The Future of the Federation : Lessons from the pandemic

There’s been a wealth of lessons to be learned as economies try to recover from the pandemic.

Most are being ignored.

A return to pre-pandemic days is what most policy makers appear to want.

Back to the days which have produced the mess we are now in.

The pandemic has brought all our problems into sharp focus.

We have a lopsided economy.

Capital and profits have increased their share of the national pie at the expense of wages. The trickle down effects haven’t eventuated. Asset prices have risen instead.  Owners want a return on their capital and to that end the financial sector  has been tasked with extracting more and more from the real economy leading to a more unbalanced economy. Government spending has been unable to keep up with the needs of the economy.

Are we going to rely on tax reform to help rebalance the economy?

We might be waiting a long time.

This note is intended to review the state of play and look for other ways to relieve the pressure on services delivery, particularly for State governments, the engine rooms for so many services that are crucial to our well-being.

Post pandemic policies have shown how government spending, borrowing and the role of the Reserve Bank interact.

As a rule most focus is either on the role of the General Government or the RBA. They are rarely considered as a consolidated Group.

Only when they are treated as one, does a realistic picture emerge of what is happening. Peer at the economy through an accountant’s lens and the view looks awfully like what Modern Monetary Theory (MMT) adherents see when they view the economy.

Government spending creates private assets. Budget repair will reduce private assets. Do those promoting budget repair understand this simple iron law of accounting?

Banks are intermediaries in the settlement process, interposed between the government (RBA) and the people. If instead of having a/cs at various banks for settlement purposes, everyone had an a/c at the RBA, then government spending would be directly credited to peoples’ a/cs. The balance of peoples’ a/c at the RBA would appear as a liability of the RBA just as notes and coins do. 

But they’re not debts that the government need to repay. This is one of the fundamental points most commentators and scaremongers fail to grasp.

With banks as intermediaries, reserves are created each time the government spends. Convention dictates that some of the reserves need to be swapped for government bonds should the government wish to spend and finds itself without any money.

It’s a convention not a necessity.

A recent development that eventually made it to Australian shores, has seen the central bank, the RBA, purchasing some of the government’s issued bonds.

A close look at effect of spending on the consolidated government (which includes the RBA) shows it makes no difference if the government spends what’s in its RBA a/c, or whether it runs an overdraft at the RBA or whether it raises funds by issuing bonds which are bought by the RBA and subsequently written off.

A government borrowing from itself doesn’t impose a burden. The reverse is more likely. Private assets are boosted when spending occurs.

Looking at the consolidated government, gives a more realistic view than focusing on just one of the members of the consolidated group, the General Government.

It is instructive to look at the Australian government’s financials, which aren’t included with the Annual Budget, but do appear 5 months after year’s end usually in November.

When RBA Governor Lowe tells us RBA bond buying is not supposed to indicate a new way to finance government spending is he saying net government borrowings of $684 billion at June 2021 compared to gross borrowings of $888 billion, the difference being those bonds bought by the RBA, is a figure without meaning. 

What does it mean then?

Surely it must mean the government only owes $684 billion to third parties.

Then why does everyone parrot on about a trillion dollars of debt?

Is it a rounding problem or a lack of understanding of what consolidated accounts mean?

As to where RBA got the money to purchase bonds, and how it was recorded in its accounts, this can be answered by having a look at RBA’s cash flow statement. It reveals how money is created in a modern economy.

The means to create money isn’t confined to the RBA. Most is created by private banks.  Outsourcing money creation to banks is an enormous privilege.

 ‘Creation’ is the operative word here. As the Bank of England reminded us in 2014, loans are not made from existing deposits. Loans create deposits. The Commonwealth Bank’s cash flow statement reveals this reality, with operating activities divided between income and expenses on one hand, and new loans and deposits on the other. It is a tell tale snapshot of how banking in a modern economy works as opposed to how most people imagine it to work.

The pandemic and the subsequent response have emphasised the crucial role State governments play in service delivery in a wide variety of important areas. Compared to the measures enacted to help banks by the RBA, much more could have been done.

If the Tasmanian experience is any guide, reporting income on a profit and loss basis by State governments, has helped disguise the cash flow losses that are likely to persist for quite a while, with the supply of services likely to fall further behind what’s needed.

Tasmania’s looming fiscal sustainability problems have been well documented but largely ignored by politicians. Admitting to problems always prompts questions about what the proposed solutions are and why has it taken so long to confess.

At this stage there are no firm solutions. The progress of tax reform is glacial, and like glaciers in the era of climate change are just as likely to melt before much progress is made.

The prospect of Stage 3 tax cuts and possible budget repair which will reduce Australian Government coffers even more, suggests States aren’t a priority for the Australian government/RBA.

We need a backup plan to assist them.

The RBA needs to be given an enhanced role in the Federation, not just as banker to the private banks but helping States and Territories as the pre-eminent deliverers of services to the people.

When the Federation is viewed as a consolidated whole, government financing and spending by the States can be carried out in the same way as the activities of the Australian government since March 2020.

All government spending increases private assets.

But the key to the future is grasping the fact that government liabilities created by spending aren’t necessarily debts which must be repaid.

They only become debts if we so choose.

We need to run the show for the benefit of the people not the banks.

Preamble

It hasn’t taken long for the new Federal Labor government to start using the same excuses as its predecessor, citing the trillion dollars of government debt inherited from its predecessor as a reason for not pursuing particular policies.

At the same time there is a growing public awareness that much of government’s increased debt has been bought by the Reserve Bank (RBA), the government owned bank, which means amounts owed to persons outside the government sector hasn’t changed much over the last two years.

The public debate has been pushed along by followers of Modern Monetary Theory (MMT).

Possibly the worst thing MMT’ers did, and most readily admit it, was to describe their approach as ‘modern’ and as a ‘theory’.

It is not a ‘theory’ in the sense that it’s a policy prescription that will, if taken, cure our current ills.  

Rather it’s a collection of observations about how monetary systems work.

Neither it is it particularly modern. Georg Knapp wrote about what would now be considered MMT over a century ago.

