Tuesday 12 May 2020

Sometimes Consistency is Costly.

In the previous post we discussed how COVID-19 changed the economic discourse about fiscal deficit spending. Here we’ll attempt to gain a deeper insight from that.

As argued previously, last March politicians, experts, journalists, and businesspeople muted their usual objections to large fiscal deficit spending. No argy bargy, no talking heads on TV formulating Very Serious (™) warnings. It’s almost as if the notions of inflation, crowding out and free markets had been magically forgotten.

Another usual stumbling block laid on the way of fiscal spending (namely the question “how will you pay for that?”) fared better, but only slightly. That I am aware, nobody seem to have asked that question when the measures were announced or when they were presented and approved in Parliament. Nevertheless, soon afterwards commentators began asking that.

Those commentators, I suppose, decided for belated consistency. Just like gloating sometimes can be justified, consistency can be fatally costly.

That’s why on April 7 the ABC’s David Taylor came forward to answer that question. The title of his piece (As Part of its Coronavirus Response, the RBA is Creating Money Out of Thin Air. Here’s How) gives its general gist.

Taylor’s goal is to correct the misleading expression “printing money”. The Reserve Bank of Australia is “printing money” to fund the Morrison Government’s response to COVID-19, he explains. With the caveat that I’m no MMT expert, I have no problem with that. Besides, Taylor also informs us, the RBA explains the same. Doubleplusgood, then.

But Taylor also sets out to explain how that fiat money, existing only in computer screens, is created. He spends much less time here. I suppose he finds the explanation the RBA Governor, Philip Lowe, delivered on November 26 (Unconventional Monetary Policy: Some Lessons from Overseas), sufficient.

The scheme above may aid understanding Taylor’s argument.

The Government, Taylor writes, issues bonds (he explains what bonds are) and sells them to Banks (actually, as he explained later, financial institutions, domestic and foreign). Those bonds grant Banks a stream of income (interests) and that’s why Banks are willing to buy them.

So far, what Taylor explains is standard neoclassical economics; indeed standard Keynesian macroeconomics.

The third box is where Quantitative Easing (QE), an unconventional monetary policy, enters. The RBA acquires those “second-hand” bonds from Banks in the secondary market. The RBA, Australia’s central bank, gives money in exchange for bonds, just like Banks did.

Taylor highlights an important detail: the RBA creates “out of thin air” its own money as “central bank reserves”. In other words, it applies QE.

Although there’s more to say about QE (and we’ll do that in the next post), it was at this point that Taylor left his exposition. We’ll follow him, because as it is it’s already sufficient to observe something that I hope is evident in that scheme: when QE is used, Banks are mere intermediaries. The RBA could have bought those bonds directly from the Government.

Taylor is not oblivious to that fact. Indeed, he writes: “If the RBA bought bonds directly from the Government it would, in effect, be directly funding the Government. And that's clearly not on.”

Banks get interests for acting as the middle-person (is that the PC appropriate term?). Why?

What service Banks provide to justify those interests? The usual answer, implicit if not explicit in standard macroeconomic textbooks (that the Government needs Banks’ money and Banks will only part with it in exchange for more money) does not apply in these circumstances.

The RBA is free to set any out of a number of arrangements. Why this choice? We’ll try to advance an answer in the next post.

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