Sunday, 22 July 2018

Progressives are their own worst enemies

Misunderstanding our current problems is reaching epidemic proportions if one is to judge by Dr Michael Powell’s comments ( see here )on the new GST arrangements and the wider more crucial issue of Federal budgetary difficulties.

Just to quickly address the GST issues before moving to the broader matters of budgetary policy.

There’s nothing new about Scott Morrison’s Magic Pudding solution to add more to the GST pie to ensure States aren’t adversely affected in $ terms by the new rules. It’s the way the current system works. Not the current GST system per se but the current system of horizontal fiscal equalisation (HFE), of which GST is a part.

Grants flow from the Feds for specific purposes and for general purposes. The latter are sourced from the GST pool. States can decide how to spend general purpose grants whereas specific purpose grants need to be spent as stipulated.

But all grants are considered when squaring up under the HFE system. For instance, Western Australia, as it was forever reminding everyone, only received 30 per cent of what it would have received had its GST entitlement been calculated on a per capita basis. However, its overall entitlement to Fed grants was 60 per cent, due to it’s mining riches, which most people east of Kalgoorlie reckon belongs to all Australians, but which ends up in WA coffers.

When WA receives specific purpose grants it receives roughly 100 per cent of what it would have received were the grants distributed on a per capita basis. That’s the way specific purpose grants have worked in the past. Most have been distributed on a roughly equal per capita basis. These are mainly for health and education, to a lesser extent housing and the environment. Only NT tends to get more than equal per capita assistance via specific purpose grants.

When it comes to dividing up the GST pool, because WA has received 100 per cent from specific purpose grants when its assessed share under HFE principles is only 60 per cent, it receives less GST, in one year as low as 30 per cent of its per capita entitlement, so that overall its share of Fed grants, both specific and general purpose, equals 60 per cent of its per capital entitlement.

Tasmania on the other hand is entitled to about 147 per cent of its per capita entitlement. If it receives 100 per cent from specific purpose grants, it needs to get a higher percentage from the GST pool to compensate. That’s why Tasmania has been receiving more than 170 per cent from the GST pool.

Every five years the Commonwealth Grants Commission does a detailed review to assess relativities. In the intervening four years it does an annual update.

Both the old and the new system consider all grants. The new GST system has reduced the ceiling and installed a floor. The proposed benchmark for equalisation will be the higher of the two biggest States rather than the richest, WA. This is, in effect, a reduced ceiling. The floor will be a minimum per cent of a State’s per capita entitlement. It will be 70 per cent, soon to become 75 per cent.

But in practice things won’t change much. The pollies will always be able to fiddle with specific purpose grants. If that doesn’t work, they can always channel own purpose expenditure outside of the grants system. All grants are considered when finalising the GST split, which is the balancing amount in the HFE process, but not all other payments.

Whilst all grants are considered, some are considered more than others. And this is what allows the system to be so easily manipulated. The future will be no different than the past. The Federal government can simply instruct the Grants Commission to ignore certain specific purpose grants when deciding on the split up of the GST pool to achieve HFE. Other grants can be partly quarantined.

When Mr Shorten comes to town and promises funds for an improved health facility in Burnie, so what? If it’s a specific purpose health grant the State’s future GST share will be reduced accordingly. If more road grants are promised, as a rule future GST will be reduced by 50 per cent. It depends on the exact terms of reference given by the Federal Government to the Grants Commission each year. Any new road in Braddon resulting from by-election promises, is likely to be 50 per cent subsidised by the rest of the State. This is the reduced share from future GST dollars that would otherwise flow into the State. The rest of the State may be ignoring what’s happening in Braddon (as many of us in Braddon are trying to do) but the simple reality is that many of the promises will be funded from their pockets.

Some grants are completely quarantined from the HFE process. The almost $400 million received from the forestry inter-governmental agreement was ignored for HFE purposes. Most Tasmanians don’t fully understand what a gigantic imposition this was on the Australian government purse. We are only 2 per cent of the Australian economy, that’s one fiftieth. Imagine if every State had put their hand up for a similar grant for their favourites causes. It would have cost $20 billion. If the forestry grants were included in the HFE process Tasmania would have lost $400 million in GST receipts. The Tasmanian budget would be in crisis.