And there have been many others since, including Abba Lerner, Hyman Minsky, Wynne Godley and the prolific and rigorous Bill Mitchell, who have contributed insights into MMT.

It’s a description of what happens.

MMT provides a lens through which one gains a different view of how economies work compared to what is presented in most mainstream textbooks and by most commentators.

For someone with an accounting background, the lens provides a common sense, readily understandable view of how economies operate.

Yet some in the economics profession view MMTers as crazy outliers and resist many of their ideas, often because they raise doubts about some of their long-held precepts.

But what MMTers see when they view an economy, is very similar to what an accountant sees.

For every debit there’s a corresponding credit.

And perhaps more crucially, all liabilities aren’t debts that have to be repaid.

Take government spending for instance. Private assets are boosted. But is the corresponding credit a liability that must be repaid?

Take budget repair to which the new Labor government is committed. This means reducing public borrowings by running government surpluses which further implies reducing private assets.

If you asked a focus group whether they supported a policy which would reduce private assets, there wouldn’t be much support. Few understand the full implications of budget repair including, dare I say, a few economists.

The lack of understanding is perpetuated by emphasis given to the annual budget’s cash outcome which mainly focuses on income and expenses in the general government itself.

How can one understand the overall position of a government (the general government plus its wholly owned subsidiaries, the most important of which is the RBA) if the Budget papers don’t contain a consolidated set of financial statements?

Annual Budget papers show detailed financial statements of the General Government sector for the budget year plus three years of forward estimates.

For the Non-Financial Corporations sector (mainly the NBN) and the Financial Corporations sector (mainly the RBA) there’s figures for the budget year only.

But nowhere in the Budget papers is there a consolidated set of financials for the whole government sector to give readers a chance to understand the government’s overall position.

It’s a perfunctory occasion when a consolidated set of financial statements for the Australian government finally appears in December, five months after year’s end. There’s no public discussion to mark the event.

Commentators continue to pontificate on the economy’s past and future without even a cursory glance at what the consolidated statements mean.

There’s a tendency, that because the RBA is operationally separate from its owner, there’s no need to view them as one.

Lots of business groups have members which operate separately. How can one understand a group without a group set of accounts?

The matter of government debt being acquired by the government’s wholly owned bank, the RBA is also harder to understand without reference to a consolidated set of accounts. So much of the discussion occurs with inadequate information.

Accounting for government spending

A recent on-line post The economy exists within society, not vice-versa: Saul Eslake on the GFC, debt-and-deficit and why we need to pay more tax highlights the relevant issues.

Let’s start with the following paragraphs where the RBA buying already issued bonds (known as quantitative easing) is discussed:

“What governments and central banks have done through quantitative easing is to substitute fixed-rate debt for floating-rate debt. This is very poorly understood.”

“If governments issue bonds to the investing public, they are in effect taking out fixed rate loans. If you issue a 10-year bond at two per cent, that rate is fixed [for the life of the bond].”

“But the Reserve Bank pays interest [on those deposits] at the cash rate minus ten basis points. Now that the cash rate has gone up to 1.35%, the Reserve Bank is paying the [commercial] banks 1.25%. If the cash rate goes up to 2.5% by the end of this year, which I think it will, then the Reserve Bank will be paying 2.4% per annum.

“People are going to say: ‘Why is the government giving the commercial banks, who make lots of money, all these billions of dollars in interest?’ The answer is that they have a legal obligation to. But at some point, people are going to ask why is that happening.”

It is likely the first para was a misquote and what Saul was referring to was that quantitative easing involves central banks substituting floating rate debt for fixed rate debt, not the other way around. For that is what has been happening with the RBA buying government bonds on the market.

Anyone who has read Stephanie Kelton’s book The Deficit Myth will know she referred to the two types of government liabilities as ‘green dollars’ and ‘yellow dollars’’.

‘Green dollars are what we call bank reserves or exchange settlement accounts, which currently attract a floating rate of interest.  Whether or not debt is an accurate description of bank reserves is a moot point. They appear as liabilities on RBA’s balance sheet.

But they are not debts in the sense they will have to be repaid.  They may be liabilities, but so is owner’s equity.

On the other hand, ‘yellow dollars’ are what we call government bonds, fixed rate borrowings over a specified term.  They can be classed as debt because there is a repayment condition. In practice, as Saul notes later, government debt is rarely repaid. It is usually replaced with new borrowings.

Reserves (‘green dollars’) are swapped for bonds (‘yellow dollars’). Then the RBA buys the bonds from the bondholder and restores the bank reserves that were there in the first place.

Only banks have accounts with the RBA.

Banks are intermediaries in the settlement process. When the RBA is directed by the government to pay someone, the payment is made to the account the person’s bank has with the RBA (the bank’s reserve a/c). Simultaneously the customer’s a/c with the bank is credited.

Bank reserve a/cs show as liabilities in RBA’s a/cs.

Settlement involves three parties: the RBA, the customer’s bank and the customer.

Where do reserves, the ‘green dollars’, come from and why is it necessary to convert some into ‘yellow dollars’? That is the key to understanding government spending/financing arrangements.

Bank reserves are created every time the Federal government spends.

How government spending occurs is best described by Warren Mosler, an important contributor to MMT thinking, when he wrote back in 2010 referring to the US:

Government spending is all done by data entry on its own spreadsheet called “The U.S. dollar monetary system.”

Here is a quote from the good Federal Reserve Bank Chairman, Ben Bernanke, on 60 Minutes for support:

SCOTT PELLEY: Is that tax money that the Fed is spending?

 CHAIRMAN BERNANKE: It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.

Computer data doesn’t come from anywhere. Everyone knows that! Where else do we see this happen? Your team kicks a field goal and on the scoreboard, the score changes from, say, 7 points to 10 points. Does anyone wonder where the stadium got those three points? Of course not! Or you knock down 5 pins at the bowling alley and your score goes from 10 to 15. Do you worry about where the bowling alley got those points? Do you think all bowling alleys and football stadiums should have a ‘reserve of points’ in a “lock box” to make sure you can get the points you have scored? Of course not! And if the bowling alley discovers you “foot faulted” and lowers your score back down by 5 points, does the bowling alley now have more score to give out? Of course not!

