Sunday, 1 September 2013

The debt fallacy

It’s not only refugees who are about to swamp us but also governments debt. The need to return the federal budget to a surplus is an article of faith by every politician running for office, all of the mainstream media and most economists. It’s only a question of how quick we proceed.

Are we being told the truth, the whole truth and nothing but the truth?

The alleged problem

A recent report on tax reform by PwC one of the leading accounting firms Protecting prosperity contained a preamble about why we needed tax reform, essentially to avoid mounting government debt. Australia’s challenge was summarised as follows.

After 22 years of continuous economic growth, Australia now faces the risk of falling incomes and increasing government debt. PwC estimates that the combined annual deficits of Australian governments will rise:

·        from $27.4bn (1.9% of gross domestic product [GDP]) in 2011-12 to $213.5bn (3.5%) by 2039-40and to $583.1bn (5.9%)by 2049-50.

And our governments’ debt levels as a proportion of GDP will rise:

·        from 12.1% in 2011-12 to 32.9% by 2039-40 and to 77.9% by 2049-50.

These trends are unsustainable as the population ages. Australian governments risk not being able to meet the key needs of our community and a further slide into debt.
And higher debt at the Commonwealth level would mean that another shock like the GFC in the next few years could see its debt climb to 30% of GDP by 2025-26.

PwC produce a graph to highlight the problem ahead.

Looks pretty bleak. It’s good to see the inclusion of both Federal and State debt. But capitalising the interest simply exaggerates the problem. Maybe that’s the intention, to draw attention to the issue?

The report was a pretty reasonable coverage of the tax reform issue, although predominantly a cut and paste from the Henry report. However it was a little disappointing that having flagged debt as a jumbo problem there was no attempt to explain why from a macro accounting perspective.

Government debt, financial assets and the other side of the ledger

Accepting for the time being that the Australian government needs to borrow to fund deficits, talking only about the size of the debt overlooks a couple of things:

·        what are the cash flow implications of the debt, and

·        what about the other side of the ledger, who’s holding the debt and what are the implications?

The inescapable ex post rule of macro accounting is that one person’s liability is another’s asset. If the government sector has financial liabilities then the private sector must have a corresponding financial asset.

Most people who comment on our debt problem have never bothered to understand this unassailable fact.

Let’s have a look at the Australian government balance sheet (estimated) as at 30th June 2013 taken from the 2013-14 budget papers. Total assets were $352 billion and total liabilities $513 billion leaving net worth equal to a negative $161 billion. The Future Fund of about $90 billion forms part of the financial assets split between investments, loans, equities etc. What is usually characterised as government debt is the government securities outstanding of $292 billion as highlighted in red.

Negative net worth of $161 billion. It may look like impending insolvency but nothing could be further from the truth.

Before we scare the horses maybe a quick glance at a short form consolidated balance sheet for all levels of government in Australia may be warranted.


The net worth of all level of government was just under $1 trillion, or $933 billion about 12% of the nation’s net worth of $8 trillion at that time.

The negative net worth of the Australian government is further confirmation of the problem of vertical imbalances between levels of government in our federal system. Not only is there the more familiar vertical fiscal imbalance between levels of government where the Australian government raises more tax than it spends and the States do the reverse, but much of what is borrowed by the Australian government is spent by the States. Any talk about Australian government debt inevitably requires a consideration of the States’ situation.

The Reserve Bank’s balance sheet

Unlike households the Australian government is not revenue constrained and more importantly it is a fiat currency issuer..... it can simply print its own currency.

Let’s therefore have a look at the Reserve Bank’s balance sheet to try to understand more about government debt. The Reserve Bank RBA is functionally independence from the Australian government, and although its financial statements aren’t included in consolidated government figures, for all intents and purposes it is part of the government.

The following is the RBA’s latest balance sheet as at 30th June 2012.

