monetizing the debt - bank of canada

8/2/2019 Monetizing the Debt - Bank of Canada

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Forum: Debt and Disorder in the World Economy

Monetizing

The Debt

LUKIN ROBINSON

Some liberal and social democratic economists, notably

the authors of the 1992 pamphlet, The Deficit Made

Me Do It, and other members and supporters of the

Committee for Monetary Reform, have proposed, as a way

of relieving the deficit and lowering interest rates, to "monet-

ize" part of the government debt.! By this they mean thatthe Bank of Canada should buy large amounts of treasury

bills and other government bonds, instead of most of them

being sold to the chartered banks and the general public as

currently happens. The interest accruing to the Bank on the

bills and bonds would be returned to the government in the

form of the Bank's increased profit, thereby reducing "net"

interest payments, and hence the budget deficit.

The proposal to "monetize" the debt is an offshoot of the

twofold proposition that, i) the Bank of Canada determines

interest rates, and ii) that interest rates, because of their

effect on business and consumer spending, largely determine

the volume of production and employment. From this point

of view, the Bank's policy of tight money and high interest

rates has been both destructive and perverse; what the Bank

should and could do is to keep interest rates low and hence

production and employment high.

Although this is currently quite a popular line of argu-

ment, it has more appeal than validity. What has been called

monetary populism has a long history; the example of Social

Credit during the 1930s comes to mind. The success of Linda

McQuaig's Shooting the Hippo, which notwithstanding some

Studies in Political Economy 48, Autumn 1995 137


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Studies in Political Economy

flaws is a good book, is a more recent example and a wel-

come sign that plenty of people are questioning the orthodoxpieties.Z However, apart from the technical difficulties of

"monetizing" the debt, it seems to me that today's monetary

reformers suffer from, or at least promote, three illusions:1) They imply that capitalism is basically fine. All it needs

to make it work is some tinkering with the monetary system

and government fiscal policy. Employment, health care, the

social safety net and the tax system, not to mention inter-

national trade and finance and the foreign exchange valueof the Canadian dollar, would then apparently take care of

themselves. Social conflict in all its forms would be mi-

raculously assuaged.2) They describe the monetary and financial system as it

was in the past, not as it is today. Technically and legally,

it is changing so fast that it is hard to keep up. I have anexcellent text - Money, Banking and the Canadian Finan-cial System, (3rd edition) by H.H. Binharnmer - but it isnow 18years old. A lot has happened in the meantime,above

all the deregulation, and explosive growth and internation-alization of the financial system, in which the dollar value

of largely speculative transactions on foreign exchange mar-kets alone is some fifty times the value of international trade

in goods and services. Even the largest countries are likesieves, whose monetary authorities have limited, and dimin-

ishing scope for independent action. Interest rates and the

foreign exchange value of each country's currency are es-sentially determined by private operators in the world-wide

financial system.3) They offer no discussion of power, and either fail to see

or ignore the fact that it would take a convulsive change in

the political balance of forces, both in Canada and abroad,

before the Bank of Canada and the chartered banks couldbe persuaded or compelled to adopt their proposal. They

write as if the Bank of Canada, simply because it is anagency of government, can dictate to the chartered banks

and financial markets; and also as if Canada were self-con-

tained and self-sufficient, surrounded by impenetrable dikes.

On their own terms, some of their proposals make sense,

but their practical unreality only emphasizes the power of

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RobinsonlDebt and Disorder

international finance and the extent to which it has gained

- been granted, commandeered, seized at gun point - the

upper hand. How to recover some of this power, and how

to use it if we ever do - that is the question. Chasing

will-o ' -the-wisps, however intellectually attractive, is a di-

version.

