Why history matters

In this recent blog – Who is in charge? – I outlined the case that all the so-called “financing” arrangements that government deploy which are held out to us as being required to allow them to spend are in fact voluntary and reflect deep-seated ideological anti-government positions. I wanted to make the point that it is governments not amorphous “bond markets” that ultimately in command of the destiny of their nations and that citizens are being grossly mislead by lies and half-truths into believing that governments have to introduce harsh austerity packages to appease the markets because if they do not the latter will “close them down”. I continue with that theme today and address some issues raised in the comments that accompanied that blog.

The point I was making in the previous blog was that the choice of these voluntary “funding” arrangements for governments that are not intrinsically revenue-constrained is always political and never financial. I argued that if citizens realised these were political choices only (reflecting ideology) then they would be better able to compare them with other political decisions such as the austerity measures. In making this point, I argued that once citizens had a better comparison and were not forced into thinking that the financial constraints were real then governments might be more carefully scrutinised and forced into making better decisions with advance public purpose rather than play hanky-panky with self-aggrandising bankers and the likes.

Anyway, one commentator who seems to be fixated on the threat of inflation wrote that the RBA does think it matters for its capacity to control inflation as to how the government spends. This is in relation to whether debt-issuance is better than the central bank just taking instructions from Treasury to credit bank accounts when the latter wanted to spend.

The commentator said:

The RBA thinks it does. One of the main justifications for using bonds to fund budget deficits was that monetary policy was too difficult to implement in the 1970s when budget deficits were funded using a mixture of bonds and cash balances (ie borrowing from the RBA). Monetary policy and fiscal policy were effectively intertwined, and at times the requirements of each were working against each other.

This is the basis justification for bond issuance – the need to separate fiscal requirements from monetary requirements. It’s not because central bankers don’t understand the workings of the money markets, or that they don’t realise that the government is theoretically not revenue constrained, or any other reason.

Further, we were all referred to a 1993 paper from the RBA (which I know well) called the The Separation of Debt Management and Monetary Policy.

The underlying implication just accepted by the commentator was that the RBA – that is, monetary policy – was the appropriate vehicle for stabilising price levels.

We are further led to believe that there were valid “technical” reasons for the policy shift – that is, in the way the government issued debt etc. By implication this makes the shifts legitimate and indisputable.

Well, the fact is that there were no valid technical or financial reasons for making the shift. The reasons were all ideologically motivated and introduced to further the political ambitions of the neo-liberal, free-market lobby which had regained dominance in the policy debate around that time.

When the changes were made, Australia was a currency-issuing sovereign government with a floating exchange rate and as such had shed its gold standard shackles. The Federal government was thus not revenue-constrained and no longer had to issue debt into the private capital markets.

The fact they continued to issue debt, and, more pointedly changed the arrangements to make it even harder for themselves to issue the debt and “raise funds” is a testamony to the dominance of the conservative ideology. To say otherwise is to ignore the historical context.

In this blog – Will we really pay higher interest rates? – I detail the historical changes that occurred.

By way of quick summary, the major (voluntary) shift was to ensure that all net spending was matched $-for-$ by borrowing from the private market. So net spending appeared to be “fully funded” (in the erroneous neo-liberal terminology) by the market but all that was really happening was that the government was coincidently draining the same amount from reserves as it was adding to them each day and swapping cash in reserves for government paper. The bond drain meant that competition in the interbank market to get rid of the excess reserves would not drive the interest rate down. The specific arrangements that were chosen allowed the private markets to price the debt.

Prior to 1982, a tap system operated where the government would set the interest rate and then supply bonds to investors up to demand. Sometimes investors did not take up as much as the Government desired. The extra funds came from contra entries in the RBA-Treasury accounts (the government borrowing from itself!).

This system was atacked in the early 1980s by the conservative government and the financial community as they all developed their neo-liberal credentials. To get an idea of the historical debate you might want read this speech, which was the text of a presentation made by Peter McCray, Deputy Chief Executive Officer, Australian Office of Financial Management (AOFM) in 2000. In terms of the fact that the tap system sometimes led to the government lending to itself, McCray says that this would be:

breaching what is today regarded as a central tenet of government financing – that the government fully fund itself in the market. It then became the central bank’s task to operate in the market to offset the obvious inflationary consequences of this form of financing, muddying the waters between monetary policy and debt management operations.

