From time to time I’ve been asked about the idea that the government bonds the Reserve Bank is now buying, and will most likely be holding for years to come, might be written off. I thought I’d written an earlier post on the idea but I can’t find it – perhaps it was just a few lines buried somewhere else – and the question keeps coming up.
The Reserve Bank’s own answer to the question – I’ve seen it recently from both the Governor and the Chief Economist (the latter towards the end of this) – is to smile and suggest that, since they are the lender, it really isn’t up to them. That, of course, is nonsense. It is quite within the power of a lender to write-off their claim on a borrower, and that doesn’t require the borrower first to default or to petition for relief. To revert back to some old posts, that is how ancient debt jubilees worked.
I guess that, in answering the way the do, the Bank is simply trying to avoid getting entangled in controversies that they don’t need. I have some sympathy for them on that, and so just possibly it might be a tactically astute approach. A better approach would be for them – as the specialists in such things, unlike the Minister of Finance – to call out the idea of that particular debt being written off for what it is: macroeconomically irrelevant.
In reality, of course, if the debt held by the Reserve Bank were to be written off, it would only be done with the concurrence of the government of the day. Apart from anything else, if the Governor (or the Board, when the new Reserve Bank legislation is enacted) were to write off the Bank’s claims on the government, it would render the Bank deeply insolvent (very substantial negative equity). You can’t have management of a government agency just deciding – wholly voluntarily – to render the agency deeply insolvent.
And that is even though the Reserve Bank is quite a bit different than most public sector entities, in that life would go – operations would continue largely unaffected – if the Reserve Bank had a balance sheet with a $20 billion (or $60 billion) hole in it. The Bank isn’t a company, its directors don’t face standard penalties and threats, and – critically – nothing about substantial negative equity would adversely affect the Bank’s ability to meet its obligations as they fall due. The Reserve Bank meets its obligations by issuing more of its own liabilities (notes or, more usually, settlement cash balances). People won’t stop using New Zealand dollars, and banks won’t stop banking at the Reserve Bank, just because there is a huge negative equity position.
(This isn’t just some hypothetical. Several central banks have operated for long periods with negative equity; indeed I worked for one of them that had so many problems it couldn’t even generate a balance sheet for years at a time. It also isn’t materially affected by arguments that seignorage revenue – from the issuance of zero interest banknotes – means that “true” central bank equity is often higher than it looks (much less so when all interest rates are near zero, and not at all if other interest rates are negative).)
The big reason why writing off the claims the Reserve Bank has on the government through the bonds it holds wouldn’t matter much, if at all, for macroeconomic purposes is that the Reserve Bank is – in substance – simply a branch of the government. Any financial value in the organisation accrues ultimately to the taxpayer, and the taxpayer in turn is ultimately responsible for the net liabilities of the Bank. Governments can – and sometimes do – default, but having the obligation on the balance sheet of a (wholly government-owned and parliamentarily-created) central bank doesn’t materially change the nature of the exposure. If anything, governments have tended to be MORE committed to honouring the liabilities of their central bank – their core monetary agency, where trust really matters – than in their direct liabilities (thus, in New Zealand – as in the US or UK – central and local governments have – long ago – defaulted, but the Reserve Bank has never done so).
It is worth remembering what has actually gone on in the last few months. There are several relevant strands:
- the government has run a huge fiscal deficit, (meeting the gap between spending and revenue by drawing from its account at the Reserve Bank, in turn resulting in a big increase in banks’ settlement account balances at the Reserve Bank, as bank customers receive the net fiscal outlays),
- the government has issued copious quantities of new bonds on market (the proceeds from the settlement of those purchases are credited to the Crown account at the Reserve Bank, paid for by debiting – reducing – banks’ settlement account balances at the Reserve Bank,
- the Reserve Bank has purchased copious quantities of bonds on market (paying for them by crediting banks’ settlement accounts at the Reserve Bank).
In practice, the Reserve Bank does not buy bonds in quite the same proportions that the government is issuing them. But to a first approximation – and as I’ve written about previously – it does not make much macroeconomic difference whether the Reserve Bank is buying the bonds on market or buying them from the government directly. In fact, it would not make much difference from a macroeconomic perspective if the Reserve Bank had simply given the government an overdraft equal to the value of the bonds it was otherwise going to purchase. There are two caveats to that:
- first, under either model the Reserve Bank has the genuine power to choose, and
- second, that the fiscal deficit itself is not altered by the particular mechanism whereby the funds get to the Crown account.
