Debt crisis — what debt crisis?

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Sunday, 10 August 2014 18:30 by 2353

Let’s face it; the Australian public has been bashed around the ears for years by the LNP about the level of government debt. Some economists would contend that Australia doesn’t have any debt — and certainly not a debt problem.

Unfortunately, this piece has to contain some history and economics to illustrate the point.

Australia started issuing currency in its own name in 1910: previously each bank issued its own currency (banknotes). In general, banknotes had a promise to pay the denomination in gold coins at a fixed rate should the bearer deliver the note to the issuing banking institution. The first ‘Australian’ currency was the private bank issued banknotes overprinted with ‘Australian Note’, followed in 1913 by the first government issued ten shilling note. Other denominations soon followed. Australian Government notes could be converted into gold coins at the head office of the ‘Commonwealth Treasury’ — the government body responsible for issuing the notes. Effectively, early banknotes in Australia and around the world were freely convertible for gold.

Countries also operated on a similar basis. An agreement between a number of countries in the early 1900’s (as represented by the USA’s Gold Standard Act) meant that gold was the world currency and that countries had to have sufficient gold in their reserves to ensure prompt payment should every banknote holder decide at the one time to convert their banknotes to gold. While a number of countries banned the holding of gold by their citizens during the period between World War 1 and World War 2, the Breton-Woods Agreement reinforced the ‘gold standard’ between countries from the conclusion of World War 2.

The Breton Woods Agreement meant that signatory countries could convert their gold to US currency at a rate of USD35 per ounce of gold, and the exchange rates between signatory countries’ currencies were fixed in advance. While countries could change the exchange rate between their own and other currencies, changes were infrequent and certainly were not quoted in the media on a daily basis. President Nixon removed the USD35 per ounce trading in gold in 1971.

Following the repeal of ‘the gold standard’ by the US, Australia fixed its currency to the Trade Weighted Index, prior to Hawke and Keating ‘floating’ the currency in 1983. Greg Jericho does a much better job than I can of explaining the whys and wherefores of fixed versus floating currencies here.

Now the history is over, we’ll start the economics. Economists will tell you that all the actions you take today will be made with an economic intent. Should you choose to purchase some milk, the rationale is that the milk is available at a price you consider to be reasonable for your purposes — whether it be to make your coffee taste better or to give nourishment to a child. You will purchase the milk knowing that your $1 per litre could be put to other purposes, say a few apples, but the ‘need’ for the apples does not rate as highly as your ‘need’ for milk.

For the milk to get to your refrigerator, there are a number of economic decisions made: including the farmer raising cows rather than say sheep; the processor deciding to purchase raw milk from the farmer; and the supermarket choosing to purchase milk from the processor. The entire production chain relies on people making a ‘rational’ (and this word is important later) decision that the milk production, retailing and consumption is the best possible use for the money expended in the exercise of getting milk into a cup of coffee.

Economists will tell you that ‘the market’ has full knowledge and is always rational. To an extent it is. If Australians suddenly developed a love of the coffee creamer powders so loved by those on the other side of the Pacific, it stands to reason that there would be a lessening demand for milk — meaning that the farmer would lower his price in an attempt to supply the same amount to the processor. If, on the other hand, in 2015 Australia sold twice as much powdered milk to the US to make additional coffee creamer than we did in 2014, the demand for raw milk would increase, ensuring our farmer better prices for his product.

So how does a discussion on banknotes and coffee creamer relate to Australia’s debt level? Glad you asked – here we go.

Under the gold standard banks needed to have sufficient reserves of gold to pay out anyone that presented a banknote to them in exchange. This process finished prior to World War 2. People still trusted banknotes after the abolition of the ability to hold a private stock of gold, even though the banknote (and coins) used as legal tender were only backed by a government promise rather than a token of some real value. There was a rational belief that sufficient reserves were available to exchange the tokens (banknotes) for intrinsic value at a rate set by the government of the day — even though it was probably illegal to have the intrinsic value in your possession. To this day, we all have sufficient trust in the economic system to accept that the $50 note we receive from the ATM will be accepted by the shop to buy the milk and, as milk costs $1 a litre, we will get some other readily acceptable tokens of value back to make up the difference between the value of the milk and the $50 note (token) we gave the shop. This system is known as fiat money.

Definition: Fiat money is money that is intrinsically useless; is used only as a medium of exchange.

In 2011, the Reserve Bank requested the scrapping of the 5 cent coin, as it cost more than 5 cents to make the coin. It stands to reason that it costs considerably less than the face value to make the rest of our currency tokens.

We still have a rational belief that the currency we use has a value, even though the tokens — plastic banknotes or metal coins — are clearly not worth the face value attached to them and there is no implied promise of backing by intrinsic value.