I will come back to this later. The AOFM is the body that now issues and manages the public debt in Australia – another neo-liberal contrivance.

The so-called “tap system” was replaced in 1982 with an “auction model” mainly because of the alleged possibility of a funding shortfall. A totally spurious concept of-course. We should be absolutely clear about this. To construct the shortfall as a problem was a purely neo-liberal contrivance. They claimed it introduced uncertainty to the funding process. It did not in actual fact to anything like that.

What it meant was that investors had converted a desired amount of their reserves into government paper and were happy with their portfolios at the rate of return on the paper that the government was offering. That is all it meant.

The auction model merely supplied the required volume of government paper at whatever price was bid in the market. So there was never any shortfall of bids because obviously the auction would drive the price (returns) up so that the desired holdings of bonds by the private sector increased accordingly. The historical evidence is clear – that large quantities of debt were always auctioned with minimal disruption to interest rates – that is, they did not get pushed up significantly.

But you get the underlying reason for the shift in arrangements from the following tract from McCray’s speech. He is talking about the so-called captive arrangements, where financial institutions were required under prudential regulations to hold certain proportions of their reserves in the form of government bonds as a liquidity haven.

… the arrangements also ensured a continued demand from growing financial institutions for government securities and doubtless assisted the authorities to issue government bonds at lower interest rates than would otherwise have been the case … Because such arrangements provide governments with the scope to raise funds comparatively cheaply, an important fiscal discipline is removed and governments may be encouraged to be less careful in their spending decisions.

So you see the ideological slant. They wanted to change the system to impose limits on Federal government fiscal policy. This was the period in which full employment was abandoned and the national government started to divest itself of its responsibilities to regulate and stimulate economic activity. The legacy is the mess we are in now. I address this issue in the historical context soon.

The investment community were also pressuring government at the time to deregulate and allow them to operate more freely in the secondary markets. They won the battle and so began the derivatives spiral which has revealed itself in today’s calamities.

Prior to the establishment of the AOFM, the central bank handled all the debt management and issuance for the Commonwealth government. It was argued at the time that this blurred things – the monetary policy roles including liquidity management and the debt management. It was clear then that the tap rate offered by the RBA was consistent with its monetary policy objective (some short-term interest rate).

The real reason for the shift to the auction model administered by the AOFM (which is really just an arm of Treasury) is provided by McCray in his speech:

The reduced fiscal discipline associated with a government having a capacity to raise cheap funds from the central bank, the likely inflationary consequences of this form of ‘official sector’ funding … It is with good reason that it is now widely accepted that sound financial management requires that the two activities are kept separate.

Read it over: reduced fiscal discipline – that was the driving force. They were aiming to wind back the government and so they wanted to impose as many voluntary constraints on its operations as they could think off. All these constraints were unnecessary because the Australian government was operating with a non-convertible fiat currency.

But they were all sold to the citizens as essential financial reforms to allow us to fight inflation more effectively.

What followed was the relentless conservative campaign, still being fought, against the legitimate and responsible use of budget deficits. What this led to was the abandonment of full employment. And as they reduced the legitimate role of government before our very eyes and imposed huge costs on the most disadvantaged workers in our communities we applauded them and voted for more.

And it got worse in the 1990s and beyond. But if these changes had not been as consequential in that regard as they have been – then anyone in their right mind who understood what was going on would not be able to stop laughing – the transparency of their motivation was so obvious!

Anyway, before I return to discussing the RBA paper, it is essential to examine this historical period in a bit more detail to allow us to more fully understand the context within which these changes emerged. I also think this is particularly important for the overseas readers of my blog who may have no understanding of these historical events.

A good starting point is to consider a 1992 speech by the then RBA Governor Bernie Fraser. After spelling out the earlier monetary policy tools (interest rates ceilings, setting bond rates, statutory reserve deposits, lending controls, monetary targets, and pegged exchange rates), he noted that:

Deregulation – and other changes have seen these controls abandoned to the point where short term interest rates are now virtually the only monetary policy instrument … The introduction of bond tenders to fully fund budget deficits in 1982, and the floating of the currency in 1983, were two especially notable changes. Another sign of this shift was that the M3 projection, the watchword for monetary policy changes between 1976 and 1984 … was dropped in January 1985.

