RBA’s Phil Lowe dismisses MMT

RBA Governor Phil Lowe has given an address to the Anika Foundation, where he flagged a turnaround in the Australian labour market and endorsed using fiscal policy to smooth out the pandemic shock. However, he attacked the idea of monetising debt via MMT:

The Labour Market

I wanted to start with the labour market because for many people, the economic costs of the pandemic really hit home when they, or somebody they know, lost their job or their hours were cut.

In April and May, employment fell by around 870,000 people and a further 760,000 people had zero hours of work, although they still had a job. Many other Australians had their hours cut, with young people bearing a lot of the burden (Graph 1). All up, total hours worked in Australia fell by 10 per cent in just a few weeks. As staggering as this fall is, it is smaller than we earlier feared. In early May, we were expecting a decline of almost 20 per cent in total hours worked. It is also a smaller than the decline we have seen in many other countries. In Canada, for example, hours fell by 28 per cent and in the United States they fell by 19 per cent.

Fortunately, we have now turned the corner. In June, hours worked increased by 4 per cent and the number of employed people rose by 210,000. Notwithstanding this turnaround, the path ahead is expected to be bumpy and there are some major cross-currents in the labour market at the moment.

On the positive side of the ledger, many firms that were heavily affected by the shutdowns are now rehiring and lifting hours as the restrictions are eased in most of the country. This is most clearly evident in the retail, hospitality and arts & recreation sectors (Graph 2). Some other firms have also hired large numbers of people as they respond to the increase in demand as a result of the pandemic. The supermarkets are a good example of this.

But on the other side of the ledger, there also factors working in the opposite direction.

Through our business liaison we are hearing that many firms, including in the construction sector and in professional services, were able to keep many of their employees over recent months because they had a pipeline of work to complete. But as new orders have declined, this pipeline is drying up. If it is not replaced soon, hours worked in these businesses will decline further, just at the same time that other parts of the economy are coming back to life.

Some firms have also used recent months to reconsider their business models. In some cases this is because of the decline in demand that is likely to persist, but for others there has been a reassessment of how they manage their workforce. Some firms have identified new opportunities and there has been plenty of innovation. Yet despite this, restructuring and the uncertainty about future demand is likely to weigh on the labour market as it recovers.

Adding to this complicated picture is the fact that the unemployment rate is likely to increase further, even with the recovery underway. This is because many of the people who lost their jobs over recent times have been classified as not in the labour force and so are not counted as unemployed. As the labour market continues to improve, we expect many of these people will start looking for jobs, and thus be classified as rejoining the labour force. This will push up the measured unemployment rate at the same time that the share of the working-age population with a job is also rising. We saw an example of that in the figures for June, released last week, when despite employment increasing by a record 210,000 people, the unemployment rate also rose to 7.4 per cent, a 21-year high (Graph 3).

Looking forward, one of the keys to returning to a strong labour market is restoring confidence.

This starts with people being confident about their own health and the public health response. The global evidence is that without this, people are reluctant to resume their normal activities and firms are reluctant to hire and invest. The other element is people being confident about their own finances and jobs, and businesses being confident about future demand. Addressing the health issues will help here, but so too will the policy response on the economic front.

Public Sector Balance Sheets

This brings me to the second issue that I wanted to talk about: the important role that is being played by public sector balance sheets in softening the economic downturn and in providing the best platform for the economy to recover. I will first talk about use of the RBA’s balance sheet and then about the government’s balance sheet.

…the Reserve Bank’s balance sheet has increased from around $180 billon prior to the pandemic to around $280 billion today and further increases are expected over coming months (Graph 4).

To date, around $25 billion has been advanced under the funding scheme for the banking system, with 66 ADIs having used the facility (Graph 5). We expect further drawings to be made over coming months, with the total amount available currently standing at $150 billion. This facility is working as expected and is contributing to the plentiful supply of liquidity in the Australian financial system…

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…

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…

What we have seen over recent times is the government balance sheet being used to smooth out large shocks to private sector incomes. By smoothing things out, the government is helping people right now and also limiting the longer-term damage to the economy…

The government can play an important role here by using its balance sheet to smooth things out and reduce the severity of the downturn. In doing so, it helps not only in the present but in the future as well…

Debt across all levels of government in Australia, relative to the size of our economy, is much lower than in many other countries and it is likely to remain so (Graph 8). As I said before, the Australian governments can borrow at the lowest rates since Federation. So the public balance sheet is well placed to smooth out the shock to private incomes and support the economy through the pandemic…

At some point in the future, attention will rightly return to addressing the ratio of public debt to GDP, as low levels of public debt do give us the capacity to use the public balance sheet to smooth out future shocks to private income.

When the time does come to address the build-up of debt, the best way to do this will be through economic growth.

Concerns around MMT aside, Phil Lowe’s prescription is clear: the federal government should not be afraid to go into debt and should pump-prime the economy to fill the gaping hole in domestic demand.

Leith van Onselen
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