The Reserve Bank will print all of the $97.5 billion the Government plans to ‘borrow’ over the next two years. Bernard Hickey asks why there is no political debate about why, how and if it should be done
The headlines from this week’s Pre-Election Fiscal Update (PREFU) were conventional enough, as were the political comments.
‘Rivers of red, a decade of deficits’ read the front page headline on Stuff after Treasury revealed the Covid-19 recession and the various recovery measures would force the Government to increase its borrowing through bond issues from $94.2b at the end of June to $210b by the end of June 2024.
Opposition leader Judith Collins accused the Government of “sugar-coating” the “dreadful and catastrophic” news in the PREFU. ACT Leader David Seymour said the Government’s spending and borrowing was “out of control.” Finance Minister Grant Robertson said the higher debt was the “price we pay” to cushion the blow of Covid-19, but that he remained committed to a “balanced plan to manage debt and reduce the deficit.”
But only Seymour hinted at the truth at the core of the Government’s borrowing, albeit without questioning that truth and using a handy cliche to describe what was going on. “All of this spending has been made possible by the Reserve Bank’s $100 billion Large Scale Asset Purchase (LSAP) program suppressing interest rates, but there is no such thing as a free lunch,” Seymour said.
However, Robertson agreed with Seymour on the lunch thing. “There is no free lunch here. These measures require significant investment. It has been necessary to use the Government’s strong financial position to do this,” said the Finance Minister as the PREFU was released.
All this commentary suggests the Government is borrowing money from overseas or local investors, who will be charging large interest costs in the years to come and will demand their money back. The suggestion is future generations will spend the rest of their lives paying off this debt, possibly with higher taxes and less Government services such as health and education.
Yet the truth is the Government is borrowing money off its own bank, who just invented it, albeit in a slightly roundabout way. In theory, the bank will eventually sell the debt back out into financial markets to tighten monetary policy and lift longer-term interest rates at some vague future date. Or it could hold the bonds to maturity and ‘make’ the Government pay back the money to the Reserve Bank when the bonds mature.
It would be like having your a son or daughter living in the basement who is able to print the money you need to buy the house off the landlord. And when the mortgage is due to be repaid, then you just cart the cash back down into the basement for the family member to stack up into piles. It’s not like having a banker who has a boss in Australia sending you rude emails to pay up or be kicked out of the house. The Government’s ‘banker’ is a family member who is unlikely to kick their parents and themselves out of the house. This relationship between the banker and the borrower is crucial. Kids usually do what the parents want. More on that relationship issue later.
The magic of free lunch making
But first, this week’s conventional comments masked the PREFU’s description of a very unconventional all-of-Government approach to both fighting Covid-19’s economic hit and achieving the Reserve Bank’s inflation targets. In previous times, the Government’s method of financing its spending — via bond sales (albeit indirectly) to a money-printing Reserve Bank — would have been deemed unthinkably and shockingly unconventional. It would have been ridiculed and unleashed banner headlines about the devaluing of the nation’s wealth.
It was just eight years ago that then-Prime Minister John Key described Green Co-Leader Russel Norman’s proposal for money printing to pay for Christchurch’s rebuild as “wacky.” “If printing money made you rich, Zimbabwe would be the richest country on the planet and it’s not,” Key said in October 2012.
Yet here we are with the Reserve Bank promising to create $100b out of thin air to buy the Government’s newly issued bonds in the financial markets, after they have been sold by Treasury to banks and pension funds. In some cases, those banks and funds are holding onto the freshly minted bonds for just days, before handing them over to the Reserve Bank for freshly minted cash. That money is often then parked in a Reserve Bank account (but that’s another story I wrote here last week.) In previous years, this scale of money printing (a third of GDP) would have sparked a run of former currency traders to buy wheelbarrows at Bunnings Warehouse to cart around cash to buy…more wheelbarrows.
