Tuesday, 24 September 2013

Debt money and QE:Lessons from the GFC

The Debt fallacy examined the question of government debt and the budget surplus mantra from an accountant’s perspective.... where there’s government debt there must be a corresponding asset in private hands and if governments run surpluses then the non government or private sector has no option but to run deficits implying more private borrowings or a rundown of private financial assets. Debt (specifically borrowings of the Australian government) is issued via IOUs or government securities and appears as liabilities on the Australian government’s balance sheet. Notes and coins are also government IOUs but these appear as liabilities on the Reserve Bank (RBAs) balance sheet. Since our currency is now longer convertible (into gold say) the only payment one will get for a note is another note.

The aim of this blog is to have a closer look at debt and how it reconciles with the money supply. We are constantly bombarded with concerns about ‘money printing’, but how exactly is money created and by whom? If one were to take a quick street poll as to who creates most of the money in our economy, the answer would be the government does, and it’s delivered round the community in Armaguard trucks. However it doesn’t work like that and it hasn’t for quite a while.

Studying economics in the sixties before the abandonment of the Bretton Woods agreement by Richard Nixon, when currencies were linked to the gold standard and were nominally convertible into gold, the explanation for the creation of money hinged around the magic of fractional reserve banking........ a deposit of say $1,000 to a bank will end up creating loans many times that amount. If a bank was required to keep say 10% or $100 in reserves it could lend out $900 which would immediately be redeposited into the banking system allowing a further 90% or $810 to then be lent and so on, a geometric series for those who remember their high school maths. After numerous iterations $9,000 would be the total of new loans created by the initial deposit of $1,000 which would remain in the banking system. The bank(s) will have expanded their balance sheets by $10,000........... $9,000 listed as loans due from borrowers and $1,000 as cash on hand or maybe cash in the banks’ exchange settlement a/c at the RBA. The corresponding liability of $10,000 will be total of new deposits from customers.(NB deposits from customers are liabilities to banks. Loans to customers are assets. The reverse is the case in the books of the customer).

With a reserve requirement of 10% the money multiplier will be the inverse or 10 times. That’s how money was supposed to be created in the old days, endogenously, by banks. First deposits are needed. Then loans are created. The proceeds of loans when spent are redeposited into the banking system to provide for further loans, and so on.

It’s a nice neat plausible theory but completely wrong in today’s world. Banks create money but they don’t require deposits to do so. Loans create deposits, not the other way around. If a borrower were to approach a bank to borrow, let’s say $1 million, the bank wouldn’t bother to check whether it had a deposit of $1 million to lend out. It’s not as if, as is widely believed, the bank is simply a facilitator between buyers and sellers of money, between borrowers and lenders in other words. The bank will only be interested in granting a loan if the deal stacks up, whether there’s enough security and whether it’ll get its money back. If OK the bank will create a loan (an asset of the bank) and a corresponding deposit a/c in the borrowers name with a $1 million balance (a liability of the bank) which will be immediately spent by the borrower for whatever the purpose of the loan. Once spent the amounts will be redeposited into accounts of other bank(s) and at the end of the day when settling up occurs between banks at the RBA the lending bank may find itself short of funds in its exchange settlement a/c (which can’t be overdrawn) in which case the lending bank will arrange to borrow from another bank at the overnight lending rate (the rate set by the RBA which makes the headlines each month) to cover any shortfall whilst it organises other funding arrangements. The banking regulator APRA sets and monitors benchmarks covering capital, loans and deposits etc for banks. It doesn’t stipulate amounts to be held in reserves as per the fractional reserve banking model.

The point is deposits aren’t required to make loans, loans create deposits. If a deal is OK a click of a lending bank’s mouse will create a loan and an offsetting deposit a/c to be spent. That’s how banks grow their balance sheets. That’s how money supply grows. It’s not by waiting for deposits and then relying on the magic of fractional banking, the money multiplier

There’s various definitions of money from Mo to M1 to M3 to broad money, from the highly liquid to the not so liquid. Usually when there’s mention of money supply, it’s a reference to broad money. Mo is the notes and coins on issue, currently about $55 billion. Including on-call a/cs at banks gives a measure of M1, currently about $274 billion. Adding term deposits with banks and other deposits with non-banks gives M3, currently $1,573 billion. A few minor adjustments give a total for broad money, currently $1,578 billion. It’s not important to understand the exact definitions, only to understand the differences across the spectrum from Mo to broad money are liquidity differences.

