By Brian Fallow*
Next month’s budget will foreshadow very large increases in Government spending over the forecast period, which raises the obvious question: where will the money come from?
The three options are (a) tax, (b) borrow and (c) just print it.
It is inevitable that a legacy of this time of peril and pestilence will be an increase in the future tax burden. An important debate needs to be held about how best to expand the tax base, render it more progressive and, hopefully, eliminate current distortions.
But a severe recession is not the right time to be raising taxes.
At the moment the difference between options (b) and (c) is somewhat fuzzy, because the Reserve Bank has embarked on large scale asset purchases (quantitative easing) for monetary policy purposes at the same time that the Treasury is undertaking large scale debt issuance for fiscal policy purposes.
It is a convenient overlap.
To the extent that the Reserve Bank’s buying of government bonds matches the scale and pace that New Zealand Debt Management (the Treasury) is issuing them, the net effect is that money newly created by the central bank flows, via a swift detour through the secondary bond market, into the Government’s bank account.
It gets the money it needs to disburse on useful things like nurses’ salaries, jobseekers’ support and infrastructure, while the central bank gets a pile of government IOUs, longer-dated than its normal stock in trade.
From the taxpayer’s point of view it is important that the bonds are held by an entity which is part of the core Crown rather than the normal holders, private sector institutional custodians of people’s savings.
It means coupon interest payments which flow across the Terrace from the Treasury to the Reserve Bank can be spun around and sent back as a larger dividend to its owner.
Likewise if the bank is sitting on a capital loss if it holds a newly issued bond to maturity which it has bought at a premium to its face value, the corresponding profit has accrued to its owner, the Crown.
These are transactions between two pockets in the same pair of trousers and should not bother anybody.
To the extent the bank’s bond buying matches the Treasury’s bond issuance, it is a means of monetising the deficit.
It is not how adherents of Modern Monetary Theory would like to see it done. The central bank should bypass the market, they argue, just create the money and give it to the Government with no obligation to repay or any other strings attached.
But in practical terms it is not all that different. In theory QE allows the Reserve Bank to later sell down its bond holdings into the market, withdrawing money from the system in the process -- running the shredder, one might say, instead of the printer.
And if the economy were running hot and inflation threatened, that would be useful thing to do.
In practice, however, where other central banks have undertaken quantitative easing there has tended to be a pretty sturdy ratchet under their bond holdings.
The experience of the US Federal Reserve is telling in this respect. When it started doing QE in September 2008 it had a balance sheet of around US$900 billion. Six years later it had increased to US$4.4 trillion.
It stayed at that level for three years and then over the two years to September last year, while the US economy was going strong, it reduced by just US$600 billion or 14% before climbing again – almost vertically lately – to US$6.4 trillion a week ago.
So pretty much one-way traffic.
As the BNZ’s interest rate strategist Nick Smyth puts it “If the central bank rolled over its QE bond holdings continuously (reinvesting the proceeds of maturing bonds), which is the default position we seem to be in at present, there’s little distinction with direct monetary financing.”
There was an instructive exchange between David Seymour and governor Adrian Orr when the latter appeared (virtually) before Parliament’s epidemic response select committee last Thursday.
Seymour raised the question of what would happen when the time came for bonds to be redeemed. “I suspect politicians here as elsewhere will find it more attractive to tax less and spend more and roll over the bonds ad infinitum,” he said.
“In that case is it a tax on people who have New Zealand dollar savings, who find that their share of the New Zealand dollars in the world is less, and the goods and services they wish to buy cost more because you have inflated the currency?”
Orr replied: “Yes over time Government debt will either be paid back or rolled over. Since the days of Julius Vogel we have owed somebody something. Fortunately this time we start from a very low debt to GDP position and, judging from what we are seeing, we are going to get back to an average historical position.
“What we [the Reserve Bank] are doing is transferring those long-term IOUs into short-term cash. We are doing it through the secondary market, not buying it directly off the Government…It is a way of effectively monetising, or creating the cash for people to spend.”
The bank could do that without fear of inflation if it was during times, like now, when there was a significant negative output gap when demand was way below sustainable potential growth, Orr said.
His point is that what would be inflationary if the economy’s resources were fully employed, is necessary when instead it is caught in a deflationary rip. Falling inflation expectations push real interest rates upwards, the opposite of what is required right now.
The large scale asset purchases are being done purely for monetary policy purposes, Orr said. “With low nominal interest rates if we weren’t doing it we would have significant deflation, which brings a whole new set of challenges.”
It should not, in short, be seen as compromising the bank’s autonomy or price stability mandate.
That leaves the empirical question of to what extent its bond buying will match the scale and pace of the Treasury’s debt issuance.
Since mid-March when the Government announced its initial fiscal support package the bond programme for the 2019/20 year has been increased by $15 billion to $25 billion and the expected increase in Treasury bills by $4 billion.
With droll understatement the Treasury adds that “It is anticipated that increases to programmes for future years will be necessary relative to those published at the Half Year Economic and Fiscal Update 2019.”
The Reserve Bank for its part announced on March 23 it would be undertaking $30 billion worth of QE over the next 12 months, to which it has subsequently added $3 billion of purchases of local government debt.
No-one expects it to end there. “On the monetary stimulus side all I can say is at most we are at the end of the beginning around what may need to be done and what we can do,” Orr told the select committee.
“We did the $30 billion QE because that was about 30, 40% of the Crown debt on issue. ” It equated to 35% of central government debt securities on issue at the start of March.
“And we don’t want to crowd out the rest of the market by being the only participant. But as that opportunity grows so does our ability to continue the quantitative easing.”
Both the Government and the central bank have emphasised the importance of maintaining the efficient functioning of the secondary bond market in all this.
That is an important consideration. When a lot of New Zealand government bonds are owned offshore and there is a non-trivial risk that a gruesome global slump will trigger Global Financial Crisis II, the sequel, there is a clear financial stability case for the bank to support the market, on top of the objective of trying to keep long-term benchmark interest rates low.
If the bank sees 40% of the stock of bonds on issue as some kind of upper limit before crowding out becomes an issue, then as a matter of simple arithmetic if the stock of bonds on issue were, say, to roughly double from 25 to 50% of GDP, it could buy up 80% of the increase before reaching that level. That would require roughly doubling its QE “budget”.
Beyond that point direct monetary financing -- currently a barely discernible dot on the horizon of possibility -- might well loom larger as a prospect.
In an interview with interest.co.nz Finance Minister Grant Robertson, when asked about the option of a more direct bilateral financing arrangement with the Reserve Bank, opened the door a crack towards that possibility.
The current system was providing the amount of financing the Government needed. “I’m comfortable for it to continue to be the way that we work,’’ he said.
“Obviously we keep it under review. If we don’t believe it’s working or if the amounts of money that are required turn out to be such that they can’t be sustained through the secondary market…then of course we would look at that.”
*Brian Fallow is a former long serving economics editor at The NZ Herald.
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