A pretty simple balance sheet. The two assets of any significance, $AUD securities of $32.6 billion, most of which are Australian government securities, and foreign exchange holdings of $43.3 billion are self explanatory. Two third of the securities and one third of the FX holdings are repos or assets temporarily held by the RBA pursuant to repurchase agreements as part of the exercise of RBA’s monetary policy goals but that’s a story for another day.

There are also two liabilities of significance. Notes on issue are $53.6 billion. That’s the amount of notes and coin in circulation... in wallets, under beds, in biscuit tins, in ATM machines, in cash registers, where ever cash is used. We always think of cash as an asset. Which it is. But if there’s an asset, there must be an equal and opposite liability somewhere else. And in the case of cash the liability is sitting on RBA’s balance sheet. Cash, or issued notes and coin are a liability of the RBA. Since the abandonment of the Bretton Woods agreement in 1971 most currencies are non convertible, in other words the holder of a note is not entitled to anything else but a note or notes in exchange. The bearer can no longer demand a piece of gold. Nevertheless notes on issue are still, for accounting purposes, a liability of the issuer. Notes and coins are simply government IOUs. The government will always accept the IOUs in payment for taxes fees and charges, in fact it is mandatory. This is the reason why notes and coins are universally accepted despite their complete lack of intrinsic worth and the lack of convertibility.

Notes and coins are IOUs that appear on the RBAs balance sheet. Government securities, IOUs with a longer maturity, appear on the general government’s balance sheet as we have already noted. In both cases they are simply government IOUs.

The second RBA liability needing a little more detail is the liability listed as ‘deposits’. The following table details the amounts held on behalf of the Australian government plus the other select band who operate accounts with the Reserve Bank.

Banks’ exchange settlement accounts are the amounts of deposits by major banks which are used to settle amongst one another each day when, for example Westpac needs to settle with NAB for the net amount of transactions between their respective clients on that day. Banks don’t have accounts with one another, instead they settle via their exchange settlement accounts at the RBA, sometimes called their reserve accounts.

Just remember if a bank deposits an amount with the RBA it is shown as liability on RBA’s balance sheet. The RBA owes the bank. It is needless to say an asset in the books of the bank.

What happens now when the government issues securities/bonds is that it swaps IOUs, cash for a government security.  Cash doesn’t physically change hands. Instead the bond issue causes a reduction in the RBA exchange settlement account of the bond purchaser’s bank and a consequent increase in the Australian government’s account at the RBA. An IOU is simply a promise by the government to pay at some stage determined by the terms of the particular IOU. In the hands of a holder an IOU is an asset, for the government it is a liability. When the bond matures the exchange is reversed, redeeming the bond in return for cash. The Australian government will never default .The USA, UK and Japan are in the same position, unlike members of the Eurozone who have forfeited their right to issue their own currency and who find themselves in a not altogether dissimilar situation to our State governments.

QE and the McKibbin heresy

Whenever the concept of purchasing a bond simply by increasing the holder’s cheque account with a click of RBA’s mouse is raised, the spectres of the Weimar Republic and Zimbabwe are invoked. Inflation will ruin us we are told. Inflation was the spectre raised when the US Federal Reserve started quantitative easing or QE in a supposed attempt to revive the comatose US economy after the GFC.

Just an aside on the matter of QE A rough appreciation of the balance sheet of a central bank like RBA helps understand QE. What the Fed Reserve, the central bank in the US is doing  with QE is simply taking on more securities from banks, adding them to assets in other words, and simultaneously increasing the liability which we call exchange settlement a/c and the Americans call reserve a/cs. There is no change in the total financial assets in the private system. Banks have swapped financial assets with longer maturities for cash. Everyone refers to QE as money printing but that’s only because cash is considered money and a government security isn’t. Those with lingering monetarist ideas popularised by Milton Friedman and his acolytes feared inflation. Others said it was worth risking inflation to get the economy moving again. Neither has happened. Asset and commodity price rises are the only outcomes. Worthwhile investments could have been funded by banks without QE. The misplaced hopes and the miserable achievements of QE, what constitutes money and how it’s created is a story for another day.

