Life after debt

By Nathan Waite -

Categories: Economics, Politics

Politicians love to whip up fear in the public. They live in a cartoon binary world of left and right, good and evil, and savers and debtors. This outlook helps politicians construct simple narratives which give our complicated social reality a sense of order but it leaves them unequipped to discuss economics with the public in any meaningful way.

One of the ways politicians scare us is by running fear campaigns about public spending and government debt levels. In particular they like to make comparisons between government budgets and household budgets. But this comparison is nonsense because as we’ll see the Australian Federal Government and Australian households are very different.

The switch to fiat

interest rate

One of the reasons for the float: interest rate volatility has stabilized since 1983 (click to enlarge). Source:

Australia switched from a fixed exchange rate system to a floating exchange system in December of 1983. Under the new system the Australian Dollar ($AUD) would “float” – increase or decrease in value – relative to the amount of goods the country exported and/or imported. As a traditionally high export/import oriented economy Australia was particularly susceptible to ‘terms of trade shocks’ under the old fixed exchange rate system, and it was anticipated that the impact of these shocks could be reduced by switching to a floating exchange system.

Aside from the buffer from external trade shocks the floating exchange offered, the switch also represents one of the most significant developments in Australia’s history because it meant that the country was now a sovereign monopoly issuer of its own currency.

Monopoly currency issuing powers is a feature of all modern fiat money systems and by uncoupling its currency from the value of other currencies or commodities in 1983 Australia had finally joined the club.

Financing Federal Government spending

The composition of the Governments annual spending 2014-15.

The Federal Governments annual spending on programs and services 2014-15. (click to enlarge). Source:

Both the Reserve Bank of Australia (RBA) and the Australian Office of Financial Management (AOFM) are tasked with handling Australian Federal Government agencies banking and payment needs. The Federal Government holds a group of accounts at the RBA called the Official Public Accounts (OPA’s) the total of which represents the Government’s daily cash position. The role of the AOFM is to ensure that the balance of the OPA’s are sufficient to meet the Federal Government’s day to day spending commitments (which amount to about $3 billion) and to invest any excess funds into approved investments.

Federal Government agencies simply debit money from the OPA’s and credit them into private bank accounts in the commercial banking system in the form of welfare payments, Medicare rebates, public sector salaries and payments to Government vendors (companies in the private sector who provide services to the Federal Government).

These payments then flow on into the private sector by creating demand for private sector goods.

But where does the money in the OPA’s come from?

The AOFM says the cash balance of the OPA consists of tax receipts (the taxes Australian citizens pay) and that any funding shortfalls are made up of debt issuance. This means that any of the Federal Governments spending commitments which cannot be met by tax revenue are met by Treasury Notes issued by the Federal Government.

A Treasury Note (more commonly referred to as a bond or security) is a mechanism used by the Federal Government to secure funding for programs and services. Treasury Notes are sold at tender to investors. They essentially operate as a loan from the Treasury Note holder to the Federal Government. In return the Federal Government must pay the value of the Treasury Note plus interest (i.e. the yield) once the loan has ‘matured’ (a period of generally under 6 months).

The Australian Office of Financial Managment says that:

‘The move to a tender system was a critical component of financial deregulation in the 1980s. The move to a tender system along with the floating of the exchange rate was a necessary condition for there to be an effective and independent control of monetary policy.’

Its important at this point to clarify that the choice to pursue independent control of monetary policy was an ideological decision. In other words, Australian Federal Governments have chosen this course of action because they want to, not because they have to.

This is where things get interesting because issuing Treasury Notes via tender or taxation isn’t necessary to fund government spending under a fiat money system.

In other words, sovereign currency issuing governments (like Australia’s) do not need to borrow from or tax the public in order to fund programs and services, they choose to.

Central banks (and the governments they answer to) can, and regularly do, create electronic money ‘from thin air’. And we can look to recent events to show that this is the case.

(Commercial banks also create money. But we’ll get to that in a forthcoming blog).

Quantitative easing

If you’ve watched the evening news at some point in the last five years you’ve probably heard the term ‘quantitative easing’ (QE). You’ve probably also heard QE described as ‘printing money’. This is inaccurate because modern money is mostly electronic, or simply keystrokes on a keyboard. So when a central bank undertakes QE money is not actually printed. It is however electronically created.

Central bank asset purchases as a % of GDP 2007-14.

Central bank asset purchases as a % of GDP 2007-2014 (click to enlarge). Source:

As you can read on the Bank of England’s (the UK’s central bank) website, QE is an asset purchasing program conducted by some central banks to increase liquidity (i.e. money) in their respective financial systems. Europe (ECB), Japan (BoJ), and the UK (BoE) are currently undertaking QE while the US ceased its program in 2014.

These assets purchased by central banks are predominantly government bonds. The theory goes that by purchasing a lot of these bonds the central bank can cause the prices of bonds to increase (because as they become scarce their value increases) and reduce their yields (because the interest earned on a bond is inverse to its price). This is supposed to encourage bond holders to sell their bonds and seek better returns from financial investments outside of the bond market.