We all know how data entry works, but somehow this has gotten turned upside down and backwards by our politicians, media, and, most all, the prominent mainstream economists.

Just keep this in mind as a starting point: The federal government doesn’t ever “have” or “not have” any dollars.

It’s just like the stadium, which doesn’t “have” or “not have” a hoard of points to give out. When it comes to the dollar, our government, working through its Federal agencies, the Federal Reserve Bank and the U.S. Treasury Department, is the score keeper. (And it also makes the rules!) You now have the operational answer to the question: “How are we going to pay for it?” And the answer is: the same way government pays for anything, it changes the numbers in our bank accounts.

The federal government isn’t going to “run out of money,” as our President has mistakenly repeated. There is no such thing. Nor is it dependent on “getting” dollars from China or anywhere else. All it takes for the government to spend is for it to change the numbers up in bank accounts at its own bank, the Federal Reserve Bank. There is no numerical limit to how much money our government can spend, whenever it wants to spend. (This includes making interest payments, as well as Social Security and Medicare payments.) It encompasses all government payments made in dollars to anyone.

This is not to say that excess government spending won’t possibly cause prices to go up (which is inflation).

That’s government spending in a nutshell. It happens regardless of any balance the government may have in its a/c at the RBA.

Government spending creates private assets for those who receive the payments.

But it also creates bank reserves held by bank intermediaries who are positioned midway between the government (as spender) and the private sector (as the beneficiaries of the spending).  

Bank reserves only exist because of the design of our financial system which interposes banks between government spending and the recipients of the spending.

A greater understanding of the process requires a look at what happens with all the players.

Let’s consider the General Government (GG) and the RBA which together (for the purpose of this explanation) comprise the Consolidated Government, and the Non-Government (NG) sector (essentially the banks and everyone else in the economy).

Let’s start by seeing what happens when the government spends:

(Note: A= asset L= liability. If an asset increases, there must be a corresponding increase in a liability or a corresponding decrease in another asset. The reverse and the converse are also true.)

In the GG, its bank a/c with the RBA falls, as does its equity position.

At the RBA, the GG’s a/c falls and reserves a/cs rise.

Combining the two, the GG and the RBA, the consolidated government’s position shows a fall in its equity position and a rise in reserve a/cs.

On the other side of the transaction, the NG sector shows a rise in reserve a/cs and an increase in NG’s equity.

Overall spending has created reserves, government equity has fallen, and non-government equity has risen.

Ipso facto government spending creates private assets.

When bank customers spend whatever is in their bank accounts, bank reserves are transferred to the bank of the person to whom the customer has made a payment.

Reserves get transferred around the banking system. That is their raison d’etre.

Although bank reserves are bank assets and RBA liabilities, it is not a debtor-creditor arrangement. Bank reserves aren’t debts which must be repaid.

Banks as intermediaries in the payment settlement system have no option but to hold the reserves and to transfer them to other banks as part of day-to-day settlement procedures in the economy.

Now let’s assume a slight variation where GG doesn’t have any funds with the RBA, yet proceeds to spend:

The GG’s bank overdraft with the RBA increases instead of its bank a/c falling as per Chart 1.

Apart from that there’s no other change. It produces the same outcome as Table 1. Spending has created reserves, government equity has fallen, and non-government equity has risen.

Let’s proceed to see what happens when GG borrows from NG before spending:

The GG’s borrowings increase, and its equity consequently falls.

There is no change with the RBA. Reserves a/cs will decrease and GG’s a/c will increase as funds are raised, but both are reversed when GG spends.

The consolidated government position reflects how borrowings have increased and equity has fallen.

In the Non-GG sector, the reverse has occurred, with its assets (government bonds) increasing, thereby increasing its equity.

Compare these outcomes to what happened in both Charts 1 and 2.

For the consolidated government the increased reserves have been replaced by increased borrowings.

From  NG’s perspective increased reserves have been replaced by increased holding of government bonds.

To paraphrase Stephanie Kelton ‘green dollars’ have been swapped for ‘yellow dollars’.

What happens when the RBA proceeds to buys bonds from NG as it has been doing over the past two year (quantitative easing), is shown below:

The outcome is the same as in Chart 1 and 2 above. The ‘yellow dollars’ have been swapped back into ‘green dollars.

Whether GG has funds at the RBA, or whether it avails itself of an RBA overdraft or whether GG borrows from NG and subsequently the RBA buys the issued bonds from NG …… the result is the same.

That’s certainly not something that’s widely understood.

In all three instances spending has created reserves, government equity has fallen, and non-government equity has risen.

Government spending however it is financed, creates private assets. Whether spending is inflationary won’t depend on the way it’s been financed.

What happens if the RBA writes off the newly acquired bonds as per Chart 4.

GG borrowings fall as does RBA’s holding of bonds.

Which means there is no change to the consolidated government’s position resulting from the debt w/off. It’s just a book entry.

NG’s position doesn’t alter either.

Which means if we look at Charts 4 and 5 combined where GG spending is accompanied with GG borrowing/RBA bond purchase/ RBA bond write off, the outcome looks like this:

It’s the same outcome as Charts 1 and 2.

In other words, whether GG has money with RBA, or whether it runs an overdraft with RBA, or whether it goes through the routine of borrowing/RBA bond buying/RBA bond write off, the outcome is the same.

The only issue is whether the banks in the NG sector hold reserves or bonds. Green dollars or yellow dollars.

It’s probably an opportune time to look at what happens if GG raised funds via taxes before spending. The outcome looks like this:

There are no changes. Reserves are drained when taxes are raised but restored when GG spends.

The overall position of the government and NG doesn’t change. Hopefully the government spending manages to shift resources within the NG sector. For that is the very point of public policy, to shift resources around for the benefit of all.

