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Economist Brian Easton points out that a fiscal deficit creates a liability for the government. Somewhere outside government in the private sector there is a private asset matching this public liability

Economist Brian Easton points out that a fiscal deficit creates a liability for the government. Somewhere outside government in the private sector there is a private asset matching this public liability

This is a re-post of an article originally published on 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 It is here with permission.

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"every financial liability is matched by an asset"
Or put it another way "Debt NEVER goes away, it just gets transferred".
Creating more of it, without tangible backing, is lunacy. And here's why: "where they may have the most unfortunate consequences and take measures to mitigate those effects". Looking for the horse after opening the barn door yourself and whipping the animal into the open and then trying to mitigate the problem is, as I suggest, lunacy.

So what happens when someone pays back their bank loan? Where does the debt go?

The outstanding debt is transferred back to the lender under repayment.
As banks can only make money from continuously lending, in all likelihood it will re-lent.
The alternative to not re-lending is for the debt to be 'repaid' to itself (the bank) as a reconciliation of asset created (the original lending) to liabilities created; a reduction in the amount of credit the bank has created, or repayment to another financial institution that itself has provided the liquidity to the originating bank.
That is one of the reasons that "the lower % rate go, the less banks can make". Any full repayment of a loan leaves the lending banks books balanced and square, except for the amount of Interest Received that is kept as it's transactional profit, and lower the nominal rates are, the less it will make.

Well the CEO gets paid $5-10 million a year...and the executives get paid a few million...

It get extinguished.

All money is created as debt, when debt is repaid money ceases to exist and one persons savings is created by anothers debt. Government debt is a record of the money that it has created through its spending but hasn't taxed back and cancelled, It becomes the net financial assets of the private sector and is held as our savings.
Reducing government debt must also reduce the net savings of the private sector. Look up Sectoral Balances online for further explanation and Modern Monetary Theory explains all of this in a more coherent manner than this article does.

All fiat money is created as debt. Just depends how long people want to continue to have faith that those debts can be paid. And if that faith fails, then it will be a mad rush to get rid of that debt off your books, then you'll question what the value of that fiat money actually is while the central bank to continues to pump more of it into the system.

Modern Monetary Theory isn't accepted as widely as its name suggests.

Orthodox economists live in a fantasy world of their own making. They believe in a theory of loanable funds where savers lend to borrowers to finance economic activity. They have no theory as to where the savers obtained this money though, in their minds it is created through a form of economic barter. They do not understand that only the banks and the government can create money.

As I understand it, right now the Government, via the Treasury, is selling bonds on the open market.
However, the Reserve Bank is very active in those markets buying the bonds.
So, the 'Greater Government' is buying and selling bonds to itself but doing so through secondary markets.
The low interest rates on these bonds are determined by the bids that the Reserve Bank makes for these bonds.
So, the somewhat mythical 'Core Government' (excluding the Reserve Bank) has been financed by the Reserve Bank.
All other things being equal, then once the 'Core Government' uses those funds either to buy services from the private sector, or to provide various forms of helicopter handouts, then we have quantitative easing, and this increase in the money supply will be inflationary.
But of course not all things are equal, particularly right now with the COVID-19 induced global depression.
However, once this depression is over, then there would seem to be significant risks at that time for inflation to 'take off'.
At that time the Reserve Bank could sell its Treasury bonds on the open market as an anti-inflationary measure. But it does not have to do so, and may chose not to do so given that its mandate also includes full employment. There seems considerable scope for inflation to take off while there is still considerable unemployment, and the inflation tool may well b the wrong medicine.

Linked to this, in the media we read a great deal about the OCR, but are not the Reserve Bank's activities in the bond market a somewhat greater monetary tool?
If there is a flaw in my thinking, I would love to hear it.

And here is another aspect of the same topic on which I would love to hear your views.
One of the tenets of monetary therory for a very long time has been that modest inflation is necessary to optimise economic growth, with this notion being originally based empirically on the Phillips Curve. But that curve was essentially derived from another time. My own perspective is that even expectations of modest inflation of say 2% or 3% lead to behaviours that misallocate resources. In the land-based sectors we have seen that expressed by the belief that farming has two components - cash and capital gain. Cash is required for survival but wealth is generated by inflation-led capital gain. And this became embedded at the heart of resource misallocation decisions. Would love to hear your views on these matters.

"an increase in money supply cannot cause a general increase in overall effective demand for goods. Only through an increase in the production of goods can this be achieved..... Once money is created out of “thin air” and employed in the economy it sets in motion an exchange of nothing for something. This amounts to a diversion of real wealth from wealth generators to the holders of newly created money. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy..... money cannot grow the economy even in the short-run. On the contrary, an increase in money only undermines real economic growth ."

"When it's over the Reserve Bank could sell its Treasury Bonds on the open market as an anti-inflationary measure."

The example of the Federal Reserve 2008 TARP program and QE issuance have been problematic. The TARP program is still partially outstanding and the QE issuance of $4 trillion still had $3.8 outstanding at end 2019. It is now up to $6.6 trillion.

Do you honestly believe NZ will be any more successful than the FED?
That stuff is baked in and will never be repaid. The only way it will disappear is by being inflated away.

Yet cpi inflation is negligible in all countries that have used qe. Eurozone, japan, us, uk.
The reason is the money supply itself is not the source of inflation. It's spending. And spending has been subdued.

:) look at house prices, share prices, bitcoin prices, photos of kittens and birds prices. We have had a massive inflation in asset prices globally. Even places like Sweden and Germany with their social housing models have been struggling with soaring house prices in the past decade. Ditto soaring debts (public, private etc).


Where's the inflation - its in the capital assets not measured by CPI.