So QE is basically a way for the central bank to create demand in the economy by increasing the amount of money (liquidity) in the financial system and encouraging investors to make investments outside of Government bonds (which are traditionally seen as a safe investment – low risk with good returns).

Whether or not this actually increases liquidity and demand in the system is up for debate. But whats interesting is the way central banks have financed their QE programs – they simply create the money electronically.

(To be clear: Australia hasn’t undertaken QE because we haven’t experienced the recessionary conditions which have afflicted the rest of the developed world since the Global Financial Crisis. Nevertheless, the RBA is just like any other sovereign currency issuing central bank and retains the capacity to electronically create money.)

The US began its QE program in 2009 following the Global Financial Crisis and ended it in October of 2014. By the end of the program the US Federal Reserve had added $3.5 trillion to its balance sheet.

To reiterate, that’s $3.5 trillion which didn’t exist before the Federal Reserve began its QE program. For some perspective, $3.5 trillion is an amount roughly worth the same as the German economy.

That $3.5 trillion was used by the Federal Reserve to purchase US Treasury Bonds. So what we’ve ended up with is a situation where the US Treasury Department is paying the interest earned on those bonds to the Federal Reserve.

But as we’ve learned, the Federal Reserve (the US central bank) is an agency of the US Federal Government. So the US Federal Government is effectively paying the interest earned on those bonds back to itself. 

This is essentially the same as not paying any interest at all. And if those bonds remain on the Federal Reserves balance sheet and are left to ‘mature’ rather than being sold, then those bonds will ‘roll-over’ and be cancelled all together.

So not only do central banks have the capacity to directly finance government spending, they can also cancel government debt by purchasing government bonds and allowing them to ‘mature’.

And all central banks with monopoly currency issuing powers have this capability.

They’re either liars or out of their depth

All of this is possible because sovereign monopoly issuers of currency are not revenue constrained. This means they cannot face insolvency or default on their debts like you or I can.

How is this so?

“There are few things less likely than Australia defaulting on its sovereign debt – we never have, there’s never been a default by this country, I don’t think there’s ever been a default by any of the states,” – RBA Governor Glenn Stephens rubbishing claims by.. Barnaby Joyce.. that Australia could default on its debts. Feb 2010. (Pic unrelated. Its just a cool pic).

Just think about it. How can a monopoly issuer of a currency (in Australia’s case the RBA) run out of money which only it has the authority and capacity to create? In other words, if the RBA is the only institution on Earth which can create (legitimate) $AUD how can it possibly run out of it?

The key point here is that the RBA, an agency of the Australian Federal Government, is the sole sovereign issuer of $AUD while Australian citizens, their households along with the businesses they own and operate and the individual states and territories they live in, are users of $AUD’s.

The distinction between issuers of a currency and users is vitally important. As currency users, our (you, me, households, businesses, states and territories) capacity to borrow money is dependent on it first being loaned to us by someone else or some other institution. Our capacity to loan money is therefore externally constrained by the willingness of others to first lend us money. On the other hand, sovereign monopoly issuers of currency can create their own money as they see fit and therefore do not face any external revenue constraint.

Now this doesn’t mean the Reserve Bank has a license to create as much money as it wishes, but it does mean that every time a scaremongering politician warns that the Australian Government is in danger of running out of money they’re either lying or they don’t understand what they’re talking about.

In the words of Alan Greenspan, Chairman of the United States Federal Reserve System from August 1987 to January 2006:

“When there is confidence in the integrity of government, monetary authorities–the central bank and the finance ministry–can issue unlimited claims denominated in their own currencies and can guarantee or stand ready to guarantee the obligations of private issuers as they see fit. This power has profound implications for both good and ill for our economies.

Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank.

That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency. A fiat money system, like the ones we have today, can produce such claims without limit.”

The implications of our fiat system

The Australian Federal Governments lack of a revenue constraint doesn’t mean it can create as much money as it would like whenever it wants to. To create money without abandon could result in inflation once the amount of money in circulation (i.e demand) outstrips the amount of goods and services for sale in the economy (i.e. supply).

But what it does mean is that the Australian Federal Governments choice to finance itself via taxation and/or issuing debt should be thought of as:

  1. a means for keeping non-government spending at below inflationary levels.
  2. a mechanism for the progressive re-distribution of personal incomes.
  3. a way to incentivise some behaviours and deter others.
  4. being in the interests of transparency in terms of government spending.

So while taxation isn’t necessary to fund Federal Government spending it does perform important social functions. On the other hand, issuing debt serves no real social function and is just an ideological hangover from Australia’s pre-fiat monetary system.

Most importantly, Australia’s sovereign control of its monetary operations gives it the capacity to provide for all of its citizens. The Australian Federal Government has the financial means to address all of the major social problems which afflict Australian society, it simply chooses not to.

In a post Global Financial Crisis world QE has become the new normal. QE has also shown us that the emperor is naked. What will we make of it?