Analysis by Keith Rankin.
“I think you have to recognise money comes from somewhere. It doesn’t just come from a big money tree.” Judith Collins 2020
“Someone has to pay the bill – there aren’t little pixies at the bottom of the garden printing cash.” John Key 2009
These messages from two different National Party leaders are like saying that babies come neither from the ‘stork’ nor the ‘cabbage patch’. And – as with sex creating babies – we can be very coy about talking about where money does come from. In a sense – albeit a nonsense – both money and babies are ‘conceived in sin’.
We also have issues about where money goes. Thus, when money is fraudulently obtained, we too easily expect it to have been hidden away somewhere, as buried treasure. When the Ponzi schemers and other bad boys of finance are brought to justice, we would like them to return the money. It’s part of our naïve notions – fuelled by National Party leaders and others – that money is a kind of zero-sum game, and that money, like Adam and Eve, was created by God.
A Fifty Billion Dollar Conjuring Trick?
For New Zealand’s May 2020 Budget, the central theme was a new $50 billion pot of money (‘rescue fund‘). As in all emergencies that affect everyone – not just the poor – there is always money when it is needed. The homilies about pixies and money trees are for the gullible.
When such large sums are created with one stroke of the electronic pen, the narrative that follows is not a reasoned discussion about the process of money creation. Rather, it’s the narrative of the ‘inevitable reckoning’; how and when are we going to ‘pay the money back’. In this 2020 case, because New Zealand has come through the Covid19 emergency better than expected, Finance Minister Grant Robertson has recently intimated that not all the money will be required. Perhaps $10 billion will disappear back to where it came from, sooner rather than later?
While the technical process of money creation varies from country to country, and varies substantially through history, it is appropriate here to focus on the NZ$50 billion rescue fund. And we need to note that almost all money in the world is held in as bank deposits; not as coins or banknotes.
The Reserve Bank in 1960
If this was 1960 the money would then have been about £2 billion. The government then would have simply drawn on its technically unlimited (but not practically unlimited) overdraft facility at its bank, the Reserve Bank of New Zealand. It would have withdrawn that money and put it in a ‘pot’; a deposit account created for the purpose of funding the emergency. And if the £2 billion was not enough, the government would have drawn further on its overdraft facility, putting additional new money into the ‘rescue pot’.
This £2 billion would be ‘new money’ – not gold bars from the Reserve Bank’s vaults. It would be written up in the Reserve Bank’s balance sheet as both a new asset (a new loan to government) and a new liability (a new deposit by government).
As well as being the government’s bank, the Reserve Bank is the banks’ bank. So, as the government spends the money from its account, it goes into people’s bank accounts, which means that it goes into the banks’ banks’ accounts at the Reserve Bank. From the Reserve Bank’s viewpoint, the money – initially created as that £2 billion loan to government – goes from one bank account to other (private) bank accounts. Later, when taxes are paid, money goes from the private accounts at the Reserve Bank into one of the governments accounts at the Reserve Bank. (If the new money facilitated new economic activity, then this would be new tax revenue; tax revenue which otherwise would not have been collectable.)
Before such new money is spent – eg while it is in the rescue pot – the government could be said to be in debt to the owners of the Reserve Bank. Because the owners of the Reserve Bank are the same people as the ‘owners’ of a democratic government, the new money is owed by the people to the people.
As the new money is spent, and ends up in private sector accounts, then the government incurs a financial deficit and the private sector incurs an equal financial surplus. This is all normal public finance in action; it’s just that in this ‘rescue’ case, the sum of money is larger than usual.
What would be very harmful would be if the government tried to ‘pay the money back’ after it had been spent. That would represent the wanton destruction of money that was supporting – circulating through – the wider economy.
The Reserve Bank in 2020
The process of money creation through government borrowing became more convoluted in New Zealand, after 1985. The key difference from 1960 is the statutory independence of the Reserve Bank. It means that the government would no longer borrow from the Reserve Bank; it meant that government borrowing would instead take the form of ‘bonds’ sold to financial businesses, such as Westpac or ANZ Bank.
For the most part, when there is an emergency requirement for money – such as the $50 billion rescue fund – the Reserve Bank and the Government both take a ‘dovish’ (opposite to ‘hawkish’) position. For the Reserve Bank, a ‘dovish’ stance is called ‘easy monetary policy’ and a hawkish stance is ‘tight monetary policy’. For the government, a dovish stance is called ‘expansionary fiscal policy’; especially a willingness to increase government spending – and government trust – through increased government borrowing. A ‘hawkish stance’ is ‘contractionary fiscal policy’ – ‘austerity’ – a desire to cut back on government spending and the setting of tight conditions on recipients of government money.
What it means is that the Reserve Bank buys existing bonds (especially government bonds) from the commercial banks, and the commercial banks buy new bonds (promises) issued by the government. In other words, the government borrows from the commercial banks and, at about the same time, the Reserve Bank lends to the commercial banks. The net effect is the same as in 1960; the government borrows from the Reserve Bank. The difference is that government and Reserve Bank are constitutionally independent parties to these transactions.
