This is a re-post of an article originally published on pundit.co.nz. It is here with permission.
This paper demonstrates the truism that for every financial liability is matched by an asset. A fiscal deficit creates a liability of the government. Somewhere outside government – somewhere in the private sector – there is a private asset matching this public liability.
This account tries to explain the rudiments of some monetary interventions through a set of scenarios. It focuses especially on what happens when the government runs a fiscal deficit. (Note the constitutional convention that the Treasury does not issue money; the RBNZ does.)
Scenario ONE - Financing a Deficit Directly (assuming there are no trading banks)
A government deficit means that the government is spending more money (in this scenario banknotes) than it is receiving. It has to acquire the banknotes. Typically (in this very simplified monetary system), it acquires the banknotes by exchanging them for government bonds, which amount to promises to repay the banknotes plus a premium (i.e. interest) at some later date.
This government debt effectively prevents the holder from spending the money injected by the deficit. The holder can only convert the bonds back into banknotes when they need them by selling them to someone else who has to give up banknotes they hold. Thus, roughly, the total amount of money/cash/banknotes in the system remain constant. In effect, the monetary injection from the fiscal deficit is ‘sterilised’.
The downside is that as the deficit increases, and so the government has to sell more of its bonds, it has to pay a greater premium (a higher interest rate) to get people to hold the increasing quantities of bonds. Thus, the base interest rate of the economy increases, which lifts all the interest rates in the economy. There are investment and distributional consequences while the fiscal burden on future generations is increased by the higher debt repayments.
Observe that the public-debt-to-GDP ratio will rise.
Scenario TWO - Financing a Deficit by Reserve Bank Purchasing the Government Debt (still assuming there are no trading banks)
While the Treasury cannot issue banknotes, the Reserve Bank can. A second way of the government acquiring the banknotes it needs, is that instead of selling its debt to the public it sells it to the Reserve Bank. In effect (when there are no trading banks), the RBNZ goes to its vaults where there are stacks of banknotes and exchanges some with the government for the government debt. The government then uses the cash to pay for its excess spending.
Observe that a banknote is, in effect, a deposit in the RBNZ. (As an aside, during times of financial crisis, as in the GFC, there can be a ‘run’ on the trading banks when the public takes its deposits out of the trading banks and converts them into banknotes – de facto deposits with the Reserve Bank.)
As a consequence of these transactions between the Treasury and the Reserve Bank (they can be called ‘quantitative easing’), interest rates need not rise.
However, the downside is that the public now holds more cash. So, the money creation of the deficit injection is not sterilised.
The bigger the deficit, if it is funded in this way, the more banknotes the public holds. While some banknotes are still needed for day-to-day transactions (and also for nefarious activities such as drug dealing), given a large ongoing deficit, the private sector will eventually have more banknotes than it wants to hold.
The next stage is explored in the next scenario which has trading banks.
Observe that because the Reserve Bank is consolidated into the government accounts, quantitative easing does not reduce the government debt-to-GDP ratio. However, the composition of the government’s liabilities changes.
Scenario THREE - Financing a Deficit by Reserve Bank Purchasing the Government Debt when there are trading banks.
This scenario focuses on the role of trading banks. It disregards finance companies, treating them like other companies (such as Fletchers) which sell bonds to the public and uses the proceeds for investment purposes. An exchange of banknotes for a corporate bond still leaves the banknotes in the private non-banking sector.
What distinguishes the trading banks is that they provide the payment system (illustrated by finance companies, as well as Fletchers, having accounts in trading banks), and also that they have the privilege of recourse to the Reserve Bank’s ‘discount window’, a central bank lending facility, which helps the trading banks manage their short-term liquidity needs.
Scenario Two left the system with people holding more banknotes than they wanted. Their easy option is to deposit the banknotes in the trading banks in return for interest.
What are the banks going to do with all this extra cash on which they have to pay interest? There are numerous possibilities; here are some major ones.
The most obvious arises from banks making their profits and covering their depositors’ interest payments by advancing credit to investors. However, the fiscal deficit usually arises because that there is insufficient private sector demand including for private investment.
A second option is that the trading banks might invest the deposits in (low interest) government bonds. The effect is back to scenario one. The government is funding its deficit by selling bonds to the private sector, using a circuitous route through the trading banks. This may not be very popular as far as the banks (or, rather, their depositors) are concerned, because of the public bond’s low interest rate.
A third option would be to repay some of the overseas debt the banks hold. Reducing overseas debt seems a good idea except what is actually happening is that the overseas lenders are swapping one sort of asset (loans to trading banks) with another (New Zealand banknotes). But why would foreigners want to hold New Zealand banknotes? They will exchange the banknotes for a foreign currency.
Who will want to be on the other side of the deal? Typically, the New Zealand private sector. Why would they want to exchange their foreign currency for New Zealand banknotes? Exporters would because they earn in foreign currency but need to convert their earnings into New Zealand currency. But there are also import purchases which use foreign currency but sell in domestic currency, so they need to exchange in the opposite direction. What this suggests that is that unless New Zealand is running a current account surplus (including covering debt servicing), there will not be sufficient New Zealanders willing to acquire the local currency that the foreign borrowers want to sell off.
What happens next gets very complicated. It includes the possibilities of the exchange rate falling or of further overseas borrowing. I leave it here. (An easy analytic solution is to pretend the economy is closed – a simplification which hugely disconnects analysis from reality.)
Note that while I have treated all money as banknotes (and coins, but they hardly matter). In practice, the bulk of New Zealand ‘money’ is in current account deposits with banknotes making only a small proportion of the total. For instance, most government payments (for goods and services, salaries and benefits) are paid by transfers into a current account. I chose this simplification because banknotes are something tangible which readers can readily grasp. Had the analysis included all money (i.e., banknotes and deposits in current accounts) it would have followed much the same path, but it would have been an even more difficult one for the reader to follow.
The Analytic Conclusion
This paper illustrates an old truism: every financial liability is matched by an asset. In this case a fiscal deficit creates a liability of the government. Somewhere outside government there is a private asset matching this public liability.
Here endeth the fundamental conclusion, but for further economic analysis (including forecasting and policy) purposes we need to ask who in the private sector holds the matching asset. If they are willing to hold it, then no matter. But if the deficit injection is large and prolonged and interest rates are low, many of the holders of the government-generated highly liquid assets (call them ‘money’) will want to dispose of much of what they hold.
We need to trace and explore where the private sector assets end up, identify where they may have the most unfortunate consequences and take measures to mitigate those effects – to ‘sterilise’ the money. Given the expected size of the fiscal deficit over the next few years this is will be a major task.
Any monetary commentator who ignores this matching of public liabilities with private sector assets is not telling a complete story. Too many also ignore the foreign sector. Any story they tell sounds plausible only to the superficial.
Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.