Most progressives still reckon it reasonable to ask, ‘where’s the money coming from’ and to acknowledge and reaffirm the constraints of debt and deficits. But in doing so, they are unwittingly acting as double agents. They are supporting conventional wisdom which is the root cause of our problems.  They are helping perpetuate the current myth-based system. Ignorance of where money comes from is no different to believing in fairies.

Where does money come from? Well, 97 per cent of money in the Australian economy has been created by private banks. They create money out of thin air. They are not passive middlemen (forgive the gender stereotype) introducing borrowers to lenders. They create loans and deposits out of thin air. Remember for every loan there must be a corresponding deposit. To every debit there’s a credit somewhere. Nothing else is possible. Every time they create a loan and a corresponding deposit they are faced with a lopsided balance sheet. Their asset, a loan to a punter, may have a 30-year term. But on the other side of their balance sheet, the deposit, the proceeds of the loan, may be an at-call account. It may disappear at a moment’s notice. The bank’s balance sheet is unbalanced. It must seek deposits, retail and/or wholesale, not to lend out but to balance its balance sheet.

How come private banks are the only ones creating money in today’s economy? We have the best financial system in the world? Or do we? Banks create money to maximise the returns to banks, their managers and shareholders? There’s not many who disagree with that. What’s the most profitable area? To businesses which may grow the economy? Nope. Too risky. Mortgages to home owners. Yep. With a taxation system that encourages investment in residential property, the demand for homes is governed by the supply of finance. What better business to be in? A oligopoly able to create money out of thin air, with a government guarantee when they need to fix up their balance sheets, being able to manipulate the demand for housing, and bank profits by controlling the supply of finance.

Credit is essential for growing economies. But if credit grows much faster than the economy itself, an imbalance must occur. That imbalance in modern Australia is a growth in house prices faster than the economy itself.  A good thing? Not if the money needed to service the ever-increasing loans has to come from the real economy. Where else?

We’ve granted banks the exclusive right to create money and it’s been channelled into excessive mortgages which increasingly need funds to be extracted from the real economy to service the loans and keep profits flowing to banks and their shareholders.

The biggest loser in all of this is the real economy as distinct from the financial world of paper shufflers, bankers, accountants and real estate agents.

Where’s the money coming from is a dumb question. Governments don’t need to raise taxes of borrow before spending as most people including progressives seem to blindly accept. Private banks create money out of thin air. The government’s bank, the Reserve Bank can do the same? Won’t that be inflationary? What about the 97% of money created by private banks. Was that inflationary? Yes it was actually. House prices have become inflated as we’ve noted. Credit has grown much faster than the economy, mostly used to buy existing houses.  We are living in a world of illusion if we think using borrowed funds to buy existing assets at ever increasing prices is the foundation for building a sustainable nation. If too much money chases too few goods, then inflation will occur. That’s what happened with housing. But it needn’t be that way. Spending isn’t inflationary per se. What if funds were used to supply more public goods and services? Would that be inflationary? Not in the current environment of flat wage growth, idle resources, an extractive finance industry bleeding the economy which all contribute to a lack of demand in the real economy. This is the crux of our current problems.

Following from evidence to the banking royal commission, investment bank UBS estimated that up to $500 billion in mortgage loans were liar loans. The current total of outstanding mortgages is about $2.7 trillion. Remember one trillion is 1,000 billion and one billion is 1,000 million. That’s a lot of money. Imagine what a fraction of that would do if spent in the real economy rather than inflating the prices of existing houses. The liar loans resulted from dodgy documentation by brokers and bankers wanting to do a deal without being overly concerned about anything other than their own well being. The dodgy figures were sometimes dodgy income estimates but more commonly dodgy estimates of borrowers’ living expenses used to calculate loan serviceability, where Household Expenditure Measures (HEM) prepared by ABS which differ little from bare sustenance levels, were used as de facto estimates of borrowers’ spending habits thereby inflating household incomes available to service loans, which meant borrowings ended up well above prudent levels.