Given such changes, it is only to be expected that the perspectives on monetary policy in the recent period would be very different – from both vantage points – from what they were in earlier periods.

The both vantage points reference is in the context that Fraser was actually talking about the fact that he had previously been the Federal Treasury boss prior to taking over as governor of the central bank and so he could appreciate the conduct of monetary policy from two different angles.

He then moved on to talk about monetary policy and inflation and starting talking about the 1960s:

Inflation was a concern, even in this Keynesian world, and to combat it policy relied heavily on demand management. Fiscal policy was seen by most economists as the preferred instrument for that purpose. Monetary policy was seen as an adjunct to fiscal policy, but doubts remained about its potency; in “liquidity traps”, for example, easing monetary policy could be like “pushing on a piece of string”.

He concluded that the stagflation of the early 1970s which arose from the OPEC oil price shocks had cleared the way for a new theoretical approach to policy making which “had its origins in the classical idea of “money neutrality”” – in other words, the Monetarist period was ushered in.

Fraser says that:

In leading the revival of the old Quantity Theory, Friedman emphasised that money and prices were closely linked, and that increases in the money supply would lead mainly to higher prices, with no long term increase in real activity. This provided a much sharper focus on what caused prices to rise. It had the policy implication that governments can and should control the money supply in order to avoid inflation … Australia … [did introduce] … a form of monetary targeting … in 1976.

He noted that fiscal policy via its “monetary impacts” and “the sale of government bonds to the non-bank public were seen as central to monetary policy”. A Treasury statement in the 1981/82 Budget Papers (Statement No. 2) said that:

The Budget is clearly a central policy instrument, both in its own right and in its contribution to the achievement of the objectives of monetary policy … unless the growth of monetary aggregates can be reduced consistently over a run of years, there can be no real prospect of winding back the rate of inflation.

So the debate had turned. While the extreme forms of Monetarism were not adopted in Australia it was clear that the Quantity Theory of Money was a dominant theoretical construct at the time and led to discussions about the way fiscal policy should be “funded”.

By 1985, monetary targetting which had been fully embraced by the government in 1976 was abandoned. Why? Because it never worked. The 1985/86 Budget Paper (Statement No. 2) said “The analytical integrity of simple monetary targeting rests on the existence of a stable relationship between the chosen aggregate and the ultimate policy objectives. That is no longer the case at present in Australia.”

In normal language – the whole theory was a crock of s…!

And then we get to the important part of the story. Fraser continued to outline his history and talks about events in the early to mid-1980s:

Of greater policy significance around this time was the emergence of a fairly common view that fiscal policy should be seen more as a vehicle for medium term structural change of the public sector than as an instrument for stabilisation. By 1983/84, the PSBR had blown out to 7 per cent of GDP, and that in itself had limited the room to use fiscal policy for counter-cyclical purposes.

Monetarism was a failure on its own terms – money supply movements were not related to the evolution of inflation and the central bank was unable to control the monetary aggregates anyway (as they were told but arrogantly ignored the advice). But while it and all its baggage (NAIRU, neutrality, natural rate of interest and the rest of it) should have been abandoned – much of the theoretical structure lived on and dominated policy makers.

Fiscal policy was seen as a danger to inflation. There was an huge deficit-fetishism in all the public debates and papers published. At that time I was still a postgraduate student and the nonsense I listened to in seminars and read on a daily basis was about as puerile as the deficit terrorism is today.

The buzz word was the PSBR (Public Sector Borrowing Requirement) – and all sorts of dodges were published to argue it was to high. What has to be realised is that at this time, the official unemployment rate was still over 10 per cent after the dreadful 1982 recession (it dropped to 7.9 per cent in October 1985).

But the micro aspects of Monetarism took care of that inconvenient fact. They just reinvented full employment to be equal to an 8 per cent unemployment rate – I kid you not! Some of my earlier academic publications in the second half of the 1980s were about why this research was fraudulent. It was crazy stuff but the policy world was drunk on it.

