Over the past month, the Commonwealth Government has announced and commenced implementing economic stimulus measures that involve the Commonwealth spending (or rebating) more than $200 billion via new initiatives. A fair question to ask is: where do they get the money for that?

There are two answers to that fair question. One is a technical answer and the other is what we might call a philosophical answer. Let’s start with the technical answer. But before we do, two important notes: when we use the term ‘Government’ in this article, we mean the Commonwealth Government. State Governments work quite differently. Secondly, this article might be a bit technical. But it should help you feel better about the large debt that the Commonwealth Government is creating. Government debt is very different to the debt that you and I hold.

Governments participate in the economy. They remove money from the economy and they inject money into the economy. Removals take the form of taxes (including things like tariffs, levies, stamp duties – anything that sees money move towards the Government). Injections involve any form of Government spending: employing public servants, welfare payments, building and maintaining public infrastructure, etc. When the Government removes more money than it injects, the Government’s Budget is said to be ‘in surplus.’  When more is injected than is removed, the Budget is ‘in deficit.’

Since the 2009 Global Financial Crisis (GFC), the Commonwealth Budget has been in deficit. This new $200 billion means that the Government Budget has moved much further into deficit. It has been spending more than it has been receiving. To spend more than you receive, you need to borrow to pay the difference. And, so, the Commonwealth Government is borrowing to pay for the deficit created by its stimulus measures.

The Commonwealth Government does not apply for bank loans like you or I do. It generally borrows by issuing financial instruments known as securities, the most common of which is a bond. The workings of the bond market are quite complex but, in essence, a Government bond works like this example:

  1. The Government issues a three-year bond for, say, $1 billion. This means that the Government promises to pay $1 billion to whoever is holding the bond in three years’ time.
  2. In addition, the Government agrees to pay periodic interest payments to whoever is holding the bond during that three-year period. The interest payments are announced in advance.
  3. Because the interest payments and the $1 billion are known in advance, potential purchasers know exactly how much money they will receive if they buy the bond. The potential purchasers then decide how much they are prepared to pay to access these cash flows. They will typically offer an amount less than the ‘face value’ of the bond.
  4. All the potential purchasers then compete to purchase the bond. The Government typically sells the bond to the highest bidder.
  5. The buyer of the bond makes its profit through the difference between what it pays for the bond and what it receives back from the Government, including the interest payments. If it buys a $1 billion bond for $990 million, for example, it will make a profit of $10 million. If the interest rate is $1.5%, it will also receive $15 million per year each year. Over the three years, it will make $55 million.

In essence, the amount the Government receives from the highest bidder is a loan. The Government then makes interest payments on this loan, before repaying the total amount of the loan to whoever is holding the bond when the bond matures (that is, at the end of the bond period).

So, that’s the technical answer to how the Government raises money to fund a deficit. But, especially in these extraordinary times, there is a ‘philosophical’ answer, as well. And, right now, this philosophical answer is probably more important.

When the Government first sells the bond, this is known as the primary bond market. The word primary is used because this is the first time the bond is sold. Once the bond has been purchased, however, the purchaser can sell it to someone else. That person can also sell it, and so on. All the trades of a bond after the initial purchase occur on what is known as the secondary bond market. So, a bond is issued in the primary market but can then be sold and re-sold in the secondary market.

The initial purchasers of Government bonds tend to be large private financial institutions. So, the Government gets its money from the private sector. But the secondary market also includes the Government itself, both directly and indirectly. Directly, the Commonwealth Government can re-purchase its own bonds if it wants to. This is relatively rare and will not happen with the bonds currently being issued.

Indirectly, the Government can enter the secondary market through the Reserve Bank of Australia (the ‘RBA’). The RBA can and does purchase Government bonds: and it has been buying quite a lot of them lately. On Monday of this week, the Financial Review announced that the RBA had already purchased $31 billion worth of securities since March 20 – and that it would keep purchasing at least $1 billion worth of securities per day. The same article stated that the RBA is expected to own about $80 billion worth of securities by 30 June 2020.

So, at least for these securities, the flow of money looks something like this example:

  1. The Government announces the issue of a bond worth $1 billion, paying 1.5% interest for three years;
  2. The bond is purchased by a large institution, such as a bank, for (say) $990 million;
  3. The Government now has $990 million cash to spend as stimulus;
  4. The Government also has a debt of $1 billion and an obligation to pay $15 million in interest each year until the bond matures;
  5. The RBA then purchases the bond from the institution for (say) $1 billion.

At the end of this transaction, the initial purchaser has made a $10 million profit (1%). And the Australian Government owes the RBA 1.5% per year and $1 billion in three years.

The thing is… while the RBA is an independent body, it is owned by the Australian people via the Commonwealth Government. So, any profit that it makes is passed on to the Government as a profit. Effectively, after this secondary transaction, the Government owes $1 billion to a bank that it also owns. Some people argue that this means that the Government does not actually owe this money to anyone anymore. This is what we mean by the ‘philosophical answer’ to the question of where the Government gets this money.

There is one obvious question: where did the RBA get its money from? Well… the RBA is the manufacturer of Australia’s currency. Take out a bank note from your purse or wallet and you will see it is signed by the Governor of the Reserve Bank of Australia. At times like these, the RBA pays for its purchases of bond securities using a system known as quantitative easing. Here is how the RBA itself defines quantitative easing:

Asset purchases – also known as quantitative easing (QE) – involves the outright purchase of assets by the central bank from the private sector with the central bank paying for these assets by creating ‘central bank reserves’. (This has been popularly referred to as ‘printing money’.)

That’s right: the RBA simply brings the money into existence (although it does not actually print it – it all happens electronically). And the net effect of this is that the Government owes money to itself. This debt can be repaid in one of two broad ways: either the RBA cancels the debt and the Government simply does not have to pay it (which is unlikely for political reasons). Or, the Government issues a new bond for $1 billion and uses the cash thus generated to repay the RBA. The RBA then looks at things and decides whether to either receive the cash and hold on to it (known as quantitative tightening because the money is removed from circulation) or to use the money to purchase further bonds, thereby keeping the $1 billion circulating in the economy.

Conventional economics says that QE can be risky, mostly because it might create inflation. When you produce additional money, this can mean that there is more money chasing the same number of things that can be purchased. This will cause prices to rise. But the current circumstances are anything but conventional. The Australian economy has a lot of under-used capacity at the moment (most of it in the form of human capital). So, the new money being generated is not chasing things that will otherwise be bought. The QE should not therefore be inflationary. Instead, the new money should stimulate further economic activity, keeping the economy operating even while so many of us are in lock down.

QE is very rare in the Australian context. It really is like mum’s good china: it only comes out for very special occasions. And the current Coronavirus crisis is one such special occasion. But please be assured that the Government stimulus is not creating a huge debt for future generations. Because those generations will also own the RBA, the stimulus need not create any net debt at all.