To get it all into perspective with the size of the economy, GDP is currently about $1,500 billion. Of more relevance than the money supply is the level of credit in the system. The latest total of private borrowings is $2,176 billon or about 145% of GDP. Of the borrowings 40% is for owner occupied residences, 20% for investor housing, 6% for other personal loans including credit cards and 34% for businesses. Australia’s private debt is quite high by international standards. It’s our government debt which is comparatively low.

When banks’ exchange settlement a/cs at the RBA are added to Mo the total is called HPM (high powered money). Currently there’s about $62 billion in HPM. HPM is sometimes called the money or monetary base. It’s what gets leveraged by banks to expand the money supply. Ten years ago broad money was 18 times the money base. It rose to 24 times before crashing to 16 times in 2008. Currently it’s higher than ever at 25 times at $1,578 billion, almost all created by private banks.

Every time a loan is created an equal and opposite deposit a/c is created, which adds to money supply. Let’s say $1 million was borrowed and paid to a property vendor in exchange for the titles to the property. The property vendor may choose to leave it in a deposit a/c adding 100% to money supply but more likely some may be used, let’s say $500,000, to pay off an existing bank liability. In which case the money supply will fall by $500,000.

Loans create deposits, deposits add to the money supply. But the total of bank reserves, the balances maintained by banks at the RBA doesn’t change. Reserves are neither created nor destroyed by money creation in the private sector. All that happens is there may be a little shuffling between banks’ exchanges settlement a/cs at the RBA as banks settle up between themselves at the end of the day. The money supply is simply leveraged off the money base. It’s all created with the click of a bank’s mouse.

To emphasise how money is created imagine for a moment a credit card with say a $10,000 limit with nothing owing. If a $10,000 purchase was affected then a loan of $10,000 is created at the same time as $10,000 is deposited into the bank a/c of the seller. The money supply receives a $10,000 boost. Over time the card holder will probably gradually reduce the amount owing by transferring amounts from other current a/cs thereby reducing the money supply each time. From a loan/ money creation viewpoint taking out a bank loan is no different to using a credit card.

The above cover loans and money creation by private banks. For every financial liability created there’s an equal and offsetting financial asset. But overall private financial liabilities and private assets sum to zero. The picture changes when the government is introduced.

First let’s just refresh our memory of RBA’s balance sheet.

The notes and coins on issue of $53.6 billion at 30th June 2012, government IOUs, are listed as liabilities, as are deposits of $18 billion. A breakup of deposits is as follows:

The Australian Government usually has about $15 to 20 billion in its a/c at the RBA. Private banks have much less in their reserve or exchange settlement a/cs. These latter don’t change overall whenever loans/money creation occurs or when the millions of transactions occur between banks on behalf of their clients. Amounts are simply shifted between reserve a/cs.

When the government spends from its RBA a/c, amounts get shifted to banks’ reserve a/cs. But the spending creates a private financial asset, an extra deposit amount, in the books of the banks, about $400 billion per annum or about $1 billion per day. The government in pursuit of its monetary and fiscal policies then arranges for taxes to replenish its RBA a/c, as transfers from banks’ reserve a/cs, and for excess reserves to be drained by AOFM, the Australian Office of Financial Management, part of Treasury, by issuing government securities.

Spending by government creates private financial assets. The money supply is increased as a consequence. When the government issues a security in exchange for some reserve deposits, the money supply is diminished but the level of financial assets in the system remains unchanged. We always hear talk about ‘the money supply’ but it’s not clear that the concept of a money supply is anything other than a matter for historical interest. It’s the financial assets and liabilities within the system that is relevant not a particular subset defined in days of yore. Withdrawing funds from a bank deposit to purchase a government security diminishes the money supply yet total financial assets don’t change. A bank IOU is swapped for a government IOU.