You can see that despite the breakdown of Bretton Woods in 1971, the Governor still believed in the gold standard constraints on fiscal policy (noting his reference to the “blown out” deficit and that this “limited the room to use fiscal policy for counter-cyclical purposes”). Even at that time, the deficit had risen relative to GDP because we had been in a major recession (the worst since the Great Depression) and unemployment had sky-rocketed.

There was no financial limitations of the use of fiscal policy at that time to deal with this unemployment (the counter-cyclical pursuits). All the limits were, as they are now, political in nature, and the politics were being driven totally by conservatives who wanted small government, less regulation, unions destroyed, welfare provisions abandoned, and a free-for-all for the corporate sector.

This is the point at which Australia (and elsewhere in the World) really shifted towards the neo-liberal panorama that has now finally see the demise of the World financial system and unemployment that will damage generations of citizens.

You will note that Fraser is talking about a de-emphasis on fiscal policy. He went on to say:

The primary objective of the new emphasis was to reduce the structural deficit and the size of the public sector over time, mainly through restraint on government expenditures. It was in keeping with the prevailing international orthodoxy. But one consequence was to push more of the burden of inflation control and counter-cyclical stabilisation onto monetary policy.

So like most Western nations the neo-liberal resurgence was changing the macroeconomic policy landscape dramatically. The dominant paradigm became centred around the concept of the natural rate of unemployment which morphed into its near cousin the Non-Accelerating Inflation Rate of Unemployment (NAIRU).

Full employment as genuine policy goal was abandoned by the resurgence of the NAIRU which asserted (in denial of the empirical evidence then and now) that there is only one unemployment rate consistent with stable inflation. Milton Friedman and Edmund Phelps were early contributors to this literature. According to this school of thought, there is no discretionary role for aggregate demand management (other than to control inflation via monetary policy) and only microeconomic changes can reduce the natural rate of unemployment.

Accordingly, the policy debate became increasingly concentrated on deregulation, privatisation, and reductions in the provisions of the Welfare State with tight monetary and fiscal regimes instituted. High unemployment persisted. The fact that quits were strongly pro-cyclical made the natural rate hypothesis untenable but the idea of a cyclically-invariant steady-state unemployment rate persisted.

While various arguments were used to underpin the NAIRU concept, they all reached the same simple conclusion: there is only one cyclically-invariant unemployment rate associated with stable price inflation.

It should always be emphasised that the Monetarist-NAIRU resurgence used difference language but wore the same clothes of the orthodox theory that prevailed before the onset of the Great Depression. It application in that period led to the Depression worsening and unemployment rising. The acceptance of Keynes’ work and the beginning of the Keynesian policy period (which lasted up until the OPEC crisis in the mid-1970s) was a recognition that the orthodoxy had failed to alleviate the Depression and its explanations for the Depression were false.

Anyway, history was forgotten and the conservatives who had been trying to undermine the Keynesian paradigm throughout its dominant period (particularly durign the 1960s) saw the chance with the stagflationary episode in the mid-1970s to regain the ascendency.

The confusion of the time – that is, the dominance of ideology over the evidence – is unintentionally expressed by Fraser in the following. He claims monetary policy became comparatively advantaged at fighting inflation and that:

We now have a more precise view of the role of fiscal and monetary policy in relation to inflation than was current in the 1960s. Few people today would see fiscal policy as the critical policy instrument in controlling inflation. That said, the thrust of the earlier analysis still seems to be correct: that excess demand can be an important cause of inflation and all macro policy instruments should be used to combat that problem when it occurs.

Note the “still seems to be”. He could hardly utter the sentence. By the way, among the “few” people was yours truly as a young emerging academic fresh out of graduate school. But you get the drift of the time in this statement. The ideology was pushing government into a reliance on monetary policy and and forcing fiscal policy to play a passive role. But it … “still seems to be” the case that fiscal policy because it directly influences aggregate demand is still important but … persona non grata.

It is stunning really when you go back and re-read this rubbish. Why were so many smart people so imbued with it?

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.

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 September 1996, when the Federal Treasurer (then a conservative government) and the Reserve Bank Governor issued the Statement on the Conduct of Monetary Policy (no longer available on-line – sorry), 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”.

