"Living Beyond Our Means..."

[lionking]

Wow, government debt is not the same as personal debt………

I learnt that in primary school, and it’s something that anyone who has any economic literacy knows……

 

[Ivor the Engineer]

Wow, government debt is not the same as personal debt………

I learnt that in primary school, and it’s something that anyone who has any economic literacy knows……

I very much doubt that. You may know it now, but it would have been vanishingly unlikely to have been part of a primary school education. To make my point, let's have a look at what Australian politicians have been saying over the last decade or so about government spending:

Here's a piece from 2014 about Australian politicians using the household analogy for government spending:

Treasurer Joe Hockey is experiencing difficult times. Deteriorating terms of trade and an uncooperative senate mean that he cannot deliver the surplus when he said he would and he cannot continue to cut government expenditure without risking a recession.

I have some comforting news for Joe Hockey: the importance of the whole deficit/surplus thing has been greatly exaggerated – with a lot of help from Joe himself of course. The focus on deficits and surpluses distracts us from what’s really important in the macro economy.

Hockey and Abbott are very fond of using household analogies when discussing government finances - Hockey again compared Australia’s economy to a household budget in his Mid-Year Economic and Fiscal Outlook. However, a government that is sovereign with respect to its own fiat currency bears no resemblance at all to a household. Such a government creates the money we all use, either physically on a printing press or, more importantly, electronically in the accounts of financial institutions.

And in 2016 Malcolm Turnbull posted this:

The Turnbull Government understands that like a household budget, when you are trying to pay off debt, you can't spend more than you save.

Each and every time we have updated the Budget books, we have made decisions that leave the Budget better off.

Sadly Labor and Bill Shorten just don't get it. At the last election, Labor's proposed spending that meant they would need borrow an extra $16.5 billion dollars just to pay for their promises - that means borrowing an extra $11 million each and every day until the end of the decade.

When the nation's AAA credit rating is under pressure, this is the wrong call.

We are delivering on our National Economic Plan. That means more jobs, more investment and more opportunities for Australians.

And this very month Susan Ley came out with this:

Government should live within its means.

Just as any household or business cannot forever spend more than it earns, neither can a nation.
Running deficits in a crisis or downturn is acceptable – even wise – to cushion the blow, but persistent deficits in good times are not.

Our default should be budgets that are balanced over the economic cycle, and surpluses in prosperous times to pay down debt.

Restraining spending growth is key to this, as is avoiding over-reliance on volatile revenue booms that may not last.

As they say the time to fix the roof is when the sun is shining.

This incorrect analogy is alive and well in Australian politics and is being used to persuade voters today.

 

[steenkh]

I do understand that banks create money by lending money they don't have. When people have repayed the loan, the money have been created. But I do not understand how the interest rate of the central bank reserves can influence the lending activity of the banks when they are in fact not taking a loan in the central bank.

 

[dirtywick]

I do understand that banks create money by lending money they don't have. When people have repayed the loan, the money have been created. But I do not understand how the interest rate of the central bank reserves can influence the lending activity of the banks when they are in fact not taking a loan in the central bank.

the way it usually goes is the central bank says hey japan, you have all these dollars you don’t know what to do with, so buy some bonds from us at 3 percent, we’ll issue that cash to private banks at 4 percent, and the bank can issue a loan to consumers at 5 percent. by controlling the rates for the first 2 steps, they can control the monetary supply

 

[Thermal]

The percentage you're paying is too high priced.

 

[Ivor the Engineer]

I do understand that banks create money by lending money they don't have. When people have repayed the loan, the money have been created. But I do not understand how the interest rate of the central bank reserves can influence the lending activity of the banks when they are in fact not taking a loan in the central bank.

Why lend money out if you can earn interest on reserves in the central bank?

ETA: I.e. a commercial bank increases the interest it charges on its loans customers when the central bank increases the interest paid on reserves.

 

[The Great Zaganza]

I do understand that banks create money by lending money they don't have. When people have repayed the loan, the money have been created. But I do not understand how the interest rate of the central bank reserves can influence the lending activity of the banks when they are in fact not taking a loan in the central bank.

the interest is actual the money being created - the repayment cancels out the loan.
What a bank does is create fictional money based on the amount of the deposits it holds plus a guesstimate on how likely the deposits are going to stay untouched, more or less. That is the book money it can lend out.

