have to say that because in as a historical fact, the Reserve Bank of Australia was constituted in 1959 to maintain full employment as one of its three goals (see Section 10 of the – Reserve Bank Act 1959 – Subsection 2).

However, since the abandonment of monetary targetting in the 1980s (the failed Monetarist experiment), the RBA was increasingly influenced by the NAIRU concept, which is a core neoliberal contrivance to disabuse governments from spending sufficient amounts to maintain full employment.

So the RBA became focused more or less exclusively on meeting an inflation target from the early 1990s. I have written extensively about how this shift in policy amounted to the central bank abandoning its legal obligations to maintain full employment.

The manipulation of interest rates to fight inflation clearly intended to use unemployment as a policy tool rather than the policy target it had been during the full employment period.

This became very clear in August 1996, when the Federal Treasurer (then a conservative government) and the Reserve Bank Governor issued the – Statement on the Conduct of Monetary Policy – which set out how the RBA was approaching the attainment of its three identified policy goals.

It showed that inflation targetting had become its primary goal. The Statement avoided any discussion about full employment except that price stability in some way generated full employment even though the price stability required “disciplined monetary and fiscal policy”.

It said that:

These objectives allow the Reserve Bank to focus on price (currency) stability … Price stability is a crucial precondition for sustained growth in economic activity and employment.

And further:

The Governor (designate) takes this opportunity to express his commitment to the Reserve Bank’s inflation objective, consistent with his duties under the Act. For its part the Government indicates again that it endorses the Bank’s objective and emphasises the role that disciplined fiscal policy must play in achieving such an outcome.

So it took discretionary fiscal policy out of the mix under the belief that if the central bank achieved low inflation, then full employment, being defined as the NAIRU would follow automatically.

Quite apart from how effective monetary policy might or might not be, if the central bank was using unemployment as a means of disciplining any inflation tendencies, then how can it meet its legal obligations under its own Act?

How did the RBA answer this apparent contradiction?

Malcolm Edey, who in 1999 was Head of Economic Analysis at the RBA said in a 1999 paper that while the Bank was sensitive to the state of capacity utilisation when it sets interest rates, the trade-off between inflation and unemployment was not a long-run concern because, following NAIRU logic, it simply doesn’t exist.

Ultimately the growth performance of the economy is determined by the economy’s innate productive capacity, and it cannot be permanently stimulated by an expansionary monetary policy stance. Any attempt to do so simply results in rising inflation.

It has always been totally false to believe that the evolution of the “long-run” growth path of the economy was independent of how it got there. The hysteresis notion tells us clearly that the future is path dependent. Where you are now is where you have been.

To think that the evolution of aggregate spending has no impact on what our economy will look like in say 40 years time is ridiculous. A protracted recession such as we are experiencing now typically reduces the growth path and it takes years to work through the persistence and hysteresis that accompanies a recession.

But under the NAIRU approach which the RBA embraced, policy makers denied that if they tightened the economy to deflate the price expectations then the unemployment would only be temporary, relatively modest in magnitude and and have no significant long-term consequences.

The empirical evidence is clear that the Australian economy (like nearly all economies operating under neo-liberal regimes) did not provide enough jobs since the mid-1970s and the conduct of monetary policy has contributed to the malaise. The RBA forced the unemployed to engage in an involuntary fight against inflation and the fiscal authorities further worsened the situation with their austerity bias.

The late Franco Modigliani (2000: 3), one of the economists who coined the term NAIRU in 1975, reflected on the legacy he had created:

Unemployment is primarily due to lack of aggregate demand. This is mainly the outcome of erroneous macroeconomic policies … [the decisions of Central Banks] … inspired by an obsessive fear of inflation … coupled with a benign neglect for unemployment … have resulted in systematically over-tight monetary policy decisions, apparently based on an objectionable use of the so-called NAIRU approach. The contractive effects of these policies have been reinforced by common, very tight fiscal policies.

So when the RBA suddenly starts claiming they plan to prioritise reducing unemployment you can take that with a grain of salt.

Further, the RBA governor admitted that the national unemployment rate would still be around 6 per cent at the end of 2022 and inflation would only be 1.5 per cent, well below the lower bound of its inflation stability target range (2-3 per cent).

That means they believe policy settings will leave around 900 thousand workers without jobs over the next two years.

In addition, participation by 2021-22 is assumed to be well below its August 2019 peak, which means that an additional 135 thousand workers are likely to be enduring hidden unemployment by mid-2022.

