Is It Time for Overt Monetary Financing?
Is It Time for Overt Monetary Financing?
A paper prepared for Modern Money Australia by
Dr Martin Watts
Emeritus Professor, Faculty of Business and Law, University of Newcastle
© 2020 Dr Martin Watts and Modern Money Australia Inc
Successive Australian Governments of both political persuasions have championed the achievement of fiscal surpluses as an indication of good macroeconomic management over recent decades. Due to the coronavirus pandemic however, the present Coalition Government was required to engage in a major fiscal response to mitigate the effects of the crisis, consequently creating a large fiscal deficit previously considered to be (politically) unthinkable.
However, citizens were soon reminded that i) due to fiscal rectitude and low debt under the Coalition Government, Australia was better prepared to address these massive shocks both to the health and economic systems, than most other countries; and ii) notwithstanding point i) gross government debt would dramatically increase with repercussions both for taxes to be paid by future generations and the exposure of the economy to external shocks.
The community remains strongly attached to the belief that taxation, debt issue and sale (ie “borrowing”), and money creation jointly finance government spending. Together, these create an ‘ex ante’ budget constraint in the orthodox economic understanding of fiscal operations. The public are told that higher government spending which is paid for by higher income taxes and indirect taxes would reduce their real disposable incomes and limit their consumption choices. Orthodox economists also emphasise that through the operation of financial markets (loanable funds theory) interest rates paid on debt would increase, when higher deficits are run, and financed by borrowing. This is a result of the increased demand for finance from the public and private sectors in aggregate. This, in turn, it is claimed, has an adverse impact on private sector spending, particularly investment. Money creation, which is misleadingly referred to as “printing money” is alleged to be inflationary. Thus, running fiscal deficits ‘financed’ by any of the three operations is alleged to be deleterious to the operation of the market economy.
But the idea of an ‘ex ante’ budget constraint for the Australian federal government is fallacious. A Government which operates with a sovereign currency can impose voluntary constraints on itself, yet it spends currency into existence by keystrokes to credit the accounts of the suppliers of goods and services to government.
This brief essay responds to two key questions:
i) is the above interpretation of the three so-called financing arguments correct? and
ii) is there a superior option to the current arrangements with respect to the conduct of fiscal policy?
We conclude that Overt Monetary Financing (OMF) should be adopted to boost aggregate demand which should silence those doomsayers who worry about paying off high levels of public debt.
Orthodox Views about Fiscal Deficits
Decisions about the balance between private and public spending in the economy are largely political. An ambitious program of government spending may need a higher rate of taxation, not to finance the spending, but to provide the fiscal space necessary for the proposed government spending to take place without creating demand pull inflation. A political decision is being made – that curtailing private expenditure is worthwhile to enable higher public spending to take place.
In this context, the argument that money creation causes inflation is a fallacy. Rather it is excessive spending that causes inflation. In the current economic conditions, of course, the concern is lack of effective demand (spending) rather than the public and private sector competing for resources and causing inflation.
To explore the crowding out argument, which is associated with debt issue, we need to consider the Institutional Practices of the Central Bank, the banks and, in the Australian context, the Australian Office of Financial Management (AoFM).
In many advanced countries including Australia and the UK, specialised departments within Treasury are responsible for debt management (eg AoFM and the UK Debt Management Office). Under the ‘full funding rule’ these agencies issue debt periodically to match the anticipated fiscal deficit which will be attained by their Treasuries over the following year and sell the debt to designated (non-Government) participants in the primary market. Neither Australia nor the UK are subject to legal restrictions on the sale of debt to their Central Banks on the primary market, where newly issued debt is purchased, but in practice primary market sales to these Central Banks are limited.
When Treasury runs a deficit, the reserves in the commercial banking system increase, through the creation of additional deposits, as noted above. Under a corridor system[Note 1], this means that the Central Bank must engage in Open Market Operations (OMO) to avoid the target interest rate set by monetary policy being compromised by banks trying to lend excess reserves which would drive down the interbank rate below its target. The prior sale of debt by the AoFM neutralises to some extent the overall impact of net Treasury spending on reserves, which means that OMO by the Central Bank will be reduced in scale. Note that contrary to loanable funds theory, deficit spending is imposing downward pressure on the interbank rate and hence interest rates more generally, which rebuts the third claim by orthodox economists that running fiscal deficits financed by borrowing leads to rising interest rates.
What is OMF?
We now turn to a description of the process of Overt Monetary Financing. Under OMF, no debt needs to be sold to the banks when Treasury net spends (ie runs a fiscal deficit), because, by setting the deposit (support) interest rate equal to the target or cash rate, there is no downward pressure on the interbank rate, since the support rate is the floor for the overnight rate. This is because banks are guaranteed this rate on their excess reserves and would not lend reserves on the interbank market at a lower rate. Thus, under current interest rate settings, the RBA would need to raise the support rate (currently 0.1%) to 0.25%, the cash rate, to enable OMF to be conducted. This interest rate configuration is known as the floor system.