* * * *The money supply as currently defined consists of cur-

rency in circulation outside the chartered banks - some$26 billion in the middle of 1994 - and deposits of all

kinds with the banks, amounting to nearly $400 billion. Some

of these are demand deposits, but most of them are notice

or term. Hence, the probability that any large proportion of

these deposits will be or indeed could be withdrawn at any

one time is small, which is why the chartered banks can

operate with a very low ratio of cash reserves. Business and

personal loans and residential mortgages are the counterpart

on the asset side of the bulk of these deposits. Thus, the

banks' ability to lend means the ability to create money, and

the money supply depends partly on how much people want

to borrow, that is, on the demand for loans from individuals,

business and government, and on how much the chartered

banks are able to lend. According to the old saying, money

is created by the stroke of a pen; today it is more likely to

be created by entering a few figures in one of the banks'

computer systems.The banks' cash reserves consist of notes and coin and

deposits with the Bank of Canada, the two together amount-

ing normally to $5 billion, give or take a billion one way

or the other. The banks' also hold some $35 billion in Treas-

ury bills, which are almost as good as cash. Some of the

treasury bills are held as secondary reserves and some as a

safe, interest-earning asset to balance the more risky assets

on the banks' books. The cash ratio strictly speaking is thusless than 1.25 percent of total deposits, while treasury bills

cover another 8 to 8.5 percent. Twenty years ago the cash

reserves and the amount of treasury bills held were almost

equal, and there were formal percentage requirements for

primary and secondary reserves. The required primary cash

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reserve ratio was 12 percent of demand deposits and 4 per-

cent of all other deposits, for a blended average of about 5or 6 percent; the secondary ratio, including treasury bills,

varied from 5 to 9 percent. Now the reserve ratios are left

to the discretion of the chartered banks, and the primary

reserve ratio is only a quarter or less of what it was. This

would seem to loosen the Bank of Canada's control over

the amount which the banks can lend, and hence over the

money supply. While the chartered banks are of course happy

that their non-interest earning assets are reduced to the barestminimum, the Bank of Canada claims that it has other means

of exercising control.

Certainly, the prevailing view is that the Bank is quite

able to impose tight money and high interest rates when it

wants to. Perhaps, however, it is the other way around: the

chartered banks and finance capital generally want high in-

terest rates and have suborned the Bank of Canada as their

agent. I doubt that either can act in defiance of the other,

or can do what the other definitely does not want it to do.

I think they share the same outlook and purpose, and work

together. Both are part of the world-wide integrated financial

system, in which no single component is powerful enough

to dominate the whole.

* * * * *When the Bank of Canada buys treasury bills, it adds to

the Government of Canada's deposit account with the Bank.The Government then spends the money by drawing on the

account; that is, it sends cheques to Tom, Dick or Harriet

in payment of goods purchased or services rendered, or in

pensions to seniors or transfer payments to the provinces.

Tom, Dick or Harriet will then most likely deposit the cheques

in an account with a chartered bank or near bank. The char-

tered bank will in turn present the cheque to the Bank of Can-

ada, which will transfer the amount of the cheque from the

Government's account with the Bank to the chartered bank's

account. The chartered bank's "cash" reserves, consisting as

they do either of actual cash or deposits with the Bank, will

thereby be increased. The chartered bank's lending capac-

ity, including lending to the government, will consequently

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as much, and 20 years ago it was close to 20 percent. If

you wonder why the percentage has fallen, the answer ispartly that the debt is much larger than it was, and partly

that chartered banks now can and are allowed to operate

with much lower cash reserves than they used to. The Bankof Canada, therefore, needs less treasury bills with which

to conduct monetary policy, i.e, to control and keep a leash

on the chartered banks' capacity to lend. The banks in tum

need less cash in their till for the same reason that people

carry less cash in their pockets than they used to in propor-tion to how much they spend, credit cards no doubt being

the main reason for this.Now suppose the Bank of Canada were to decide to buy

treasury bills and government bonds, not in terms of its

monetary policy, but rather so that the government wouldhave to pay less interest to other holders, that is, as the

saying goes, to "monetize" the debt. About $7 billion worthof new treasury bills are sold at each week's auction, andalmost as many outstanding bills are redeemed. Suppose the

Bank were to buy the entire treasury bill offerings for thenext four weeks. The consequence would be that the char-

tered banks and other financial institutions would exchangesome of the treasury bills they now hold for cash and the

same thing would happen for all other holders of treasury

bills, who would then deposit in their bank accounts thecash they would receive for the maturing bills they now

hold. The chartered banks' interest earning assets in the formof treasury bills would decrease, and their cash reserves (as-

sets) and deposits (liabilities) would increase. Since thebanks' cash reserves would increase, so would their capacity

to lend and the potential money supply. The chartered banks'combined balance sheet before and after are summarized inthe table at right.