In a stagflation environment if price spirals reflect cost-push and distributional conflict factors, such an approach can surely never work.

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.

This is the point I discussed in my blog – My Sunday media nightmare. It was always 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 (upon which my PhD and early academic articles were based) 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.

Further, persistently high rates of labour underutilisation (that is, high rates of long-term unemployment) also reduce the capacity of the economy to produce. Not only do idle workers not contribute to income generation but they also develop related pathologies (sickness, substance issues etc) which reduce their productive potential.

And, relatedly, persistently high rates of underemployment and a trend towards part-time casualised labour markets in response to neo-liberal styled deregulations of working conditions reduce the incentive of workers to invest in sophisticated skills. The lower rate of human capital accumulation reduces the potential labour productivity growth.

For all these reasons, aggregate supply movements are intrinsically related to the evolution of aggregate demand. A fully employed, high pressure economy is much more productive and conducive to high rates of investment than an economy that maintains a persistent slack due to deficient aggregate demand.

But under the NAIRU approach which the RBA was embracing, 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 complementary austerity.

In my recent book with Joan Muysken – Full Employment abandoned – we cover the development of economic theory in this period in great detail and show that was basically flawed from the outset but dressed up in the fine NAIRU clothing of the day that dazzled the conservatives (and progressives alike – excluding yours truly).

Bond-issuance versus central bank borrowing

I went into that background a bit because it seems to be forgotten when contemporary commentators are talking about this period. To see why there was a shift in arrangements with respect to how the government spent and the operations that were associated with net positions (debt-issuance, central bank operations etc) you really have to appreciate the massive ideological shift that occurred in that period.

You cannot just read a 1993 RBA information paper devoid of this historical context and believe the mantra that is being outlined.

Anyway, lets now consider the paper noted at the outset where the RBA discuss the The Separation of Debt Management and Monetary Policy.

The ideologically loaded opening paragraph of the RBA justification sets the tone:

Debt management is the means by which the government issues securities to finance its deficit (or retires its debt if the Budget is in surplus) and manages the costs of the resulting stock of government debt. Monetary policy is concerned with influencing the cost and availability of money and credit in order to contribute to sustained low-inflation growth. Sound financial management is more likely to be realised when the two activities are kept separate.

First, the paper perpetuates the myth that a sovereign currency-issuing government such as Australia has to “finance its deficit”. Finance means raise money that is required prior to spending it. The Australian government does not have to do that and didn’t at the time this paper was written. The statement is totally ideological and expresses the dominance of the erroneous mainstream macroeconomics.

Second, it assumes – as per the historical discussion above – that monetary policy is about controlling inflation.

Third, the use of the term “sound financial management” is an ideological construction which means at worst balanced budgets over the business cycles and maintaining a buffer of unemployed so that wage shares are low (profit shares are high) and inflation is low.

The RBA paper notes that under the tap arrangements (and prior cash loan arrangements), if the:

Commonwealth Government did not sell sufficient debt to finance its deficit, the shortfall was made up by borrowing from the Reserve Bank. When it sold more than required, it accumulated cash balances at the Reserve Bank. In both situations, the result was a flow of cash to or from the money market which was outside the control of the authorities.

They claim this undermined monetary policy because of:

  • “unpredictable net contributions by the Government to the amount of cash in the money market, much of the Reserve Bank’s open market operations (or liquidity management) was directed to offsetting or trying to prevent unwanted and destabilising injections or withdrawals of funds from this source” – to which I say – so what?, and because
  • “the yields set by the authorities on CGS became important for monetary policy”. Here they claim the problem was that if yields were too low then bonds might become unattractive if the RBA tightened monetary policy which would widen the “funding shortfall” etc. To which I say – so what? This is only an issue if you consider monetary policy as the primary counter-stabilisation policy tool and you erroneously believe the sovereign government is revenue constrained. Both propositions are faulty.

They also noted that there were problems because the government was operating a “quasi-fixed exchange rate under which the exchange rate was announced by the authorities and the Reserve Bank bought and sold foreign exchange in whatever volume the market desired at the announced rate.” While true, this was a hangover from the gold standard and has no application under the flexible exchange rate we now run. At any rate, many of the changes that the RBA talks about were introduced after the exchange rate was floated in December 1983.