The RBA would pay the interest on the higher stock of reserves, rather than Treasury paying interest on newly issued debt, but in effect this makes no difference. The RBA still plays a key role in the payments system, including when a fiscal surplus is run and financial assets are purchased from banks to replenish their reserves (see below).
Is OMF desirable?
The introduction of OMF would expose the mysticism surrounding fiscal deficits and “debt” . The view that fiscal deficits lead to a rising gross debt to GDP ratio[Note 2] for a developed, currency sovereign economy, which in turn leads to higher interest rates, the possibility of default and future generations being saddled with higher interest payments, is challenged. We discuss political accountability below. The need to issue debt would be largely removed, which means that over time the debt to GDP ratio would fall, both due to debt being retired and growing GDP, which should quieten the doomsayers. Recently, Percy Allan outlined the OMF option in the Sydney Morning Herald (Allan, 2020).
We appear to accept that the RBA can choose to buy Australian denominated debt in the secondary market (that is after the debt was initially sold to designated buyers in the primary market) without either an adverse macroeconomic effect or the need for scrutiny. Indeed RBA Governor Lowe remarked that ‘[t]he Bank will do what is necessary to achieve the 3-year yield target, with the target expected to remain in place until progress is being made towards the goals for full employment and inflation’ (RBA, 2020b). Thus, limited Quantitative Easing is being practised with the RBA committing to buy (sell) government debt of 3 year maturity, when its yield rises above (falls below) its target of 0.25%. The RBA had spent $90b by early May.
Is OMF more stimulatory and hence inflationary due to the growth of reserves in the banking system, when compared with the case of conventional OMO, in which excess reserves are absorbed through the sale of bonds? Former Vice-President of the ECB, Victor Constancio (2011, p. 5) explains that:
‘Central bank reserves are held by banks and are not part of money held by the non-financial sector, hence not, per se, an inflationary type of liquidity. There is no acceptable theory linking in a necessary way the monetary base created by central banks to inflation.’ [emphasis added].
Quite simply, banks’ decisions to make loans are not predicated on the presence of sufficient reserves either in the form of vault cash or their deposits at the Central Bank.
Another argument is that when a prospective fiscal deficit is accompanied by debt issue and sale there is a higher inducement to save (to buy the newly created bonds) than if OMF was conducted. However, the quantum of saving is a residual, after the consumption decision, which may include unforeseen expenditures. In turn the placement of new saving in a bank account or the purchase of a financial asset is a separate decision to the consumption/ saving decision. Hence money creation (OMF) is no more stimulatory than debt issue and sale because portfolio choice is quite separate from the consumption/saving decision.
The sequence of fiscal surpluses run by Treasurer Costello between 1997 and 2006 led to a falling public debt ratio, with maturing debt being paid off and less new debt being created. This caused consternation in the financial sector, given the reduced availability of riskless government securities to be held within portfolios. The ensuing Review of the Commonwealth Government Securities Market in 2002-03 examined whether the declining CGS market remained viable and was persuaded by the pleas of the financial sector. This meant that CGS could be issued independently of the fiscal position. The MMT position, recently reiterated by Bill Mitchell in a recent blog post (Mitchell, 2020), is that ongoing CGS issue is unnecessary and largely provides corporate welfare for the financial sector. Further discussion of this topic is beyond the scope of this essay.
Adair Turner, chair of the UK Financial Policy Committee, until its dissolution in March 2013, has long recommended the implementation of OMF, by countries such as the UK, USA and Japan and also Eurozone members (Turner, 2013). He argues, however, that the Bank of England (BoE) should have the power to set a limit on the portion of the fiscal deficit which is subject to OMF, which would enhance its macroeconomic influence.
The ostensible reason put forward by debt management agencies for full funding through debt issue and sale is accountability and transparency on the part of Treasury and the Government, with respect to its (net) spending and the separation of debt management from monetary policy. The implication is that Treasury must borrow to finance its net spending and must be fully accountable for its level of borrowing. The question is ‘accountable to whom’?
Under Turner’s proposal, an unelected, largely unaccountable body, whose members are typically appointed by the incumbent Government, would not only set monetary policy but also influence fiscal policy. This undermines the proposition that incumbent Governments are responsible for economic management and should be judged by a well-informed electorate at the ballot box.
Allan, P. (2020): ‘The ‘free ride’ we can’t afford to spurn: how the RBA can jump-start our economy’, Opinion, Sydney Morning Herald, 21 May 2020.
Mitchell, W.F. (2020): ‘Why do currency-issuing governments issue debt? – Part 2’, Billy Blog, 2 June 2020.
Turner, A. (2013): Debt, Money and Mephistopheles: How Do We Get out of this Mess? (mimeo) Cass Business School, 6 February 2013.