Home Future payments It is the last taboo of the central bank. So, will the RBA review examine how money is created?

It is the last taboo of the central bank. So, will the RBA review examine how money is created?


Last week, the federal government announced its intention to conduct a review of the Reserve Bank of Australia.

The review is Terms of reference are broad, so its panelists will be able to examine a wide range of issues.

But you know what would be great to see? The panelists took the opportunity to seriously discuss one of the last central bank taboos: the bank’s ability to create money.

Should the Reserve Bank fund government spending?

In 2020, a young generation of Australians saw for the first time how the federal government could extract huge sums of money out of thin air.

Suddenly, in the first year of the pandemic, the government found hundreds of billions of dollars to subsidize the incomes of millions of households during lockdowns.

Where is he from?

The government “raised” the money by asking the Australian Office of Financial Management (AOFM) to sell bonds on its behalf, leading to an explosion in public debt.

But could the government have raised funds in another way?

Why would a government that issues its own currency, and therefore has the power to create money to pay for things, want to fund its deficit spending with borrowed money?

It’s a fascinating question.

And that’s getting into controversial territory that Reserve Bank Governor Philip Lowe has done his best to avoid during the shutdowns.

Government bonds for all

Let’s take a quick look at the process.

When the Australian government wants to spend more money in the community than it collects in taxes, it borrows money to cover the expenses.

And it does this by issuing bonds.

Specifically, AOFM sells bonds on behalf of the government and it sells the bonds to authorized institutional investors (large foreign and local banks).

These institutional investors then take the bonds and create another market for them (called the “secondary market”), where entities such as super funds, hedge funds, insurance companies, private banks and central banks can buy and sell bonds.

These entities are always keen to buy government bonds in the secondary market because the bonds guarantee them a source of future income.

What does that mean?

Well, when the Australian government sells a bond, it promises to pay regular interest to the owner of the bond.

For example, suppose the AOFM issues a bond with a term of 10 years with an annual interest payment of 2%.

If the face value of the bond is $100, the government has promised to repay that $100 to the bond owner when the term of the bond expires in 10 years.

But during those 10 years, the bond owner will also receive an annual interest payment of 2% of the face value of the bond (i.e. $2 per year).

So the Australian government says, “If you lend us $100 now, we promise to pay you back that money in 10 years and we’ll pay you $2 every year for the next decade.”

It is these interest payments that provide a guaranteed source of future income for the bond owner: $2 a year, every year, until the bond expires.

But this traditional practice of the government borrowing money (at interest) to finance its deficit spending is what has contributed to the explosion of Commonwealth government debt during the pandemic.

Isn’t there a cheaper way to raise funds?

Is there no alternative?

Well, in late 2020 former Prime Minister Paul Keating said there was no reason the RBA couldn’t just buy Australian government bonds directly from the AOFM and bypass the secondary market altogether. .

He said the RBA could buy a huge amount of government debt and lock it into its own balance sheet.

He said this kind of direct monetary financing of the government’s stimulus program would make the government’s job of funding “much easier”, but the RBA was too timorous to do so.

“You have to remember that these are the high priests of the incremental,” Mr. Keating said.

“Being absolutely certain that no banking toe will cross the line of central banking orthodoxy.

“Certainly not buy bonds directly from [the AOFM] – wash your mouth on that one – what would they say about us at the annual meeting of the Bank for International Settlements in Basel?”

And a few months later, economics professor Ross Garnaut agreed.

During the heady days of the pandemic, when AOFM raised emergency funds for the government by issuing bonds, authorized institutional investors (i.e. large banks) could buy the bonds knowing full well that the RBA would be keen to buy the bonds in the secondary market, so they could be sure they wouldn’t be stuck holding bonds they didn’t want.

Professor Garnaut said it was not necessary.

“We’re really talking about angels dancing on a pinhead when we’re talking about difference,” he told reporter Alan Kohler in early 2021.

“The only difference between the government selling bonds in the market and the Reserve Bank buying them is that you give margin to the small number of bond market players, to the banks that participate in this trade.

“I would say, let’s take their free lunch.”

Why is it necessary to do this?

During the first year of the pandemic, RBA Governor Philip Lowe was repeatedly asked about the issue of deficit financing.

He has repeatedly rejected suggestions that the RBA should fund government stimulus spending directly.

However, he never said it wasn’t possible. He just said it wasn’t necessary.

There is a big difference between the two.

“I want to make it very clear that monetary financing of fiscal policy is not an option being considered in Australia, nor does it need to be,” he said in July 2020.

“The Australian government is able to finance itself in the bond market, and it can do so on very favorable terms.”

Why wouldn’t he think of it?

Probably because there’s an old argument on this issue, dating back centuries, that politicians shouldn’t be allowed to get too close to printing presses.

He says politicians should be forced to borrow the money they need to cover their extra spending plans because it will impose some discipline on them.

You can see the argument in David Ricardo’s famous Plan for the Establishment of a National Bank (published posthumously in 1824):

“It is said that the government could not be safely entrusted with the power to issue paper money; that it would most certainly abuse it.” he said.

“There would be, I confess, a great danger if the government, that is to say the ministers, were entrusted with the power to issue paper money.

“But I propose to place that trust in the hands of commissioners, not removable from their official position but by a vote of one or both houses of parliament.

“I also propose to prevent all communication between these commissioners and these ministers, by prohibiting any kind of transaction of money between them. Commissioners should never, under any pretext, lend money to the government, nor be the least of the world under his control or influence.

“If the government wanted money, it should be compelled to raise it legitimately; by taxing the people; by the issue and sale of treasury bonds, by funded loans, or by borrowing from one of the many banks that might exist in the country, but under no circumstances should it be allowed to borrow from those who have the power to create money.

I guess that’s why Dr. Lowe says he wants to maintain some separation between the issuance of bonds by the AOFM and the financing of government expenditure by the Reserve Bank.

But let’s think about that for a second.

Australians now face much higher levels of public debt than they did before the pandemic, thanks to stimulus spending by the Morrison government.

Would you say that all of this spending has been disciplined?


AFR columnist Joe Aston has made an art form of cataloging the blatant trash in the JobKeeper scheme.

“[Josh] Frydenberg passed a free money law as part of a no-recourse honesty system. What did he think was going to happen?!” Aston cried at one point.

Should we consider ourselves lucky that the orthodox way of financing deficit spending has been used for the pandemic? I mean, it imposed so much discipline.

So, would it be possible to avoid this situation in the future by having an agreed mechanism – to be used in an emergency – that would increase the government’s fiscal firepower without giving the banks a free lunch in the bond market?

Even some orthodox economists are quietly wondering if, perhaps, we would find ourselves in a future situation in which nominal interest rates were close to zero and inflation was exceptionally low, the RBA could get creative with its financing public spending.

Or could there be even better ways to think about government funding?

The RBA exam would be the perfect place to discuss this.