To better understand some of this we need to consider the operations that occur when the government runs a deficit without issuing debt? Note I am talking her about present day Australia, which like many countries is sovereign in its currency (runs a flexible exchange rate). Scott Fullwiler has a nice blog about this too.

Like all government spending, the Treasury would credit the reserve accounts held by the commercial bank at the central bank. The commercial bank in question would be where the target of the spending had an account. So the commercial bank’s assets rise and its liabilities also increase because a deposit would be made.

The transactions are clear: The commercial bank’s assets rise and its liabilities also increase because a new deposit has been made.

Further, the target of the fiscal initiative enjoys increased assets (bank deposit) and net worth (a liability/equity entry on their balance sheet).

Taxation does the opposite and so a deficit (spending greater than taxation) means that reserves increase and private net worth increases.

As I have explained many times, this means that there are likely to be excess reserves in the “cash system” which then raises issues for the central bank about its liquidity management. The aim of the central bank is to “hit” a target interest rate and so it has to ensure that competitive forces in the interbank market do not compromise that target.

When there are excess reserves there is downward pressure on the overnight interest rate (as banks scurry to seek interest-earning opportunities), the central bank then has to sell government bonds to the banks to soak the excess up and maintain liquidity at a level consistent with the target.

Some central banks offer a return on overnight reserves which reduces the need to sell debt as a liquidity management operation. Note the terminology – there is no sense that these debt sales have anything to do with financing the government net spending. The sales are a monetary operation aimed at interest-rate maintenance.

So M1 (deposits in the non-government sector) rise as a result of a deficit without a corresponding increase in liabilities. It is this result that leads us (MMT) to say that deficits increase net financial assets in the non-government sector.

What would happen if there were bond sales? All that happens is that the banks reserves are reduced by the purchase price but this does not reduce the deposits created by the net spending. So net worth is not altered. What is changed is the composition of the asset portfolio held in the non-government sector.

The only difference between the Treasury “borrowing from the central bank” and issuing debt to the private sector is that the central bank has to use different operations to pursue its policy interest rate target. If it debt is not issued to match the deficit then it has to either pay interest on excess reserves (which most central banks are doing now anyway) or let the target rate fall to zero (the Japan solution).

There is no difference to the impact of the deficits on net worth in the non-government sector.

But of-course, the neo-liberal textbooks all claim that the former (borrowing from central bank) is inflationary while the latter (private bond sales) is not. These claims are without foundation.

I have dealt with these issues in detail in the following blogs – Building bank reserves will not expand creditBuilding bank reserves is not inflationary and The complacent students sit and listen to some of that.

The summary findings of those blogs are:

  • Building bank reserves does not increase the ability of the banks to lend.
  • The money multiplier process so loved by the mainstream does not describe the way in which banks make loans.
  • Inflation is caused by aggregate demand growing faster than real output capacity. The reserve position of the banks is not functionally related with that process.

So the banks are able to create as much credit as they can find credit-worthy customers to hold irrespective of the operations that accompany government net spending.

This doesn’t lead to the conclusion that deficits do not carry an inflation risk. All components of aggregate demand carry an inflation risk if they become excessive, which can only be defined in terms of the relation between spending and productive capacity.

It is totally fallacious to think that private placement of debt reduces the inflation risk. It does not.

What it does it to increase the political pressure on governments running deficits. The “debt bomb” arguments always carry political weight as do the findings that “bond yields are rising”. These are all voluntary constraints and stem from the initial ideological choices made to limit fiscal policy and allow monetary policy free reign to target inflation.

The RBA paper says that in 1986, the Federal government adopted:

… the principle of full funding implied that gross issues of securities would equal the Budget deficit plus maturities of existing debt, and could be estimated once the Budget deficit estimate was known.

This allegedly gave the bond markets a clear division between debt-issuance for so-called fiscal policy purposes and debt sales associated with open market operations. The RBA claim that once they formally moved to inflation targeting the monetary policy signal was cleaner.

As argued all this was ideological and aimed at limiting the use of fiscal policy and promoting the primacy of the policy decisions of the unelected and therefore unaccountable RBA board.