The process gets interesting – and often problematic – when the Reserve Bank and the government take different positions. Such conflict exists today. Generally, since 2008, central banks (eg the Reserve Bank) have taken a dovish stance towards money creation. In 2009, governments were equally dovish (though the New Zealand government was less dovish than most). From 2010 many governments became hawkish – austere – especially in Europe. The result was ultra-low interest rates as central banks tried to lend to governments, but governments were reluctant to accept the cheap new money. Even now, in 2020, many governments are far from dovish – especially the ‘frugal four’ in northern Europe (Netherlands, Sweden, Denmark, Austria). The New Zealand government today is moderately hawkish; for example it is not sharing its emergency fund with local governments, forcing local governments (which do not have comparable borrowing privileges) into inappropriate spending retrenchment.
When the present process became the worldwide norm – from the 1970s to the 1990s – the more usual problem was hawkish central banks and allegedly dovish governments. (The new monetary environment was created by hawkish governments, however, of which the Lange-Douglas New Zealand Labour government was one.) The result was very high interest rates in the 1980s.
New Zealand had a significant episode of conflict in 1997, when the Reserve Bank was hawkish, but the finance ministers were dovish; Winston Peters was committed to substantial new government spending and Bill Birch had already legislated for a tax cut.
When interest rates are near zero, a dovish Reserve Bank must resort to quantitative easing as its main method of increasing the money supply. Quantitative easing is this active policy by central banks to buy promises (bonds) held as assets by the commercial banks. It makes central banks an active ‘player’ in ‘secondary financial markets’ (more later).
For the most part in the 2010s, the New Zealand Reserve Bank was able to decrease interest rates, creating incentives for all parties (not just government) to borrow and spend. The commercial banks have practically unlimited overdrafts with the Reserve Bank; lower interest rates are the banks’ incentive to use those overdraft facilities to expand their lending to governments, businesses, land speculators and other private borrowers.
Because New Zealand’s central governments were fiscally hawkish in the 2010s, most of the new money was pushed into the private sector. New Zealand’s main economic problem became the reluctance of the government to make use of the available new money, leaving almost all of it instead to private borrowers.
The Economy and the Casino
When new money is created by central banks, it can circulate in the economy (spending, employment, income creation) or in the ‘casino’; or it might not circulate at all (or circulate very slowly). By far the most effective way of getting new money to circulate in the economy is through the government borrowing the new money, and spending it. When governments – in the 2010s – said there wasn’t any money, they were wrong, very wrong. The Reserve Bank supplied money became even cheaper, and circulated in the casino rather than in the economy.
The ‘casino’ is the secondary financial marketplace. Secondary markets are markets for items that already exist (eg used cars). The most important examples include the sharemarket and real estate (especially the residential land market). In general, there are three main classes of secondary markets: financial assets (shares and bonds), real estate, and commodities (such as gold and silver). Prices go up in these markets when large swathes of new money are injected into the casino rather than to the economy. It’s not the fault of dovish central banks that this happens; rather it is the fault of hawkish governments favouring austerity over responsibility. It’s because governments are choosing to not have the money to do the many things that governments could be and should be doing.
In 2020, the casino remains as active as ever.
Where does the money go?
For the most part, the money goes nowhere; it sits idly, on rich people’s balance sheets, or circulates in the casino until it is destroyed in a financial crisis. Money is destroyed in the exact opposite process to which it is created, when the assets of central banks are repaid or otherwise devalued. (Much of the world’s money was destroyed in the 2008 global financial crisis, and had to be recreated through quantitative easing.) Governments cannot force people to spend money; indeed hawkish governments ask people to not spend (ie to save) their money. Thus, new money is regularly needed to replace idle money as well as to facilitate a growing economy. Money that goes straight to the casino may never circulate in the economy; it inflates asset prices and eventually dies in a financial crisis. Much money that goes into the economy ends up in the casino – just think of what happens to money spent on Apple products – but at least such money does economic work before it ends in the casino.
The most important reforms will only take place when enough of us make an effort to understand money, and to appreciate just how trite the featured comments by Judith Collins and John Key really are. When we understand that money is our most important social technology – and not stardust or some alchemical wealth potion – then we can become the masters rather than the servants of money.
Yes, there are situations when there can be too much money in circulation in the economy, and inflation can result – examples include Germany in the early 1920s, Hungary in the mid-1940s, and Zimbabwe in the mid-2000s. But these are few and far between, and are symptomatic of other severe problems in those places and at those times. The much bigger problem is to ensure that governments properly respond to the incentives set by central banks, while noting that central banks themselves are not immune from making mistakes.
By far the most coherent school of commonsensical monetary and fiscal policy is called ‘modern monetary theory’ (MMT). I don’t particularly like the name – because the school is really about the shortcomings of government fiscal policies – and not the shortcomings of modern central banks. The best known economists in this school include (Taiwanese) Richard Koo (who coined the term ‘balance-sheet recession’ to explain Japan’s experience in the 1990s), (American) Randall Wray (who has been a regular contributor to the Sydney conferences of the Australian Society of Heterodox Economics), and (Australian) Bill Mitchell who is speaking this Sunday afternoon (via Zoom) to the New Zealand Fabian Society.