In the Before column, the banks' cash reserves are equal

to 5.7 percent of the sum of demand deposits and personalchequable savings accounts, but to only 1 percent of all

deposits. Cash reserves plus treasury bills are equal to 9.6

percent of all deposits. In the After column, where as yet

(unrealistically) the banks have made no new loans or added

to their deposits on behalf of borrowers, cash reserves have

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Chartered Banks' Balance Sheet

(in billions of $'s - mid-1994)

Assets Liabilities

Before After Before After

Currency and deposits Demand deposits 31.0

with Bank of Canada 4.0 34.0 Personal savings

Treasury bills 33.5 27.5 - chequable 39.5Govt. of Canada bonds 34.0 34.0 - non-chequable

71.5 95.5 and fixed term 234.5

Loans Non-personal termand

Personal 73.5 notice deposits ---8 1 .Q

Business 125.0 392.0 416.0 ~Q

Residential mortgages 167.5 Other mostly non-liquidco

5 i'Non-residential ~ liabilities 93.5 ' "Q

382.5 Shareholders' equity 39.5 ~Other Canadian $ assets 91.0 ~co

Total Canadian $ liabilities 525.0. . .

-- II)

Total Canadian $ assets 545.0Foreign currency liabilities 275.0 =

Foreign currency assets 255.0Q.

s :

$800.0 $800.0' "

Total 824.0 Total 824.0 Q.,. . . . Q. Source: Bank of Canada, Monthly Review (various, 1994), Tables Cl-4

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risen to over 40 percent of the sum of demand deposits and

chequable savings accounts, and to 8.2 percent of all de-posits. Cash reserves plus treasury bills have risen to 14.8

percent of all deposits.

The chartered banks currently hold about 20 percent of

outstanding treasury bills and other financial institutions

about 25 percent. Thus, if in four weeks the Bank of Canada

were to buy $30 billion more treasury bills than it now does

each month, the chartered banks would find themselves with

about $6 billion in extra cash reserves in place of a similar

amount of treasury bills, and $24 billion worth of altogether

new cash reserves; on the liabilities side, their deposits would

increase by $24 billion. Their cash reserves would be mul-

tiplied by eight-and-a-half, and the sum of cash and treasury

bills would be increased by 64 percent or even more (not

all of the banks' treasury bills are held as secondary re-

serves). Their lending capacity would thereby also be in-

creased by 64 percent. This would mean a huge potential

increase in the money supply and in potential purchasingpower of individuals, business and governments, in the form

of loans or deposits on which they could draw. Total dollar

demand would increase far beyond the economy's productive

capacity and potential increase in supply. If the Bank of

Canada wanted to prevent such an increase and the conse-

quent rise in prices, it would have to increase the combined

cash and treasury bill reserves from 9.6 percent to 14.3 per-

cent.Suppose the Bank were to continue buying all treasury

bills at each weekly auction for several months. The char-

tered banks would find themselves with cash reserves of

$170 billion, equal to more than 30 percent of their swollen

deposits, and no secondary reserves in the form of interest-

earning treasury bills. Other operators in the financial mar-

kets would also be unhappy at losing an interest-earning but

at the same time almost 100 percent liquid asset. However,

the main consequence would be that the chartered banks'

theoretical lending capacity would be multiplied by 4.6 -

if they could find credit worthy borrowers. Imagine the money

booming to 2.5 times GDPl

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To prevent the chartered banks from increasing their loans

even halfway in proportion to the increase in their reserves

and setting off a roaring inflation, as well as a free fall in

the foreign exchange value of the dollar, the Bank of Canada

would have to increase the required reserve ratio from the

9.6 percent which they now hold in the form of cash and

treasury bills to 32.9 percent. Instead of having less than 1

percent of their Canadian dollar assets in non-interest earn-

ing cash reserves, the banks would then have 25 percent.

Unable to make more loans - that at least would be thepurpose of increasing the required reserves - and deprived

of treasury bills, the banks would nevertheless have 35 per-

cent more deposits to take care of. Either bank charges, or

interest rates, or both, would go up, or profits would go

down.