The scale of it is astonishing and utterly unreported to the wider public, or debated in Parliament or on television, radio or on news websites. I couldn’t bear to imagine what is being debated in the nether regions of Facebook…and I’m not planning on going there any time soon.
Printing more than is being borrowed
So far, the Reserve Bank has bought $28.5b worth of Government bonds since it started printing on March 25, which is actually more than the $19.25b worth of new bonds sold into the primary market by the Treasury over the same time. It has pledged to buy $100b by June 2022, which is actually more than the $97.5b planned to be issued over that time by Treasury’s Debt Management Office (NZDMO). (By the way, that borrowing programme was reduced by $10b this week because interest rates have fallen to almost zero percent, although that wasn’t reflected in the tone of the commentary.)
On the current run rates of NZDMO issuance and Reserve Bank buying, the Reserve Bank will have hoovered up 59.5 percent of all the bonds on issue. That is right at the limit of the 60 percent that the bank has been given permission to buy, and up from the 50 percent it originally limited itself to when it started buying in late March. Any further drop in the Government’s borrowing appetite would not leave the Reserve Bank any room to complete its bond buying programme, which it says it needs to do to get inflation back up to around two percent.
The Reserve Bank is hoovering as fast as it can, but in the process is paying a hefty price to the bankers and pension funds who are holding on to the bonds they bought from the Treasury for a few days. It is also effectively increasing the measure of net debt that many politicians focus on, although actual ratings agencies and bond investors are much less focused on that measure. They care much less about the ‘out of control’ debt levels than the politicians, otherwise interest rates would be through the roof and bond tenders would be failing. They’re clearly not.
Clipping the ticket
Just last week the Reserve Bank invented $910m to buy Government bonds in the secondary market from banks and pension funds, including $220m worth of bonds due to mature in April 2023. One particular sale gives an example of what is happening, and how the Reserve Bank is effectively paying a little bit extra for the bonds when it has to use the secondary market.
On September 3, the NZDMO sold $450m worth of 2023 bonds to banks and fund managers through a ‘primary’ auction process, including parcels of bonds with a face value of $220m for $255.814m at an effective yield of 0.078 percent. You may wonder why banks are ‘giving’ the Government $5.8m more for the bonds than has to be repaid in April 2023. That’s because the bonds are sold as fixed interest securities, including ‘coupons’ or interest payments of 5.5 percent per year. Over time, the bond holder gets paid the coupons, so the market price of the bond will be higher than the face value if the market yield drives expected yields well below the fixed coupon. Remember: in bond markets yields fall as prices rise.
Six days later the Reserve Bank went into the secondary market to buy those same bonds. It paid a yield of minus 0.008 percent or a total price of $256.353m, which meant the banks holding the bonds made a trading profit of $540,000 for those six days of ‘work’. However, it’s not pure profit. Over those six days the market yield fell by about eight basis points (ie the price rose) so the Reserve Bank isn’t really ‘over-paying’, but there is a trading profit for the banks, which they would argue is the compensation for taking the risk that prices might fall (and yields might rise). But still, it’s money the Government didn’t absolutely need to spend.
Why not go direct?
Treasury has worked out the initial cost to the Government of this ticket-clipping. On page 60 of the PREFU it points out that the costs to the Government’s books of the Reserve Bank’s buying of bonds at a premium because of falling interest rates were $3.3b in the 2019/20 year and are forecast to be $6.1b in 2021/22 and $1.7b in 2021/22. That’s a total of $11.1b over the three years, although Treasury said that cost is reversed out in subsequent years because the Government is effectively borrowing from the Reserve Bank at the official cash rate of 0.25 percent currently, which is lower than the coupons regularly paid on the bonds.
Having to think about what would happen if the Reserve Bank cut the OCR to a negative level is mind-bending. The Reserve Bank would be paying the Government money to look after the Government’s money, which the Government borrowed from investors, who then sold the bonds to the Reserve Bank, who printed the money in the first place.