But that seems a safe conclusion for now under our current institutional arrangements and culture.
From a private sector perspective, the net effect of the various transactions I listed earlier has been that:
- private firms and households have been net recipients of government fiscal outlays, (which, in turn, boosts the non-bank private sector’s claims on banks)
- banks have much larger holdings of (variable rate) settlement cash balances at the Reserve Bank.
Those settlement cash balances are the (relevant) net new whole-of-government debt.
By contrast, quite how the core government and the Reserve Bank rearrange claims between themselves just doesn’t matter very much (macroeconomically) at all.
Suppose the Minister of Finance and the Governor did get together and agree no payment needs to be made in respect of the bonds that Bank holds at maturity. What does it change? It doesn’t change is the appropriate stance of monetary policy – determined by the outlook for the economy and inflation. It doesn’t change the nature and extent of the Reserve Bank’s other liabilities – which still have to be met when they mature. And it doesn’t change anything about the underlying whole-of-government fiscal position.
I guess what people are worried about is that the government might feel it had to raise taxes – or cut spending – more than otherwise “just” to pay off those bonds held by the Reserve Bank. But remember that the Reserve Bank is just another part of government. What would actually happen in that scenario is that settlement account balances held by banks at the Reserve Bank would fall (as, say, net taxes flowed into the government account at the Reserve Bank) – and those are the new claims the private sector currently has on the government. In other words, the higher taxes or lower spending still extinguish net debt to the private sector. And if the government didn’t want to raise taxes/cut spending, it could simply issue more bonds on market. In the process they would (a) repay the bonds held by the Reserve Bank, and (b) reduce settlement cash balances at the Reserve Bank, but (c) increase the net bonds held by the private sector. Total private claims on whole of government aren’t changed.
(Now it is possible that at the point where the bonds mature, the Reserve Bank still thought that for monetary policy reasons settlement cash balances needed to be as large as ever. If so, then of course they could purchase some more bonds on-market, or do some conventional open market operations. Neither set of transactions will change the overall claims of the private sector on the government sector – net fiscal deficits are what do that.)
And what if the bonds were just written off? As I noted earlier, write off the bonds and the Reserve Bank has a deeply negative equity position. I don’t really think that is a sustainable long-term position. It is a bad look in an advanced economy. It is a bad look if we still want to have an operationally independent central bank. And we can’t rule out the possibility that, for example, risk departments in major international financial institutions might be hesitant about continuing to have the Reserve Bank of New Zealand as a counterparty, including for derivatives transactions, if it had a balance sheet with a large negative position – even though, as outlined above, the Bank could unquestionably continue to pay its bills. So at some point of other, the Bank would have to be recapitalised. But again that has little or no implications for the rest of the economy – or the future tax burden. The government subscribes for shares…and settles them by issuing to the Bank…more bonds. The government, of course, pays interest to the Bank – whether on bonds or overdrafts – but, to a first approximation, Bank profits all flow back to the Crown.
This post has ended up being quite a lot longer than I really intended, as I’ve tried to cover off lots of bases and possible follow up questions. Perhaps the key thing to remember is that what creates the likelihood of higher taxes and lower spending (than otherwise) in future is unexpected/unscheduled fiscal deficits now.
Those deficits might be inevitable, even desirable (as many, perhaps most, might think of those this year as being), but it is they that matter, not what are in effect the internal transactions between the core government and its wholly-owned Reserve Bank. That is true even in some MMT world, provided one takes seriously their avowed commitment to keeping inflation in check over time. You could fund the entire government on interest-free Reserve Bank overdrafts and the consequence would be explosive growth in banks’ settlement cash balances at the Reserve Bank. But real resources are still limited (see yesterday’s post). Over time, if you are serious about keeping inflation in check, you still have to either pay a market interest rate on those balances, or engage in heavy financial repression of other sorts, imposing additional imposts on the private sector just by less visible means.
Perhaps the other point worth remembering is the relevance of focusing on appropriately broad measures of true whole-of-government indebtedness, not ones dreamed up from time to time for political marketing purposes.