ECONOMIC AFFAIRS by Colin TeeseNews Weekly
Lesson of Japan's debt-free economic stimulus
, December 6, 2014
This article starts with a puzzle — like those we find in a Christmas cracker. However, the answer to this puzzle is more complicated and difficult than the sort we might find in a cracker.
Shinzo Abe, Prime Minister
“What is the difference between our current Treasurer borrowing on the Commonwealth government’s account the sum of AUD$8.8 billion (allegedly for the purpose of strengthening the balance sheet of the Reserve Bank of Australia), and the Bank of Japan taking up almost all of the government bonds available for purchase?
Within a month of taking office, the Treasurer of the incoming Coalition government, Joe Hockey, announced that the government had borrowed some AUD$8.8 billion to strengthen the balance sheet of the Reserve Bank of Australia (RBA) against the possibility of tough economic times ahead.
There was only minimum discussion of this decision in the mainstream media. Stephen Koukoulas, did, however, give the matter some attention at the time in the online publication, Business Spectator (October 25, 2013).
He suggested that the government’s purpose was more political than economic. The RBA had not asked for funds. Indeed, it had been able to pay substantial dividends to the Howard, Rudd and Gillard administrations — twice as much, in fact, during Peter Costello’s time as Treasurer under Howard as during Wayne Swan’s time under Rudd and Gillard.
Koukoulas concluded that Hockey’s motive was “political”, since the Treasurer had referred to Labor plundering RBA reserves without reference to what had happened under Mr Costello’s treasurership.
Beyond revealing these facts Koukoulas’s article was really beside the point.
Along with Hockey, Koukoulas either does not understand, or chooses to proceed as if did not understand, how our financial system can and should work.
These two are not alone. Most of the West’s political elite choose to follow the same delusional economic path as we do here in Australia. Because our politicians and their advisors slavishly follow theory-laden textbook economics, they remain ignorant of the reality of banking operations, and of how governments with their own currencies can and should behave.
At the beginning of this year, the Bank of England gave them the chance to understand, when it authorised the publication of a remarkable 14-page paper, “Money creation in the modern economy” (Bank of England Quarterly Bulletin, Vol. 54, No. 1, 2014). Its authors, Michael McLeay, Amar Radia and Ryland Thomas, sought to set the record straight on the nature of banking and credit creation. Textbooks, they pointed out, don’t describe how banks operate.
Bank deposits are not the source of the money that banks lend to borrowers. Rather, banks simply create deposits in borrowers’ bank accounts when they approve loans. Further, these same banks, in the course of normal trading, need funds to settle overnight accounts with each other. This they obtain by maintaining overdraft facilities with the central bank (in our country’s case, the Reserve Bank of Australia).
The RBA for its part creates, as necessary, the funds to cover ordinary bank overnight borrowing. Without a system of this kind, day-to-day commerce would be impossible.
Put simply, in a country with its own currency, its central bank can never run out of money needed to fund the requirements of the economy — money which it feeds into the economy through the commercial banks. Whatever Koukoulas or anyone else thinks, the Reserve Bank of Australia never needs cash injections to cover its outlays.
A government with its own currency is not like a family or business. The latter, as users of the currency, cannot spend more than they earn; they must balance expenditure against income. The government is not a user of the currency: it holds a monopoly over creation of the Australian dollar and therefore can never be financially constrained. No less an authority than Alan Greenspan, former Chairman of the U.S. Federal Reserve, is on record as confirming this fact. Balancing a government budget, as an end in itself, is a practice which seriously limits the government’s ability to manage the economy.
Market economies, left to themselves, proceed through cycles of business activity — sometimes known as the boom-and-bust cycle. A government can, and should, use its financial policies to offset these fluctuations in economic output and employment by ensuring a steady annual growth in total spending which reflects the underlying growth in the productive potential of the economy. In this way, a government can help ensure the economy operates at or near the limits of its capacity. Only in this way can a government ensure that maximum growth possibilities are exploited.
Do government injections of spending into the economy necessarily fuel inflation? Not while the economy is operating below full capacity.
Conversely, when the economy is operating at full capacity, an excess of total spending will cause inflation. To prevent this eventuality, governments need to restrain their spending and even withdraw purchasing power from the economy — if necessary by increasing taxation or raising interest rates.
Our political leaders (on both sides of politics) are proceeding on the basis of ideologically-inspired advice which prevents them from properly understanding these important facts.
Thus it was completely unnecessary for Mr Hockey to borrow AUD$8.8 billion to shore up the RBA’s balance sheet. Perhaps, though, it was less as politically motivated than a product of misguided economic ideology.
Maintaining, as Treasurer Hockey does, that the Commonwealth government’s budget deficit is serious, how else can one explain his adding $8.8billion (plus $350 million a year in interest) to the debt burden for money that the Reserve Bank of Australia did not need?