The RBA also note in the paper that contemporary bond issuing arrangements are now:

… made with a view to minimising the Commonwealth’s long-term borrowing costs, in a manner similar to that which any company would apply.

So you see the application of the mainstream myth that there is a valid analogy between the household/firm budgeting processes and those of the national government. This falsehood is one of the basic ideological tools used to limit government activity. Clearly, there is no similarity between the two budgets except both use the came currency … which is the point!

The national government issues the currency and is never financially constrained. The household/firm sector uses that currency and is always financially constrained. Promoting this myth is a very powerful way to deceive the citizenry into believing that government deficits are essentially “unsustainable”.


The official sophistry is all housed in terms of “financial efficiency” and “policy efficiency” etc. But all these terms and justifications were always designed to hide the fact that all these changes were unnecessary once Australia fully abandoned the gold standard and assumed the status of a flexible exchange rate/non-convertible currency nation.

All the justifications are hiding the underlying ideology that neo-liberalism has promoted since its morphed out of the slime as Monetarism. The underlying theme is that governments should have a minimal role to play and at the macroeconomic level policy should be only directed at minimising inflation. Monetary policy is then claimed to be the most effective option in this regard.

Meanwhile, the more important policy goal of full employment has been subjugated and unemployment used to further the free market ambitions which ultimately are designed to redistribute national income away from workers into the hands of capital. Along the way, the dominance of financial capital has somewhat usurped this process with deadly results as we are witnessing now.

Of-course, the proponents of the same agenda have willingly put their hands out for billions of dollars of fiscal support to bail them out of trouble that they themselves caused. Now they have pocketed that public booty they are once again in full on attack mode against anyone else enjoying the benefits that fiscal interventions provide.

The obvious solution is to first, abandon the use of monetary policy – that is, let the short-term interest rate go to zero (as in Japan) and let all longer maturity rates adjust according to risk (and inflation expectations). This will provide a much better private investment climate and provides better incentives for productive capital augmentation.

Second, introduce wide ranging financial market reforms along the lines suggested in this blog – Asset bubbles and the conduct of banks.

Third, address price bubbles in specific asset classes using well-targetted fiscal policy (capital gains taxation etc) along the lines suggested in this blog – Asset bubbles and the conduct of banks – for more discussion on this point.

Fourth, address general inflation fears using properly scaled fiscal policy interventions. along the lines suggested in this blog – Functional finance and modern monetary theory .

Finally, trawling out an official government paper and quoting from it without also understanding or relating the historical context is not a very sound way to mount an argument. I hope that this rather long blog (it wasn’t meant to be!) has brought home the point as to why history matters

Digresssion: Eurozone insight …

I thought this quote from an originally published in the UK Daily Telegraph and written by its economics editor Edmund Conway was something I might have written except he does it better.

The article, syndicated by Sydney Morning – Why politics trumps economic logic as Greek tragedy unfolds noted that the Greek situation will force some sort of compromise within Europe. But then he asks whether the current mess:

Sounds like a muddle? Correct, but for blame one must look to the euro’s original architects, who made a concerted decision when creating the currency not to allow for eventualities like this. After all, to do so would have been to suggest that the project might fail. Quelle horreur!

But their refusal to see the economic logic – that in the end a currency union will fail unless there is some form of central economic government with fiscal powers – has left the European project facing its greatest test yet.

It was possible to sweep this uncomfortable truth underneath the carpet for the single currency’s first decade, but now the full scale of the Greek crisis has brought it back on to the agenda …

Even after the current mess is cleared up, the euro zone will find itself faced with an awkward question: does it admit that currency union was a mistake and dismantle it, or does it press on and create an effective European economic government to fill in the missing gap? To do nothing seems untenable.

My sentiments pretty much exactly.

Another digresssion: What the Russians are talking about …

Some traffic came into my site overnight from Russia. I was curious to see what they were talking about and went to the originating site where there was a discussion going on about learning economics and sources of information.

I got Google translator into action to see what the Ruskies were saying. This is a screen capture of a bit of the forum discussion (edited to allow it to fit).

I loved the Google turn of phrase: “Mankiw not read. He only be suitable for fuel barbeques”.