Just to digress a little, taxes are a crucial policy instrument to address inequality and inefficiency problems, and/or dampening down an overheated economy, or as Bill Mitchell describes it ……. “creating the non-inflationary real resource space to absorb the scale of government spending desired”……. not as the sole source of funds for government spending.

If we ever get to the stage where a government proceeds with so called budget repair, this is what will happen:

GG borrowings will fall meaning its equity position will rise.

There will be no change in the RBA’s position.

The consolidated government position therefore shows, a fall in borrowings and a rise in its equity position.

On the other hand, the NG’s assets (bonds) will fall and hence its equity position will also fall. It will see a temporary rise in reserves as bond redemption proceeds are received, but these will be returned to the government when taxation exceeds spending, which is what will happen with budget repair.

Budget repair means running down private assets. This is not widely understood.

To sum up government spending creates reserves. From time to time some are converted to government bonds.  If the RBA buys the bonds, reserves are restored.

As Saul Eslake observed above, both bonds and reserves are paid interest.

By increasing reserves when RBA purchases government bonds the level of reserves attracting interest will rise. At some point as Saul says, people are going to ask, why are we paying banks all this interest?

This raises two points:

First, the RBA isn’t required to pay interest at the rate it currently does. It could pay a lower rate. There have been times when reserve a/cs attracted no interest.

Second, reserves only exist because banks have been interposed between the RBA and customers. If we were to design a settlement system for today’s age, we wouldn’t have the system we currently have.

Over time banks provided customers with cheque facilities. The need for banks to settle amongst themselves on behalf of all customers led to the interbank settlement arrangements we still have. Reserves are a necessary part of that system.

It would be a simple matter to rid the system of the arcane requirement to have reserves.

If instead of customers having a/cs at individual banks the system was tweaked so that everyone had an a/c with the RBA, and their nominated bank simply provided the necessary services to operate that a/c, that would mean we all had an a/c with the RBA.  A bit like the NBN which requires us to arrange an internet provider, we’d arrange for a bank provider to service our a/c at the RBA.

That would mean there would be no bank reserves. Depositors’ a/cs at the RBA would appear as an RBA liability replacing bank reserves. It wouldn’t be a debt that the RBA would ever pay. We went off the gold standard many, many moons ago.

If we refigured the system from the current settlement arrangements with a few large private banks as intermediaries, to a system where everyone had an account with the RBA, this is what would happen when the government spent:

GG’s spending would lead to a rise in depositors’ a/cs (a liability) for the consolidated government. Its equity would consequently fall.

For the NG, deposit a/cs (asset) rise. So does its equity.

Removing reserves from the system, replacing them with direct deposits with the RBA would remove the problems of paying interest from the public purse to already profitable banks with reserve a/cs. Any interest would be paid direct to deposit holders.

Of course, banks would resist the changes. They would have to pay interest at rates greater than the RBA would pay on deposit a/cs, to entice depositors to transfer deposits to them. With the current system there’s a huge swathe of deposits which attract little or no interest. Banks would have to fight a bit harder to attract deposit liabilities needed to balance their positions every time they created more long-term assets in the form of customer loans. 

Prudent banking under the current system requires a bank to have sufficient reserves to look after its customers’ needs, but excessive reserves tend to be underperforming assets from a bank viewpoint.

They much prefer to own bonds to excess reserves.

Recent bond buying by the RBA which was intended to drive down interest rates to help the economy recover from the pandemic has given windfall profits to banks. As interest rates fell the market price of the fixed rate bonds rose. Therefore, banks have probably made handy capital profits from selling bonds to the RBA. They’re unlikely to have sold at a loss.

It is not surprising therefore that MMT’ers sometimes describe issuing bonds to drain excess reserves from the banking system as welfare for banks…. as handouts to those who least need them.

Some bonds and a lot of other financial assets were also sold to the RBA with repurchase arrangements in place (repos to use bankers’ lingo) as part of the Term Funding Facility. The RBA offered banks $188 billion worth of loans at the bargain basement rate of 0.1 per cent, hoping banks might make loans to business customers they otherwise wouldn’t make and at lower rates, to help the economy recover post pandemic. It was a surprising vote of confidence in the banking sector given the findings of the recent Royal Commission into banking. Unsurprisingly most of the new loans were for housing which only served to raise house prices.

Most banks took up the RBA’s offer. Money for jam. Banks transferred assets to RBA. RBA gave them loans in consideration.

Essentially banks handed over assets as collateral and the RBA credited their reserve a/cs. Reserve a/c balances rose as did assets on RBA’s balance sheet.

At the end of the term, the repurchase agreement means the assets acquired will be transferred back to banks. Reserve a/cs will fall and the assets will be removed from RBA’s balance sheet.

The difference between the sale and purchase prices of the banks’ assets transferred to and from the RBA, represents interest on the deal, which at only 0.1 per cent pa won’t amount to much more than a row of beans.

Meanwhile the banks have made huge profits. Paying the RBA 0.1 per cent on loans whilst receiving interest on reserve a/cs (currently 1.25 per cent) surely can’t be the best use of public money. The extra cash on banks’ balance sheets made book balancing easier as more loans were created principally for housing, further unbalancing our lopsided economy.

The banks as intermediaries are reaping windfall profits for doing very little apart from being in the right place at the right time, profiting from their privileged position in banking arrangements designed in the pre digital age.

The above comments about removing reserves from the system is not a policy recommendation per se, rather a way of emphasising that reserves represent the de facto equity depositors have in our nation, and which arise as a consequence of having a system of bank intermediaries in the settlement process.  Reserves are not debts that have to be repaid.

Consolidated government financial statements

The consolidated financial statements for the Australian government issued in December each year are worth a look if one wishes to understand the make up on the total government sector.

Just a quick glossary:

·        GG is the General Government comprising departments and agencies. The Future Fund with assets of almost $200 billion at 30th June 2021, is included with GG.

·        PNFCs are Public Non-Financial Corporations, the large ones being, in order, NBN, Snowy Hydro, Australia Post and Australian Rail Track Corp.

·        PFCs are Public Financial Corporations the most significant by far being the RBA.