Ideally, Central Banks are only there for reassurance. Banks have to deposit some of their funds their proportional to the total amount of money they have given to lenders. This is usually not attractive, as the central bank interest is lower than you can get elsewhere. But it is more flexible, so banks that are into speculating tend to do this.

 

[dirtywick]

central banks are often referred to as the lender of last resort

 

[lionking]

I very much doubt that. You may know it now, but it would have been vanishingly unlikely to have been part of a primary school education. To make my point, let's have a look at what Australian politicians have been saying over the last decade or so about government spending:

Here's a piece from 2014 about Australian politicians using the household analogy for government spending:



And in 2016 Malcolm Turnbull posted this:



And this very month Susan Ley came out with this:



This incorrect analogy is alive and well in Australian politics and is being used to persuade voters today.

Who said I learnt that at school? And those politicians you quote are wrong.

 

[angrysoba]

Who said I learnt that at school?

You did!

I learnt that in primary school, and it’s something that anyone who has any economic literacy knows……

 

[psionl0]

If you trust the government then there is no problem allowing it to run deficit budgets financed either by borrowing money or printing new money. The money supply needs to be able to expand to enable economic growth.

Otherwise, you need an independent financial regulatory authority that has enough teeth to be able to tell Trump what he can do with his "big beautiful bill" (one that the SC won't overrule).

 

[psionl0]

I do understand that banks create money by lending money they don't have. When people have repayed the loan, the money have been created. But I do not understand how the interest rate of the central bank reserves can influence the lending activity of the banks when they are in fact not taking a loan in the central bank.

Banks credit the borrower's account with the amount of money borrowed. This is new M1 money that is now in circulation.

Of course, the bank needs to have money in reserve (vault cash or credits at the central bank) in case the borrower withdraws the money or transfers it to a different bank. If the bank is short of reserves then it can either borrow it from another bank or from the central bank (at a slightly higher rate of interest). Conversely, if the bank has surplus reserves then it can either lend the surplus to another bank or deposit it with the central bank (at a slightly lower rate of interest).

To illustrate, consider the case where the central bank has set the official "cash" rate at 2%. This is the rate of interest that banks can charge each other for lending out reserves. The central bank would pay something like 1.75% on reserves deposited with it (so it is more profitable to lend the reserves to another bank) and charge something like 2.25% on reserves borrowed from it (so it is cheaper to borrow from another bank). Individual banks are not necessarily legally obliged to borrow/lend at 2% but would be dependent on the less profitable central bank if they didn't.

If the central bank changes its interest rate then all the banks have to follow suit or miss out on being able to borrow or lend money to another bank (depending on which way the interest rate is changed). The higher the central bank interest rate is, the less profitable it is to create new loans.

 

[Ivor the Engineer]

Banks credit the borrower's account with the amount of money borrowed. This is new M1 money that is now in circulation.

Of course, the bank needs to have money in reserve (vault cash or credits at the central bank) in case the borrower withdraws the money or transfers it to a different bank. If the bank is short of reserves then it can either borrow it from another bank or from the central bank (at a slightly higher rate of interest). Conversely, if the bank has surplus reserves then it can either lend the surplus to another bank or deposit it with the central bank (at a slightly lower rate of interest).

To illustrate, consider the case where the central bank has set the official "cash" rate at 2%. This is the rate of interest that banks can charge each other for lending out reserves. The central bank would pay something like 1.75% on reserves deposited with it (so it is more profitable to lend the reserves to another bank) and charge something like 2.25% on reserves borrowed from it (so it is cheaper to borrow from another bank). Individual banks are not necessarily legally obliged to borrow/lend at 2% but would be dependent on the less profitable central bank if they didn't.

If the central bank changes its interest rate then all the banks have to follow suit or miss out on being able to borrow or lend money to another bank (depending on which way the interest rate is changed). The higher the central bank interest rate is, the less profitable it is to create new loans.

The highlighted is misleading. If commercial banks loan out money at (say) 0.5% higher than the central bank base rate then the higher the base rate is the more profit commercial banks make, not less. The reasons a higher central bank interest rate reduces lending are: (i) fewer consumers can afford to borrow at the higher interest rate and don't; (ii) consumers want to borrow but fewer are considered credit worthy by commercial banks at the higher interest rate; (iii) consumers would rather earn higher interest on their own deposits than borrow money.

