Sunday, 8 March 2015

Intergenerational nonsense

The fear of burdening our grandchildren with debt, we are forever being told, is the reason why there is a need to return to a budget surplus.

Few argue with the proposition, most only quibble about the speed to reach a surplus.

But not since the days of the flat earthers have so many unquestionably swallowed such nonsense.

Clearly if the Jones borrow long term from the Smiths, the younger members of the latter family may suffer a reduced standard of living by having to repay the debt, compared to the older members who received the benefits of the loan.

That certainly applies where the older members simply consumed the benefits.

It is less obvious when the benefits are of an enduring nature. Borrowing to build the Sydney Harbour Bridge would have few detractors on this score, especially given hindsight.

To extrapolate a family situation to the whole economy is however, complete nonsense, another example of the fallacy of composition, not unfamiliar in economics.

Another instance is thrift at the household level. If everyone did it the economy will shrink. This however doesn’t deter adherents of austerity from pursuing their agenda trying to prove the paradox of thrift is wrong.

The implicit assumption when making the leap from a micro to a macro truism in the case of government debt requires the conflation of ‘debtors’ and ‘creditors’ with ‘current generation’ and ‘future generation’.

It must be remembered that for every debt there exists a corresponding financial asset.  One person’s debt is another’s asset. The iron law of accounting provides no alternative.

From a macro perspective government borrowings are internal borrowings and any future repayment is simply a distribution within the economy. It is not a flow out of the economy which may diminish the living standards of the future generation, as may happen at the micro level when, in the above example the Jones have to repay the Smiths.

Even if the government bonds are held by foreigners, they are denominated in $AUD and any repayments are made into an Australian bank account. If the foreign owner wishes to take the proceeds out of Australia he will have to swap his $AUD with someone else holding his preferred currency.  There may be a secondary exchange rate issue with possible flow on macro effects, but the repayment proceeds will remain here.

In practice government debt is rarely repaid, it is rolled over. Only interest payments need to be made.

Most people find this a scary prospect, but once again extrapolating what may be true at the household or business level gives a misleading view of the macro situation.

Take the case of BHP. It has net assets of $86 billion, mainly retained earnings but also some contributions by shareholders in the form of issued capital. It also has $31 billion in borrowings, so its net assets excluding borrowings total $127 billion.

The Australian government doesn’t have issued capital.

Nor does it have retained earnings. A prolonged period of surpluses would be needed before any accumulated retained earnings emerge.

A prolonged period of government surpluses implies a prolonged period of private sector deficits.

Nothing else is possible.

This is not Keynsianism or any other ideology. It is a reflection of universally accepted double entry bookkeeping. Just as one and one will always equal two, so will the sum of the debits equal the credits.

Without borrowings the net assets of the government will be zero.

This simple accounting reality escapes most people.

Zero borrowings imply a government of a size only dreamt of by Tea Party advocates.

And maybe Senator Abetz?

There is no prima facie optimum size for governments as a proportion of the total economy. The mantra that we need to reduce the size is simply that... a mantra. While reductions can be logically argued in some areas, so too can increases in other areas.

Not only will borrowings by the Australian government always exist, they are necessary.

Whilst there may be valid arguments against particular uses of government borrowings, borrowings per se aren’t imprudent.

Australian government borrowings should realistically be regarded as the issued capital which a properly functioning government requires. Because in most instances they are never repaid they are akin to perpetual securities issued by many companies which require interest only to be paid but with no set redemption date.

Bond interest is costing us $1 billion per month thunders Treasurer Hockey. We can’t afford it.

Joe’s right it is costing about $12 billion per year but in the context of the Australian government budget that’s only about 3% of outlays.

Interest doesn’t consume resources; it is simply a split up of the national pie. If anything the national pie should be larger as a result of borrowings provided there are enduring benefits flowing from whatever the borrowings were spent on, whether infrastructure, improving health and educational outcomes or whatever, the list is endless.

Interest payments, needless to say, don’t form part of gross domestic product GDP which is a total of what we produce, whether it’s consumed, invested or exported.

One person’s spending is another’s income. Hence the other side of the accounting ledger from spending on what we produce is what we receive as income.

National income is the other side of the ledger from GDP.

National income is consumed, saved or paid in taxes.

Income comes in many forms. Interest is one.

Paying interest is just splitting up the pie. The government can to some extent determine the rate of interest. It can determine how much is clawed back via taxes.  It can even influence as we see below who receives the interest.