Before the pandemic unemployment was 690 thousand (December 2019) and that was already well above the level that was attained in February 2008.

And the February 2008 level (4 per cent of the then labour force) was also too high.

In Tuesday’s statement, the RBA responded to the question “Is the RBA now out of firepower?”. It replied:

The short answer here again is no. The Reserve Bank is not out of firepower. We have additional monetary policy options and we are prepared to use them if the circumstances require.

Well there’s the contradiction.

1. They want to prioritise the high unemployment.

2. They claim they have more options “if the circumstances require”.

3. They admit unemployment and broader underutilisation will be much higher than the pre-pandemic levels (which were already too high).

4. So if they thought they can do more – why is unemployment going to persist at such high levels for at least 2 more years?


What is new at the RBA?

In Tuesday’s decision, the RBA determined to:

– first, a reduction in the cash rate target, the three-year yield target and the interest rate on new drawings under the Term Funding Facility to 10 basis points, from the current 25 basis points.

– second, a reduction in the interest rate on Exchange Settlement balances to zero from the current 10 basis points.

– and third, the introduction of a program of government bond purchases. In particular, we are intending to buy $100 billion of government bonds over the next six months, purchasing bonds issued by the Australian Government as well as by the states and territories.

So, the policy rate is now at record lows.

The – Term Funding Facility – is the way the RBA extends loans to authorised deposit-taking institutions (banks and others) – in other words, cheap cash for private profit seeking.

They claim this will help banks extend loans “to support businesses during a difficult period”, which just rehearses the fiction that bank lending is reserve constrained.

The reason the banks do not extend loans during recessions is because there is a shortage of credit worthy borrowers lining up due to the uncertainty facing businesses and households.

Even though the RBA is providing reserves to the banks at low cost to them, that doesn’t necessarily alleviate the shortage of borrowers.

The Exchange Settlement Balances are our term for bank reserves. These are accounts that the banks keep at the RBA to facilitate the payments system on a daily basis.

So now the banks will earn nothing on those reserves.

I will come back to that presently (see below under financial repression)

The third aspect of Tuesday’s decision will see the RBA government bond purchases rise by 200 odd per cent on what they have so far accumulated since they began their recent purchasing program on March 20, 2020.

Their last reported transaction was on September 9, 2020, when they purchased $851 million worth of 3-year Australian government securities and $1,149 million of 4-year securities.

By the end of September, the RBA had purchased federal debt worth $52,250 billion, and $11,098 billion of debt issued by the states/territories.

With the project fiscal deficit to rise to $213.7 billion over 2020-21.

So the RBA will be holding a considerable chunk of the debt that is issued to match the increase in the deficit.

While the RBA denies that they are funding significant proportions of the increase in the fiscal deficit, the reality is, of course, different.

In press interviews following the decision, the RBA Governor tried to deny they were funding government deficits.

The Governor must think we are stupid in saying:

If the bond has been issued in the last week, we will steer clear of that bond. We are doing this partly because we want to avoid any possibility that people see us as financing the government. If a government issues a bond that we go and buy at the same time then people incorrectly assume that we are financing the government. Is the RBA now financing the government? The answer is a simple no.

Got that.

Okay, private bond purchasers say, gosh, we have to hold this debt for one week before we can offload it onto the RBA and get a capital gain.

The RBA governor also claimed:

The RBA is not providing finance to the government, but our actions are lowering the cost of government finance.

But the RBA is part of the government.

It serves the neoliberal fictions to maintain this pretense that the RBA is not part of government. The so-called central bank independence narrative has been a principle vehicle for depoliticisation of government decisions.

The treasurer can always claim that the RBA is separate but the two arms of government have to maintain close communication and coordination of their policy decisions because the conduct of monetary policy would be difficult without it given that fiscal policy impacts on the liquidity in the economy which the RBA has to manage.

The RBA governor also said that the federal government will have o repay the debt:

… in exactly the same way as would occur if the bonds were held by others. The fact that the RBA is holding some bonds makes no difference to the financial obligations of the government, other than through a lower cost of finance.

Oh well, let me help you work through this.

1. The Treasury via its Australian Office of Financial Management issues debt in the primary issuing auction to the non-government sector.

2. The debt then starts circulating as a speculative asset in the secondary bond markets. Investors speculate on price and yield movements to try to gain on the buy and sell process in the secondary markets.

3. The RBA enters the secondary bond market as a buyer, which pushes up the price of bonds and drives down yields. That is the impact of quantitative easing.