How jolly convenient. And coincidental, of course.


Absolutely - as I posted earlier, this current form of capitalism has turned into a self licking icrecream cone where we pretend there is no inflation so we can drive interest rates to zero so a bunch of asset owners can feel wealthy for a while to fund their retirements.

It's not the base money supply growing that causes inflation. It's the spending. Deficit spending now is just replacing lost private spending. I doubt it will cause inflation. When things normalise reduce the deficit appropriately through a mix of lower spending and higher taxation. But don't worry about that too early.

Great article Brian. Interested in your thoughts on how fiscal spending interacts with taxation. For example, would you agree with the following:

Government, as the issuer of the currency, must spend first (credit private bank accounts) before it can subsequently tax (debit private accounts). Government spending is the source of the funds the private sector requires to pay its taxes and to net save and is not inherently revenue constrained.

Source: Bill Mitchell - Stock-flow consistent macro models.

How could it logically be any other way? Unless you are an amazing counterfeiter.

No it's not. Check this out here and here for a comprehensive overview.

Banks create credit where the assets and liabilities created cancel each other out, (horizontal money). Only the government can create currency, (vertical money) and only the government can create reserves and put them into the banking system.

Banks create new money when they lend, which can trigger and amplify financial cycles

The fact that banks create credit and money out of nothing which, if used productively, results in non-inflationary growth, is important for developing countries. Often it will not make sense to borrow from abroad in order to stimulate domestic growth: the foreign money does not enter the economy, and the country gets ensnared in spiralling foreign currency debt, when actually the foreign banks just created the money out of nothing, something the developing country could have arranged for through its own domestic banks. It also has implications for the question of who should pay for bank bailouts, shifting the pendulum from burdening tax-payers towards central bankers (Werner, 2012).Link


There were two major evolutions in money and banking that seem to fall outside the orthodox narrative. The first was a shift of reserves and bank limitations from the liability side to the asset side. The second was the rise of interbank markets, ledger money, as a source of funding rather than required reserve balancing: replacing the old deposit/loan multiplier model. Courtesy of J. Snider from Alhambra

Banks use double entry book keeping when they issue loans, they have the asset that they lent against on one side and the money loaned is a liability on the other side. No net financial assets are created.
This BOE bulletin may explain better.
An MMT perspective here.

Where does kindness wellbeing fit in to all this?

As a replacement.

When a large percentage of what believers (like Easton) think of as assets, turn out to be worth whatever an A4 with a bit of printing on it, is worth.

Economics, as taught, meet finite planet.

We could just tack on, "And dob in your neighbour wherever possible."

It's the new definition of kindness.

"Every financial liability is matched by an asset"

Except for bank loans created on a computer, where a loan is treated as an asset - ie a liability becomes an asset. That liability/asset is then leveraged 10 or more to one. Bank in fact has only 3% roughly of the loans extant, as capital. Otherwise known as a confidence trick

I almost thought Brian had injected a little sarcasm/comedy with this statement; "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." But then I realised he was talking theory only, without acknowledging that his theoretical system has broken down with the banks not paying much if any interest to anyone whose money they are using. In effect they are just taking it with little to no accountability.

The biggest problem I have with this is the trading banks creating money by loaning at some ratio of their deposits (capital ratio), and driving an imbalance in the economy. Brian's commentary suggests that a bank's liability towards a depositor must be balanced on the other side by an asset. But a depositor with $10,000 in the bank may result in assets on the other side of the ledger of $100,000 (CR of 10:1). So a borrower would have purchased an asset valued at $100,000 + (borrowing $100,000), but the bank's liability would only be $10,000 to it's depositor. Or do I understand this wrong?

Sorry , I beg to differ !

Governments simply dont have the money to do anything else , the bulk of their income comes from taxes on the productive sector .

And so what if some Government liabilities end up as someone else's asset ?

And in any event , not all Government liabilities are assets held some private concern

Take the toll roads, we have , there is a PUBLIC liability , incurred when the roads were built, likely funded with government issued paper

There is also a PUBLIC asset , in this case , the Toll road , which is an asset held for public good , like schools or hospitals or ACC

And then there is income attributable to the state from Tolls , ACC levies or administered charges for users , and so on

The same applies to much public debt , there is a liability matched by an asset , but to suggest that the asset is always private is just patently wrong .

In any event , the State is simply not able to fund everything in cash ( much like households buying a home or a car ) in the scenario we are facing after Covid , so private capital forms a major part of the solution .

Great article Brian...thanks!
Question, you mentioned ultimately the deficit would result in depreciated NZD or more foreign loans... be good if you or someone here could point out the scenario as I can only see end-game of NZD depreciated. This is because ultimately payment of foreign-currency loan will require exchange of NZD.... if less investors are willing to hold NZD then this must depreciate (as will any market asset). I guess maybe RBNZ could raise rates or Govt raise taxes but this will only further depress the 'deficit' environment the Govt found itself in the first place.

Regards, Michael

The NZ Government is not dependent upon the bond market, the government creates currency first through its spending and taxation and borrowing come afterwards. Borrowing does not in fact finance spending it lowers bank reserves for the purpose of maintaining the Reserve Banks interest rate settings.

Thank you Mr Easton.

I think this paper should be more widely published so the more conservative thinking people in our country can stop criticising the coalitions response to Covid and also better understand where the Key Government went so badly wrong in the post gfc, post Chch quake years. The economic damage caused by doing 'nothing' to stimulate the derailed regional economies, particularly, has been enormous. Usual story in this country being we won't change anything until a crisis forces us to...hopefully we learn from this and try to foster a intergenerational mindset shift to keep building and investing in our country instead of simply extracting profits...