Which tells me that the majority of macroeconomic students, who are forced by their mindless lecturers to use this book, should start holding mass barbeques. These events will help them get to know the other students at their universities a bit better (to reduce the anti-social tendencies that students develop while studying mainstream economics) and will save trees because they can use their Mankiw textbooks to fuel the barbies.

Although I might add – only vegetarian barbeques are approved of on billy blog.

And finally … the Saturday Quiz

Sometime tomorrow the weekly Saturday Quiz will appear with some devilish challenges. I might focus on Austrian School logic! But then I would have no questions given they have no logic.

That’s enough for today!

This Post Has 5 Comments

  1. Hi Bill,

    What is your take on Bradley review on Australian higher education. It seems the reccommedation is that G-8 should focus on research whereas other universities should be focus teaching. This report seems to be influenced by a similar review in the UK which concludes that only top 40 of the British Universities should offer PhD programs, while the rest should focus on undergraduate teaching only.


  2. Bill, I recently posted a question regarding the mechanics of the ECB system as it relates to deficit spending. Specifically I want to understand how it works: when Greece runs a deficit of 2% of GDP by spending do they simply create a credit the same way The Fed does? And does that credit then have to also be sterilized by borrowing (due to the accounting customs)? And would not Greek recipients of the newly issued EUR then have the option of investing in ANY EUR asset (say German Bunds)? So in this situation, even without the limitations of the Maastricht Treaty wouldn’t Greece still have a difficult time financing a large deficit (at the previous low rate) if the EUR they credit into existence end up in Germany? I asked this question yesterday and Tom Hickey was nice enough to link to previous posts on this matter but, although they were helpful, the specific mechanical question was not thoroughly answered (or I didn’t see it). Rammanan posed the following question that went unanswered, perhaps you or some of the other participants can answer:

    “A few basic questions. I understand that the whole Euro system has a lot of self imposed constraints. So it is not like the case of the US. On top of that there are these NCBs in addition to the ECB. My questions are:

    1. Who conducts the open market operations ? The ECB does them but do the NCBs do them as well ? How do they work together in achieving the overnight interest rate target ? At a less detailed level, it must be the same as other central banks – just needed to get into details. Plus I need to know how interbank settlement works.

    2. When a government X spends it credits bank accounts, but where are the reserves created ? I can understand a system with just the ECB – the NCBs are confusing me and I don’t see their role.

    3. How do the flow matrix and the balance sheet matrix of the ECB and the NCBs look like ? Is there something like an ECB bond which the NCBs hold ?

    4. How does accounting of the “fines” work ? If a government breaks the rules of the Maastricht treaty, what are the flows ? It seems to me that a government can just walk away by paying the ‘fines’.”

  3. Yossarian,

    I’ve been looking for answers too. Recall that Bill, apparently joined by Galbraith Junior has repeatedly said that there cannot be a liquidity crisis in the US. I deduce from what Warren Mosler says below (he is talking on his own behalf, not relating the view say of a rating agency, I think) :

    If all the national govts had started with zero debt when they formed the union, the markets never would have let them get beyond maybe 20% debt to GDP.

    that the member states of the EU are revenue-constrained. And since volontary political constraints, such as SGP can be relatively easily scraped, or suspended, it must be a matter of design in how the ECB operates and its (lack of) arrangement with the member states; The NCBs, are just branches of the ECB, they shoudn’t obfuscate the issue. Furthermore,

    Instead they came in at the 60-100+ debt to GDP ratios they got to when they had their own currencies when it didn’t matter for liquidity/funding purposes, as with their own currencies liquidity and solvency wasn’t an issue, and whether they knew it or not their deficits were simply offsetting the economys’ nominal savings desires at the then current exchange rates.

    Note the past tense to describe the situation when solvency wasn’t an issue, but overnight, on entering into EMU, their stated debt levels, purely an accounting statement until then, became binding. Actually, to be totally accurate, I read that at least one country that joined EMU already was financially constrained since the 1970s and its legislation reproduced in the EMU treaty.

    Source : Germany Said to Consider Greek Aid Beyond Loan.


  4. Bill, that’s a tremendous summary of the historical context around the time of the move to the current system of the separation of monetary and fiscal policy in Australia. Thanks.

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