4. The Treasury then pays the RBA interest and principle on maturity, by instructing the RBA to credit and debt accounts by typing in numbers to computers.

5. Any net income that the RBA makes as a consequence of this charade is then transferred back to the Treasury as dividends.

See this Chapter from the RBA’s 2020 Annual Report – Earnings, Distribution and Capital.

Got it.


1. Right pocket of government gives the left pocket some income earning asset. Some numbers are typed in accounts.

2. Left pocket earns income.

3. Left pocket transfers income back to right pocket.

4. End of story.

The other aspect of this decision is that it has implications for the way the Commonwealth and the States interact.

In Australia, the States have most of the spending responsibilities but the Commonwealth have most of the revenue raising powers. As a result of this vertical imbalance in our federation, there is an elaborate redistribution formula to channel the revenue down to the financially-constrained states and territories.

Most of that revenue comes via the Goods and Services Tax (GST), which is raised at the Federal level and recycled back to the States and Territories.

They also issue debt in their own right, which they have to pay back and service through their revenue including the GST funds.

So the RBA is now buying up state and territory debt.

The states and territories will have to pay the RBA interest and principle on maturity, out of their revenue.

The RBA transmits income (above its costs) back to the Treasury.

So the federal governments ends up getting the some state and territory GST revenue that they transferred to them under the distribution process, which limits the capacity of the state and territories to recover from the crisis.

It would be far better for the RBA to buy up all the debt issued at that level of government and then write it off to zero.

They may claim that this would encourage the state governments to overspend.

At this point in time, it is hard to imagine what ‘overspending’ might be given the scale of the pandemic disaster. There is so much scope to spend before we get close to any inflation constraint.

And ultimately, if the states just waste the cash, then the voters will ultimately work that out and vote then erring governments out of office.

Financial Repression – the poor dears!

When governments run fiscal deficits, the new currency that enters the non-government spending typically ends up as bank reserves after all the transactions are worked through.

As regular readers will understand, an reserve excess in the banking system cannot be eliminated by the actions of the banks.

They can try to loan those reserves to each other (some banks might still have shortfalls on any particular day) but that just shuffles the excess.

That shuffling process drives down the return in the interbank market (where banks make loans to each other) – as the banks with excesses would rather earn something than nothing.

This observation runs counter to the mainstream macroeconomic theory which claims that fiscal deficits drive up interest rates. In the real world, they put downward pressure on rates when inflation is stable.

The payment of a support rate from the RBA can intervene and curtail that competitive process. But now the RBA has declared the support rate will be zero.

Only the RBA can eliminate the excess reserves by selling government bonds to the banks in return for writing down the reserves. That is what open market operations is all about.

But right now the RBA is buying bonds in large volumes.

But some observers consider this move – where banks are forced to carry excess reserves is financial repression and encourages the banks to create new financial institutions outside the ambit of the regulative structures.

In the 1970s, many banks created finance companies to shift business away from the regulated sector and the authorities claimed this reduced their capacity to run monetary policy and regulate the industry.

First, they could have stopped that behaviour any time they wanted to by introducing approach restrictions on the bank licences and outlawing financial intermediation that is outside the stated regulative structures.

Second, the argument that excess reserves compromise the conduct of monetary policy – as noted above – if left in the banks, competitive processes drive the short-term rate towards zero (Japanese style).

All this means is that the way we conceive monetary policy – which was formally defined in terms of setting the policy rate – has changed. It also changes the way we think about the yield curve, which I will deal with in a separate blog post.

Of course, open market operations are equivalent in terms of policy rate maintenance to paying a return on excess reserves.

Third, some say that the excess reserves mean that interest rates are below some ‘equilibrium’ level and distorts saving and investment decisions.

I have written previously about the how the mainstream insistence that monetary policy dominate counter-stabilisation policy (‘inflation first’ strategies) with discretionary fiscal policy biased towards running surpluses has undermined the business model of the financial sector (pension and insurance funds, investment funds).

The financial sector has increasingly realised that the mainstream predictions about deficits, public debt, bond yields, interest rates and inflation projections have not materialised, and profits have been sacrificed as a result.

The fiscal austerity bias coupled with relatively ineffective monetary policy has created stagnation, elevated levels of labour underutilisation and subdued inflation rates.

Wages growth is flat, and households have accumulated record levels of debt making financial stability more precarious.

Stifled public infrastructure development has restricted low-risk investment opportunities that have historically formed the ‘bread-and-butter’ sources of profit for large investment funds.

