Friday, 30 May 2014

Understanding macro accounting

The broken promises and shameless lies of the recent Federal budget are easily justified if one accepts the  argument of the Liberal Member for Lyons.

Just like the millions of Australians it represents who all have to live within their means, this Government believes that our country has to be financially responsible for the sake of our children and grandchildren.”

Sounds plausible?

One problem however. It’s false.

Sophistry at best. Another lie at worst.

It’s instructive to compare the Federal government’s balance sheet with a private company.

Take BHP for instance. It’s got assets of $150 billion. These are funded, in part at least, by borrowings of $38 billion, retained earnings of $72 billion and issued capital of $2 billion.

Most companies follow a similar pattern, although the mix between retained earnings and issued capital will vary. BHP is an old successful company with lots of retained earnings.

The Australian government’s balance sheet is quite different. It has assets of $400 billion and gross borrowings of $350 billion. There are other liabilities as well which puts it in a negative equity situation. It doesn’t have retained earnings as these are precluded by running balanced budgets over a business cycle. Nor does it have issued capital.

How will the government buy assets needed, infrastructure, defence equipment for example, and make investments in infrastructure assets via capital grants to the States if borrowings are wound back if not abolished altogether?

With nil borrowings the government’s balance sheet would be a fraction of the current size.

There are some who wish to see this occur; a Reagan inspired ‘starve the beast’ strategy now adopted by the Tea Party and other conservatives.

But most don’t.

This leads to the realistic conclusion that government borrowings are not borrowings in the same way as household and business borrowings which need to be repaid, but rather are the de facto issued capital necessary for the Federal government to operate.

If one looks at the US experience, borrowings via government bonds have existed ever since 1791 and are never fully repaid. Invariably proceeds of new bond issues are used to redeem maturing securities.

Government bonds should therefore be regarded as perpetual redeemable income securities. The issued capital of a government in a mature economy.

What about interest payments? Won’t that impoverish our grandchildren? Aren’t a lot of bonds owned by foreigners?

The latter is true. Two thirds of bonds are owned by foreign residents. Interest is paid in $AUD to an Australian bank account.

But bondholders can’t simply put the interest in a suitcase and catch a plane. They need to find someone with the particular foreign currency required willing to swap it for $AUD.

So the interest stays here.

But it’s taking an increasing share of budget outlays? $1 billion a month?

That’s true. Bond interest next year will be $13.5 billion. But that’s only about 3% of Budget outlays.

Bond interest doesn’t use up resources. It’s only a distribution. Our grandchildren will still face the same decision as we do: how to split up the pie.

In reality the pie will be larger if the bonds requiring interest are sensibly spent. It is not difficult to think of infrastructure which improves our lives that has been financed by borrowings in the past.

The talk about debt usually sidesteps the iron law of accounting: for every credit there is an equal and opposite debit.

A government liability implies a private financial asset.

If government debt and the consequent interest distribution are considered a threat to the prosperity of our grandchildren then they ought to be integrated more with our current superannuation system, a compulsory system containing $1.5 trillion. That’s $1,500 billion.

The system is growing faster than investment opportunities available and fund managers are simply bidding up the price of existing assets and lobbying the government to sell its remaining infrastructure assets provided they come with regulated if not guaranteed returns.

Perhaps if superannuation funds are to retain the tax concessions which mainly accrue to high income earners, there should be a return to the situation in the early 1980s where superannuation funds were required to hold a certain level of government and semi government debt securities to qualify for favourable tax treatment.

Any distribution of interest to bond holders would form part of the income of a more coordinated retirement income system.

Kill two birds with the one stone.

The understanding of government debt and central bank operations has been greatly enhanced since the GFC.

For the last few years the US has been conducting a real time experiment in an attempt to revive an ailing economy. The central bank, the Federal Reserve, or the Fed as it’s called, has been engaged in what is termed ‘quantitative easing’ which has involved, in part at least, the purchase of government bonds from banks simply by crediting their accounts at the Fed.

The operation is the reverse of what happens when bonds are issued.

It certainly begs the question as to why the bonds need to be issued in the first place.  

Does the government need to raise every last $ by taxation or borrowing before spending?

Or can the government spend first and then claw back via taxation and bond issues what is required to keep the economy humming from a distributional/equity viewpoint and from a monetary policy/ interest rate viewpoint?

Will the sky fall in if the government doesn’t claw back in taxes and bond issues all that is required to fund outlays?

The answer is no.

Conventional wisdom also believes deficits are tolerable at times but surpluses are desirable.

A surplus budget, given the iron law of macro accounting means the private sector runs a deficit. Most people don’t understand this simple reality. Most think we can all run surpluses. This is a logical impossibility. The Howard-Costello surpluses implied private deficits funded by a decline in private financial assets and/or an increase in private borrowings. This is not a polemical assertion. It is the unequivocal reality. Nothing else is possible.

Given Australia has an unhealthy large private debt burden do those advocating a return to surplus understand that private debt will increase? Already private debt is over 140% of GDP more than 10 times the size of government debt.

Take a look at a graph of Australia’s government debt and private debt since 1990 from Steve Keen’s blog. The Y axis (the vertical one) is debt as a % of GDP.


Private borrowings were also used to finance consumption or to bid up the prices of existing assets, residential housing and shares creating the illusion that we had found the pathway to eternal prosperity.

The view that all our problems started with the election of the Rudd and Gillard governments in 2007 is not apparent from this graph.

Budgets should primarily be about ensuring the nations’ available resources are fully utilised not about moving to a surplus.

The threat to our grandchildren is not from a large national debt but from a failure to ensure our idle resources are put to good use.
A deficit of understanding macro accounting is more a problem than deficit spending.

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