It’s difficult discussing what’s happening here without also considering events in the US. In the case of QE or quantitative easing as currently carried out by the US central bank, the Federal Reserve, the process of issuing government securities is simply being reversed. Securities are being taken over by the central bank in exchange for an increase in banks’ reserve a/cs. It’s expanding the Fed Reserve’s balance sheet by adding government securities as assets and increasing bank reserves as liabilities.It’s described as money printing but financial assets in the system don’t change. It’s exchanging an asset with a longer maturity for an asset with a much shorter maturity. QE we are told is necessary to provide banks with liquidity. The basis for so doing is based on the fractional reserve doctrine, that deposits are the necessary prerequisite to making loans needed to get the economy moving. In this regard QE has been a monumental failure. There are even fewer fractional banking believers than previously. Then why QE3? Simply to prop up asset prices. The failure to make meaningful changes following the GFC and to allow failed companies and banks to go to the wall, means we are stuck with the old model which is dependant, given the amount of private debt in the economy, on rising asset prices. That what QE3 is all about. It’s what we hear incessantly on the nightly news every evening, how asset prices be they houses or shares fared in the last few hours. Our chosen path to riches is swapping existing assets amongst ourselves using increasing amounts of debt. We have sadly lost our way. Even sadder the GFC didn’t bring the much needed changes. Hopefully a few lessons may emerge.

The term ‘money printing’ has a much more pejorative sound to it than exchanging assets with different maturities. The term has carried over from the Friedmanite monetarist days when the money supply was considered the most important determinants of economic activity. With QE, it might be termed printing money but why not call it repurchasing government debt instead? When the securities eventually reach maturity won’t the IOU simply be cancelled? Isn’t this a painless way to repay government debt? Non inflationary? Where are all the government debt hysterians? But it does beg the question was it necessary to issue the securities in the first place. Just assume that if the government’s RBA a/c needed topping up what is wrong with the RBA just adding some with a click of the mouse making sure there was enough in the a/c to make any necessary government payments. This has been done in the past. Former RBA Governor Ian MacFarlane in his 2006  Boyer lectures The Search for Stability referred to past practices of the RBA lending the government funds to cover deficit spending.Why do we now issue a government IOU? To drain reserves in pursuit of monetary policy objectives? Or to raise funds for deficit spending?


·        Almost all new money is created by private banks.

·        In a modern economy deposits aren’t required by banks before making loans. The model of fractional reserve banking has no current relevance.

·        Loans create deposits not the other way around.

·        For every financial asset there is an equal and opposite financial liability.

·        Money as variously defined from Mo to M1 to M3 to broad money is a subset of the financial assets in an economy.

·        Despite the decline of monetarism in the last 20 years terms like ‘money printing’ still dominate the media rather than macro accounting terms such as increasing and decreasing financial assets and liabilities.

·        Private spending does not alter the total level of bank reserves held as exchange settlement a/cs at the RBA, only the split-up between banks

·        Government spending creates private financial assets reflected in increases in banks’ reserve or exchange settlement a/cs at the RBA.

·        Taxes represent transfers from banks’ exchange settlement a/cs to the government RBA a/c.

·        The government drains excess balances from banks’ exchange settlement a/cs by issuing government securities or IOUs.

·        Issuing government securities or IOUs isn’t a necessary prerequisite to undertake deficit spending.

·        Quantitative easing or QE in the US has failed to kickstart new spending on new projects providing further evidence that deposits aren’t required to fund loans.

·        QE whilst termed money printing is the swapping of longer maturity assets for those with shorter maturity (cash). The level of financial assets remains unchanged.

·        QE has resulted in the repurchase of government debt with no consequent rise in inflation.

·        QE has propped up asset prices to help stave off debt deflation. As a by product of the increased liquidity, overseas and emerging market economies have been destabilised with speculative money inflows, all for the greater good of boosting US equity prices.

Australia will face challenges inevitably as mining capex falls away, Australia will need to find a way to increase capex and infrastructure spending given other constraints including the self imposed constraint on deficit spending. A future blog will take a macro accounting look at our much lauded superannuation system, which is a form of private domestic savings which in turn implies higher government deficits. How can superannuation savings be harnessed from an effective macro accounting viewpoint to help fund infrastructure spending?

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