Some 80 years ago, the famous British economist, John Maynard Keynes, revealed in his path-breaking book, The General Theory of Employment, Interest and Money, why failing to boost total spending during an economic downturn was a sure recipe for perpetuating lower growth and fewer employment opportunities.
The curious thing is that the Abbott government — while sceptical on the question of climate change — seems happy to follow a low-growth strategy exactly in line with what the radical environmentalist Greens movement wants.
Ordinary Australians, sadly, are paying the price.
Let us now turn to the question of Japan.
The Japanese economy was badly affected by a property boom in the mid-1990s. We know that this had a similar, though less devastating, impact on the Japanese economy than the flawed banking practices in the United States and the European Union had on the world economy some 20 years later.
At the time of Japan’s financial crisis there was no shortage of gratuitous advice from the world’s economic commentariat. Japan’s political elite, content to follow economic orthodoxy, was inclined to accept the advice. Thus, they implemented policies which were no help in restoring Japan to economic health.
As later happened in the U.S. and Europe, Japanese banks were overloaded with debt and consumption collapsed. What Japan avoided, by the government’s running budget deficits, was the worst effects on employment. But it was not able to restart private spending.
Prime Minister Shinzo Abe came to office in December 2012 with a radical new approach, although one that was controversial in orthodox economic circles. He announced that he was intended to lift the Japanese economy out of its deflationary malaise by substantially increasing government spending.
His approach, which became known as “Abenomics”, cannot be said to have been a wholehearted success, but at least some progress has been made.
A new policy arm was added in 2013 when a harsh critic of the Bank of Japan’s previous policies, Haruhiko Kuroda, was appointed as the bank’s new Governor. He quickly made clear his intentions for Japan’s economy: these were to break free from deflation and to establish an annual inflation of about 2 per cent. To achieve this end, his plan was to double Japan’s monetary base in just over a year.
He has been buying government bonds at a furious rate, and more recently has started buying equities from Japan’s pension funds. The official term for this practice is “quantitative easing”. More pejoratively, it is known as “printing money”.
Mr Kuroda’s most recent actions have stirred up controversy overseas — especially with the economic commentariat worldwide, and supported by bond-traders. All have been quick to condemn the Bank of Japan’s expansionary strategy.
The bond market grumbles because the Bank of Japan is setting the interest rate — presumably because it precludes the market from making its usual profit on bond-dealing.
What Governor Kuroda has demonstrated is that governments with their own currencies are fully able to neutralise the influence of bond-traders. Contrary to popular belief, bond markets cannot punish governments which don’t exercise the fiscal restraint that these markets deem appropriate.
Those with long memories will remember what a hold bond-traders can have over timid governments. Treasurer Peter Costello was able to announce that, because the then Coalition government had no debt, it had no reason to issue government bonds.
The bond market had apoplexy. “What about our profits?” they cried. Costello, intimidated, backed off; but he was right. Quite obviously, there was no need for bonds. Indeed, governments with their own currency never have any need to borrow.
The Governor of the Bank of Japan understands this. So far as Japan’s debt in yen is concerned, it is he, Governor Kuroda, not the markets, who is calling the tune. What the Japanese government does not understand is that its action in raising the country’s consumption taxes is undermining the stimulatory policies of the Bank of Japan.
While the bank is trying to stimulate total spending, the government has decided to curb consumption expenditure. At one and the same time, one policy encourages spending, while another stifles it! Is it any wonder that, in the face of these confusing signals, consumers have curbed their spending and thereby offset some part of the bank’s stimulatory policy.
Now we come to the point of the puzzle raised at the beginning of this article: what exactly is the difference between what our Australian government is doing and the conflicting financial policies being pursued in Japan? Not much.
Mr Hockey has unwittingly saddled his government with an unnecessary debt of almost $9 billion dollars. By his own measure of the interest that will have to be paid, the flow-on from this will certainly limit future growth possibilities. And that is surely the opposite of the Treasurer’s intentions.
In Japan’s case, Governor Kuroda’s attempts to make a real contribution to Mr Abe’s efforts to restore the health of the Japanese economy have been frustrated by the Abe government’s decision to raise the level of Japan’s consumption tax.
What becomes clear is that following the path of economic orthodoxy is an impediment to good economic management. This Japan appears to have recognised, and has moved some distance away from the pure path of orthodoxy,
Australia has, thus far, not been willing to take the first steps in that direction.
Colin Teese is a former deputy secretary of the Department of Trade.
Jaromir Benes and Michael Kumhof, The Chicago Plan Revisited, IMF Working Paper: WP/12/202, (Washington DC: International Monetary Fund, August 2012).
Colin Teese, “Radical bank reform that could help end economic instability”, News Weekly, December 8, 2012.
Colin Teese, “A debt-free way to lift output and employment”, News Weekly, May 25, 2013.
Stephen Koukoulas, “The trouble with bolstering the RBA’s reserves”, Business Spectator (Australia), October 25, 2013.
Michael McLeay, Amar Radia and Ryland Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin, Vol. 54, No. 1 (2014), pages 1–14.