Central bankers have responded by progressively cutting interest rates, to the point where negative rates are not uncommon. In turn, we are now seeing negative yields on long-term bonds in many jurisdictions.

Take pension funds, which are now facing increasing maturity mismatch as returns on assets have become compromised by these developments.

As a consequence, fund managers are taking riskier investment positions to increase earnings given their contractual liabilities. This is an unsustainable situation and insolvency risk is heightened.

But a fiscal strategy that sustains full employment income growth is good for households who can save more and better manage their future spending patterns.

Fourth, the Australian banks earn massive excess returns as it is, gouging their clients with ridiculous fees and charges and engaging in all sorts of duplicitous practices that were exposed in the recent Royal Commission.

Returns between 15.8 per cent up to 19 per cent have been recorded by our banks when returns elsewhere in the world are much lower than this.

I covered this topic in this blog post – Friday lay day – banksters misbehaving again but Portugal offers hope (October 23, 2015).


My recommendation is the RBA should fund all state and territory government deficits for the foreseeable future to allow them to recover from the pandemic.

They should also buy all the federal government debt to allow them to get on with the business of creating jobs.

They should also pressure the federal government to introduce a large-scale job creation program to provide high-skill work to advance the shift away from carbon-intensive production.

And at the lower end of the labour market, the RBA should announce they will 100 per cent a Job Guarantee program and seek a partnership with the federal government to make that operational.

It could then announce it will fund 400,000 new social housing constructions to allow low-income families to enjoy the benefits of home ownership and take them out of the repressive rental market.

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.

This Post Has 5 Comments

  1. “The contractive effects of these policies have been reinforced by common, very tight fiscal policies.”

    Does the mainstream belief ever take expectations into account here?

    From talking to NK “True Believers” the general idea seems to be that monetary policy is active, and fiscal policy is supposed to passively follow that signalling, viz:

    In mainstream theory monetary policy is capable of uniquely determining the inflation rate because it implicitly controls fiscal policy when it determines the unexpected component of inflation.
    In order for the standard NK argument for inflation determination to work, the fiscal authority has to care deeply about the central bank’s inflation target and passively respond to changes in monetary policy.
    In the end, any inflation determination model deals with two equations. A fisher equation with a monetary policy rule and the government’s intertemporal budget constraint.
    For one of those equations to determine the inflation rate/the price level, you have to impose restrictions on the other equation.

    The problem is that the “passively responding” ends up being expectations bound. If the Government spends more (or even cuts taxes), the belief is that requires more borrowing which necessarily means a higher interest rate bill. But spending more (or cutting taxes) means higher interest rates in the future (because the central bank will respond) and the expectation is therefore that the interest rate bill will go up. So they don’t spend now – which breaks the mechanism baked into the NK model.

    We’re seeing this expectations effect by the bucket load right now. The nutty end of the commentary goes like this:

    Rishi insisted on making any extension of the Furlough scheme time-limited because HM Treasury long ago ran out of cash and the staff of the Debt Management Office are having a collective nervous breakdown. Seriously – some of the staff in that office are off with stress. At some point, the tap has to be turned off or no one will take our paper.

    What we need is something fiscal that genuinely passively responds invariant of the future. I wonder what that might be…

  2. In Canada peculiar things are happening. The federal government is running a very high deficit, about 15% of GDP. Some conservative types are squawking but most aren’t. Notably the big banks, the most powerful single economic and political group in the country, are quiet. Conversely their main lobbying group (the CD Howe Institute) is appalled and repeating all the neo-liberal mainstream nonsense imaginable: the government needs to raise taxes dollar for dollar for all spending, interest rates will soar eventually, etc. Nonetheless it’s starting to look like the government is doing full-on MMT (functional finance part, no Job Guarantee) unapologetically. It has announced new national programs for prescription drugs and childcare and a plan to renovate the train system in eastern Canada and other programs. The prime minister and minister of finance have said they will keep spending as long as needed to support the economy and they will not establish the “fiscal anchor” conservatives are asking for any time soon. Significantly, the new minister of finance has stated the government is not doing MMT, a sure sign it is. We’ll see what develops…

  3. And, on top of what Keith Newman says, a good deal more spending is being lined up for the recovery. One wonders what would be the Government’s line if they had a majority, rather than being supported by the NDP…

  4. As much as I fully support the idea of the RBA funding all state and territory government deficits without undue restriction, I think co-ordination would be important here.

    They are separate states and territories but are a single country and with limitless fiscal resources made available to them, there could be fierce competition among the sub-national governments for real resources.

    First priority would always be true full employment.

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