The letter, "Borrow from Bank of Canada", January 24, 2009, propagates a misconception that there is a costless way to pay for government spending by borrowing from the Bank of Canada (BoC). I would like to point out some problems with the author's reasoning.
To begin with he writes, "Banks must be finding it hard to contain their glee at the propect of the federal government running deficits that could amount to $100 billion..." (in anticipation of all the interest income). There are two problems: first, banks usually are not the ones that lend to the federal government. The money comes from investors such as people saving for
retirement through pension funds, mutual funds, and life insurance policies. Banks are in the business of making riskier and higher yielding loans such as to businesses, entrepreneurs, and home buyers. Second, investors holding government bonds won't be gleeful. On the contrary, when the federal government sells bonds to finance its spending, that extra supply will push down the value of investors' bonds.
The author is correct in saying that financing government spending by borrowing directly from the BoC is like telling the BoC to print money and give it to the government. Printing $100 billion certainly could be inflationary. As the author suggests, to prevent inflation, the BoC could force commercial banks to put an extra $100 billion in reserve but that would be $100 billion no longer available to finance the investment and job creation that we sorely need now. It would be like slamming the brakes on the economy. The BoC could raise interest rates to prevent inflation, but that would have the same effect of slowing down the economy.
On the other hand the BoC could be instructed to stand back and let the Loonie inflate. That is a valid policy choice, but we should be clear to Canadians what is really being proposed in that case. People on fixed incomes and indeed the whole economy would have a certain price to pay. Also, the independence of the Bank of Canada from political influence would be threatened.
The unsurprising truth is, there is no free lunch. But it's also true that the Government of Canada can borrow money at the lowest possible interest rate on Canadian dollars because there is no risk of default - it could always print the dollars needed to repay those loans. The cost of borrowing money is not the issue. The issue is, in this time of economic crisis, whether our federal government chooses the right things in which to invest that money.
Original Article:
Borrow from Bank of Canada
Banks must be finding it hard to contain their glee at the prospect of the federal government running deficits that could amount to $100 billion over the next few years. Even at 3% interest, that would amount to a perpetual income of $3 billion and a perpetual charge to the government. This interest would be added to the $63 billion we are already paying every year on the debts of our three levels of government.
The sad part is that the added cost of this interest is entirely unnecessary. The federal government could borrow money interest-free from the Bank of Canada. The government owns the Bank of Canada, so profit from the bank is returned to the government as a dividend.
When the government borrows from a bank, the bank creates the money it lends simply by entering a credit in the account the bank has set up for the government. The government then draws upon this credit and pays whatever interest is charged. When it borrows from commercial banks, the interest charged remains with the bank. When it borrows from the Bank of Canada, the interest charged eventually returns to the government minus a tiny amount for the cost of administering this process.
So why does the government borrow from private sources? Ask your MP. The answer, if you are not ignored, will likely be that doing so would cause inflation by putting too much money in circulation. To counteract this, the government must reinstate the statutory reserves that were disring the Brian Mulroney government. This would require the commercial banks to put money in reserve to reduce the amount in circulation. Richard Priestman Kingston
7 comments:
If borrow from the Bank of Canada will cause inflation, then why didn't inflation occur during and after WWII, when the Bank of Canada was chaged with creating the majority of the countries money?
Hello Stewart,
The premise of your question is wrong.
There was enormous inflation from 1945 to 1951, about 50% in total. During the war, the economy was centrally managed for the war effort. Instead of prices going up, certain consumer goods became scarce.
I don't really understand what you mean by, "when the Bank of Canada was chaged with creating the majority of the countries money?"
Hello Ted,
I did some more reading and I concede that all wars are inflationary.
The thing I'm having a hard time grasping is that the BoC from 1938 to 1974 created at least 50% of all required money for the government of Canada and inflation wasn't an issue except during WWII.
Another thing that I find troubling is that the national debt did not begin to accumulate in earnest until the BoC decided that all deficit borrowing was considered inflationary in 1974 and the Government of Canada began to borrow 98% from private sources, both banks and private investors.