When the three sectors, GG, PNFC and PFC are consolidated to produce consolidated financial statements for the Australian government, inter sector amounts are eliminated. For instance, GG’s bank a/c at the RBA is eliminated because there’s an offsetting a/c in RBA’s books (as occurred in the above Tables 1 to 9).

We’re interested in the balance sheets, the statements of position of the sectors.

Table 10: Aust Govt balance sheet by sector at 30th June 2021
	GG	PNFC	PFC	Elims(a)	Consol
	$m	$m	$m	$m	$m
Assets
Financial assets
Cash and deposits	62,411	2,166	896	-57,739	7,734
Advances paid	81,403	15	4,957	-14,825	71,550
Other receivables	60,014	2,275	126	-3,127	59,288
Investments, loans etc	191,633	1,236	540,067	-206,750	526,186
Equity investments	147,789	244	819	-61,518	87,334
Total financial assets	543,250	5,936	546,865	-343,959	752,092
Non-financial assets(c)
Land	12,070	1,763	252	-	14,085
Buildings	43,311	3,980	470	-12	47,749
Specialist military equipment	74,387	-	-	-	74,387
Other P&E & infrastructure	17,714	51,609	158	-	69,481
Intangibles	9,795	3,735	93	51	13,674
Investment property	192	156	-	-	348
Inventories	10,606	184	60	-	10,850
Heritage & cultural assets	11,861	-	-	-	11,861
Tax assets	-	1,394	5	-1,399	-
Other non-financial assets	4,872	743	54	-49	5,620
Total non-financial assets	184,808	63,564	1,092	-1,409	248,055
Total assets	728,058	69,500	547,957	-345,368	1,000,147
Liabilities
Interest bearing liabilities
Deposits held	598	18	415,609	-60,211	356,014
Government securities	888,419	-	-	-204,504	683,915
Loans	10,540	28,390	4,192	-14,556	28,566
Leases	19,440	12,508	25	-9	31,964
Other int bearing liabs	7,871	572	2,955	-	11,398
Total int bearing liabilities	926,868	41,488	422,781	-279,280	1,111,857
Provisions & payables
Superannuation liability	406,940	27	539	-	407,506
Other employee liabs	37,779	1,964	227	-	39,970
Supplier payables	9,964	3,857	91	-44	13,868
Personal benefits payable	3,015	-	-	-	3,015
Subsidies payable	989	-	-	-13	976
Grants payable	6,800	21	-	-	6,821
Aust currency on issue	-	-	95,485	-	95,485
Tax liabilities	-	1,090	1	-1,091	-
Other payables	2,425	599	2,839	-2,814	3,049
Other provisions	58,481	891	1,772	-324	60,820
Total provisions & payables	526,393	8,449	100,954	-4,286	631,510
Total liabilities	1,453,261	49,937	523,735	-283,566	1,743,367
Net worth	-725,203	19,563	24,222	-61,802	-743,220

 

 

The GG, PNFC and PFC balance sheets are listed in the first three columns. The consolidated figures are derived by adding the first three columns and eliminating those assets and liabilities with offsetting amounts in another sector.

The eliminations in the column highlighted in green sum to zero. For every credit that’s eliminated there’s a corresponding debit elsewhere that’s also eliminated.

The major eliminations are:

·        Cash and deposits (assets for GG and PNFC) are reduced because there are offsetting deposits at the RBA (liabilities in PFC.)

·        Advances paid (mainly from GG) are offset against loans (liabilities) to PNFC’s. GG’s loan to NBN falls into this category.

·        GG’s equity interest in PFCs and NFPCs are offset against the equity/net worth of PFCs and NPFCs.

·        RBA holdings of bonds (included as assets under investments, loans etc in PFC) are offset against bonds listed with GG as Government securities.

As a consequence of the bond eliminations, the net liability for government securities at 30th June 2021 for the consolidated government was $683.9 billion, compared to the liability stated in GG’s balance sheet of $888.4 billion, an elimination therefore of $204.5 billion. Essentially these were the bonds held by RBA on 30th June 2021.

Assets under the label ‘Investments, loans etc’ include the other assets transferred to RBA as collateral for the $188 billion Term Funding facility (in PNFC) and assets of the Future Fund (in GG).

The figures in the consolidated column are the figures which arguably should be used in public discussions about governments and budgets.

In order to understand the full effects on the government’s consolidated position it is instructive to look at the consolidated position at 30^th June 2020 compared to 12 months later. The 2021 year was the first full year of the post pandemic era.

The column highlighted in green displays the changes in the balance sheet items over the 12-month period.

 

Table 11: Aust Govt balance sheets consolidated 2021 & 2020
	2021	2020	change
	$m	$m	$m
Assets
Financial assets
Cash and deposits	7,734	7,981	-247
Advances paid	71,550	64,784	6,766
Other receivables	59,288	66,684	-7,396
Investments, loans etc	526,186	394,595	131,591
Equity investments	87,334	63,043	24,291
Total financial assets	752,092	597,087	155,005
Non-financial assets(c)
Land	14,085	13,621	464
Buildings	47,749	47,353	396
Specialist military equipment	74,387	72,147	2,240
Other P&E & infrastructure	69,481	67,600	1,881
Intangibles	13,674	13,059	615
Investment property	348	369	-21
Inventories	10,850	9,987	863
Heritage & cultural assets	11,861	11,975	-114
Other non-financial assets	5,620	5,724	-104
Total non-financial assets	248,055	241,835	6,220
Total assets	1,000,147	838,922	161,225
Liabilities
Interest bearing liabilities
Deposits held	356,014	78,985	277,029
Government securities	683,915	725,868	-41,953
Loans	28,566	18,960	9,606
Leases	31,964	32,476	-512
Other int bearing liabs	11,398	10,331	1,067
Total int bearing liabilities	1,111,857	866,620	245,237
Provisions & payables
Superannuation liability	407,506	431,077	-23,571
Other employee liabs	39,970	34,425	5,545
Supplier payables	13,868	11,914	1,954
Personal benefits payable	3,015	4,670	-1,655
Subsidies payable	976	1,027	-51
Grants payable	6,821	2,859	3,962
Aust currency on issue	95,485	90,102	5,383
Other payables	3,049	4,027	-978
Other provisions	60,820	72,104	-11,284
Total provisions & payables	631,510	652,205	-20,695
Total liabilities	1,743,367	1,518,825	224,542
Net worth	-743,220	-679,903	-63,317

 

The jump in Investments, loans etc of $131 billion is due mainly to the extra assets on RBA balance sheet. It is not the Australian government bonds that were bought, for they were eliminated during the consolidation process. It’s other financial assets, including bonds issued by State governments, that were acquired as part of the RBA quantitative easing and the Term Lending processes.