The myths about government debt deficits and surpluses peddled by all sides of the political divide are rooted in a fuzzy view of the money system.

When payments are made by the Federal government they end up in private accounts. When the government raises taxes or borrows, private accounts are depleted. Amounts are transferred to and from the government’s a/c at the Reserve Bank (RBA).  To facilitate these operations, we arrange for private banks to assist, as none of us has an account with the RBA. So, if the government pays us for whatever reason, the government transfers funds to our bank. The bank’s account at the RBA therefore increases. Simultaneously the bank increases our deposit a/c with the bank. From the bank’s viewpoint what the bank owes us, our deposit a/c, increases at the same time as the amount owed to the bank by the RBA. Both sides of the bank’s balance sheet increases………… what it owes us (the liability) and what is owed to it by the RBA (the asset).

A payment by the government to a recipient happens instantly in cyber space, but the reality is it’s a two-stage process involving private banks.

When we make payments to the government the process is reversed.

Hence the total of funds in accounts that private banks have with the RBA, known as reserve a/cs or exchange settlement a/cs, fluctuate up and down depending on whether the government is paying us, or we are paying them.

When we make a payment to someone with an account at another bank, the banks swap reserves amongst themselves on our behalf. But the overall level of reserves does not change.

Banks either swap reserves amongst themselves or with the government. So where do the reserves come from in the first place? From the government ……. that’s where. As a rule, only the government can create reserves and it does that by spending………… and only the government can remove reserves. It does that by taxing or borrowing. The crucial thing to understand here is that spending precedes taxation not the other way around. Spending occurs before taxes can be paid. Taxation is not a prerequisite for spending.

Just as deposits aren’t a prerequisite for private banks to lend, taxes aren’t a prerequisite for government to spend. A glance at the RBA’s balance sheet will show what happens in the real world. This is the 2016/17 balance sheet:

See how total assets have increased by $27 billion in the 2016/17 year, from $167 billion to $194 billion. This has occurred at the same time as an increase in deposits. Who owns these deposits? Let’s have a look at Note 9:

The deposits consist mainly of private banks’ reserve a/cs (exchange settlement a/cs) and the deposits of the Australian government used to fund government spending. The Australian government’s deposits have gone up by $27 billion. If they were sourced from taxes or borrowings there would have been a reduction in the exchange settlement balances, the total reserves in the system used, as we have seen, by private banks to settle on our behalf, whether receiving payments from or making payments to government. Yet reserves have gone up by $4 billion not down by $27 billion. So where did the extra $31 billion come from? Let’s have a look at the cash flow statement:

The extra $31 billion coming into the RBA a/cs via financing activities is highlighted. How does RBA raise finance? With the click of a mouse that’s how. The funds ended up in the Australian government’s a/c. This is the exception to the general rule that only the government can create reserves …….by spending. Just as private banks can create deposits out of thin air, so too can the RBA.

When you read the RBA’s Annual Report it will explain how expanding the balance sheet as they have clearly done in 2016/17 was part of its monetary operations, buying and selling bonds and foreign exchange as part of monetary policy (see net payment for investments of $36 billion under operating activities). These investments, mostly short-term arrangements are called repos, short for repurchase agreements. The RBA purchases mainly bonds but sometimes other investments from banks to provide them with liquidity. Reserve accounts get depleted as funds are transferred to the government to pay taxes or to pay for a new round of government bond issues. But then the RBA arranges to repurchase the bonds to restore the banks’ reserve accounts. The RBA does it all with the click of a mouse, money created out of thin air, just like private banks do when making loans.

However, it does beg the question why raise money from bond issues in the first place if the RBA then turns around and repurchases them? The RBA could just boost the government’s a/c with a mouse click just like private banks do when making loans?

