Last Wednesday, The New Zealand Initiative published a 13-page research report explaining why reliance on central bank credit to fund fiscal deficits is not a free lunch and it is economically dangerous to claim otherwise.
The New Zealand Social Credit Association subsequently placed a full-page advertisement in the weekend’s Herald espousing the opposite position. (Older readers will remember the Social Credit Political League from the 1950s and 1960s with its ‘funny money’ A+B theorem.)
Its argument is that conventional borrowing helps banks and wealthy investors while hurting the public, and Reserve Bank credit was a costless alternative.
If the reader has a queasy feeling this position is too good to be true, or that trickery is afoot and someone must be paying for the $9-10 billion paid out in wage subsidies and much more, this article explains why those fears are justified.
The first claim, that conventional borrowing benefits banks and wealthy investors, is false. There is no wealth transfer when a person buys a car, a house, an item on Trade Me, or government stock at fair market value. The asset seller gets the buyer’s cash, and vice versa. The government gets investors’ cash, investors get government bonds of equivalent value. Neither the Crown’s nor investors’ net worth is changed.
The second headline assertion – that funding by Reserve Bank credit is costless – is seductive, false and dangerous for the stability of New Zealand’s financial system.
When the Crown borrows from the Reserve Bank, the bank treats the loan as an asset and the amount it credits to the Crown’s account as a liability. Neither the Reserve Bank’s nor the Crown’s net worth are changed because no wealth has been created or transferred.
To fund its fiscal deficit, the Crown can now draw on its deposit balance at the Reserve Bank. The recipients of that spending deposit the money in their bank accounts. Their banks record those deposits as a liability and hold the asset deposited as a claim on their banker, the Reserve Bank.
This means the Crown’s deficit spending has been funded by borrowing from the banking system. The reduction in the Crown’s deposit account at the Reserve Bank is offset by increased banking system deposits at the Reserve Bank. It also means Crown net worth falls because of the fiscal deficit while the public’s net claims on the banking system rise. The banking system’s net worth is unchanged just like the Reserve Bank’s net worth. There is no free lunch.
Why doesn’t the Reserve Bank just write-off its loan to the Crown? After all, no debt surely means no cost? Not so. The value of the Crown’s ownership of the Reserve Bank would fall by the amount written-off. The write-off would not alter Crown net worth.
Nor can the Reserve Bank reduce the cost to the community by refusing to pay interest on the banking systems’ deposits (settlement balances) at the Reserve Bank. To do that effectively taxes bank depositors, borrowers and shareholders in some way by widening the interest rate margin between bank borrowing and lending.
A basic point is that when the government reallocates resources, it stops some people from using those resources in a different way. For instance, when the Crown employs builders on its social housing projects, they are not available to build homes on the private market.
Another twist to this free lunch argument is the academic ‘thought’ experiment that the government could drop irredeemable paper money as if from a helicopter. The hope behind this imagined giant lolly scramble for adults is that the expanded money supply will induce extra spending to lift output and incomes, without increasing the public debt.
Yet if the helicopter money is irredeemable and so not public debt, anyone who gathered some of these banknotes would not be able to use them to pay IRD. So, what would the notes actually be worth? If the government will not accept its own money, why would anyone else? The Initiative’s paper examines this proposal in much greater detail.
Another idea, perhaps to save helicopter fuel, is for the government to simply gift $1500 to every New Zealand adult and $500 for children. That should generate applause from an unthinking public and make a great campaign slogan: “Vote for us if you want $1500!”
But if central bank funding is costless, as some believe, then why would government be so miserly? Why not make it $15,000 or $150,000 for that matter?
Disturbingly, the Minister of Finance has not ruled out a gift money option, but he has acknowledged one difficulty – that the gifting plan is not targeted at need. To give money to those who do not need it is to fail to give the same money to those who do.
Money handed out to Kiwis must be taken from other Kiwis, one way or another, sooner or later. A conservative estimate is that it costs the community $1.20 for every $1 the government gives away. “Free” money is far from free.
A good fiscal constitution should constrain politicians from deciding to fund deficits by borrowing from their central banks. Transparent, non-inflationary funding of fiscal deficits is much safer. To do otherwise is a slippery slope of treating deficits and debt as unimportant, threatening financial stability.
The case for fiscal deficit spending to fuel economic recovery is a different issue, as is the question of the best monetary policy actions for the current time. Either way, central bank credit financing of fiscal deficits is not a free lunch.