The government faces distributional problems all the time. Its role is to solve them.

Reducing the size of the pie by restricting borrowings is a dumb idea.

The question of whether borrowings are needed before governments spend also needs to be considered. Modern money theorists led by the irrepressible Prof Bill Mitchell, plus other heterodox economists who don’t fully embrace Bill’s purist position, sometimes on theoretical grounds, at other times from the viewpoint of the difficulties of its implementation, have different views about money debt and deficits, which are gradually having an impact in academic economist circles but as yet little impact in the public arena where herd mentality and conventional wisdom suppresses any new ideas.

Suffice to say that governments around the world have had few qualms about spending before first raising funds via taxation or issuing IOUs called government bonds.

In the USA quantitative easing QE has been used. QE is part of a process aimed at increasing bank reserves, ostensibly in the hope this will lead to increased borrowings. In hindsight it’s been a mechanism to bail out the banks and fix their liquidity problems, not to precipitate borrowings. Borrowings are dependent on willing and able borrowers not on the existence or otherwise of bank reserves. Loans create deposits not the other way around.

QE comes after IOUs have been issued by Treasury usually to banks. Treasury‘s account at the Federal Reserve increases as a result, enabling the government to spend.

The QE stage involves the Fed Reserve purchasing the bonds or IOUs from the banks by simply crediting their reserve account at the Fed with the click of a mouse. It’s the exception that proves the double entry accounting rule. It is a single entry. The Fed’s balance sheet increases with the click of a mouse.

Rather than go through a two stage process of issuing bonds and then arranging for the Fed to purchase them, there is nothing in theory preventing the Fed from simply increasing Treasury’s account at the Fed with a click of a mouse, and say, allow the Fed to spend money on infrastructure , fixing the health system or whatever. Spending the money will in turn increase bank reserves in exactly the same way as purchasing IOU’s from them.

The fear that QE would be inflationary has not eventuated. Problems may arise in the future which can be addressed at the time. The possibility of unknowns shouldn’t mean we do nothing. Any risk analysis can isolate where the benefits of spending exceed the possible downsides.

In theory the RBA here could put funds in Treasury’s account to enable infrastructure spending for instance. It doesn’t need to wait for funds from taxation or borrowings.

However let’s assume that tax revenues or borrowings are deemed necessary before a government spends.

Currently we have a superannuation system driven by compulsion and tax advantages for higher income earners that is showing increasing signs of failing to meet expectations. The benefits inequitably accrue to the top 5% to10% of taxpayers, particularly baby boomers.

Before Keating changed the landscape in 1983, superannuation funds if they wished to take advantage of concessional tax treatment needed to hold 30% of their assets in government securities, of which 20% could be semi government securities as they were then called, Telecom and Hydro bonds for example.

Today we have the Australian government with about $300 billion in gross debt and a superannuation system with about $1,800 billion in assets.

Fund managers largely buy existing assets, swapping them amongst themselves hoping the capital gains will prop up returns.

The current system has bred a greedy lazy bunch of paper shufflers who skim 1.5% from the asset pool each year. To hear them talk about ‘investing’ is a joke. Buying existing assets doesn’t meet the economist’s definition of investment. It belongs in the same camp as playing the horses.

Yet the earnings of superannuation funds in pension stage, and that comprises the bulk of earnings over a superannuants lifetime, occurring any time from 55 years of age onwards and even whilst still working pursuant to transitional to retirement concessions, are completely tax free.

The Henry Report recommended 7.5% tax on earnings regardless. A groundswell of support to cut superannuation concessions to the rich will almost certainly result in changes.

If there was a return to the days when superannuation funds needed to hold government bonds in order to qualify for tax concessions, especially in the pension stage, then any payment of interest to bondholders, a distribution of the national pie as we have seen, will be part of a broader retirement incomes policy rather than a burden we can no longer afford.

Any national conversation on the way forward is pointless unless the myth of government debt burdening the next generation and the corresponding surplus fetish persist. Abandon them and the way forward can be made so much easier and fairer.

A more enlightened view is crucial to any reform of federalism, critical to finding a more sustainable fiscal path for Tasmania.

1 comment:

  1. John, Most of us are never taught how to manage our own household budgets let alone taught any macroeconomics/accounting. Basic business skills? Not in the curriculum either! Is it any wonder that we are in the state we are in? Look to our State Parliament for clear evidence of this gross lack of simple understanding. It makes us all blind sheep to be easily misled by those few who do understand. Cheers!