The RBA could buy existing securities owned by others and put them on its balance sheet by simply increasing the holder’s bank’s exchange settlement a/c with the click of a mouse. But what would the banks do with the increased reserves. If it lends to someone, the funds simply are redeposited into some other bank’s exchange settlement account. The best course of action for the bank maybe is to hold the funds in government securities. Which all suggests that the issue of government bonds is not necessary to fund a deficit, as a prerequisite to spending, but rather is the tool which governments use to drain excess reserves out of the private system in the pursuit of monetary objectives such as interest rate and inflation control?  The popular assumed chronology seems wrong--- that government increase their debt in order to spend. Rather it is a case of governments spending first, thereby increasing banks’ exchange settlement accounts at the RBA then draining excess amounts back out of the system by issuing government IOUs. About $400 billion passes through Australian government bank a/cs each year. Money is coming and going each and every day . It is very much a dynamic cash flow management exercise. To characterise it in the same terms as a household is silly. To pretend that the government raises all the necessary funds before spending is working capital nonsense. The government has cash flows of $400 billion per annum. It is spending and receiving on average over $1 billion per day. It tends to have between $15 billion and $20 billion at any stage in its account with the RBA. The government spends, instantaneously adding to banks’ exchange settlement accounts then extracts amounts via the issue of government securities what it doesn’t receive via taxes, as part of monetary policy to control interest rates and to prevent the possibility of any increases in money floating around the system causing inflation. Seen from this viewpoint government debt is not quite the problem it’s made out to be. One thing for sure is that the Australian government is not like a household which requires funds in the bank whether or not from borrowed sources, before spending is undertaken.

The RBA taking on extra assets and crediting other banks’ exchange settlement accounts has also been recently raised, in late 2012 from memory, by Warwick McKibbin a mainstream but fiercely independent economist and former RBA board member who floated the possibility of the RBA issuing $AUD to foreign central banks keen on holding $AUD. The context of the suggestion at the time was the stubborn refusal of the $AUD to act as the text books said, failing to fall when the terms of trade started falling. The terms of trade is a measure of export prices relative to import prices (NB not the $ level of exports compared to the $ level of imports, but a measure of the comparative prices). Iron ore prices found record levels. The terms of trade helped keep the $AUD at record levels with all sorts of flow on effects which we won’t go into at this stage. Anyway the terms of trade started falling but the $AUD didn’t. One reason for the $AUD’s strength was the carry trade effect whereby overseas investors borrowed at extremely low interest rates, in Japan for instance, and invested in $AUD where the interest rates have been higher. It is believed the demand for $AUD from the carry trade helped push up the price of the $AUD. Another reason for the higher $AUD was the competitive devaluation effect whereby foreign central banks prefer to hold assets in other currencies rather than convert all foreign earnings into local currency before remitting back to their respective homes. What Prof McKibbin essentially said, if I’m not mistaken, was that if foreign central banks want to hold $AUD, then simply accept the foreign exchange holdings from the foreign central bank and include them as an asset on the RBA’s balance sheet  and simultaneously create an exchange settlement account in the foreign bank’s name with an equivalent amount of $AUD. It wouldn’t add to money supply and it wouldn’t affect inflation. Coming from a mainstream economist it caused raised eyebrows. Just money printing. Too risky. Not the RBA’s role blah blah. If the suggestion were heeded the RBA would be sitting on a profit given the $AUD’s subsequent fall from over $1.05 to about 90c today.

