Why Banks as Intermediaries?

Last time we saw that banks act as intermediaries between the Morrison Government and the Reserve Bank of Australia, Australia’s central bank. Although banks acquire the bonds the Government issues, the RBA is their ultimate purchaser. The banks, however, get interests for that.

The RBA could have chosen a different scheme. For instance, it could have funded the Government. But that’s not on, as David Taylor adds. Why not? What service those banks provide?

Let’s try to understand that.

In a follow-up piece (“Coronavirus Chaos has hit the Economy and the RBA’s Approach to Money Printing is Supposed to Save it”), Taylor answers “a flood of emails, texts and calls” about the original article:

1. “What are bonds?”
2. “Is there a limit to how much money the RBA can create?”
3. “For how long can it occur?”
4. “Doesn’t money printing lead to hyperinflation?”

Judging by that list, I’d bet many of those contacting him (unlike most politicians, experts and journalists) do remember the set of standard objections to fiscal deficit spending.

Although Taylor doesn’t mention MMT at all in his pieces (which is kind of surprising), I’d also bet local MMTers may have also contacted him, as they are very vocal about those subjects (I myself didn’t, but then again, I ain’t no MMTer).

Anyway, some quibbles aside, Taylor’s answers to those questions are clear and direct. For example, the shorter answer to question 2 is no.

So far, so good.

Towards the end of the article, however, things go a bit off the rails. There Taylor tackles a fifth question (“doesn’t it [the debt the bonds represent] have to be ‘paid back’ at some point?”) and a couple of closely related questions (“why can’t the Reserve Bank just write off the debt?” and “why can’t the RBA just buy the bonds directly from the Government?”).

Taylor believes those issues are difficult to understand. I could be mistaken but I believe there’s more at play than that.

Take his answer to “why can’t the RBA just buy the bonds directly from the Government?”:

“By putting the private sector between the Government and the Reserve Bank, you create a crucial buffer. It means the Reserve Bank can’t simply write off the debt (which would compromise the integrity of the entire monetary system). It’s not even tempted to do that.”

Taylor’s choice of words is unfortunate. “Integrity” is not the first thing most Australians associate with finances and Banks (and financial institutions, domestic and foreign). :)

More seriously, when precision is vital, his language becomes vague. QE doesn’t put the “private sector” between anything. It puts Banks. Part of that confusion Taylor writes about may be of his own making (we’ll find another case soon).

So, for clarity’s sake, let’s stick to our original cast of characters: Government, Banks and RBA.

So, suppose RBA decided to write off the Government debt those bonds represent (remember: RBA bought those bonds from Banks, which means that few or no bonds should remain in the balance sheets of Banks). It isn’t obvious to me why that write-off should compromise the integrity of Banks.

Readers may object that here Taylor introduced the “entire monetary system”. What about its integrity?

Well, that question is even harder to answer. The first thing would be to define what the “entire monetary system” actually is. Unfortunately, Taylor didn’t do that. It would also be necessary to spell out how that integrity would be compromised, which Taylor didn’t do either

More importantly, however: by abstaining from buying those bonds directly from Government, RBA allows Banks to get involved as intermediaries. Why allow that if Banks’ mere involvement is a risk to their integrity?

Vagueness is a bitch.

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I, of course, can’t speak for those who contacted Taylor. On my own behalf I say that the problem is not that I don’t understand his argument, but that I don’t find it persuasive or satisfactory.

Perhaps it’s matter of language. But the burden of clarifying his ideas is his, not mine.

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Let’s try a different explanation. Remember our scheme.

Although the red and blue labels look exactly the same, in reality they aren’t. When Banks buy the bonds from Government, the end result in Banks’ balance sheets is simply an asset swap: Banks started with money but no bonds; they end with bonds but no money. One kind of assets (money) turns into another (bonds). Whatever financial effects on Banks’ financial position, their assets and liabilities do not change: net equity is not affected.

Things with RBA are somewhat different. The “blue” money RBA uses is in reality “central bank reserves”. Unlike the “red” money Banks used, central bank reserves are not assets in RBA balance sheet. They are liabilities. RBA balance sheet remains in balance (i.e. net equity does not change), as in the case of the Banks, but that’s because liabilities and assets change in the exact same measure.

That’s the crucial difference.

The fundamental equation of double-entry accounting (Net Equity = Assets – Liabilities) may provide additional insight.

When Banks buy $100 worth of bonds using its limited cash this is what happens:

Net Equity = [Assets + (-$100+$100)] – Liabilities.

You scratch one asset (cash) and write down another (bond).

But when RBA buys $100 worth of bonds using their unlimited “central bank reserves”:

Net Equity = (Assets + $100) – (Liabilities + $100).

You add to assets (bond) and to liabilities (central cash reserves), so the list of assets and liabilities gets longer: “balance sheet expansion”.

Paraphrasing Taylor: by putting Banks between the Government and the Reserve Bank, you create a bottleneck in the flow of bonds the Government can issue, for the cash Banks own is strictly limited. It means the Reserve Bank controls the tap of funding: it can increase or reduce that flow at its discretion. As a bonus, you make Banks richer and we need to pay the debt.

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ABC journalists have a reputation for asking difficult questions. It’s well-earned. We’ve all witnessed fiery interviews where Kerry O’Brien, Leigh Sales, Tony Jones, Barrie Cassidy, Virginia Trioli, among others, demand answers from reluctant and even hostile interviewees. Andrew Probyn is the latest example.

It’s a proud reputation, too, for they are acting in the public interest. And the public needs to know why we are being burdened with an unnecessary debt measured in several hundred billion dollars and which will take decades to repay.

So I will suggest next time ABC journalists interview Philip Lowe they ask him questions about this fragment of his speech:

“A third side-effect is a possible blurring of the lines between monetary and fiscal policy. If the central bank is buying large amounts of government debt at zero interest rates, this could be seen as money-financed government spending. In some circumstances, this could damage the credibility of a country's institutional arrangements and create political tensions. Political tensions can also arise if the central bank's asset purchases are seen to disproportionally benefit banks and wealthy people, at the expense of the person in the street.”

Questions like these: What’s the problem with blurring the lines between monetary and fiscal policy, exactly? Or with money-financed government spending? What are those circumstances when money-financed spending could damage Australia’s institutional arrangements? Has the RBA taken into account the political tensions the need to repay an unnecessary debt will create? Why shouldn’t the person in the street be concerned about wealthy people and banks earning interests, when the RBA could have replaced them without any demanding repayment?

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Sorry to play the party pooper, David, but having Banks fighting among themselves to buy Australian bonds may prove to be a costly source of national pride.