There is a worldwide demand for currency to pay for imports and exports — and some currencies have greater acceptance for this purpose. In essence, there is also a supply and demand for currency, similar to the discussion on milk prices above. Where there is a market for a commodity, there are also people who will speculate on the ongoing supply and demand of the item. So in addition to the use of a currency for the payment of goods and services, there is also a speculation market for currency, just as there used to be for pork bellies, an indicator of pork production — apparently! Both systems rely on trust and a rational belief that the currency they purchase today will have a value tomorrow — of course, the speculator hopes the value is higher!

Australia has a Council of Financial Regulators (more detail here) that:

… is a non-statutory body whose role is to contribute to the efficiency and effectiveness of financial regulation and to promote stability of the Australian financial system.

Effectively it monitors the health of Australia’s financial system; there is no overarching reference to an external value base or agreement as there was until the 1980’s.

Following conventional economic theory, the value of the Australian Dollar since 1983 has not been tied to the value of a gold brick but whatever the market decides is the correct price at the time of the transaction. In effect, while the Reserve Bank does buy and sell currency in foreign markets to ‘manage the currency’, it is not the final arbitrator of the value of the dollar in relation to other currencies.

The US Federal Reserve and the Bank of England have been using a policy of ‘quantitative easing’ to generate some life into their respective economies for the past few years, following the GFC (‘Global Financial Crisis’) of 2008. The US Federal Reserve has at times effectively printed USD40 Billion per month, after trying a number of more ‘conventional’ strategies such as reducing interest rates (which failed to achieve the desired results) in order to generate spending in the community.

L. Randall Wray is a Professor of Economics at the University of Missouri, Kansas City, and Senior Scholar at the Levy Economics Institute of Bard College, New York. His full biography is here. He writes a blog Great Leap Forward and explains a concept called Modern Monetary Theory here. Very briefly, the theory suggests that while most will pay taxes to the Government and rely on others to provide them with a source of income (salary, wages, welfare, dividends and so on), Governments are the source of money and can clearly manage the supply and demand for money to suit their own purposes. Bill Mitchell, the Professor of Economics at Charles Darwin University has a blog site where he frequently writes about Modern Monetary Theory and argues that poor economic choices, such as austerity (frequently used as an economic tool to ‘pay back debt’), contribute to social problems.

While countries as far back as Germany, in the period between the World Wars, and more recently Zimbabwe and Japan, have attempted to print their way out of economic recession and failed, the US and UK have maintained the confidence of the financial markets. They are issuing the money by way of issuing securities to financial intermediaries and claiming they are producing assets, not currency. The financial intermediaries then profit from the interest paid by the government ‘borrower’. It is worth mentioning here that while the UK and USA were printing money and remaining ‘solvent’, the so-called ‘PIGS’ of Europe (Portugal, Ireland, Greece and Spain) didn’t have the option as they use the European Community currency known as the Euro. It was impossible for the “PIGS’ to print their way out of trouble as they couldn’t manufacture the underlying ‘security’ as well as control the issue of the currency — Euros are not country specific.

Rudd’s $900 cheques issued to a majority of Australians during 2008/9 was another method of ensuring there was a significant input of money into the economy. It really doesn’t matter how much of the money was used for ‘useful’ endeavour or spent at the TAB, the spending of the money keeps people employed, and they then go and spend money and so on.

John Kelly, writing on the Australian Independent Media Network website claims there is a Ridiculous Debt and Deficit Scam where 90% of us pay to benefit the remaining 10%. Basically we all pay taxes which go to the government — the government then pays interest on debt over securities it created and borrowed against in the first place in the commercial money market. The lenders in the commercial money market include those same financial institutions that collectively report billions in profit each year.

So while most of us have three options to ensure we have sufficient income to pay our debts — receive a higher income, reduce expenditure or win the lottery — governments have a far ‘better’ option: they can make more currency by issuing intangible assets, borrow on them and then pay interest to the finance industry.

Evidence of the reality of Australia’s debt crisis is the country’s current credit rating which is a reflection of how concerned lenders would be if approached by Australia for a loan. Issuing intangible debt will not work forever as there has to be an element of trust to a rational person that the currency does represent something, and the US and UK seem to understand this.

However, if the current Australian Government’s low percentage of debt to GDP suggests we have a ‘debt crisis’, why isn’t there continual coverage on when the US or UK economies will collapse, causing a global financial depression greater than the GFC and Great Depression combined, together with ‘experts’, time clocks and the usual level of media hyping. Could it be that Australia’s debt crisis is politically motivated rather than a reflection of the current global perception of our ‘national debt’?

Is the current rhetoric to repay debt necessary?

Should the Australian Government be attempting to improve the wealth of all Australians rather than reducing expenditure?

What do you think?