The Origin of Currencies (or: the deficit-savings equality)

This is the first of a series of introductory posts I would like to make to avoid cluttering future commentary with superfluous explanation.

It is well known but poorly understood that our currency (and the currencies of many other nations) has no intrinsic value; it is not officially convertible to gold or any other commodity. This is not a bug, it’s a feature. Productivity and unemployment suffer badly during periods of price instability, which are prone to happen when prices are tied to the fluctuating value of a commodity like gold. Depressions were more common when currencies were backed by gold. Recessions were deeper and lasted longer. Removing the commodity backing from currencies has generally been successful in enabling monetary policy to stabilise prices. In countries like ours where prices are strongly affected by lending the central bank can buy and sell unlimited amounts of debt in its own currency to control interest rates. In countries like Singapore where most necessities are imported the central bank can stabilise prices by buying and selling unlimited amounts of its currency internationally to maintain the exchange rate. This kind of flexibility is only feasible when the currency issuer has no obligations of convertibility to any commodity, and we are better off for having it. This system of currency is called fiat money, meaning that it is money by order of the government.

The simple difference to older commodity currencies has far reaching consequences, many of which remain unrecognised by policy-makers today. The old economic models treat money as a commodity like any other, a simple abstraction from a direct barter economy, or ignore it completely. To the general public a dollar still does represent a simple unit of exchange – a store of value. To the treasury it represents a means of adjusting the distribution of private wealth. To the central bank it represents a cancellation of part of the debt assets it holds which it paid for by printing that dollar. Usually I will speak of the federal government and the central bank together as “the government”, and use “the treasury” when there is a need to distinguish the federal government from this wider definition. We’ll come back to those interpretations of a dollar later. To understand them we need to first consider how money is created.

Imagine a newly formed nation with a government and a private sector who wish to set up a fiat currency system. The government creates money by spending it in the private sector and destroys it through taxation. By being the sole issuer of the currency the government controls the money supply, and by making it the only way of paying taxes it creates demand. Since it is the origin of money the old mantra of “tax and spend” must be reversed. The government must spend in order to tax. After money enters the private sector by government spending the money supply expands by being lent and re-lent through the fractional reserve banking system, but every positive balance created by this process is balanced by a negative one held somewhere else (actually this is true of all fiat money, since it represents a liability to the central bank, more on this in a future post). Thus the government acts not only the sole issuer of currency, but the sole provider of net savings. If the government were truly to be debt-free and in surplus – to have taxed more of its own currency it has spent – there would be no net savings in the private sector. If all private debts were also settled then there would still be an outstanding debt to the government and not a single note or coin left to pay it.

This relationship between deficits and net savings can readily be shown symbolically with the function for Gross Domestic Product (GDP). GDP is the dollar value of everything produced within a country (not counting things like components of a machine for which the value has already been included in the value of another product) minus all the money that left the country from imports. It is written as:
GDP = C + I + (G - T) + NX
This function is known as a macroeconomic accounting identity, meaning it is true by definition. C represents spending on private consumption, I represents investment spending on capital, G represents government spending, T represents taxation and NX represents Net Exports, or exports minus imports. Since every dollar spent must also be earned, GDP is sometimes used synonymously with income. There is another way of calculating GDP using incomes directly, but for now it will be sufficient to understand that they are equivalent. Income is written as Y, so we can also write the GDP function like this:
Y = C + I + (G - T) + NX
Since every dollar of income earned must either be spent or saved, we can represent net private savings using symbols from this formula as Y – C – I or income minus consumption minus investment. In more elaborate models savings is better defined as Y-C and I includes items ranging from mortgage payments to cash reinvested in the business that earned it. The government budget deficit (or surplus) is government spending minus taxes, or G – T. Rewriting the formula in terms of the deficit gives us:
G - T = (Y - C - I) - NX
Meaning that aside from the balance of trade, the change in private net savings is determined entirely by the size of the deficit. When the government runs a surplus the private sector is forced to dis-save. The government hasn’t reduced its¬†liability¬†in any way since it has no obligation to convert the cash to any real commodity. It has simply removed savings from the bank accounts of its citizens.

Update: Someone asked me if the government borrowing from individuals causes this kind of analysis to break down. It’s a good question – the government borrows from the private sector all the time since its debt is the sole type of asset traded in the open market operations system by which monetary policy is enacted. The answer is no. Since the government only borrows to spend, if it borrows directly from the private sector two things happen:

  1. Savings change hands between lender and the recipient of subsequent spending.
  2. A debt asset is created in the private sector.

There are a couple of ways of thinking about this: either that debt asset cancels out a debt liability somewhere else in the private sector thus increasing net savings (the net present value method) or the interest payments on that loan will be a steady flow of new savings into the private sector. Either way, net savings have increased. It does not matter who the government borrows from, it creates money when it spends.