Additional equity investments of $24 million mainly relates to shares held by the Future Fund.

There were negligible changes in non-financial assets such as land buildings infrastructure, military equipment etc.

Deposits held (liabilities) increased by $277 billion. That almost entirely relates to the extra reserves created by the RBA as part of quantitative easing, by buying Australian government bonds and other financial assets, and entering repo arrangements with banks as part of the Term Loan Facility.

Net government securities on issue actually fell in the year, down by $42 billion. This means the RBA acquired more bonds than were issued  by GG during the year. Our debt to third parties was reduced. 

The other major change, a reduction in the superannuation liability largely resulted from changes to actuarial assumptions.

The liabilities highlighted in yellow mostly come from RBA’s balance sheet. Of the $356 billion of deposits at 30^th June 2021 (2020: $79 billion), $341.8 billion are Reserve a/cs (2020: $73.5 billion).

Currency in circulation $95 billion at June 2021 (2020: $90 billion) is also an RBA liability, issued when banks swap reserves for currency usually at the request of customers.

Although currency on issue is a liability for RBA, it is not a debt that has to be repaid by the RBA. It gets passed around the system.

Reserves too are accounting liabilities.

Reserves represent people’s equity in the Australian government, created by government spending.

Lest we forget, government spending creates private assets. Reserve a/cs simply reflect the existence of the banks as intermediaries in the settlement system.

Allow everyone to have an a/c with the RBA and there wouldn’t be reserves. Peoples’ equity in the system would be reflected by the balances in their deposit a/cs.

Therefore, both currency on issue and reserves comprise people’s equity in the Australian government. The Australian government doesn’t have contributed capital like companies.

But realistically it does have owner’s equity represented by reserves and currency on issue. This de facto equity at 30^th June 2021 was $437 billion.

If these amounts were to be reallocated to equity, alongside the government’s net worth, this is what the 2020 and 2021 balance sheets would look like

 

Table 12: Aust Govt balance sheet consolidated  2021 & 2020 (adjusted)
	2021	2020	change
	$m	$m	$m
Assets
Financial assets
Cash and deposits	7,734	7,981	-247
Advances paid	71,550	64,784	6,766
Other receivables	59,288	66,684	-7,396
Investments, loans etc	526,186	394,595	131,591
Equity investments	87,334	63,043	24,291
Total financial assets	752,092	597,087	155,005
Non-financial assets(c)
Land	14,085	13,621	464
Buildings	47,749	47,353	396
Specialist military equipment	74,387	72,147	2,240
Other P&E & infrastructure	69,481	67,600	1,881
Intangibles	13,674	13,059	615
Investment property	348	369	-21
Inventories	10,850	9,987	863
Heritage & cultural assets	11,861	11,975	-114
Other non-financial assets	5,620	5,724	-104
Total non-financial assets	248,055	241,835	6,220
Total assets	1,000,147	838,922	161,225
Liabilities
Interest bearing liabilities
Deposits held	14,214	5,488	8,726
Government securities	683,915	725,868	-41,953
Loans	28,566	18,960	9,606
Leases	31,964	32,476	-512
Other int bearing liabs	11,398	10,331	1,067
Total int bearing liabilities	770,057	793,123	-23,066
Provisions & payables
Superannuation liability	407,506	431,077	-23,571
Other employee liabs	39,970	34,425	5,545
Supplier payables	13,868	11,914	1,954
Personal benefits payable	3,015	4,670	-1,655
Subsidies payable	976	1,027	-51
Grants payable	6,821	2,859	3,962
Other payables	3,049	4,027	-978
Other provisions	60,820	72,104	-11,284
Total provisions & payables	536,025	562,103	-26,078
Total liabilities	1,306,082	1,355,226	-49,144
Net worth represented by
Accum losses and reserves	-743,220	-679,903	-63,317
Equity	437,285	163,599	273,686
Total net worth	-305,935	-516,304	210,369

 

In the 2021 year, by treating reserves and issued currency as de facto equity in the Australian government, its net worth/equity position improved by $210 billion for the year during the pandemic recovery year.

The rosy picture painted for 2021 with reserves treated as equity will likely change when the repurchase arrangements which led to banks transferring bonds and assets to the RBA is triggered. RBA holdings of these financial assets will reduce as will reserve a/cs. The net worth of the government as presented in the unadjusted consolidated a/cs won’t change.

The point of reclassifying currency and reserves as equity is to demonstrate that government spending should not be regarded as debt, as a burden on future generations.

Money creation by government

Every time the Australian government spends, reserves are created.

When people spend, reserves get passed around the system from bank to bank. The total of bank reserves, a liability at the RBA, doesn’t change.

Reserves only reduce under two scenarios.

First when Australian government taxes are paid.

Second when governments issue bonds. When green dollars are swapped for yellow dollars. It’s done for several reasons, some more convincing than others.

Bonds are a useful tradeable asset for players in the financial sector, and gives the RBA a way to influence interest rates

The least convincing reason, that GG needs to have money in the bank before spending, is based on the budget constraint myth. If GG doesn’t have enough funds on hand, then it needs to borrow reserves from banks. That’s what the budget constraint myth implies. Reserves need to be swapped for bonds before spending. This is the myth which underpins most peoples’ understanding of the government budgetary process.

