The RBA’s job is done, according to Phil Lowe:
I would now like to address one idea for the use of the central bank’s balance sheet that I sometimes hear – that is, we should use it to create money to finance the government. A variant on this idea is that the central bank should just deposit money in every bank account in the country – this is sometimes known as ‘helicopter money’ because, before we had an electronic payments system the idea was that banknotes could simply be dropped by helicopter.
For some, this idea is seen as a way of avoiding financing constraints – it is seen as holding out the offer of a free lunch of sorts. The central bank, unlike any other institution, is able to create money and the resource cost of creating that money is negligible. So the argument goes, if the government needs money to stimulate the economy, the central bank should simply create it in the public interest.
The reality, though, is there is no free lunch. The tab always has to be paid and it is paid out of taxes and government revenues in one form or another. I would like to explain why.
I will start with some central bank accounting. When a central bank creates money to finance government spending it does so by crediting the government’s deposit account with it. These extra deposits represent a liability of the central bank. And on the asset side of the balance sheet, the central bank might have an IOU from the government to be paid in the future.
Now suppose that the additional government spending is successful in stimulating the economy and this starts to push inflation up. At some point, interest rates would need to be increased to avoid inflation rising too far. If this lift in interest rates did not occur, inflation would rise, perhaps to a very high level. In this case, it would be through the inflation tax that the community pays for the extra government spending. So there is no free lunch – the spending is just paid for in a different way.
Now instead suppose that interest rates are increased to avoid high inflation successfully. Even then, there is still no free lunch. How the tab is paid though depends on the nature of the arrangements that are in place.
One possibility would be for the government to pay back the IOU along with any accumulated interest at some point down the track. This repayment would need to be funded by future taxes.
If instead the IOU was not interest-bearing and was not repaid, the central bank would start accumulating losses as the interest rate it paid on its deposit liabilities increased and there was no offsetting income. This would lead to a decline in dividends to the government and possibly a future recapitalisation of the central bank. Both have to be funded through tax revenue.
Another possibility would be to increase the general level of interest rates to deal with inflation, but to maintain the low interest rate on deposit balances held at the central bank. This approach would limit losses at the central bank even if the IOU was not interest bearing. But it would effectively amount to a tax on the banking system, as it is the banks that would hold these low-interest balances once the government has spent the money. In this case, it is this tax that would help finance the extra spending.
The message here is that somebody always pays. It certainly is possible for the central bank to change when and how the spending is paid for, but it is not possible to put aside the government’s budget constraint permanently. Where countries have, in the past, sought to put aside this constraint the result has been high inflation.
Notwithstanding this historical experience, some prominent mainstream economists, including Stanley Fischer, a former governor of the Bank of Israel and Vice Chair of the US Federal Reserve, have recently argued that central bank financing of government spending may be appropriate in some circumstances.
In particular, they have focused on the situation in which:
- conventional monetary policy options have been exhausted
- the central bank is falling short of its goals, and crucially
- public debt is high and the government cannot borrow in financial markets on reasonable terms.
They argue that under these particular circumstances, central bank financing may be welfare enhancing, provided that there are strong safeguards to avoid the inflation problem.
The main safeguard proposed is that the amount of monetary financing and the conditions under which it is provided, are determined solely by the independent central bank, not by the government. It is envisaged that the central bank provides finance up until the point that its goals for inflation and perhaps unemployment are met. Importantly, the government would continue to determine how the financing is spent. This idea has attracted a lot of attention recently, although many commentators have pointed out that there are likely to be very significant challenges in maintaining this type of safeguard over time.
It is worth repeating that this proposal is only relevant to the situation where high government debt constrains the ability of the government to provide necessary fiscal stimulus financed through the normal channels. Clearly, it is not relevant to the situation we face in Australia.
So I want to make it very clear that monetary financing of fiscal policy is not an option under consideration in Australia, nor does it need to be. The Australian Government is able to finance itself in the bond market, and it can do so on very favourable terms. There is strong demand for government debt and the Australian government can borrow for five years at just 0.4 per cent and for ten years at just 0.9 per cent (Graph 7). These are the lowest borrowing costs since Federation.While monetary financing is not an option in Australia, the Reserve Bank Board continues to review overseas experience with other monetary options. We had another discussion on this at our meeting two weeks ago.
Central banks around the world have all moved in the same general direction, but they have configured their monetary support packages differently. Using international experience as a guide, it would have been possible to configure the existing elements of the RBA package differently. For example, the various interest rates currently at 25 basis points could have been set lower, at say 10 basis points. It would also have been possible to introduce a program of government bond purchases beyond that required to achieve the 3-year yield target. Different parameters could have also been chosen for the Term Funding Facility.
After discussing these possibilities, the Board concluded that that there was no need to adjust our package of measures in the current environment. The Board has, however, not ruled out future changes to the configuration of this package if developments in Australia and overseas warrant doing so.
At our meeting, we also reviewed some alternative monetary policy options.
One of these is negative interest rates.
There has been no change to the Board’s view that negative interest rates in Australia are extraordinarily unlikely. Our reading of the international evidence is that the main potential benefit from negative rates is downward pressure on the exchange rate. But negative interest rates come with costs too. They can cause stresses in the financial system that are unhelpful for the supply of credit. They can also encourage people to save more, rather than spend more, so they can be counter-productive from that perspective too. So this is not a direction we need to head in.
Another monetary option that has been used elsewhere is to intervene in the foreign exchange market. The evidence here is that when the exchange rate is broadly in line with its economic fundamentals, as the Australian dollar is currently, this approach has limited effectiveness. It can also involve substantial financial risks to the public balance sheet and complicate international relationships. So this too is not a direction we need to head in.
The conclusion of our discussions at the July Board meeting was that the best course of action is to maintain the mid-March package and to continue to monitor the effects of the pandemic on the economy. The Board has not ruled out future changes to this package, though it recognises that, in the current environment, there are limitations to what more can be achieved through monetary policy.
Given these limitations, and the outlook for the labour market, there is an important ongoing role for fiscal policy and use of the government’s balance sheet. I would now like to turn to this issue.
In one sense this speech is useful. It shows that monetary policy innovation to aid recovery is very possible. All Lowe does is explore who will be the winners and losers in each apparoach. This makes monetary innovation a political question and debate.
Yet, in another way, this speech is shockingly obtuse. How can Dr Lowe see no benefit in policy innovation (like but not exclusively MMT) that lifts inflation and interest rates? Dr Lowe faces rampant deflation and his job is to turn that into 2% plus so why would he not welcome new tools that can get him there? On the second, why wouldn’t Phil Lowe want higher interest rates for the world? That is a prerequisite to restoring capitalism by giving it back a price of capital. The great bubble manager appears to fear the very outcome he is employed to produce.
The unfortunate corollary of these two howlers is that Phil Lowe has dispensed with every possible new tool that the RBA might develop for further stimulus. With the real unemployment rate sitting somewhere above 15% and inflation cratered to unknown depths in the abyssal of the output gap, the RBA has put the cue in the rack. Bravo, eh. Pip, pip!
Iposo facto, it’s time we furlough the RBA. We’ll have to wait years longer than we need to for an economic rebound so we don’t need it over that period. Indeed, the RBA’s absence will be more inflationary than its presence given we won’t have a #%$& talking up the currency at every opportunity.
The RBA has cut interest rates from 0.75% to 0.25% so its turnover has fallen enough to qualify for JobKeeper.