Tuesday, 24 May 2016

Jobs and growth within our means

It’s not long since Prime Minister Turnbull promised an end to three word slogans and the start of a mature conversation with voters.

Alas we are still waiting.

Many were hoping the PM would pinpoint the problems as he sees them and explain why his policies offer a solution. He’s now using a three word slogan, jobs and growth, to promote a solution to the problem he didn’t bother to explain.

We all know the symptoms of the problem, too many borrowed funds devoted to buying and selling existing houses instead of investing in the real economy, private debt sky high, real wage increases slowing down, oodles of unused supply capacity both capital and labour. Unused capacity and unmet demand. Nobody’s buying.

What to do? Cut penalty rates? That may increase the supply of lattes but where will the extra demand come from? From other industries? But won’t all industries suffer if wages share of the national pie falls? What if café owners reduce their high private debt instead of employing more staff? The economy will be worse off. The paradox of thrift may strike again. Cutting wages may have some effects at the margin but the case is not overwhelming. Government austerity suffers from the same drawbacks. The comprehensive rejection of the 2014 Federal budget shows the general sentiment in the community. People struggle to understand the underlying assumptions of proposals when politicians present them.

How about more jobs and growth by cutting company taxes as the PM is now promoting? If there’s unused supply wouldn’t a better solution be to find a way to introduce Mr Supply to an eligible Ms Demand? How will cutting company taxes promote jobs and growth if nobody’s buying? What comes first, the cart or the horse?

The jobs and growth plan is just another name for a two hundred year old economic theory known as Say’s law that economists used to explain how the economy works……… supply creates its own demand. The Great Depression revealed that an economy was a liitle more complicated than Say’s Law assumes. But it has never disappeared completely. Thatcher and Reagan revived it. Recently it’s been variously described as supply side economics or trickledown economics. It fades from view from time to time, and then reappears after its failings are forgotten. The jobs and growth plan is the latest reincarnation.

Even if new supply creates its own new demand, what about those who became underemployed or unemployed because of low demand before new supply created new demand? What do we do about them? Give them new skills? Apply a supply side solution to expanding VET courses and job placement agencies? Has it worked? Build bigger universities? The suppliers are building their own businesses funded almost entirely by governments but will the supply of a more skilled workforce be enough? It’s as if all the problems are on the supply side. Fix that and you’ll fix the economy? If that’s what the PM believes he should say so. After all he’s supposed to be the Great Communicator.

Underpinning the jobs and growth plan is the constant chant of the need to live within our means. It’s this falsehood, that there is a finite supply of funds the Federal government can lay its hand on that is condemning the economy to a sub-optimum future.  Sure a household may have to live within its means. It needs money to survive, income or maybe even loan funds. Any politician who says the country is like a household and has to live within its means, doesn’t understand banking at the macro level.

It’s not hard to follow what happens at the national level because all transactions are conducted at the Reserve Bank. The big banks all have accounts there. Every day they settle between themselves on behalf of all us bank customers. If a CBA account holder pays a retailer who has a NAB account, the two banks settle between themselves on behalf of the two parties. Each bank has an account called an Exchange Settlement account. These contain what are often called bank reserves. Reserves get shuffled between banks each day. They aren’t lent out. They are used to provide liquidity when banks settle between themselves.

When taxes are paid reserves get transferred to the government’s account. The same happens when the government borrows. The reverse happens when the government spends. Banks’ reserve account balances are restored. Only the government can create reserves which it does by spending. Private transactions just shuffle reserves between banks. Banks only want to hold enough reserves to enable daily settlement on behalf of account holders. They prefer to earn a return on reserves, which is one major reason why banks are keen to buy government bonds. But governments don’t need to borrow before spending. All around the world central banks, in Japan, UK and the US, have spent vast amounts buying back previously issued bonds without first raising taxes or using other proceeds such as borrowings.