‘Green dollars’ need to be swapped for ‘yellow dollars’ so the government can create more ‘green dollars’.

It’s a fairy story.

As we saw above with Table 1, 2 & 3 the outcome is the same regardless of whether the government had money in the bank.

All that happens is that reserves (a liability but not a debt) is swapped for bonds (a debt). 

The budget constraint myth asserts the governments have to borrow back  reserves they’ve created before they can create more. 

As Warren Mosler explained citing Ben Bernanke:

The Chairman of the Federal Reserve Bank is telling us in plain English that they give out money (spend and lend) simply by changing numbers in bank accounts. There is no such thing as having to “get” taxes (or borrow) to make a spreadsheet entry that we call “government spending.”

We need to be careful however when using the term ‘creating money out of thin air’ (I’m as guilty as many in that regard) because as soon as people hear the phrase they immediately assume reckless behaviour.

It’s not at all like that, it’s simply the way money creation in a modern economy works. Governments do it. So do private banks.

How the newly created government money enters the system is best seen in RBA’s cash flow statement. The 2021 cash flow statement is as follows:

Pretty simple.

New deposits are created and more currency issued on the liability side.  More bonds and financial assets on the asset side.

Money creation by private banks

Banks create money in a similar fashion to governments. Extra loans to customers on the asset side and extra deposits from customers on the liability side.

The reality of how money is created by private banks has gradually gained currency ever since the Bank of England’s seminal 2014 paper on money creation  pointed out the precept that banks require deposits before lending was false.

A closer look at banks’ financial statement confirms how banks account for money creation in their financial statements.

Take Commonwealth Bank (CBA) as an example. Its 2021 cash flow statement is quite revealing, summarised below to make it more accessible:

Chart 14: CBA cash flow statement 2021
	$m
OPERATING ACTIVITIES
Operating cash
Interest received	25,203
Interest paid	-6,424
Other op income  received	4,775
Expenses paid	-9,886
Income tax paid	-3,672
Insurances business net	145
Total operating cash (net)	10,141
Changes in op assets & liabilities
Incr deposits & other public borr (net)	61,189
Increase loans etc	-39,858
Increase repos (net)	2,441
Other changes net	7,399
Net cash from changes in op assets & liabs	31,171
Net cash from operating activities	41,312
INVESTING ACTIVITIES
Disposal controlled entities	682
Purchase other assets (net)	189
Net cash from investing activities	871
FINANCING ACTIVITIES
Dividends paid	-4,132
Debt securities (net)	-31,756
Term funding RBA	50,357
Loan capital (net)	4,183
Principal payments of lease liabilities	-428
Other financing	87
Net cash from financing activities	18,311
NET CHANGE IN CASH	60,494

 

Under Operating Activities, revenue (interest and other income) is offset against interest paid, expenses and income taxes, which produces Total operating cash(net) of $10.1 billion. This represents the revenue and expense side of operations.

The money creation side of Operating Activities is listed under Changes in operating assets and liabilities. The yellow highlighted bits show the major items, $61.2 billion (net) extra deposits (liability) and an increase in loans to customers (asset) of $39.9 billion. Essentially this demonstrates how loans create deposits. Deposits aren’t a prerequisite for loans. The reverse is true, loans create deposits, contrary to popular belief.

Investing Activities are small given the scale of CBA…...buying new plant equipment, intangibles, disposing of old stuff, selling off non-core parts of the business. For 2021 this represented a small inflow in total.

Under Financing Activities can be found the ins and outs of financing the bank’s operations. Not funds for lending, for they are created under Operating Activities, rather funds to square up CBA’s books to ensure it satisfies prudential requirements. 

Financial Activities for the 2021 year showed a $18 billion net inflow as the Term Loan funds from the RBA flowed in which were used in part to discharge $31.7 billion of existing debt securities.  (as an aside, the net fall in debt securities disguises the reality that CBA and the other major banks bought each other’s debt securities to satisfy prudential requirements. Were consolidated financials prepared for the bank cartel there would be an elimination of the cross holdings of reserves/debt securities. More evidence the RBA operates for the prime benefit of banks maybe?)

The rise in overall cash of $60 billion overstates the increase in CBA assets, as assets transferred to RBA as collateral for the Term Loan facility were not recorded in the cash flow statement. Note: CBA net assets only improved by $6.78 billion for the year.

The following is a snapshot of CBA’s balance sheet for 2021 and 2020.

Table 15: CBA balance sheets  2021 & 2020
	2021	2020	change
	$m	$m	$m
Assets
Cash and liquid assets incl reserves	100,041	44,165	55,876
Loans and other receivables	811,356	772,980	38,376
Investments & other fin assets	154,342	170,099	-15,757
Other assets	26,223	28,227	-2,004
Total assets	1,091,962	1,015,471	76,491
Liabilities
Deposits	766,381	703,432	62,949
Debt/borrowings	103,003	142,503	-39,500
Term funding RBA	51,856	1,500	50,356
Other fin liabilities	45,926	50,673	-4,747
Provisions	3,733	3,461	272
Other liabilities	12,985	14,607	-1,622
Loan capital	29,360	27,357	2,003
Total liabilities	1,013,244	943,533	69,711
Shareholder's equity	78,718	71,938	6,780

 

It’s a simplified version of the statutory a/cs, but it highlights what banks do and what CBA did in particular.

In 2021 80 per cent of CBA’s assets were customer loans ($811 billion). The rest mainly comprises cash and other investments.

On the liability side deposits from customers represented 75 per cent of the total with the remainder mostly comprising debt (wholesale funding), term funding of $51 billion from the RBA, loan capital (from investors) and other financial liabilities.

Unlike politicians after winning elections, one never hears from newly promoted bank CEOs rueing the legacy of debt left by predecessors. Most get the job because they plan to increase debts.

Yet governments are pilloried for what is considered virtuous entrepreneurial behaviour by banks.

There are far more similarities in the way banks create money compared to governments, than there are differences.

 

Money creation and government spending: Key points

Just as many were slow to accept the underlying science of climate change, so too are many reluctant to accept the accounting realities from observing how financing modern economies occurs.