The banks would of course not like this at all, and the

whole financial system would be upset by the disappearance

of treasury bills as a profitable and completely liquid in-vestment instrument. Of course, instead of concentrating on

treasury bills, the Bank of Canada could divide its purchases

between them and longer-term bonds. The resulting impact

on the cash reserves of the chartered banks would be the

same, although the consequences for the financial system

as a whole would be somewhat different.

The proposal to "monetize" the debt raises political as

well as technical issues. The banks could be expected to

resist it and to apply their ingenuity to evading it. Why

should we, they would argue loudly, bear the cost of the

government's profligate spending and insatiable borrowing

appetite, instead of the taxpayers on whose behalf the gov-

ernment spends? (You can just imagine the columns Terence

Corcoran would write in the Globe and Mail's Report on

Business!)

It is also unrealistic to expect that the banks would accept

billions of dollars of idle cash reserves and not find some

way of putting them to profitable use, with consequences

likely to be disruptive and sure to be inflationary. For reasons

which should by now be well understood, the prospect and

fear of inflation, whether justified or not - "inflationary

expectations" in the bankers' and financial commentators'

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well worn phrase - will themselves lead to higher interest

rates. To prevent this would be difficult, and much deregu-

lation would have to be reversed; the relationship between

the banks and the near banks and other financial institutions,

some of which the banks have absorbed, would have to be

examined, and new regulations devised to prevent the spill-

over of cash and credit from one to the other. International

complications would add greatly to the difficulty. Our mone-

tary reformers and debt "monetizing" enthusiasts have given

little or no thought to any of these problems.

* * * * *There was a time, of course, often cited by monetary

reformers, when the context of monetary policy was very

different from what it is today. During World War II and

the early post-war years interest rates were kept low and

the Bank of Canada held a much larger proportion of the

government debt than it does now. A network of governmentpolicies and regulations on production, prices, capital in-

vestment, borrowing, and of course foreign exchange, sur-

rounded and supported the Bank's policy. All but the most

unrepentant capitalists accepted this network as necessary

to the war effort. After the war the network was only slowly

dismantled and the labour movement and popular organiza-

tions had muscle which made itself felt. Fifty years ago the

great Ford strike was underway in Windsor. Many politi-

cians, senior bureaucrats and even capitalists were imbued

with Keynesian ideas. They realized that massive unemploy-

ment and a repetition of the Great Depression (which was

widely feared) were not the best way to assure them a stable

future.

When, after 1975, stagflation replaced the long-term growth

of the previous 30 years, ruling class ideology and policies

changed. Tight money and high interest rates, which are not

limited to Canada, are only one expression of the change.To read the documents of the Department of Finance and

the Annual Reports of the Bank of Canada for the last ten

years or so alongside those of the 1950s or 60s is to be

made aware of the sea-change that has occurred. All the

tendencies and formations of the Left were left behind, in

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strength, intellectual clarity and confidence. The labour

movement also suffered.Hence the question of how to organize resistance to the

right-wing onslaught, how to recover some of the Left's for-

mer influence, and how to use it if we ever do remains

open. I think the proposals for monetary reform are useful

only insofar as they help to show the difference between

what seems logical and in the general interest on the one

hand, and how the system actually works and in whose in-

terest on the other. Thus, they illustrate the modus operandiof those in power, and what we are up against in working

for change.

Notes

The main part of this article was written in response to a request to explain

the means by which the Bank of Canada might "monetize" part of the

government's debt; the opening and closing paragraphs were added later.

Its scope is thus quite narrow and it is in no wayan adequate examination

of monetary policy in general, how it is determined and by whom, nor its

consequences and limitations. Such an examination, however difficult, ought

certainly to be undertaken - all the more considering how much the context

and instruments of monetary policy have changed and continue to change.

Thus, what I wrote in various articles in the Canadian Forum in the early

1980s is already in some respects out of date.

1. H. Chorney, J. Hotson and M. Seccareccia, '''The Deficit Made Me

Do It!' The Myths About the Government Debt," (Ottawa: Canadian

Centre for Policy Alternatives, 1992); and Committee on Monetary

and Economic Reform, Economic Reform, monthly newsletter.

2. L. McQuaig, Shooting the Hippo: Death by Deficit and other Cana-

dian Myths (Toronto: Viking, 1995).

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