One small step

If the McKibbin suggestion is a serious mainstream idea, then it is only a small step for the RBA to simply lend the Government money. Click the mouse and increase the government’s account at the RBA. What if the government can’t repay the loan? Is the RBA going to send a couple of guys with baseball bats round to the Treasury building? This is not an open slather money printing suggestion but rather acknowledgment that the Australian government, unlike a household, can spend without having to borrow funds. But that only leads to inflation? Yes it may, but currently it seems inflation is the least of the world’s problem despite there being so much money sloshing about. Inflation is allegedly caused by too much money chasing too few goods. Right now the money isn’t chasing newly produced goods. There’s idle resources everywhere both labour and capital available to produce more if demanded. But the money is mainly being used to buy existing assets to try to boost asset prices with the hope that the wealth effect will precipitate a fresh round of borrowing and spending to boost growth.

It is important to note that there is no one size fits all measure of money supply or debt for a particular country, whether it’s debt as a % of GDP or money supply as a % of GDP. In China for example the money supply estimated by observers is 200% of GDP. In the USA the figure is only 60%.

Debt, surpluses and the government’s balance sheet

If one were to look at a balance sheet for a private company the net worth of the company would be represented by three components...... issued capital, retained earnings and revaluation reserves.

Revaluation reserves are just the other side of the book entry whenever a fixed asset such as land for instance is revalued above historical cost in order to reflect current market prices for balance sheet purposes. It is not a cash amount available to be spent.

In the case of retained earnings, if a government runs a balanced budget over the economic cycle there won’t be any.

And thirdly for a general government balance sheet there is no equivalent to a private company’s issued capital. We don’t contribute capital per se. If anything borrowings can be thought of as contributed capital for a government. Borrowings are rarely repaid, they are invariably rolled over, the proceeds of a new issue often used to redeem maturing bonds. In that sense, borrowings are more like equity than debt, perpetual tradable securities. It’s the long term capital for the general government trying to grow and meet demands for public goods and services.  And that is further reason why the negative net worth of the Australian government identified above is of no concern.

Hence if a government is required to balance its budget over time and if borrowings are taboo, its net asset position or net worth won’t change much. So how will the government acquire assets to provide services which everyone expects and demands? Maybe by cutting out other services but how else? And Tony Abbott is promising to shrink the government sector even further.

Under current arrangements to pay back existing debt a government needs to run surpluses and that means taxing more than spending.

If the government sector is in balance so too is the private sector. If the government sector is in surplus the private sector must be in deficit. Government surplus/deficits and private surplus/deficits always sum to zero. Another iron law of macro accounting.

The rough plan which all politicians seem to be following is to gradually move to a situation with government surpluses where spending is less than taxes which means the private sector will inevitably be in deficit. It will have no alternative but to add to its already heavy debt load.

Without any government borrowing, net financial assets in the private sector will be zero. Some will have financial assets, some with financial liabilities but overall the net assets for the private sector will be zero.

For the private sector to have net financial assets, governments need to run deficits. Every time a government runs a deficit private savings increase.

Just go back and read that again in case you missed it. Every time a government runs a deficit private savings increase.

Why is everyone against them? (At this point just a word of caution. Because something may be true as an ex post observation doesn’t necessarily imply the deficit spending causes increased private savings. The direction of causation may be the other way. Private savings may be necessary to fund deficits. I accept the former and will cover in a future post.)

Bob Menzies ran deficits in every one of his 17 years. The Howard Costello surplus fetish was a fashionable phenomena and look where that got us, public debt replaced by even larger amounts of private debt. If there are sceptics about the public policy efficacy of private debt replacing public debt in the manner of the recent past they need only to google Sydney Airport or check HERE The tide is slowly turning maybe? NAB’s CEO Cameron Clyne was recently reported as saying ''Australia has a debt problem - we don't have enough.'' It would be too cynical to respond that he would say that wouldn’t he? After all he knows growing public debt implies increasing private assets.

If governments run surpluses permanently, financial assets in the private sector will gradually fall to zero. Continuing ad infinitum one may have to start paying taxes with non financial assets, say leaving the second car in the ATO car park with the keys in the ignition!!.