·        Bank loans (bank assets) create deposits (bank liabilities).

·        Loan repayments reduce deposits.

·        Existing deposits aren’t lent. From a bank’s perspective they are needed to balance up customer loans on the other side of the balance sheet.

·        Government spending creates reserves and increases private assets.

·        Taxation reduces reserves and private assets.

·        Replenishing the government’s bank a/c at the RBA is not essential before government spending occurs.

·        The position of the consolidated government is the same after spending, regardless whether the GG has funds at the RBA, or is granted an overdraft facility by the RBA or raises funds with a bond issue which is then acquired by the RBA and written off.

·        Bank reserves aren’t lent. They are assets transferred from bank to bank as part of settlement procedures.

·        Reserves only exist because banks operate as intermediaries in the payments settlement system.

·        If everyone had an a/c with the RBA there wouldn’t be any reserves.

·        Paying interest on reserves is optional.

·        Reserves are RBA liabilities for accounting purposes, but they are not debts that need repaying.

·        Swapping reserves for bonds is optional and is done partly for monetary policy reasons and partly as a favour to banks.

·        Budget repair implies government surpluses which will reduce private assets

·        Most money is created by private banks making loans not by government spending.

·        If new loans exceed loan repayments, then money in the economy will keep growing.

·        Taxation serves other purposes in an economy other than providing funds for spending.

The budget constraint myth stifles sensible government spending.

There are mutterings about tax reform. There always are. It will happen at some stage. But we can’t wait for that to happen pretending when it does occur, we’ll be able to spend a little more on where it’s needed.

We can’t afford to wait that long.

But like climate change, the clock is ticking towards midnight.

Yet our political leaders keep ignoring the problems and make little attempt to understand how the system works, relying instead on outdated platitudes.

What does this mean for State governments?

The term ‘government’ used thus far has related to the Australian government unless otherwise specified.

If we were to include the governments of States and Territories, and local governments, we would have a consolidated government sector for the whole Federation.

As we saw above, the position of the consolidated Australian government is the same after government spending, regardless whether the GG has funds at the RBA, or is granted an overdraft facility by the RBA or raises funds with a bond issue which are then acquired by the RBA and written off.

It therefore follows that the public sector as a whole across Australia can pursue the same approach.

It only needs a tweak in Federal State relations.

The Australian government needs to share the money creation advantages of the RBA that it has used as part of various pandemic response measures, with the States.

It’s the only way States will be able to deliver the services people need.

In Tasmania the 2016 Fiscal Sustainability Report showed the massive problems ahead for the Tasmanian government, with projected revenues falling well short of outlays. The gap between services delivered and those needed will inevitably widen.

The 2021 update was even bleaker. The first real admission by governments was in Treasurer Ferguson’s 2022/23 Budget speech on May 2022 when he told Parliament he’d “tasked Treasury with providing advice to me on strategies to ensure our debt levels remain within manageable limits into the future so we can again use our balance sheet to shield Tasmanian jobs and families should external shocks to our economy occur in the future.”

Debt levels have to manageable, so the Treasurer says.

We are such a long way from doing anything about raising State taxes in Tasmania if the bogus economic arguments used in the last six months to bestow favours on poker machine operators and cut land tax, are any guide.

Which leaves more debt as the only other option currently on the table.

Budget reporting by State governments is also misleading. Budget bottom lines always focus on a profit figure, which is pointless when sustainability is questionable, cash is scarce and service delivery falling further behind, except maybe in WA. The bottom line of the cash flow statement is much more significant.

Furthermore, States report capital grants from the Australian government as revenue in their P&Ls which ignore capital outlays.

For such a small country as Australia making sense of the fiscal sustainability of the Federation is harder due to the lack of consistency between States and the Australian government.

To put this into its proper perspective, the Australian government currently produces cash deficits every year, which will continue into the foreseeable future, and must borrow to make capital grants to States, thereby increasing losses and reducing its equity, whilst the States record the grants as income, ignoring the subsequent outlays.

It has led to the absurd situation where Tasmanian Treasurers skite about profit surpluses and hoped for surpluses in the not too distant future, whilst running cash deficits propped up by capital grants from the Australian government funded by borrowings.

It’s not a sensible basis to make sensible decisions about the Federation.

Capital grants to States (plus some to Local Governments) total about $20 billion per year in Australia. So, it’s not small beer.  A large chunk of Australian government accumulated losses are due capital grants to States.

Capital grants from the Australian government are, for all intents and purposes, equity contributions from a parent company into members of a Group.

We need to view the Federation in that context. The Federation is a Group, wholly owned by the people of Australia.

There is no evidence that spending on essential services is what’s causing current inflation. The culprits are Putin’s war, supply disruption in China, floods and the pricing power of some monopoly suppliers.

If spending on more essential services won’t exacerbate inflation and State governments are the pre-eminent service delivers, and there are ways to spend internally generated funds which won’t burden future generations with debt, why aren’t we doing it?

RBA Governor Lowe has pointed out that the RBA buying government bonds including bonds issued by State government is not supposed to signal a way for governments to finance operations. He’s implying that government consolidated financial don’t mean what the figures suggest. What do they mean then?

There’s a hint that quantitative easing, bond purchases, will be reversed. Quantitative tightening as it has been labelled will occur at some stage. When hasn’t been determined? The RBA makes it up as it goes, methinks.

If more reserves are needed back in the system, why sell the bonds? So banks can be rewarded with more interest on their reserve a/c balances?

Why not create more reserves with more properly targeted spending, provided of course there’s a need and resources are available?

Or perhaps make the payments direct from the RBA to State governments say, bypassing Australian budget arrangements?

It’s not within RBA’s mandate to look after the States, so they don’t bother too much. Behind the noble aims enshrined in statute, RBA is a bank which tends to be run for the benefit of private banks.

We’re constantly told we can’t spend too much.  It’ll be inflationary and there’s already a trillion dollars of debt.

Stockholm syndrome is rife. We have become hostages of a system that serves a privileged few.