Here’s a great little article Ann Pettifor also wrote today on the budget discipline farce, this time in the UK context. Seems like people are having this problem everywhere! Enjoy the read.

I’d like to make a couple of notes:

You’ll notice that she talks about the relationship between the UK government and its central bank, the Bank of England (BoE). We have a similar relationship here in Australia with our central bank, the RBA, that I didn’t go into in the previous post for simplicity.

Essentially the Australian government (Treasury & govt departments) have a group of bank accounts with the Reserve Bank of Australia, called the Official Public Account Group (OPA). These accounts show the daily cash position of the government. All of the private banks (CBA, Westpac etc) also have an account with the Reserve Bank, and these accounts show the reserve balances of each private bank. (reserves are essentially money held to ensure payments made throughout the economy clear on a daily basis).

Professor Bill Mitchell covers the mechanics of government spending and the payments system here. Below are the key points:

1: When the government spends, say makes welfare payments, it simply debits its own accounts with the RBA and credits the accounts of the private banks at the reserve bank – these credits appear on recipients’ accounts held with their respective private bank throughout the system.

2: When the government taxes, say collects income taxes, the accounts of the private banks with the RBA are debited (and the accounts taxpayers hold with the private banks are debited throughout the system), and the government’s account with the RBA is credited.

3. If the government runs a deficit, it has simply net credited the private sector (accounts held by the private sector).

4. If the government runs a surplus, it has simply net debited the accounts held by the private sector.

Government deficits create private sector savings. So the government cannot face an insufficient supply of savings. These are operational identities. They are true by definition.

Ann Pettifor writes “the British government has a bank [its Central Bank] that can create £10 billion…to lend to the British government…[and] this money can be used for the purpose of financing British government expenditure and investment”.

This occurs because not of operational constraints, but because of institutional or political constraints. The primary policy instrument of central banks, the BoE and the RBA, is to set the interest rate, or the official cash rate, on overnight loans in the money market. This is the rate of interest paid on loans to private banks – and why would private banks require these loans? If they don’t have enough in their reserve balances held in accounts with the RBA. Remember reserves are money held to ensure payments made throughout the system every day clear. On any given day households and firms will be making payments to each other. In the aggregate, at the end of each day these just represent flows of money from one private bank to another, representing changes in the individual private bank’s reserve balances at the RBA. Sometimes there may be a case where one bank is short of reserves – in this case the RBA stands to lend this bank whatever reserves it desires at the given rate of interest. By guaranteeing the smooth functioning of the payments system, this overnight market ensures the economy as a whole also operates smoothly.

But when the government runs a deficit, it net credits private sector accounts at the RBA. This creates excess reserves in the private banks accounts with the RBA. The private banks need to hold some minimum amount of reserves to ensure the payments system functions, but the net credits in the private sector translate to more reserves than the banks need to clear transactions made day to day. With excess reserves, this means there is less demand for the RBA’s loans, so the official cash rate gets bid down. That’s right – government deficits actually have a depressing effect on the interest rate (often you’ll hear in the mainstream media, that the opposite is true). So the excess reserves create less demand among the commercial banks for the RBA lending. This has a depressing effect on the official cash rate, but as I mentioned earlier, the official cash rate is the primary policy instrument of the RBA. It wants to maintain that rate to affect whatever intentions it has for the management of the economy.

It follows that it does this by issuing government bonds. Government bonds are offered to the private banks as an interest earning alternative (interest paid using a “computer mark up”) to holding excess reserves, and so excess reserves are drained from the system maintaining the RBA’s target official cash rate. So this should help give some background for some of what Ann Pettifor is talking about regarding the mechanics of government spending through the central bank. There is still no operational constraint on government deficits, the issue of government debt/bonds to the private sector is merely an institutional arrangement.

The corollary:

1. Don’t let anyone tell you that government deficits puts upward pressure on interest rates. It does the opposite!!!

2. Don’t let anyone tell you the government needs to finance spending by raising taxes.

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