One potential outcome never mentioned in the debt debate is that negative Government bond yields for a sustained time would mean the lenders to the Government would be paying the Government money to look after their money. If it was long enough, the lenders could in effect themselves pay off the debt owed by the Government. There would be some sort of weird justice and irony in all of that. That analysis, however, doesn’t take into account the real interest rate, after adjusting for inflation. The biggest problem with deflation is it progressively becomes harder to repay the face value of debt as nominal prices fall.
So if it is costing the Government money in the short term for the Reserve Bank to print and lend to the Government in this roundabout way, why not just go direct? This is called lending directly and is seen by some as ‘monetising deficits’.
It’s all about independence
Robertson and the bank think it is worth it to keep doing it this roundabout way because it maintains the pretence at least of Reserve Bank independence, and keeps overseas and local investors convinced that the bonds are not suddenly going to ‘disappear’ or be cancelled. It would be like finding out that the original Rembrandts you bought were actually photocopied ones and the art dealer is not afraid to use the photocopier. The Reserve Bank and the Government fear any perception of a loss of independence, which could spook markets into thinking the currency is being devalued, which they fear could drive up interest rates and spark inflation. It’s an expensive price to pay to convince people that our money is real and that this Reserve Bank money printing is a rare and temporary thing, and won’t be used by politicians wanting to get re-elected in the next four weeks.
Currently, Robertson and Governor Adrian Orr are singing from the same song sheet about the need to print money, but in a way that maintains the impression of independence. But that is not guaranteed, if for example, National was to win the election and Paul Goldsmith became finance minister. What if Goldsmith said he did not want more money printing, and Orr said he needed to to achieve his inflation targets by doing more money printing? Who would prevail?
Currently, the Reserve Bank has the absolute power, although in practice it has involved the Governor asking for permission from the Finance Minister in a series of letters. But that is pure convention, and the current situation is a recipe for a constitutional standoff.
This leads to the broader issue of whether the Reserve Bank can remain truly independent when it is effectively doing “fiscal policy in drag” when having to print money to buy Government bonds to stimulate the economy once it has cut interest rates to zero percent. It is also doing social policy because the money printing has had the effect of increasing asset prices and inequality. Treasury is forecasting a 16 percent rise in house prices over the next four years, despite the worst recession in living memory. That would increase the value of houses by $192b to $1.42t. Yes that’s a T for Trillion.
Money printing makes the rich richer
Our Reserve Bank regime built in 1989 never imagined the fall in the official cash rate to zero percent or the massive scale of money printing when it decided to take the power to print money and set interest rates out of the hands of politicians and give it to the Reserve Bank Governor personally.
When monetary policy sets fiscal policy and is driving inequality and housing affordability, that should be a question for politicians able to be voted in or out.
This is one of the questions that should now be being debated, along with whether the money printing will spark much faster inflation than the Reserve Bank’s two percent broad target. I don’t think that’s a risk at the moment, but some people do worry about that.
Is fiat money real, and can we trust it?
The bigger issues are around whether the Reserve Bank lends direct to the Government and whether the bank can or should remain independent. I think it should borrow direct and give up the pretence and practice of independence. It’s a fossil of the 1980s when inflation was the biggest fear of voters and politicians. Now deflation is a much bigger fear.
The true bombshell issue though is what should happen when the bonds mature, assuming the Reserve Bank has not been able to sell them back into the market. It could agree to cancel the debt, thus removing all the angst around gifting a heavy debt load to future generations.
But doing that would also pose a dangerous and huge question about whether we can trust our money as a stable store of value. In olden days, the users of bank notes believed they were backed by stores of gold. New Zealand hasn’t been anywhere near a gold standard for nearly a century and we have believed our money, even in the days when inflation was nearing 20 percent in the 1980s.
Whatever the case, these issues should be debated in public by politicians. Currently no major (or even minor) party politicians are debating these issues. That needs to change. It may be difficult in the middle of this Covid-19 election, but it needs to happen soon because the Reserve Bank is printing about $1b a week at the moment.