My question would be the following:
Let's say the government of Canada has to borrow 20 billion dollars to make up a deficit. Why would it be considered more inflationary in borrowing 10 billion from the BoC and 10 billion from private sources, then borrowing 0.4 billion from the BoC and 19.6 billion from private sources.
Also taking into account that interest drives up the cost of everything. If you borrow 10$ to buy 10$ worth of goods but are charged 10% interest(simple interest), then you are paying back 11$ which really makes the cost of goods 11$ not 10$. So by borrowing from private sources it actually drives up the cost of the goods and services purchased, would that not be considered inflationary? Considering that all new money created at present must be borrowed into existence, which automatically tacks on an interest component which increases what one must pay for everything.
Hi Stewart,
Thanks very much for your post. Let me try to respond.
It's okay for the BoC to create some money and not have it be inflationary. If it increases the money supply by X% over 10 years, and the economy also grows by X% over those 10 years, then it probably won't be inflationary.
By the way, the flip side to that is during the days when the currency was on the gold standard. Sometimes, the economy grew faster than the supply of gold. But the amount of money was tied to the amount of gold. So you got deflation and you put the brakes on economic growth. Rich people with money were happy because it could buy more. Poor people without money, who needed economic growth to create jobs, were not happy.
This is basically the background behind William Jennings Bryan's famous line, "You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold".
Anyways, I digress. Perhaps over the years 1938 to 1974 there was more than enough economic growth to absorb the creation of money by the BoC.
I think what happened starting in 1973-74 was that you had stagflation - inflation without economic growth. And I think that in such a situation, increasing the money supply isn't matched by economic growth and so you just get more inflation.
So to answer your question, other things being equal, especially the amount of economic growth, I'd say that creating an extra $10 billion of money, by having the government borrow from the BoC means more money chasing the same amount of goods, resulting in possible inflationary pressure
As for the interest argument, I have to wave my hands a little more, but I'd say that if you are willing to borrow money at 10%, you probably have in mind an investment that will at least pay you back 10% (and here I'm getting a little abstract because if could be an investment in education, research, healthcare, military spending, where it's not so obvious how to measure the return on investment). You only have to pay the interest after one year. But after one year
the $10 you invested would have grown to $11. The economy would have grown by that extra $1 of interest that you have to pay back, so there may not be inflationary pressure as long as the money is well spent.
I hope this helps, though I do not guarantee that it's all correct!
The mechanism of borrowing is largely overlooked. When a person gets a loan, bank makes two changes:
a) Adds loan amount to the borrower's account.
b) Adds loan amount to the bank's internal account called "Asset". You see, bank views a contract for a loan (or a mortgage) repayment as an asset.
The assets further divided into high liquidity and low liquidity. Cash on the asset account is highly liquid. On the other hand, the loan contract is less liquid: bank may sell it only if it finds a buyer.
Can bank set up loan contracts for the total amount exceeding its high liquid assets. That is an interesting question. I read, that a long time ago the ratio was capped at 85%. In other words, the total amount of loan contracts at any given time never exceeded 85% of all available liquid assets.
As the time passed, the ratio was gradually climbing up. What is happening when the ratio crosses 100% level? Essentially, bank lends more funds than it has currently on books. Such transaction frequently characterized by "money creation from nothing".
By the way, such creation does not necessarily leads to an inflation. Indeed, one may trace the "created money" and their limited life span: once the borrower pays down the debt, the contract becomes closed, and the "created money" cease to exist.
In this relation I would be interested to hear from readers:
1. The Government (at any level) can borrow from the Bank of Canada using the above mechanism. Why the Government turns this matter to a middle man (a chartered bank)?
2. Would it be prudent for the Government (at any level) to use the approach (1) and minimize or even eliminate interest on the borrowed funds?
Money created by the Bank of Canada to lend to the Government would only be inflationary on a temporary basis, wouldn't it? As the money is repaid to the Bank of Canada it would be effectively removed from the money supply. Am I way off here?
Hello Jake,
No, you are not way off. Quite opposite, your reiteration (of the scenario from my post) is accurate and to the point.
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