Note that “creating money” in this sense is not the same as printing it and indeed usually happens without a corresponding issue of new notes and coins. These two processes are operated separately by the treasury and the central bank respectively. The treasury is ultimately managed by our elected officials and its decisions are referred to as fiscal policy. The central bank (Australia’s central bank is called the Reserve Bank of Australia) is an operationally independent organisation which has been granted the legislative power to manage the nation’s money supply by making decisions called monetary policy. When the treasury creates money (by spending it) it borrows from the central bank at interest. The central bank may choose to issue new notes and coins or may simply debit the treasury’s account electronically and use its existing reserves of cash from the commercial banks that hold accounts there. The central bank chooses when to print new money and at what interest rate to lend it in order to achieve its goal of price stability. The treasury chooses where to spend money and who to tax it from in order to achieve its goal of increasing the well-being of the citizens.

The most important result to note from this is that the government as currency issuer is not like an individual or business in that it does not need to “balance the books” to remain solvent. The notion of a monetarily sovereign government becoming insolvent in its own currency is absurd. The role of the government in spending and taxation should only be to the benefit of its citizens, which is most cases involves two things: ensuring access to essentials and creating a fairer distribution of wealth and income. Pursuing a balanced budget for its own sake is more likely to do harm than good, removing scarce savings from an already over-leveraged, debt-laden society.

Flaunting bad to distract from worse: the zero-deposit diversion

A dangerous old mortgage product is picking up steam again amongst Australian banks: the so-called ‘zero deposit home loan’. The offer is usually some variation on the same general themes: borrow up to 120% of the house sale price, no deposit required, instant or fast-tracked approval and available to anyone with a job and a guarantor – usually the parents. It isn’t all that surprising that a lot of people disapprove. In Australian culture buying a house is a rite of passage into adulthood in much the same way as getting married and having kids. It is a sign of growing up, a mark of maturity earned by the struggle of saving for the initial deposit. So far as a zero deposit home loan erodes this tradition, the bulk of the criticism that the banks will receive will be focussed on this aspect of the product.

It is a masterful ploy. The standard response is predictable, effective and absolutely right: everyone is different, the barrier to purchase (the deposit amount) is fairly arbitrary and not a good indicator of a person’s ability to make payments years down the track – ‘past performance is not a good predictor of future performance’. Why should responsible adults be waiting while they are forced to jump through some arbitrary hoops when a) they need a house and b) the faltering housing market needs them? Why should we constrain ourselves to outmoded ideas about who “deserves” to be a home owner, when a future where every family can own their own home is for the first time now within reach?

Why indeed. By framing the main product feature as enabling zero deposit home loans the bank gets to choose the terms of the debate. To the bank the size of the deposit is totally irrelevant. Some even offer essentially negative deposits, paying out a percentage in addition to the house price to cover furnishing costs. The real question is ‘how?’ and the short answer is ‘by having parents guarantee the loan repayments.’ The long answer requires us to think about the role of banks in society.

The function banks provide to the community is to match short-term lenders (deposits) with long-term borrowers (loans). The banks take a slice of the interest payments from borrower to lender in exchange for shielding the lender from default. The difference between the interest rate earned on your deposit account and the interest rate paid on a home loan could be thought of as an insurance payment to the bank so that if the borrower defaults your money is safe. It is in the bank’s interest to lend money responsibly, because it bears the cost of any loans that fail to be repaid. Responsible lending allocates idle savings to safe investments at fair interest rates while risky projects and speculation are discouraged with higher costs. A bank’s social responsibility to the community is therefore inseparable from its financial responsibility to its shareholders. Both fall apart whenever the bank finds a way to offload this risk back into the community, which is exactly what writing a guarantor into the mortgage contract does: since the bank can liquidate the guarantor’s assets if the borrower defaults, it bears no risk in the loan. The bank has no financial incentive to be discerning in who it lends money to and gets to write the value of these indiscriminate loans on its balance sheet as being virtually risk-free. The risk that once justified the bank’s slice of interest is gone, and the new bearer of that risk doesn’t see a cent of it.

The function of the bank becomes nothing more than a middle-man taking a substantial cut of a transaction it has no interest in. It is the bank’s unique position of having essentially unlimited access to cash that enables it to profit at both the risk and expense of society. It is a pure example of an arrangement where the rich get richer just for being rich. If these types of loans become widespread enough it opens the frightening possibility of a crisis which could rival the Great Depression. All the key ingredients are there: a massive and highly overvalued asset market, high and widespread private debt and the potential for rapid price deflation following mass liquidation of assets. Irving Fisher coined the term ‘debt deflation’ after the Depression to describe the cycle through which prices are depressed by the sale of assets, which raises the real value of the debt and makes it more difficult to repay, which in turn causes more assets to be sold off. Indiscriminate lending combined with the potential for self-perpetuating mass sell-offs certainly appear to lend themselves to another period of debt deflation.

If you are considering entering one of these mortgages as either borrower or guarantor I urge you to reconsider. If you simply must buy a house with no deposit you can do it much more safely by having your would-be guarantor lend you the amount of the deposit by borrowing it themselves against their house or mortgage. You still get to buy a house immediately and after you pay the deposit off to your guarantor then you expose them to no further risk. Should the worst happen and you do find yourself unable to make your repayments to the bank your guarantor can still help you – the difference is that they will be doing it by choice, not because the bank is threatening to take their own house away.