Under current arrangements governments borrow to fund deficits. Too much borrowing however is seen by many as burdening future generations with debt. But so what? Isn’t one man’s debt is another’s asset. When a consolidated balance sheet for Australia as a whole is viewed, the public liability and the corresponding private asset cancel one another. Just because the government owes it doesn’t mean we as a nation are indebted. Although it may, depending on whether amounts are due to overseas persons. Not that that necessarily implies problems as we will see shortly.

The national balance sheet

A national balance sheet, the latest available, is as follows:

All domestic financial liabilities (loans, accounts payable etc) have been offset against domestic financial assets (deposits and loans owing, accounts receivable etc). It will also be evident that there are no domestic shares or equities included. These are simply financial assets which are offset against the net worth or equity of companies etc, in other words the financial liability owing to shareholders. Any non financial assets of a company-- land or inventories for instance, remain and are included in the consolidated balance sheet.

Getting debt into perspective

The fact that with the national balance sheet financial assets and liabilities cancel one another isn’t meant to suggest that debts owing amongst ourselves aren’t a problem. What is meant is that the existence of government debt is not necessarily a problem per se. As we’ve noted it enhances private financial assets.

Too much debt may be a problem even though it is owed amongst ourselves. Quite clearly the GFC exposed some alarmingly high levels of private debt with correspondingly high levels of financial assets of questionable quality. After the GFC hit, debt defaults occurred affecting both borrowers and lenders. Asset prices then fell leading to more defaults and so the downward spiral went until governments bailed them all out.

As an aside, the role of debt in an economy is attracting much more debate in the economics blogosphere since the GFC. For a long time most economists treated debt in a neutral manner, that is when they didn’t ignore it completely. Bankers were middlemen, mere facilitators arranging transactions between conservative lenders and more impatient borrowers who felt they could achieve returns greater than the costs of borrowing. But along the way bankers became the main players and the financial sector grew out of all proportion relative to the rest of the economy. Working out the role of public and private debt in any future economy is one of the major challenges. One of the best examples of the abject failure by politicians to understand the role of government in a modern economy and the public vs private debt problem was the classic doorstop interview of Tony Abbott by Craig Reucassel of The Chaser HERE. It’s worth 1 ½ minutes of your time if you haven’t seen it. Not only is it funny but Craig really nails the public vs private debt conundrum.

Before succumbing to debt hysteria it may be worth looking at the Australian government’s cash flow to witness the impact of our current debt.

The 2013-14 budget forecast cash inflows to the Australian government of $375 billion (including taxes of $355 billion). Only $12 billion will be needed to pay interest, about 3%. $110 billion will go to the states and $122 billion in benefit payments to individuals. There’s no need to be too alarmed.

Burdening our grandchildren?

But then there’s the hoary old chestnut...... if we don’t pay off the debt we’ll be saddling our children with an insufferable burden. That’s just emotive nonsense. In any event the amount of interest is quite low both in $ terms and relative to the amount of other transfers. Furthermore in the future, regardless of the level of debt assuming it is not too large that it inhibits economic activity as private debt has done in the post GFC era, our children will be faced with exactly the same decision as we do. Our entire national income is consumed, saved or paid in taxes. Another iron law of macro accounting. How much is paid in benefits, interest or tax is essentially a distributional problem. And as we’ve already observed borrowings are rarely repaid, they are invariably rolled over, and in that sense is more like equity than debt, perpetual tradable securities. It’s the only way the general government funds growing demand for public goods and services.

Just to explain national income a bit more. Our national income comes from what we produce...... either things we consume, or things which we call investment goods used to make other things, or things we export. We supplement consumption and investment goods with imports and these need to be subtracted to derive domestic production. That’s where our national income comes from. As to where it goes, we either consume it, save it or pay it to governments as taxes. Nothing else is possible.