So a higher central bank interest rate reduces the number of loans consumers want to take out and the number of loans commercial banks are willing to make. But on the loans that commercial banks do make they become more profitable the higher the central bank interest rate is.

 

[The Great Zaganza]

If you trust the government then there is no problem allowing it to run deficit budgets financed either by borrowing money or printing new money. The money supply needs to be able to expand to enable economic growth.

Otherwise, you need an independent financial regulatory authority that has enough teeth to be able to tell Trump what he can do with his "big beautiful bill" (one that the SC won't overrule).

an independent financial regulatory authority with an army?
Or what makes it independent?

 

[Brainster]

The highlighted is misleading. If commercial banks loan out money at (say) 0.5% higher than the central bank base rate then the higher the base rate is the more profit commercial banks make, not less. The reasons a higher central bank interest rate reduces lending are: (i) fewer consumers can afford to borrow at the higher interest rate and don't; (ii) consumers want to borrow but fewer are considered credit worthy by commercial banks at the higher interest rate; (iii)
consumers would rather earn higher interest on their own deposits than borrow money.

So a higher central bank interest rate reduces the number of loans consumers want to take out and the number of loans commercial banks are willing to make. But on the loans that commercial banks do make they become more profitable the higher the central bank interest rate is.

The last sentence is incorrect, because of the highlighted part. Yes, they make more money in interest on higher rate loans, but at the same time they have to turn around and offer their depositors higher rates as well, so on net they make roughly the same amount.

 

[dirtywick]

you’d have to assume that they are able to generally run a larger margin on a lower rate as well

 

[Ivor the Engineer]

The last sentence is incorrect, because of the highlighted part. Yes, they make more money in interest on higher rate loans, but at the same time they have to turn around and offer their depositors higher rates as well, so on net they make roughly the same amount.

It doesn't work that way. E.g., depositors get base rate - 0.5%; borrowers get base rate + 0.5%. The bank's profit is the difference between the amount it gets in interest from borrowers minus the amount it has to pay in interest to depositors. This difference grows as the base rate is larger, even if the difference between the two interest rates is held constant.

Profit = Principal.(1+(r+0.5))^n - Principal.(1+(r-0.5))^n = Principal.(1.5 + r)^n - Principal.(0.5 + r)^n = Principal.[(1.5 + r)^n - (0.5 + r)^n]

If you don't believe me try it on a spreadsheet.

 

[Brainster]

It doesn't work that way. E.g., depositors get base rate - 0.5%; borrowers get base rate + 0.5%. The bank's profit is the difference between the amount it gets in interest from borrowers minus the amount it has to pay in interest to depositors. This difference grows as the base rate is larger, even if the difference between the two interest rates is held constant.

Profit = Principal.(1+(r+0.5))^n - Principal.(1+(r-0.5))^n = Principal.(1.5 + r)^n - Principal.(0.5 + r)^n = Principal.[(1.5 + r)^n - (0.5 + r)^n]

If you don't believe me try it on a spreadsheet.

Your formula is flawed; for starters r+0.5 is adding 50% to the rate, not 50 basis points. Let's use your example, where the base rate is 5%. If we have a billion dollars in both loans and deposits, then we receive 55 million in interest and pay out 45 million, netting 10 million. If the base rate is 7% instead, we receive 75 million in interest and pay 65 million, netting 10 million again. The bank makes precisely 1% because that is the spread between what it charges borrowers and what it pays depositors.

 

[psionl0]

an independent financial regulatory authority with an army?
Or what makes it independent?

You could ask the exact same questions about the SCOTUS.

I have some ideas about how the financial regulatory authority might work (it would essentially be a 4th arm of government) but doubt that anybody would be interested. It would probably be a derail anyway.

 

[psionl0]

It doesn't work that way. E.g., depositors get base rate - 0.5%; borrowers get base rate + 0.5%. The bank's profit is the difference between the amount it gets in interest from borrowers minus the amount it has to pay in interest to depositors.

Banks don't lend money that has been deposited. They create new deposits when they make loans. And any interest they pay on transaction accounts is minimal.