In places like the
U.S. and Europe, it is actually difficult—if not impossible—for a
government to have its central bank pay for government programs. All
government spending must be financed by issuing bonds to the public or
collecting taxes.
Canada, my home country, is an interesting counter-example. The financial
relationship between the Federal government and the Bank of Canada—our
central bank—is fairly permeable. The government has the authority to ask the
Bank of Canada to directly fund a portion of its spending.
This avenue is rarely taken, however. Justin Trudeau, our current Prime
Minister, currently uses bonds and taxes to fund almost all of the Federal
government's spending. Just one small and unknown government program is
directly funded by the Bank of Canada: the prudential liquidity management
plan, an old Stephen Harper-era program. (I wrote about it here
and here).
The goal of the prudential liquidity plan is to provide a cash cushion that
the Federal government can rely on to “safeguard its ability to meet payment
obligations in situations where normal access to funding markets may be
disrupted or delayed.”
The details of the program aren't really that important. The point I want to
make is that the Federal government hasn't had to issue bonds to the public
in order to fund the prudential liquidity management plan, nor has it had to
wait for taxes to be paid. All it did was tell the Bank of Canada to create
some dollars for it out of nothing, and the Bank of Canada shrugged and complied.
So would it make sense for Justin Trudeau to have the Bank of Canada fund
other programs than just the prudential liquidity management plan? Why not
get it to fund the Federal government's share of health spending, or national
defence, or Old Age Security?
Let's take the example of national defence. Say that the Trudeau government
has been planning to follow conventional funding procedure and intends to
issue $400 million in new treasury bills to pay the salaries of our soldiers
for the months of April and May. But Trudeau changes his mind and tasks the
Bank of Canada to create $400 million in fresh deposits for the government, ex
nihilo. As the soldiers' salaries come due, the dollars will be wired to
the commercial banks where the soldiers do their banking, these banks in turn
crediting the soldiers' accounts.
Are there any real differences between the two funding scenarios? Under both
the treasury bill and Bank of Canada route, the soldiers will get paid. Are
there any cost savings? The Bank of Canada is obligated to pay interest to
banks on the $400 million in new balances it has created. It pays a rate of
1.75% or so, which is pretty much equivalent to what the government would
have paid on $400 million in new treasury bills.
Thus, from a cost savings perspective there's really no difference between
the two scenarios. Either way, the government is going to be paying 1.75% in
interest to whomever happens to be holding the instruments it has issued.
So my initial reaction is: meh, who cares which way Trudeau funds soldiers'
salaries.
There is one asymmetry that might worry me as a citizen. Treasury bills are a
useful instrument for individuals and businesses (like insurers) because they
are quite safe. Bank of Canada deposits are likewise very safe, but whereas
anyone can buy a treasury bill, deposits are exclusive. Only commercial banks
can keep an account at the central bank. So if our soldiers are to be paid
$400 million by the Bank of Canada, the supply of treasury bills will
contracts by $400 million leaving folks like me with fewer options for
investing.
But there's an easy way to fix this shortage. Introduce central bank accounts
for all. In short, allow non-banks like insurers or individuals to keep
accounts at the Bank of Canada. A similar fix would be to provide a means for
commercial banks to establish 100%-reserve pass-through accounts. Life
insurers and individuals who open a pass-through accounts at a bank would be
assured that these accounts are 100% backed by Bank of Canada deposits, the
interest flowing straight from the Bank of Canada to the account holder.
These accounts would function just like treasury bills.
There is one other potential asymmetry. It has to do with the unit-of-account
function of money.
Like the metre, kilogram, or minute, the dollar is
a key element of Canada's system of weights and measures. The dollar is
by far the most complex of these standardized measurements. Unlike metres,
kilograms, or minutes, Canadian prices are measured in terms of a set of
items—banknotes and Bank of Canada deposits—that are constantly fluctuating
in value. By carefully regulating these items, the Bank of Canada tends to
the pricing standard.
Treasury bills have no role to play in the pricing standard. If a car has a
sticker price of $10,000, this indicates ten thousand one-dollar banknotes,
or a thousand ten-dollar banknotes. The "$10,000" indicated on the
sticker is not represented by a given quantity of treasury bills.
This has important implications. If all Canadians simultaneously decide that
they want to reduce the quantity of Bank of Canada notes and deposits that
they hold, then every price in the Canadian economy will have to rise. After
all, these instruments are the standard media that people use for describing
prices. But if all Canadians decide they want to hold fewer treasury bills,
goods and services prices needn't adjust—treasury bills aren't the media that
Canadians use to describe the dollar. Only the price of treasury bills will
have to adjust.
So if Trudeau decides to use the Bank of Canada for financing, he could have
a direct affect on the standard itself. Every price in the Canadian economy
will have to adjust. But if he relies solely on treasury bills/bonds for
financing, his influence over Canadian prices will be muted. We might prefer
if Trudeau doesn't have too much influence on Canada's system of weights and
measures... more on this later.
It may be useful to work through an example in which Trudeau decides to use
the Bank of Canada for a large percentage of government spending. Say that
Justin is fighting for his political survival, so he comes up with a bright
idea. Let's increase the number of Canadian provinces by occupying Burkina
Faso. That way Canadians will have a warm place to go in the winter. Trudeau
promises voters that he will carry out the invasion without burdening
Canadians with new taxes. That very month he tells the Bank of Canada to
start creating billions in new deposits and quickly spends them on military
equipment.