A closer look at the cash flow statement shows a distribution to the government of $3 billion, which is the RBA dividend payment to the government as 100% owner of the RBA. Netting off the increased government deposits against the dividend paid gives a figure of $27 billion, all created out of thin air. There is no loan owing by the government to the RBA because of these operations. Even if there was, so what? The government owns the RBA so what’s the problem if it owes money to itself?

The point is the RBA can and does create money out of thin air. It might do it principally for monetary policy reasons, but the fact is it can do it. Wouldn’t it be preferable for the government to create some extra money for fiscal reasons, rather than allowing private banks to be the sole money creators, which is essentially done to serve their interests rather than the broader economy. If in doubt about the way banks have put their interest well ahead of anyone else, check the evidence of the current royal commission into banking.

Taxes aren’t necessarily needed before spending. Rather their principal role should be distributional. There’s nothing wrong per se in cutting personal income tax rates. The problem with cutting marginal rates of tax the way the government has just done is that it increases inequality, which is exacerbated even further by taxing income from personal exertion at twice the rate as income from passive capital gains. Tax savings to the middle class won’t boost the economy if past patterns are a guide. They will end up servicing larger home loans. Perhaps that’s the real point of the exercise?

Implicit with almost any progressive agenda is the acknowledgment that the government’s goal should be a surplus. Timing is usually the only issue. No one I’ve met who regards surpluses as preferable to deficits fully understands a government surplus implies a private deficit. There Is No Alternative. TINA as Mrs Thatcher would have said. Government deficit aren’t bad per se. Government deficits create private assets. TINA again. Government surpluses on the other hand will see a run down in private assets. Does everyone who thinks surpluses are bad understand that basic inviolable accounting truism?

We have a private business sector that is not, on average, heavily indebted. But the private household sector is being crushed with debt mostly due to the behaviour of banks. Taken as one, the private sector would struggle if it had to move into deficit, spending more than it receives, which is what will happen if the government moves into surplus. They both can’t run surpluses. It’s an accounting impossibility.

So who’s going to buy the goods and services that will need to be sold by the private sector to justify its increased borrowings as it moves into deficit at the same time as the government sector moves into surplus, and by implication gradually withdraws its stimulus spending, which is what will happen? Not only who’s going to buy the extra goods and services, but how are they going to pay for them? With credit cards? More borrowings?

The reason why we‘ve moved on from the talk about a debt and deficit disaster is the realisation by the current government that the only alternative to government deficits was for the private sector to run deficits at the same time as the private household sector has become burdened with the second highest level of debt in the known universe. 

In the short space of a few years we’ve had a dramatic policy turnaround from a debt and deficit disaster to a sustained campaign to reduce taxes. It’s a policy reversal of Trumpian proportions. Surely, there’s something fundamentally wrong with a belief system than can accommodate such policy changes with the barest of explanations. It’s seat-of-the pants public policy making at its worst.

Unfettered financialisaton has extracted increasing amounts from the real economy under the pretext of making the economy more efficient. But we have ended up with an unbalanced economy, one that is leaving more and more people losing contact with the peloton. It’s not just the housing market. Infrastructure, such as electricity transmission networks and airports are even worse when it comes to the amounts extracted by the finance sector to the detriment of consumers and the real economy. Greed masquerading as efficiency.

But the talk is still about a distant government surplus. Does it really matter who runs a deficit and who runs a surplus if we achieve a fair and equitable society? Government deficits, if financed by borrowings, will result in more of the pie being distributed as interest to the bond holders. But that’s a distributional problem, which all governments face every day of their existence. If our children and grandchildren are the bondholders, in other words they own the debt, then a payment of interest is simply a distribution of the pie. Should extra debt ever be a problem then governments can create money out of thin air to do anything it wants without borrowing as we have seen the RBA do. It won’t necessarily lead to outbreaks of inflation as scaremongers suggest.

Taxes should be seen as distributional mechanisms in a progressive caring society. Government outlays shouldn’t be dependent on taxes, especially capital outlays. Governments can always find the money if they want to. But they don’t. They’re happy to continue with the fiction of how the system operates, a fiction that unfortunately is supported by most of the system’s critics. Progressives are their own worst enemies.