Bank reserves are needed to make tax payments to and to buy bonds from national governments. These transfers are not prerequisites for spending. It can occur regardless. Spending drives taxes not the reverse. The taxation/spending cycle is not as politicians tell us, that if there’s no money in the bank, we have to go to bed hungry, all part of living within our means. It’s simply untrue.

The Federal government spends an average of $8 billion per week. Suppose there wasn’t quite enough in the government’s bank account one week, tax payments were slow or Treasury’s Office of Financial Management misjudged the required level of government borrowings. Would the Reserve Bank bounce the government’s cheques? Of course not. Could the government run an overdraft with the Reserve Bank? Of course it could. Would it burden future generations? Of course not. The government owns the Reserve Bank. Any arrangements between them are just internal accounting matters. Just as members of the same household lending to one another doesn’t affect the household’s position with the outside world.

Build up too many reserves in the banking system and banks will not be happy. Excess reserves don’t generate much revenue. That’s why banks welcome the chance to buy government bonds. Bond sales are a form of corporate welfare for banks, as well as being a tool of government monetary policy impacting interest rates. To view bond sales as simply deficit funding by governments is wrong.

The standard argument against borrowings by national governments is that payment of interest and principal will burden future generations. This is untrue. Payment of interest does not consume resources or reduce GDP. It’s simply a split up of the national pie. It’s income to the bondholder.  It can easily be mandated that superannuation funds, especially those in pension stage paying nil tax wishing to retain their generous tax concessions, use a small fraction of their $2 trillion in assets to buy government bonds. This was the case pre 1985. Payment of interest, splitting the GDP pie, then becomes part of retirement income policy.

There’s an oft repeated and widely accepted view that national governments should balance their budgets over the economic cycle as well as keeping borrowings to a minimum for fear of burdening our kids. Imagine for a moment what the government’s balance sheet would look like. Unlike large companies governments don’t have issued capital. If budgets were to balance over a few years there wouldn’t be any retained earnings either. These two factors imply government equity of zero, assets equalling liabilities in other words. Without borrowings public assets would be very small. The government’s balance sheet would be very skinny.

Government borrowings are rarely repaid. They are usually rolled over. The most realistic view of borrowings is they are perpetual redeemable preference shares issued by governments representing equity in the nation’s public assets. It is an ideological assertion to characterise government borrowings as a blight on future generations. The reverse is arguably true if borrowings result in a larger national pie.

Few universal truths in economics stand the test of time. Accepted theory and practice soon become relics of the past. Some like Say’s Law keep making comebacks. The idea that sovereign governments like ours that issue their own currency are constrained to live within their means as politicians describe to us is an ideological assertion not a truism. It’s a view that persists right across the political spectrum. Progressives quibble about the degree of this self imposed budget constraint but most accept the basic tenet.

It’s not that spending shouldn’t be prioritised or that taxation isn’t required for equity reasons and to nudge the economy in the right direction. There are more possibilities than austerity and jobs and growth trickle down economics.

The big downside to a better understanding is that it shows politicians how to manufacture pork to win elections. That’s a little scary given the calibre of the current crop. But we live in a democracy where an informed and vigilant electorate is still the best basis for solving our problems.

It’s time to update the notion of living within our means. The current anachronistic paradigm is choking the economy.  


  1. Thanks John, just a thought what would happen if governments gave up on the pretence that they needed to balance budgets. What if they decided not to tax people but just to print the money they needed and to only tax big companies and charge royalties for resources that are removed?

  2. You’re right, balancing budgets should not be the primary aim.

    Taxation is still important from an equity viewpoint. Also from a viewpoint of trying to move the economy in a chosen direction. I don’t think we can always rely on the market to do that.

    There is also the problem of creating too many reserves in the system. That then becomes a problem for monetary policy, trying to set appropriate interest rates.

    But a mix of what you’re suggesting is appropriate. It’s a Modern Money Theory/ Henry George hybrid. Both schools of thought have much to offer.

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