Precisely who owns Australian securities is not always clear because most are held by nominee companies or custodians. The beneficial ownership is usually not disclosed (unlike say a substantial shareholding in a listed company). But ABS reckons about 75% of government securities are owned by foreigners. Doesn’t that mean therefore that the interest paid to foreigners will be lost to the economy? No. All interest is paid in $AUD . Revisiting the RBA balance sheet, funds are transferred out of the Australian government deposit a/c  as interest payments into the account of the bond holder at an Australian bank regardless of whether the bondholder is resident or non resident. The bond holder can leave the funds, reinvest somewhere else or simply buy Australian goods and services. In the latter two cases the money will end up as a deposit in someone else’s bank. At the RBA funds will simply be shuffled from one bank’s deposit a/c to that of another bank. Money won’t be lost or destroyed it will just move about. But what if the non resident wants to take the funds out of Australia? Well, they can’t simply just put it in a case and hop on a plane. It’s in $AUD. Let’s say the non resident is the proverbial Japanese carry trader Mrs Watanabe who wants to send interest back to Japan. She’ll have to buy some Yen from someone holding Yen who is happy to accept $AUD. Maybe an Australian exporter who has just sold goods to Japan and was paid in Yen and wishes to bring funds home. Mrs W and the exporter do a deal, she ends up with Yen and the exporter ends up with $AUD. The original interest payments get shifted around from Mrs W’s Australian bank a/c to the bank a/c of the exporter. Hence the small proportion of government outlays paid to non residents as interest gets spent here anyway. So what’s the problem?  Are we really burdening our grandchildren if we take on a bit more debt?


·        From a debt perspective the Australian government in no way resembles a household. It is not revenue constrained as it can raise taxes

·        The $AUD is a non convertible currency. Since the abandonment of the Bretton Woods agreement in 1971 the need for convertibility into gold no longer constrains the issue of new currency.

·        In practice the government doesn’t need to borrow before spending. It borrows to drain excess bank reserves created by government spending.

·        Government deficits lead to an increase in private financial assets. Government surpluses diminish private financial assets.

·        Bob Menzies ran 17 consecutive budget deficits.

·        The Howard Costello surplus fetish simply shifted debt to the private sector.

·        NAB’s CEO Cameron Clyne recently expressed the view that Australia needs more public debt.

·        Government debt is like a perpetual tradable security without which public assets would be much lower

·        Private debt is more of a problem than public debt. It is not only much higher as a % of GDP but it has to be repaid.

·        Without borrowings and if governments were required to balance its budget, government net assets would be nil.

·        Government debt will not burden our grandchildren who will face the same problem we much to consume, how much to save and how much to pay in tax? It’s only a distributional problem.

One feature of the post GFC landscape is that most experts trying to explain what happened and why we’re on an uncertain road to recovery, use the very same methodology that failed to predict  the GFC in the first place. Queen Elizabeth nailed it for a lot of people when she observed on a visit to the London School of Economics in November 2008 "Why did nobody notice it?" Exactly Liz. Economists don’t understand accounting. Accountants studying  for business degrees can avoid any mention of economics. Neither knew exactly what the finance guys were doing as they manufactured  financial derivatives, their weapons of mass destruction as Warren Buffet called them, which eventually blew up the world in 2008. Some economic theories are built on dubious assumptions, others fit a set of prevailing facts. When the facts change, however, the theories becomes redundant. We’re at that stage now. There are a few myths that need to be cast aside.

The need to reach a consensus across the whole federation on tax reform, government debt and how to fund necessary infrastructure spending is the challenge. In fact all issues are interrelated.

Australia’s vital conversations, it seems, are interrupted by elections. Australia is in a wonderful position to capitalise on its strong balance sheet. However never has there been such a complete lack of understanding of basic macro accounting truisms amongst those chosen to represent us.

A future post will cover the macro accounting aspects of money and its creation, bank reserves, how the government and the RBA handle and control debt and how in certain circumstances compulsory superannuation is a dumb idea.


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