At some point the recipients of these new deposits (anyone with a Bank of
Canada account) will suffer deposit bloat. They will try to get rid of their
excess, and as they do so prices across the Canadian economy will start to
rise.
In order to preserve the standard unit, the Bank of Canada has a useful tool
for halting this incipient inflation. It can increase the interest rate it
pays on reserves. A higher reward will coax those who would otherwise have
spent their unwanted Bank of Canada deposits into keeping them on ice. And
this should alleviate the pressure on prices.
But what happens if Trudeau keeps on spending? His next idea is to send a
fully-manned space mission to Pluto without raising taxes or issuing treasury
bills to fund the mission. He tells the Bank of Canada to create $50 billion
and immediately starts to spend it on building a rocket.
The Bank of Canada can of course raise rates again. But if you think about
it, the Bank of Canada gets the money to pay higher interest by issuing more
brand new dollar deposits. If the underlying cause of the inflation is
Trudeau bringing too much money into existence, issuing even more of the
stuff as an inducement to hold what has already been created doesn't seem
like a long-term solution. At some point, the Bank of Canada will have to
attack the root of the problem--the bloat of deposits itself--by reducing the
supply.
There are a couple of ways to reduce the supply of deposits. The first would
be to "sterilize" Trudeau's spending. The Bank of Canada can try
and coax depositors to lock their funds into central bank term deposits
rather than keeping them in their regular Bank of Canada accounts.
Transferring the funds to a term deposit renders them non-spendable and
removes the bloat, at least temporarily.
But Trudeau keeps on spending new Bank of Canada deposits, this time on the
construction of a 5-metre high border wall between Canada and U.S. The Bank
of Canada will have to convince an ever-growing crowd of deposit owners into
locking away their funds. At some point the demand for term deposits will be
saturated, and the Bank of Canada will have to increase the carrot they
provide by raising term deposit rates. Additional deposits will have to be
created to generate this reward. But as before, fixing an excess of deposits
with more new ones only kicks the can down the road.
The Bank of Canada has a permanent way of removing the deposit bloat: it can
buy deposits back and cancel them. But to do this, it needs to have some real
assets sitting in its vaults. Gold, property, mortgage-backed securities,
bonds, etc. Because Trudeau has been spending deposits into the economy
willy-nilly, the Bank of Canada simply doesn't have assets to carry out a
buy-back.
Which leaves the Bank of Canada with one last option for removing supply.
Rather than repurchasing deposits, it can just destroy them outright. By
declaring that x% of all deposits that have been issued will simply cease to
exist, it can remove the bloat once and for all. Thus ends the inflation.
But the Bank of Canada doesn't have the power to annihilate depositors'
funds. This would basically constitute a tax, and democracies don't generally
give central bankers the power to tax (understandably so). Which means that
only Trudeau can carry this operation out on behalf of the Bank of Canada.
To do so, he will have to levy a new tax and then destroy the proceeds. (He
can't re-spend the deposits, this would only recreate the problem). Once
destroyed, the deposit bloat has been remedied. But if Trudeau is determined
to follow through on his vote gathering strategy of spending on programs
without raising taxes, then he won't see much to be gained in carrying out
the annihilation. So the inflation will continue.
I think that all of these threads can be brought together to provide an
argument for why we don't want Trudeau to rely too much on the Bank of Canada
for funding.
Low and consistent inflation is valuable to Canadians. Just as our measures
of time, volume, and weight stay consistent (the metre doesn't get longer or
shorter from one year to the next), the dollar unit should be reliable. If we
all have a pretty good idea where average prices will be down the road, we
can better coordinate our long-term plans. Price stability is also the
fairest way to ensure neither debtors nor creditors benefit at the other's
expense.
The Bank of Canada has all the tools to provide this service to the public,
save one. In the extreme event that the Prime Minister decides to resort to
the Bank of Canada for financing of a bunch of novel government services, and
the inflation target is exceeded, the Bank of Canada can't salvage things by
resorting to the definitive response: annihilating deposits. Instead it must
rely on Trudeau to destroy deposits on its behalf via a tax. If the Prime
Minister refuses to do this, then the reliability of the unit of account is effectively
sacrificed.
Were Trudeau to rely on treasury bills and bonds rather than central bank
financing to invade Burkina Faso, send a rocket to Pluto, and build a border
wall with the U.S., then the Bank of Canada would never have to ask the Prime
Minister to annihilate deposits in order to hit its inflation target. And so
the dependability of the unit of account would be assured. Instead of every
price in the economy having to adjust to Trudeau's new programs, only the
market price of treasury bills and bonds would have to bear the burden of
adjustmet.
So should governments finance themselves through their central bank? In
general, it's probably harmless. For instance, it makes no difference whether
the prudential liquidity plan is financed by the Bank of Canada, the
taxpayer, or government-issued treasury bills.
But in a scenario where the government is being wildly imprudent, a degree of
separation between the Prime Minister and the Bank of Canada is advisable.
Imagine if the whims of Canada's politicians could cause metre sticks all
over Canada to grow or shrunk a bit each year. That would make for a
confusing system of weights and measures, wouldn’t it? The dollar is one of
Canada's most important weights & measures. It too deserves to be immunized
from the political process.