Wednesday, April 23, 2014

Can the Australian Government run out of money?

The Federal Treasurer, Joe Hockey, is worried that the Australian Government is 'running out of money'.


From the perspective of Modern Monetary Theory, the Treasurer's worries are misplaced (he'll still have worries, just not this one). The Australian Government is centrally involved in the creation of Australian money, and cannot run out of it.

For all practical purposes, the money we use in Australia is Australian dollars. Anything that's for sale here can be paid for in Australian dollars, and just about all financial liabilities incurred here are accounted for in Australian dollars.

Australian dollars don't stand for anything else: not gold, for example, and not some other currency, such as the American dollar. (You can buy these things with Australian dollars, but you don't have the right to insist on your Australian dollars being converted into gold or $US, and there's no fixed price for either – it is up to you to find a willing seller and strike a bargain.) At the end of the day, one Australian dollar will always get you... one Australian dollar.

This means there's no necessary limit on the number of Australian dollars in existence. A relative few exist physically in the form of polymer notes and copper alloy coins; very many more exist merely as electronic entries in the accounts of the institutions – the banks, and the Reserve Bank of Australia – that make up our financial system. 

And this is where our money comes from. Money is created when banks advance it to someone; it is, so to speak, loaned into existence by clerks stroking keys on the banks' computers. Apply to a bank and, if you're creditworthy, the bank will keystroke up for you an agreed-upon number of electronic dollars (in return, the bank gets from you a promise: that you will pay, over time, that number of dollars, plus interest, to the bank). These dollars, so created, sit in an account to your credit at the bank, to be transferred to other persons' accounts, in payment for whatever you're buying.

Transfers between accounts at the same bank can be settled by the bank itself. To settle transfers between accounts at different banks, banks participate in the payments system operated by the Reserve Bank. This is effected by banks maintaining reserve accounts ('exchange settlement accounts') at the Reserve Bank. These reserves ensure that payments between banks can be cleared and settled. They, too, comprise electronic dollars – keystroked into existence by the RBA, to the credit of each bank.

If, at the end of the day, a bank needs more money in its reserve account, it can borrow from another bank (in return, the first bank promises to repay the money with interest). Banks with surplus reserves not lent to other banks earn interest on them from the Reserve Bank; these interest payments get keystroked into existence by the Reserve Bank. Alternatively, the bank can borrow reserves from the Reserve Bank's liquidity facilities, which will keystroke up for the bank the necessary dollars (in return for the bank's promise of repayment or transfer of assets).

Alternatively again, it may be that a bank cannot get those reserves, because it cannot make convincing promises of repayment (because its assets are lacking: eg a bunch of loan contracts with people who are a dubious prospect). If things are so bad that not even the Reserve Bank will lend to them, it's game over for this bank. People who have deposits with the bank will be in trouble too – but they may get their money back under the Government Financial Claims Scheme, under which the Australian Government will direct the Reserve Bank to keystroke up for the claimant the appropriate number of dollars in the reserve account of their (new) bank.  

The Australian Government makes and receives payments through the same payments system, using its bank accounts – the Official Public Accounts Group – at the Reserve Bank. To make a payment to someone, the Bank keystrokes a debit against the Government's account and keystrokes a corresponding credit to the reserves of the recipient's bank. The Government receives payments into these accounts too, but it does not need prior receipts for the bank to keystroke up a payment from the accounts. (Note that the OPAG has an overdraft facility – 'strictly limited' by the Reserve Bank, but really that's a limit on government by itself).

There's the polymer notes and the copper alloy coins that the Reserve Bank issues to banks for the purposes of cash withdrawals. When a bank asks for some of these forms of money, the Reserve Bank keystrokes the appropriate debit against the bank's reserve account; and when a bank returns notes and coins to the Reserve Bank, the latter keystrokes a credit to the bank's reserve account.

Ultimately, it is only Government payments that effect a net increase in reserves in the system. Individually, banks may need more reserves (because they've increased their lending and advanced more money to people) or have reserves to spare (because they've reduced the amount they've advanced), and can make transfers amongst themselves with no net increase in reserves; but when the system overall has advanced more money, the additional reserves can only come from the Government keystroking them into existence.

As you can see, the Australian Government creates money – Australian dollars – through its spending, its lending and crediting of reserves to banks, and its issuing of notes and coins, and there's no necessary limit to how much it can create. The Australian Government cannot run out of Australian money. It issues the currency.

You'll also notice that this account has not referred to the Government's ability to impose taxes or issue bonds – and in particular, we've not referred to either taxes or bonds as the source of the Government's money (because they're not). We'll return in future posts to taxes and bonds, and just what it is they really do in an economy such as Australia's.

6 comments:

  1. You may wish to mention inflationary pressures. Somewhat relevant to this issue.

    ReplyDelete
  2. This completely ignores the fact we have a floating currency and if we "magic up" some more money as the article would have you do then everything we buy globally has it's price affected.
    Make a lot more money and our dollar is worth less globally so it costs more of our money for the same thing to be imported.
    So while the government could just make more money it would play havoc with business in Australia.

    ReplyDelete
  3. Hi Anon

    On the contrary, this analysis assumes a floating currency. If we did not have a floating currency - ie it was convertible at a fixed rate to some other currency - the Government would be constrained by the need to maintain reserves of the other currency. The floating rate removes that constraint.

    It is true that too much money can cause inflation - just look at what too much speculative money has done to house prices. But looking elsewhere in the economy, there's useful activity that might be undertaken – work done, and real wealth produced – if there was more money spent on it.

    Keep in mind too that the RBA 'magics up' money every time it engages in open market purchases.

    ReplyDelete
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  5. Which bank was left to collapse? Ah none.

    ReplyDelete
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