Quantitative Easing in Australia (Wonkish)

For the first time in our country’s history, Australia has embarked on Quantitative Easing (QE). On Thursday, the Reserve Bank of Australia (RBA) slashed the Cash Rate to 0.25%, which is effectively the floor of the Cash Rate before hitting negative interest rate territory [1]. With QE, the RBA will purchase government bonds to drive up their prices and hence lower their yields to lower interest rates throughout the economy, particularly longer-term interest rates [2]. Some tabloid journalists have referred to this as ‘money printing’ or ‘monetising debt,’ but neither of these claims are true. QE, like other monetary policy operations [3], does not create what we call net financial assets. If the RBA purchases a government bond, it sells reserves in return. The commercial bank holds fewer bonds, more returns, but their net financial assets are unchanged. What changes instead are yields as the decrease in the supply of bonds pushes up their price.

What about claims surrounding ‘monetising the deficit.’ Usually what people mean by this is creating ‘new money’ to finance a budget deficit, which is inapplicable for a few reasons. First, if the RBA has a positive Cash Rate target, its supplying of reserves is non-discretionary and will increase or decrease when the demand for reserves changes so that the overnight interest rate aligns with the Cash Rate [4]. In other words, if we run through the scenario of the RBA directly purchasing public bonds as the government runs a budget deficit, the excess of spending over taxation would generate excess reserves in the commercial banking system. Such an excess would cause the overnight interest rate to fall to zero. In order to make the overnight interest rate match the Cash Rate target, the RBA would need to sell an equivalent amount of bonds (the RBA buys reserves in exchange) as it had purchased so that it eliminates the excess supply of reserves that it had initially created.

Second, the money (here I mean net financial assets) used to purchase public bonds is the result of deficit spending in the first place, which raises an interesting question of why we have a ‘public debt’ if the government is the issuer of Australian Dollars (AUD). Well, as part of the emergency response to the coronavirus, we have seen the ‘debt ceiling’ raised to about $850 billion [5], which makes it sound fairly arbitrary. The functional purpose of the public debt is not to raise revenue through borrowing from the public (people would have no net financial assets with which to purchase government bonds if those net financial assets did not exist in the first place through deficit spending on part of the treasury or ‘fiscal policy’ [6]) but, rather, to control interest rates. If there is deficit spending, there is a surplus on part of the recipients of the deficit spending. This means that commercial banks will have more reserves than before, putting downward pressure on their price (their overnight interest rate). To maintain a particular Cash Rate, government bonds are sold to the private sector to drain the excess reserves and so to prevent the overnight interest rate from falling. This happens to be equivalent to QE in not issuing bonds in the first place.

Will QE do much? I have my doubts. The idea of lowering longer-term interest rates is to raise the demand for credit to finance real investment on part of the business sector. The problem is that in a downturn, businesses will not invest if they do not expect to make money in doing so. Will refinancing effects allow for higher disposable incomes on part of households? Not if the assets that are the collateral backing the debt plunge in value (people will struggle to refinance if they are in negative equity).

In other words, shifting interest rates becomes akin to pushing on a string. As much as borrowing can be made cheaper through lower interest rates, the demand for loans must exist for credit to be created. During a downturn, people are less creditworthy as unemployment spikes and job hours are slashed, reducing the capacity for people to borrow. Businesses with fewer sales also have less creditworthiness. In this sense, credit expansion follows rather than leads the business cycle, intensifying booms and busts rather than stabilising the boom-bust cycle.

 

[1]. The way the RBA makes the overnight interest rate – the rate at which commercial banks lend to one another – align with its Cash Rate is through a ‘corridor’ system. In effect, because the RBA (usually) pays commercial banks 0.25% below the Cash Rate on their exchange settlement (ES) balances (the reserves that commercial banks have with the RBA), commercial banks with a surplus of ES balances have an incentive to lend them to other commercial banks at the Cash Rate because that yields more interest. By the same token, if a commercial bank wishes to borrow reserves directly from the RBA, they will pay a premium interest rate 0.25% above the Cash Rate, which provides them with an incentive to borrow at the Cash Rate from another commercial bank. This time, with the Cash Rate at 0.25%, the RBA has decided to pay commercial banks an interest rate of 0.10% on their ES balances rather than 0.00%.

[2]. https://www.abc.net.au/news/2020-03-19/rba-cuts-interest-rates-coronavirus-covid-19/12070494

[3]. Monetary policy is basically what the Central Bank does. The other arm of economic policy decision-making is called fiscal policy, which concerns government spending and taxation.

[4]. http://bilbo.economicoutlook.net/blog/?p=2943

[5]. https://www.fxstreet.com/news/australian-treasurer-frydenberg-will-lift-debt-ceiling-to-a850-billion-202003200630

[6]. The private sector can create ‘money’ in the form of credit but this is not a net financial asset because private-sector lending to itself creates a financial liability. In other words, as part of an endogenous money supply, this is called ‘horizontal money.’ Vertical money creation is sourced through deficit spending as it creates net financial assets.

As another point, to avoid confusion, public bonds and net financial assets are not equivalents per se. Public bonds can be a component of one’s net financial wealth, but this is a portfolio choice. In other words, if the government did not issue public bonds, the recipients would still see their net financial assets rise when there is deficit spending. To make this point in another way, if a private agent used private credit to buy a government bond, it would not have net financial assets. While the government bond is an asset, the loan used to purchase the bond is a liability that must be paid back. As explained before, why public borrowing tends to coincide with deficit spending is to maintain control over interest rates as an instrument of monetary policy. With QE, this function is obsolete because QE floods the commercial banks with reserves.